Evaluation of Credit Risk, Counter Party Credit Risk and Market Risk

This study evaluates the Bank of International Settlements' credit risk measurement approach and explores the challenges associated with credit valuation adjustment. It also provides an overview of the Fundamental Review of the Trading Book (FRTB) and its impact on market risk management. The study discusses the standardized approach and internal rating-based approach for credit risk measurement, counter value adjustment, Monte Carlo simulation, and the challenges associated with CVA implementation. The study also covers the Basel committee's key reforms, including the move from VaR to Expected Shortfall and stressed calibration, and the two approaches suggested for dealing with market liquidity risk.

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An evaluation of the Credit Risk
Counter party credit Risk and Market Risk
Prepared By
Student’s Name:
Date:

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Executive Summary
The purpose of our study is to critically analyze the Bank of International settlements (BIS) most
preferred credit risk measurement approach which has also been recommended for the other
internationally active banks too. At the same time, an attempt has been made to explore the
challenges associated with the credit valuation adjustment for systematically important financial
institutions that forms the part of the first part of our analysis.
The second section named as part B consists of the performance of the value at risk analysis
along with the findings based on such analysis. Further it is intended to prove the fundamental
overview of the FRTB along with the evaluation of the fact of the impact of this new regulation
within the Financial Service Industry in terms of the market risk management.

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Table of Contents
Executive Summary.........................................................................................................................2
Introduction......................................................................................................................................4
Part A-..............................................................................................................................................5
Part B...............................................................................................................................................9
References........................................................................................................................................9

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Introduction
The Part A, being the first part of our study provides an analysis on the Bank of international
settlement’s most preferred credit risk measurement approach along the detailed discussion on
the challenges on the implementation of the credit valuation adjustment. The part B provides the
application of the VaR analysis along with the overview of the FRTB and its effect on market
risk management. (240)

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Part A-
Credit Risk and Counter Party Credit risk
Bank for international settlement has been established in 1930 to serve the purpose of guiding
the Central banks worldwide in terms ensuring the implementation of the financial and monetary
policy stability in their own countries along with financial cooperation fostering perspective
across the world community. It can also be termed as the Bank of the Central Banks spread
worldwide. At the same time, it is committed to provide its valuable financial service in terms of
the transactions carried out between any of the central bank with any other international
organization (Abdullah & Said, 2017).
Credit risk measurement is also one of the important functions needed to be addressed by the
banks. Banks are in the business of providing loans and in case the banks fails to recover the
same there are high chances that the banks might go into lot of debt, hence it becomes imperative
that banks should analyze the overall credit risks of the customers and the parties to whom they
are providing such loans.
As per the Basel III requirement the minimum capital requirement for the Banks is at least 8% of
its risk-weighted assets to ensure the efficiency along with the financial stability in its business
operation. For the calculation of the minimum capital requirement the tier I and tier II capitals of
the banks are added together. The tier 1 capital is the core capital consisting of the equity and the
reserves, whereas the tier II capital is used to absorb those losses arising from the liquidation
(Awasthi, Omrani, & Gerber, 2018).
The standardized approach is the methodology to be adopted by the banks in a uniform and
consistent way for the measurement of their credit exposures that is generally found associated
with its on and off-balance sheet items to ensure the most accurate determination of the capital
requirements for its business. While using this approach the major things to be kept in mind.
As per the internal rating-based approach the banks use their own input or the estimated risk
parameters to calculate their regulatory capital required for the business. But there are certain
conditions subject to which the banks can use this approach that are in relation to its disclosure
requirements and the requisite approval from its national advisors (Boghossian, 2017).
The major elements of the Internal rating-based approaches are the Probability of the default,
loss given default, exposure at default which reveals the obligator risk, transaction risk and the
size of the exposure along with some other elements in form of the maturity and the borrower
size. each of these are explained in brief as hereunder:
Probability of the default means the chances or the prospect of the fact that the borrower shall
not be able to repay his or her obligation.

