Study Guide: Credit Risk 1 (Ch.

10)

Credit Risk Analysis & Measurement

Part 1: Traditional Qualitative Analysis

Before looking at the numbers, lenders must act like “detectives” to understand the borrower’s
character and business environment.

A. The Frameworks

Financial Institutions (FIs) use these frameworks to standardize subjective analysis.

Framework Components Key Insights

People (Honesty/Ability)

Purpose (Loan use)

Focuses on the “People” factor (management
The 5 Ps Payment (Source of repayment)
team) as a primary driver of trust.
Protection (Collateral/Covenants)

Perspective (Risk/Return fit)

Character (Reputation)

Capacity (Repayment ability) Capital is crucial because own-investment

reduces information asymmetry. Conditions
The 5 Cs Capital (Skin in the game)
account for external factors like the business
Collateral (Security) cycle.

Conditions (Economic env.)

B. Warning Signals (Red Flags)

Be alert to these “abnormal” qualitative signs that suggest credit deterioration:

• Management: Frequent changes in leadership or owners being absent.

• Operations: Rapid inventory changes, selling off real estate, or “cut-price dumping” of products
to generate quick cash.

• Relationships: Major customers going bankrupt or sudden changes in the main lending bank.

Critique: Traditional analysis is subjective, bias-prone, and labor-intensive (costly).

Part 2: Strategic Mitigation (Collateral & Covenants)

Lenders use contractual tools to solve Information Asymmetry problems: Adverse Selection
(hidden information before the loan) and Moral Hazard (hidden action after the loan).

A. Collateral as a Screening Tool

Collateral is not just a backup asset; it forces borrowers to reveal their true risk type (“Separating
Equilibrium”).

• The Problem: Without collateral, safe borrowers effectively subsidize risky borrowers in a
“pooling” contract (everyone pays the same average rate).

• The Solution: The bank offers two contracts:

1. Secured (Collateralized): Lower interest rate.

2. Unsecured: Higher interest rate.

• The Outcome:

◦ Safe borrowers choose the Secured loan because they know they won’t default, so the low
rate is attractive and the risk of losing collateral is low.

◦ Risky borrowers choose the Unsecured loan because they fear losing the collateral (high
default probability) and prefer paying a premium to avoid that risk.

• Moral Hazard Impact: Collateral acts as a “hostage,” discouraging the borrower from switching
to riskier business strategies after getting the cash.

B. Covenants

These are legal clauses acting as guardrails for borrower behavior.

1. Affirmative: Things the borrower must do (e.g., maintain specific financial ratios).

2. Restrictive/Negative: Things the borrower cannot do (e.g., no M&A, limits on dividends, limits
on new debt).

3. Default Provisions: Triggers for immediate repayment (e.g., bankruptcy, fraud, breach of other
covenants).

Part 3: Quantitative Scoring Models

These models aim to remove subjectivity by mapping characteristics to a mathematical probability

of default (PD).

1. Linear Probability Model (LPM)

• Method: Uses past data to run a linear regression.
 ◦ Formula: 𝑃𝐷𝑖 = ∑ 𝛽𝑗 𝑋𝑖𝑗 + 𝑒𝑟𝑟𝑜𝑟

• Inputs: Factors like Leverage (Debt/Equity) and Efficiency (Sales/Assets).

• Weakness: The calculated PD can mathematically fall below 0 or above 1, which is impossible
in reality.
2. Logit Model

• Improvement: Fixes the LPM weakness by restricting the output between 0 and 1 using a logistic
transformation.
1
◦ Formula: 𝐹(𝑃𝐷𝑖 ) = 1+𝑒 −𝑃𝐷𝑖

3. Linear Discriminant Model (Altman’s Z-Score)

Instead of a probability, this calculates a score to classify firms into risk “buckets”.

