Risk Weighted Assets
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Constantin TheodorRisk Weighted Assets
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Constantin TheodorRisk weighted assets (Part 1)
Author: Theodor M.
Date: 30th November 2020
Contents
Collateralized transactions........................................................................................................................ 1
Guarantees and credit derivatives ............................................................................................................ 4
Assignemt:................................................................................................................................................. 4
Credit risk mitigation techniques allow to decrease credit risk exposure or to increase recovery rate
in case of default. The main techniques are: Collateralized transactions, Guarantees, Credit derivatives
and Netting agreements.
I will discuss in this note about the Basel II and III accords on each type of technique.
Collateralized transactions: -- in such operations, the credit exposure of the bank is partially hedged
by collateral posted by the counterparty. BCBS(2006) defines the following eligible instruments:
1. Cash and comparable instruments
2. Gold
3. Debt securities rated AAA to BB- when issued by sovereigns and AAA to BBB- when issued by other
entities or at least A3-/P3- for short term debt instruments.
4. Debt securities which are not rated but fullfill certain criteria (senior debt issued by banks, listed on a
recognized exchange and sufficiently liquid).
5.Equities that are included in a main index.
6. UCITS and mutual funds, whose assets are eligible instruments and which offer a daily liquidity.
7. Equities listed on a recognized exchange.
Approaches:
1. Simple approach RWA = (EAD – C)⋅ 𝑅𝑊 + 𝐶 ⋅ max(𝑅𝑊, 20%), C=market value of the collateral.
The 7th item above is not eligible for the standard approach.
2. Comprehensive approach (using haircuts): RWA = 𝑅𝑊 ⋅ 𝐸𝐴𝐷 ∗ where 𝐸𝐴𝐷 ∗ = max(0, (1 +
𝐻𝐸 )𝐸𝐴𝐷 − (1 − 𝐻𝐶 − 𝐻𝐹𝑋 ) ⋅ 𝐶) where 𝐻𝐸 is the haircut applied to the exposure, 𝐻𝐶 𝑖𝑠𝑡ℎ𝑒 haircut
applied to the collateral, and 𝐻𝐹𝑋 is the haircut applied to the currency risk.
Table of standardized supervised haircuts for collateralized transactions (Basel II).
Rating Residual maturity Sovereigns Others
AAA to AA- 0-1Y 0.5% 1%
1-5Y 2% 4%
5Y+ 4% 8%
A+ to BBB- 0-1Y 1% 2%
1Y-5Y 3% 6%
5Y-+ 6% 12%
BB+ to BB- 15% Identical with sov.
Cash 0% --
Gold 15% --
Main index equities 15% ---
Equities listed on a 25% --
Recognized exchange
FX risk 8% --
For haircuts the bank can use internal mode or standardized approach.
Internal mode of haircuts is based on 99% VaR for a holding period depending on the collateral type and
the remargining frequency.
Basel III haircuts table
Ratings Residual Sovereigns Others Securitization
maturity exposures
AAA to AA- 0-1Y 0.5% 1% 2%
1Y-3Y 2% 3% 8%
3Y-5Y 2% 4% 8%
5Y-10Y 4% 6% 10%
10Y+ 4% 12% 16%
A+ to BBB- 0-1Y 1% 2% 4%
1Y-3Y 3% 4% 12%
3Y-5Y 3% 6% 12%
5Y-10Y 6% 12% 24%
10Y+ 6% 20% 24%
BB+ to BB- 15%
Cash 0%
Gold 20%
Main index equities 20%
Equities listed on a 30%
recognized exchange
FX risk 8%
Below going further I present here the two tables of ratings in Basel II and Basel III approach.
Basel II Risk Weights in the SA Approach
Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- CCC+ to C NR
Sovereigns 0% 20% 50% 100% 150% 100%
Banks 1 20% 50% 100% 100% 150% 100%
2 20% 50% 50% 100% 150% 50%
2 ST 20% 20% 20% 50% 150% 20%
Corporates 20% 50% BBB+ tp BB- B+ to C- 100%
100% 150%
Retail 75%
Residential 35%
mortgages
Commercial 100%
mortgages
Basel III Risk Weights in the SA Approach
Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- CCC+ to C NR
Sovereigns 0% 20% 50% 100% 150% 100%
PSE 1 20% 50% 100% 100% 150% 100%
2 20% 50% 50% 100% 150% 50%
MDB 20% 30% 50% 100% 150% 50%
Banks 2 20% 30% 50% 100% 150% SCRA
2 ST 20% 20% 20% 50% 150% SCRA
Covered 10% 20% 20% 50% 100% (*)
Corporate 20% 50% 75% 100% 150% 100%
Retail 75%
Exercise 1:
We consider a 10-year credit of 60mn $ to a corporate firm rated A. The credit is guaranteed by 6
collateral instruments: a cash deposit (2mn $), a gold deposit (3mn $), a sovereign bond rated AA with a
2-year residual maturity ($8 mn), repo transactions on Microsoft stocks ($4 mn), shares at Sanofi worth
1mn$ and shares at EuroNext worth 2mn$ .