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Loss given default talks about the losses caused to the default taken place.
Exposure at default represents the size or the volume of the exposure associated with the debt.
Counter value adjustment is the technique to represent the difference between the true value of
the portfolio and the risk-free portfolio by taking into the probability of the counterparty risk or
in other words it may be told that it is the measurement of the market value of the counterparty
credit risk. It is the reason for bringing the change in the market value of some derivative
instruments with which the counterparty risk is associated with.
This can be understood with the help of an example that if an investor is having the portfolio of
some derivative instruments and if the counterparty makes default before the trading date of the
derivative, then the net to market value shall be calculated and the one party shall be required to
compensate the other party. But if this portfolio has the positive value associated with it then one
party shall only be able to recover the partial value from the other, that is only because of the
default committed by the other party or in other words it is the counterparty (Borit & Olsen,
2012).
Monte Carlo simulation is a computerized technique of mathematical application being used
when our decision is associated with the several uncertainties, variability along with the
ambiguity. It is just because the future is quite uncertain that’s why before making the decision
we need to see the various outcome possibilities if a course of action is being chosen along with
the impact of the risks being associated with it. The Monte Carlo simulation helps us to carry out
this function. Monte Carlo analysis s used because it considers for the extreme possibilities of the
outcomes. It has been used in the various areas of application like engineering, finance,
production, marketing etc.
It is primarily used technique because often it is not possible to experiment with the actual
system as it may not only be costly but also may prove to be quite disruptive too. For this
purpose, a model of the system is created, and the requisite experiment is carried out with this
model. Then based on the findings that resulted from the experiments carried out on the model of
the system the final decision is taken to keep the level of risk at the lowest. It not only saves the
time and cost but also seems to be one of the most easily quantitative techniques that one can
plan to use (Cayon, Thorp, & Wu, 2017). For this is needed is to ascertain the probability of the
occurrence of a specific event. With this probability or frequency, the cumulative probability
distribution table is formed in which the random number chosen for performing the simulation is
being fitted into to get the desired outcome along with its impact. It is the most popular technique
of simulation being used.
The Basel committee while making the final revision to the BASEL III framework in December
2017 has clearly suggested either of the two credit risk measurement approaches to be adopted

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by the internationally active banks which are known as standardized approach of the credit risk
and the second being the internal rating-based approach.
The fundamental idea behind the standardized approach is that goes for the assignment of the
risk weights to the various exposure classes and at times there are certain jurisdictions that allow
the use of external credit ratings for the determination of the risk weights too and if this is the
case then the Banks can initially adopt it only when such credit rating institutions are approved
by its national supervisors for the capital papooses as recognized (Charles H, Giovanna, Dennis
M, & Robin W, 2015).
The various exposure classes s identified by this approach are individual exposures in form of
exposures to sovereigns, central government public sector undertakings, multilateral
development banks, banks, covered Bonds, securities firm and other financial institutions,
corporate, subordinated debt, equity and other capital instruments, retail exposures, real estate,
exposures with the currency mismatch, off balance sheet items, defaulted exposures and other
assets.
Why the adoption of the CVA (credit valuation adjustment) has become a challenge while
it implementation
Credit valuation adjustment simply measures the credit loss arising because of the counterparty
transaction default.
The challenges associated with the implementation of the CVA approach can be categorized as
the issues associated with the model, issues associated with the organizational structure and the
hedging and the systems, these are discussed hereunder.
The major organizational issues associated with the implementation of the CVA are explained
hereunder:
1. The desk which transfer profit and loss of the entity to the CVA desk is different hence
may cause the inter-desk political manipulation.
2. There are various reasons provided for the entities for the implementation of the CVA
function that may differ from institution to institution.
3. The various other parts of the organization get affected by the CVA function like finance,
regulatory risk etc.
The major modeling issues in this regard can be following:
1. The easiest approach to calculate the CVA is simply multiplication of the expected
positive exposure with that of the static probability of the default and loss given
default, but it is not very sophisticated.

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2. The calculation of the expected positive exposure is again an issue.
3. While considering the order of the default of the counterparty along with the Bank
may further increase the number of calculations of the CVA.
4. The determination of the correlation between the counterparty default and the
transaction default may be difficult to determine.
The major issue associated with the hedging and systems are as follows
1. How to ensure the accuracy of the PFE calculation
2. What is the approach to be adopted to determine the possibility of extending the PFE to
calculate the CVA?
3. How to ensure that the system shall be able to perform in a sufficient way.
The implementation of the CVA requires the single risk engine for the calculation of the
PFE and the CVA that seems to be quite difficult in the given case.