• The Formula (Manufacturing):

𝑍 = 1.2𝑋1 + 1.4𝑋2 + 3.3𝑋3 + 0.6𝑋4 + 1.0𝑋5

◦ 𝑋1: Working Capital / Assets (Liquidity)

◦ 𝑋2: Retained Earnings / Assets (Cumulative profitability/Age)

◦ 𝑋3: EBIT / Assets (Operating efficiency - highest weight)

◦ 𝑋4: Market Value of Equity / Book Value of Liab. (Leverage)

◦ 𝑋5: Sales / Assets (Asset turnover).

• The Zones:
◦ Z < 1.81: High Default Risk (Do not lend/Restructure).

◦ 1.81 < Z < 2.99: Grey Area (Indeterminant).

◦ Z > 2.99: Safe.

• Pros/Cons: It is objective and low-cost but relies on backward-looking accounting data and
ignores non-linear relationships.

• Evolution: The ZETA Model was developed later to handle non-manufacturing/service firms
and includes more variables.

Part 4: Market-Based Models (Term Structure)

This approach assumes market prices reflect all available information. We derive PD from the
“spread” between risky corporate bonds and risk-free Treasuries.

A. The Core Logic

If a corporate bond offers a higher yield (k) than a risk-free Treasury (i), the difference is the risk
premium.

• Probability of Repayment (p): Derived from the “No Arbitrage” condition where the expected
return of the risky bond equals the risk-free return.

p (1+k) = 1+i
1+𝑖
p=
1+𝑘
• Probability of Default: 1-p
B. Multi-Period Calculation (Step-by-Step Guide)

To find the probability of default in Year 2, you must use Forward Rates derived from the yield
curve.

Step 1: Find Risk-Free Forward Rate (𝒇𝟏 ) Using 1-year (𝑖1 ) and 2-year (𝑖2 ) Treasury rates:

(1 + 𝑖2 )2
(1 + 𝑓1 ) =
(1 + 𝑖1 )

Step 2: Find Risky Forward Rate (𝒄𝟏 ) Using 1-year (𝑘1 ) and 2-year (𝑘2 ) Corporate rates:

(1 + 𝑘2 )2
(1 + 𝑐1 ) =
(1 + 𝑘1 )

Step 3: Calculate Marginal Repayment Probability (𝒑𝟐 ):

1 + 𝑓1
𝑝2 =
1 + 𝑐1

Step 4: Calculate Cumulative Default Probability (𝒄𝒑 ) Probability of surviving Year 1 AND
Year 2: Cumulative Default: 𝑐𝑝 = 1 − 𝑝1 ∙ 𝑝2

C. Pros & Cons

• Pros: Forward-looking, impartial, updates continuously with the market.

• Cons: Requires liquid markets for “Zero-Coupon” (discount) corporate bonds, which rarely exist.
Using standard coupon bonds makes extraction of probabilities difficult due to lack of transparency.
Synthesis Analogy:

To solidify your understanding, imagine assessing a driver’s risk for car insurance:

• Traditional (5Cs/5Ps): You interview the driver. Do they look responsible? Do they have a job?
Is their car dented? (Subjective, “Detective work”).

• Collateral: You ask for a large deductible. A safe driver agrees (cheaper premium); a reckless
driver refuses (fears paying the deductible) and goes elsewhere.

• Credit Scoring (Z-Score): You plug their age, car horsepower, and years of experience into a
formula. If the score is below 50, no insurance. (Objective, based on historical stats).

• Market-Based: You look at the betting odds in a prediction market regarding whether this driver
will crash. (Forward-looking, relies on the “wisdom of crowds”).

Credit Risk 2 (Ch.10, Ch.11)

Credit Risk Management & Modeling

Part 1: Introduction to RAROC (Risk-Adjusted Return on Capital)

Concept: RAROC is a comprehensive metric used to evaluate the profitability of a loan relative to
the risk capital required to support it. It aligns loan profitability with the bank's Return on Equity
(ROE) targets.

•The Formula:

•The Components:

◦ Numerator (Net Income): Calculated as (Spread + Fees − Cost of Funds − Expenses) × Dollar
Value of loan.