a. Without the collateral how much would be the Risk-Weighted exposure under Basel II and III?
b. What is the risk-weighted exposure with the collateral posted under each approach (Standard and
Comprehensive)?
Solution:
a. RWA (Basel II) = 60 mn × 50% = 30 mn$
RWA (Basel III) = 60 mn × 50% = 30 mn$
b. Basel II:
Simplied approach: (60-2-3-8-4-1)⋅50%+(2+3+8+4+1)⋅ 20%=21 + 4.2 = 25.2 mn$
The Euronext shares are not eligible for standard approach but are for comprehensive approach.
Comprehensive approach: The adjusted exposure at default is 𝐸𝐴𝐷* = 60 ⋅ (1 + 8%) − 2 ⋅ (1 + 0%) −
3 ⋅ (1 − 15%) − (1 − 2%) ⋅ 8 − (1 − 15%) ⋅ 4 − (1 − 15% − 8%) ⋅ 1 − (1 − 25% − 8%) ⋅ 2 =
46.9𝑚𝑛$ because the Sanofi and Euronext stocks present currency risk (being denominated in euros).
So the RWA = 50% (for A grade corporate)× 46.9 = 23.45 mn $
We remark that 8% is applied to the entire exposure, while on cash there is no haircut (2 mn $), on gold
it is 3mn $, etc.
BASEL III:
Standardized approach has the same result.
In the comprehensive approach, the haircuts change in case of gold (from 15% to 20%), main index
equities (Microsoft and Sanofi, from 20% to 25%) + equities listed on a recognized exchange (Euronext,
from 25% haircut to 30% haircut). The sovereign haircut remains the same.
So 𝐸𝐴𝐷*= 60*(1+8%) – 2*(1+0%)-3*(1-20%)-(1-2%)*8-(1-20%)*4-(1-20%-8%)*1-(1-30%-8%)*2 = 47.4
mn$
Guarantees and credit derivatives
Banks can use these credit protection instruments if they are direct, explicit, irrevocable and
unconditional. In this case, banks use the simple approach described at the beginning.
If there are maturity mismatches, when the residual maturity of the hedge is less than that of the
underlying asset, the bank uses the following collateral adjustment:
min(𝑇𝐺 ,𝑇,5)−0.25
𝐶𝐴 = 𝐶 ⋅ min(𝑇,5)−0.25
where T is the residual maturity of the exposure and 𝑇𝐺 is the residual maturity
of the guarantee (or collateral)
EXERCISE 2
The bank A has granted credit of 40 mn $ to the corporate firm B, which is rated B+. In order to hedge
the default risk, A buys $20 mn of a 3-year CDS protection on B from the bank C, that is rated A+.
a. What is the required capital if the credit expires in 2 years?
b. What is the required capital if the credit expires in 7 years?
Solution:
a. In the first case, simplified approach suffices because the hedge covers the remaining lifetime of the
underlying asset.
So RWA = (40 − 20) ⋅ 150% + 20 ⋅50%=40𝑚𝑛$
min(3,7,5)−0.25 2.75
b. If the credit expires in 7 years, the collateral is adjusted so 𝐶𝐴 = 20 ⋅ = 20 ⋅ =
min(7,5)−0.25 4.75
11.57 so the RWA = (40 − 11.57) ⋅ 150% + 11.57 ⋅ 50% = 48.43𝑚𝑛$
Assignemt:
Suppose a european bank grants a 6 year credit to the company X, US-based, rating (BB-), with notional
𝑁 = 7,000,000 euros, and that poses 500,000 $ deposit collateral, and also 2,000 shares of Microsoft,
whose share price is 𝑆0 = 215$.
The bank also enters into a 5 year CDS on the notional 𝑁 = 2𝑚𝑛€. What is the RWA according to Basel
II and III using standard approach?
Use the simplified approach and comprehensive approach in both cases. Which option is the least
expensive?