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Part B
Overview of the FRTB and its effect on market risk management
It is the Basel committee which is committed to the ensure the adequate capital requirements for
the Banks for which the capital standards are required to be set for the market risk exposure
faced by the Banks. The contribution of the material weakness in form of the financial crisis
significantly affects the capitalization of the trading activities of the Bank. In other words, it can
be said that the determination of the capital requirement based on trading book has failed to
compensate the loss arose from such exposure.
The major reason that has been identified for the weakness in the design of the capitalization of
the trading activities of the bank is nothing but the regulatory boundary that has been established
between the Banking book and the trading book. one of the basis for the formation of such
boundary is the intention of the Bank of the trade. It is this intent which is difficult to bring
within the purview of the prudential perspective
For this purpose, the committee decided to provide the two-different basis for the definition of
this boundary and these are trading evidence-based approach and the valuation-based approach.
Because of which the banks have been provided a revised boundary by establishing the linkage
between those books which are retained by the banks as regulatory trading book and the
instruments it is deemed to be held by them for the trading purposes, but at the same time trying
to reduce the probability of any arbitrage. This is the reason some of the instruments have been
designated under the trading book and the other as the banking book simultaneously presuming
some of the instruments as the trading book only to develop a level of understanding amongst the
supervisors. The Basel committee also emphasized the need for the banks to provide with the
supervisors a set of documents so that to assist these supervisors in terms of their reporting
requirements in relation to both valuation approaches adopted by the banks (Wellmer, 2018).
To reduce the prospect of any such arbitrage it is proposed to restrict the switching between the
trading and the banking books and to prevent the capital benefit when such switching is
permissible. The committee is also focusing on the need to bring the requirements relating to the
trading books as much closer as to the Banking book requirements. This is the reason why a

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differential approach between the securitization and the non-securitization exposures have been
suggested because during the period of financial crisis it is the credits provided that become the
major source for the losses caused to the Banks.
In respect of the securitization exposures it is found that the Basel committee expressed its doubt
on the internal risk methodology adopted by the Banks as it felt that it is unable to adequately
capture the risks that are associated with the securitized product. That is the reason it has
suggested that the capital charges for the securitized product shall be calculated based on the
revised standard approach. For the non-securitized exposures though it has agreed to rely on the
internal modelling but has suggested the concept of the joint modelling in terms of the default
risk and the spread risk. For these non-securitized products, it has recommended for the seated
charge in form of the incremental default risk charge.
One new charge in form of credit valuation adjustment charge has too been introduced by the
Basel III committee to capture the changes in the capital value adjustment (Webster, 2017).
While making the risk measurement for the minimum capital requirements the Basel committee
is intended to suggest the two major key reforms in the form of move from VaR to Expected
shortfall and the Stressed calibration’s reason to reject the VAR is its inability to measure the tail
risk. In terms of stressed calibration, it tries to ensure that the regulatory capital should be
sufficient enough to meet the stress period requirement.
The risk associated with market liquidity has been considered as one of the major factor to be
dealt with by the Basel committee for which it has basically suggested the two different
approaches which are explained hereunder:
The first being the incorporation of the liquidity horizon into the market risk metrices and the
second thing that has been suggested is introduction of the add owns against the jumping of the
liquidity premia .The reason behind the same is that at times the historical prices used for the
market risk metrices have seemed to fail the disclosure of the sufficient amount of risk (Vieira,
O’Dwyer, & Schneider, 2017).

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It further talks about the hedging and the diversification as a measure of the achievement of the
optimum trade portfolio, but during the time of stress the diversification can also prove to the
failure. The recognition of the hedging and diversification is to be achieved by using the internal
model-based approach by imposing certain constraints while the revised standard approach to be
used for this is expected to increase the amount of recognition that is aligned with the current
approach (Coate & Mitschow, 2017).
The relationship between the internal model approach and the standard approach has too been
elaborated nicely by the committee.
The Committee is taking several steps to strengthen the relationship between models-
based and standardised approaches. First, it is establishing a closer link between capital charges
resulting from the two approaches. Second, it will require mandatory calculation of the
standardised approach by all banks. Third, it will require mandatory public disclosure of
standardised capital charges by all banks on a desk-by-desk basis. Finally, the Committee is also
considering the merits of introducing the standardised approach as a floor or surcharge to
the models-based approach.