◦ Denominator (Capital at Risk): Represents “Unexpected Losses” (i.e., Value at Risk - VaR).

• Decision Rule:

◦ If RAROC > Hurdle Rate (e.g., the bank’s target ROE), Approve the loan.

◦ If RAROC < Hurdle Rate, Reject or re-price the loan.

Estimating Loan Risk (The Denominator of RAROC)

The central challenge in RAROC is calculating the denominator. The sources outline two primary
methods for this:
Method A: The Duration Approach

• Logic: Uses the duration (interest rate sensitivity) of the loan to estimate the worst-case change
in the loan’s value due to credit risk changes.

• Formula:

∆𝑅
∆𝐿𝑁 = −𝐷𝐿𝑁 × 𝐿𝑁 ×
1+𝑅
◦ ∆𝐿𝑁 : Dollar capital risk exposure (change in loan value).

◦ 𝐷𝐿𝑁 : Duration of the loan.

◦ 𝐿𝑁 : Size of the loan.

◦ ΔR: Worst-case increase in credit risk premium (e.g., 99th percentile).

Method B: The Loan Default Rate Approach

• Logic: Used by large institutions with extensive databases. It estimates risk based on historical
default probabilities.

• Formula:

◦ Numerator: Net Income.

◦ Denominator: Loan Risk = Unexpected Default Rate × Loss Given Default (LGD).

Part 2: Advanced Modeling: The Option-Based Approach (Merton Model)

Concept: This approach utilizes Black-Scholes-Merton option pricing theory to evaluate the
default risk of a firm by analyzing its capital structure.

The Analogy:

• Equity as a Call Option: Shareholders hold a call option on the firm’s assets (𝐴𝜏 ).

◦ Underlying Asset: Total firm assets (𝐴𝜏 ).

◦ Strike Price: Face value of debt (B).

◦ Payoff: Max{𝐴𝜏 - B, 0}.

 If assets > debt, shareholders keep the surplus. If assets < debt, shareholders get nothing (limited
liability).

• Debt Valuation:

◦ Risk-free Debt Value = 𝐵 × 𝑒 −𝑖𝑇 (Present value of face value).

◦ Risky Loan Value (L(τ)) = Asset Value (𝐴𝜏 ) - Equity Value (Call Option).

◦ Alternatively: Risky Loan Value (L(τ)) = Risk-Free Bond - Put Option (Value of Default).

Calculating the Implied Risk Premium (ϕ): Using the option model, you can calculate the fair
risk premium a bank should charge.

• Current market value of the loan:

◦ Where d is the leverage ratio (𝐵𝑒 −𝑖𝑇 /A).

• Implied default risk premium:

◦ 𝑘(𝜏): Required yield on risky debt.

Practical Implementation: The KMV Model

The Problem with Merton: The Option Model requires the Market Value of Assets (𝐴𝑀 ) and Asset
Volatility (𝜎𝐴 ). These are not directly observable in the market.

The KMV Solution:

• KMV uses observable market data:

1. Market Value of Equity (𝐸𝑀 ) (Market Cap).

2. Volatility of Equity (𝜎𝐸 ).

• Methodology: KMV sets up two simultaneous equations:

1. 𝐸𝑀 = Function (𝐴𝑀 , 𝜎𝐴 , Debt, r, τ)

2. 𝜎𝐸 = Function (𝜎𝐴 ,...)

• By solving these simultaneously, the model derives the unobservable 𝐴𝑀 and 𝜎𝐴 to calculate
the Expected Default Frequency (EDF).
Part 3: Portfolio Credit Risk Management

Managing risk at the portfolio level allows for diversification, but loans present unique challenges
(illiquidity, non-normal returns).

Approach 1: Modern Portfolio Theory (MPT) Application

• Step 1: Calculate individual loan statistics.

◦ Expected Return 𝑅𝑖 = AIS𝑖 − (EDF𝑖 × LGD𝑖 )

◦ Variance 𝜎 2𝑖 = EDF𝑖 (1 − EDF𝑖 ) × LGD 2𝑖

◦ Volatility 𝜎𝑖 = √EDF𝑖 (1 − EDF𝑖 ) × LGD𝑖

◦ Key Terms: AIS (All-in-Spread), EDF (Expected Default Frequency), LGD (Loss Given
Default).

• Step 2: Estimate correlations (𝜌𝑖𝑗 ) between loans.

• Step 3: Compute Portfolio Risk (𝜎𝑝 )

• Limitation: It is very difficult to estimate correlations because loans are not frequently traded
assets.

Approach 2: Loan Volume-Based Model

• Concept: Assumes a national benchmark portfolio is fully diversified. Measures how much a
specific bank’s portfolio deviates from this benchmark.

• Formula:

◦ 𝑋𝑖𝑗 = Asset allocation proportion of Bank j in sector i.

◦ 𝑋𝑖 = National asset allocation in sector i.

◦ N: Number of loan categories.

• Interpretation:

◦ High Deviation (𝜎𝑗 ): Suggests high concentration risk (undiversified).

 ◦ Caveat: High deviation isn’t always bad; it may reflect a bank’s comparative advantage or
specialization in a specific sector (e.g., a local bank knowing local real estate better than the
national average).

Capital Adequacy 1 (Ch.21)

Part 1: Fundamentals of Bank Capital

1. Why do banks need “Own Capital”?

Capital serves four primary functions:

• Absorb Unexpected Losses: Maintains confidence for depositors and counterparties.

• Protection: Protects depositors, the deposit insurance fund, and taxpayers (from bailouts).

• Incentives: Reduces the “agency problem” by putting the bank’s own money at risk, encouraging
prudent management.
• Funding and Growth: Acts as a macroprudential “brake” to limit overly rapid asset growth,
which often signals a crisis.
2. The Core Objectives of Basel Regulations

• Risk-Sensitivity: Capital requirements should reflect the actual size of the risk.

• Safety: Lower bankruptcy probability.

• Level Playing Field: Ensure fair competition internationally.

• Internal Improvement: Encourage banks to enhance their own risk management capabilities.

Part 2: The Basel Framework (The Three Pillars)

The Basel 2 framework (and continuing into Basel 3) relies on three mutually reinforcing pillars.

Pillar Focus Who Acts? Key Function

Minimum Capital 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Pillar 1 Shareholders Quantitative calculation of the ratio:
Requirements 𝑅𝑊𝐴

Qualitative assessment: “Is the ratio enough?”

Pillar 2 Supervisory Review Regulators Covers risks not in Pillar 1 (e.g., concentration
risk).
 Market Disclosure requirements allowing
Pillar 3 Market Discipline
Participants investors/analysts to pressure banks to be prudent.

Part 3: Pillar 1 – The Numerator (Own Capital)

Capital is divided into tiers based on quality (ability to absorb losses).

1. Common Equity Tier 1 (CET1) – Highest Quality

• Includes: Common stock, paid-in capital, capital surplus, legal/special earnings reserves,
retained earnings, and non-controlling interests.
2. Additional Tier 1 (AT1)

• Instruments: Perpetual non-cumulative preferred stock and subordinated bonds.

• Key Feature: “Non-cumulative” means missed dividends do not have to be paid later.

• Loss Absorption: Absorbs losses while the bank is still a “going concern” (operating normally).

3. Tier 2 (T2)

• Instruments: Perpetual cumulative preferred stock, subordinated debt, convertible bonds, and
general provisions for bad debt.

• Loss Absorption: Absorbs losses upon “gone concern” (failure/liquidation).

Part 4: Pillar 1 – The Denominator (Risk-Weighted Assets)

The fundamental formula for RWA conversion is based on the reciprocal of the 8% minimum
capital ratio: RWA = Capital Charge × 12.5 (Since 1 ÷ 0.08 = 12.5).
A. Credit Risk RWA

There are two main approaches:

1. Standardized Approach (SA): Uses regulator-set risk weights based on external credit ratings.

◦ Sovereigns (Governments): AAA to AA- is 0%; Unrated is 100%.