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Revised models-based approach
As stated in the first consultative paper, the Committee has identified several weaknesses with
risk measurement under the models-based approach under the 1996 market risk amendment.
Specifically, the 10-day VaR calculation did not adequately capture credit risk or market
liquidity risks; incentivised banks to take on tail risk; inadequately captured basis risk and proved
procyclical due to its reliance on relatively recent historical data. In seeking to address these
problems, the Committee proposed to: (i) strengthen requirements for defining the scope of
portfolios that will be eligible for internal model’s treatment; and (ii) strengthen internal model
standards to ensure that the output of such models reflects more fully the relevant trading book
risks from a regulatory perspective (Vieira, O’Dwyer, & Schneider, 2017).
To strengthen – and make more objective – the criteria for allowing banks to calculate
capital requirements using internal models, the Committee has agreed to break the model
approval process into smaller, more discrete steps, including at the trading desk level. The
Committee has also agreed on a set of quantitative tools to measure the performance of models.

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First, a P&L attribution process that provides an assessment of how well a desk’s risk
management model captures risk factors that drive its P&L. Second, an enhanced daily back
testing framework for reconciling forecasted losses with actual losses. Where a trading desk fails
these tests, the bank would be required to calculate capital requirements for that desk using the
standardised approach. Finally, as mentioned above, the Committee will also pursue the
introduction of a non-model-based tool for the risk assessment of desks (Norberg, 2018).
To strengthen model standards, the Committee has agreed to limit diversification
benefits, move to an ES metric and require calibration to periods of market stress that are
particularly relevant to banks’ own portfolios. In addition, it is introducing a more robust process
for assessing whether individual risk factors can be deemed as “modellable” by a bank. This
would be a systematic process for identifying, recording and calculating regulatory capital
against risk factors deemed not to be amenable to market risk modelling, largely due to data
quality issues.
The Committee has sought to incorporate the lessons learned from its recent
investigations on the variability of market risk-weighted assets in the revised requirements. The
proposals in this paper seek to provide additional specificity with respect to certain modelling
choices identified by the hypothetical portfolio drivers as important drivers of variability across
banks.
Revised standardised approach
The revised standardised approach should achieve three objectives. First, it must provide a
method for calculating capital requirements for banks with business models that do not require a
more sophisticated measurement of market risk. Second, it should provide a credible fall-back if
a bank’s
Fundamental review of the trading book: A revised market risk
framework 5
internal market risk model is deemed inadequate, including its potential use as a surcharge or
floor to an internal models-based capital charge. Finally, the approach should facilitate
transparent, consistent and comparable reporting of market risk across banks and jurisdictions.

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As discussed above, the Committee has agreed that the revised standardised approach will be the
only method used to capture the risk of securitisations (Kaufmann, 2017).
The first Consultative Paper consulted on a “partial risk factor” approach and a “fuller
risk factor” approach as alternatives for use as the revised standardised approach. After further
consideration, the Committee has decided to use the “partial risk factor” approach, recognising
that it is more likely to deliver a standardised approach that can be applied by both small and
large banks.
Specifically, under the revised standardised approach, instruments that exhibit similar
risk characteristics are grouped into buckets and Committee-specified risk weights are applied to
the aggregate market value for each bucket. Greater differentiation according to risk
characteristics will result in broader risk capture relative to the current standardised approach.
Risk weights have been calibrated based on observed market price fluctuations in periods of
stress. Hedging and diversification benefits will be better captured through the incorporation
of regulatory-determined correlation parameters (Johan, 2018).
The Committee has sought to balance the different objectives for the revised
standardised approach. The increase in risk sensitivity that is required for the standardised
approach to function as a fall-back to internal models comes at a cost in terms of increased
complexity. The Committee therefore encourages participation from a broad spectrum of banks
in the QIS.

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Conclusion
Hence it is to be concluded that the Basel committee report I too effective to introduce reforms in
the international Banking sector.
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