◦ Corporates: AAA to AA- is 20%; BBB+ to BB- is 100%; Unrated is 100%.

◦ Banks: Generally receive more favorable weights than corporates (e.g., BBB rated bank is
50%, BBB corporate is 100%).
◦ Retail Portfolio: Bundled loans to individuals/small businesses get a 75% weight.
 ◦ Real Estate (Basel 3): Based on Loan-to-Value (LTV). LTV < 50% gets 20% weight; LTV >
80% gets 50% (for general residential).

2. Internal Ratings-Based (IRB): Banks use internal models to estimate risk components.

◦ Components: Probability of Default (PD), Loss Given Default (LGD), Exposure at Default
(EAD), and Maturity (M).

◦ Foundation vs. Advanced: In F-IRB, banks only estimate PD. In A-IRB, banks estimate all
components.

B. Market Risk RWA

Calculated for trading activities.

1. Internal Models Approach (IMA):

◦ Uses Value-at-Risk (VaR) calculated daily at 99% confidence over 10 days.

◦ Capital Charge (Pre-2012): Max of yesterday’s VaR or (Multiplier × Average 60 day VaR).
The multiplier is determined by backtesting accuracy (Green/Yellow/Red zones).

◦ Capital Charge (Post-2012): Adds a “Stressed VaR” (sVaR) component using data from a
crisis period (e.g., 2008) to correct for the failures of standard VaR.

C. Operational Risk RWA

Risk of loss from failed processes, people, systems, or external events (excluding
strategic/reputational risk).

1. Basic Indicator Approach (BIA): Capital charge is 15% of average Gross Income.
2. Standardized Approach (TSA): Income split into 8 business lines with different “Betas” (12%,
15%, 18%).

Part 5: Pillar 2 (Supervisory Review)

• Four Principles:

1. Banks must have an ICAAP (Internal Capital Adequacy Assessment Process).

2. Supervisors must review and evaluate this process.

3. Banks should operate above the minimum regulatory ratios.

4. Supervisors must intervene early (Prompt Corrective Action).

• Gap Filling: Pillar 2 accounts for risks Pillar 1 misses, such as Credit Concentration Risk and
Interest Rate Risk in the Banking Book (IRRBB).
Part 6: Criticisms & Complexity

• Pro-cyclicality: Basel 2 risk models often force banks to hold more capital during recessions
(when risk is high), causing them to cut lending and worsening the economic downturn.

• Credit Rating Flaws: Ratings are “lagging indicators” and not fine-grained enough (e.g.,
grouping BBB+ and BB- together despite different VaR profiles).

• Complexity: The rules are difficult to verify and may lead to “capital arbitrage” (banks finding
loopholes).

Analogy for Understanding the Pillars

To solidify the “Three Pillars,” imagine constructing a safe building:

• Pillar 1 (Minimum Requirements) is the Building Code: The strict math and engineering rules
(quantitative) that dictate exactly how thick the walls (Capital) must be to support the roof (RWA).

• Pillar 2 (Supervisory Review) is the Building Inspector: The official who visits the site to
check things the code might miss, like the specific soil quality (Concentration Risk) or the builder's
competence (ICAAP), and can order extra reinforcements if the code isn’t enough.

• Pillar 3 (Market Discipline) is the Real Estate Listing: The public report that tells potential
buyers (Investors) exactly how the house was built, allowing the market to value the property
accurately and avoid buying “unsafe” houses.

Study Guide: Capital Adequacy 2 (Ch.21)

Part 1: Basel 3 Capital Adequacy & Liquidity Reforms

Overview and Objectives: Basel 3 was a direct response to the 2008 financial crisis. Its primary
goals were to strengthen the quality of capital (focusing on Common Equity Tier 1 or CET1) and
increase the quantity of capital held by financial institutions.

Capital Ratios and Buffers: Basel 3 introduced stricter minimums and added “buffers” to ensure
resilience.

1. Minimum Capital Ratios

The baseline requirements (Pillar 1) are:

• CET1: 4.5%
• Total Tier 1: 6.0%
• Total Capital: 8.0%

2. The Buffer System

To avoid restrictions, banks must hold capital above the minimums.

• Capital Conservation Buffer (2.5%): Mandatory for all banks. This raises the “real” minimum
CET1 requirement to 7.0% (4.5% min + 2.5% buffer), Total Tier 1 requirement to 8.5% (6.0%
min + 2.5% buffer), and Total Capital requirement to 10.5% (8.0% min + 2.5% buffer).

• Countercyclical Buffer (0% – 2.5%): A discretionary buffer set by national regulators.

◦ Purpose: To fight “pro-cyclicality” (cooling down booms and releasing capital during busts).

◦ Trigger: Based on the “Gap” between the current Credit-to-GDP ratio and its long-term trend.
If the gap exceeds 2%, the buffer phases in; it hits the max 2.5% if the gap exceeds 10%.

3. Payout Restrictions (The Enforcement Mechanism)

If a bank’s capital dips into the buffer zone, it does not fail immediately but faces restrictions on
dividend payouts (and bonuses) to conserve earnings.

• Zone 1 (Top of buffer): Bank must conserve 0% of earnings (can payout 100%).
• Zone 2: Bank must conserve 40% of earnings (can payout 60%).

• Zone 3: Bank must conserve 60% of earnings (can payout 40%).

• Zone 4: Bank must conserve 80% of earnings (can payout 20%).

• Zone 5 (Bottom of buffer): Bank must conserve 100% of earnings (can payout 0%).

4. The Leverage Ratio

• Formula: Tier 1 Capital / Total Exposure (On & Off-Balance Sheet).

• Purpose: A “backstop” to prevent banks from using internal models to manipulate Risk-
Weighted Assets (RWA) down to near-zero.

• Key Feature: The denominator is not risk-weighted. The minimum requirement is 3%.

Part 2: Liquidity Standards (The New Pillar)

Basel 3 addressed the “blind spot” of liquidity with two complementary ratios.

1. Liquidity Coverage Ratio (LCR) — “The Sprint”

• Goal: Survive a 30-day severe stress scenario (e.g., a bank run).

• Formula:
• HQLA (High-Quality Liquid Assets):

◦ Level 1 (100% weight, 0% discount): Cash, Central Bank reserves, sovereign bonds.

◦ Level 2A (85% weight, 15% discount): Highly rated corporate bonds (AA-), some gov bonds.
◦ Level 2B (25-50% discount): MBS, BBB corporate bonds.

◦ Caps: Level 2 assets cannot exceed 40% of total HQLA; Level 2B cannot exceed 15%.

• Net Cash Outflows:

◦ Calculated using “run-off rates.” Stable retail deposits run off at 3–5%, while “non-operational”
wholesale deposits run off at 40%.

◦ Inflow Cap: Inflows are capped at 75% of outflows to ensure banks hold actual HQLA.

2. Net Stable Funding Ratio (NSFR) — “The Marathon”

• Goal: Ensure structural stability over a 1-year horizon. It limits maturity mismatches (funding
long-term assets with short-term debt).

• Formula:

• ASF (Numerator): Sources of funds weighted by stability.

◦ 100% factor: Equity, liabilities > 1 year maturity.

◦ 90-95% factor: Stable retail deposits.

◦ 0% factor: Short-term interbank borrowing.

• RSF (Denominator): Assets weighted by illiquidity (how much stable funding they require).

◦ 0% factor: Cash.

◦ 65% factor: Mortgages.

◦ 100% factor: Illiquid assets, real estate, derivatives.

Part 3: Risk Calculation Revisions

Basel 3 revised how the denominator (Risk-Weighted Assets) is calculated.
1. Operational Risk

• Change: Replaced all previous methods (AMA, Standardized, Basic Indicator) with a single
Standardized Approach.

• Formula:

Operational Risk Capital = Business Indicator Component * Internal Loss Multiplier

◦ BIC: Based on the bank’s size and scale of operations (1. Interest, Lease, and Dividend
Component; 2. Services Component; 3. Financial Component).

◦ ILM: Based on the bank’s historical losses (15x average 10-year losses). If a bank has high
historical losses relative to its size, its capital charge increases.

2. Market Risk (FRTB)

• Metric Shift: Moved from Value-at-Risk (VaR) to Expected Shortfall (ES).

◦ Why? VaR ignores “tail risk” (severity of loss beyond the 99% confidence level). ES averages
the losses in the tail.

• Liquidity Horizons: Risks are now categorized by how long it takes to exit a position (ranging
from 10 days for currencies to 120 days for volatility).

Part 4: Prompt Corrective Action (PCA)

A US-based framework designed to solve regulator “forbearance” (waiting too long to act) and
banker “moral hazard” (gambling when near failure).
The 5 Zones:

1. Well Capitalized: No restrictions.

2. Adequately Capitalized: Minor restrictions (e.g., brokered deposits).

3. Undercapitalized: Mandatory dividend suspension; must submit capital restoration plan; asset
growth restricted.

4. Significantly Undercapitalized: Forced recapitalization; bonuses restricted.

5. Critically Undercapitalized (Tangible Equity / Assets 2%): Regulator must appoint a

receiver/conservator within 90 days (bank is seized).

Critique: PCA relies on book value (backward-looking), which may not reflect true economic
health or imminent failure.
Part 5: Key Formula Summary for Review

Metric Formula Requirement

Leverage
Tier-1 Capital / Total Exposure ≥ 3%
Ratio

Stock of High-Quality Liquid Assets (HQLA) / Total Net Cash

LCR ≥ 100%
Outflows over 30 days

NSFR Available Stable Funding (ASF) / Required Stable Funding (RSF) ≥ 100%

Analogy for Understanding LCR vs. NSFR

To solidify the difference between the two liquidity ratios:

• LCR (The Sprint): Think of this as your emergency fund. Do you have enough cash in your
savings account (HQLA) to pay your rent and groceries if you lose your job today (stress scenario)
and have no income for the next month?

• NSFR (The Marathon): Think of this as sensible debt management. If you buy a house (an
illiquid, long-term asset), you should fund it with a 30-year mortgage (stable, long-term funding),
not by maxing out a credit card that demands repayment next month (unstable, short-term funding).

Study Guide: Deposit Insurance and Other Liability Guarantees (Ch.20)

Part 1: The Macro Problem – Procyclicality in Basel Pillar 1

Before understanding deposit insurance, it is crucial to understand how bank capital requirements
react to the economy. The current Basel Pillar 1 framework creates a “feedback loop” that can
worsen economic swings.
• The Core Mechanism:

◦ Pillar 1 sets capital requirements based on three risks: Credit, Market, and Operational.

◦ Credit Risk Calculation: Relies on internal models to estimate Probability of Default (PD),
Loss Given Default (LGD), and Exposure at Default (EAD).

◦ The Trend: When PD and LGD estimates rise, risk weights rise, requiring banks to hold more
capital.

• The “Procyclical” Loop:

 1. Economic Boom (Good Times): GDP grows, collateral values (like real estate) rise, and
defaults are rare.

2. Model Reaction: Banks’ models show low PD and low LGD. Consequently, risk weights
drop.

3. Capital Effect: Capital requirements decrease. Banks appear “safer” and have excess capital
capacity.

4. Bank Behavior: Banks aggressively expand lending, lower standards, and fuel the boom
further.

• The Reversal (Bad Times): When the economy turns, PD/LGD spike, capital requirements jump,
and banks are forced to cut lending, deepening the recession.

Part 2: Deposit Insurance (DI) Fundamentals

Deposit insurance acts as a safety net to prevent the instability described above from causing panic
among depositors.

• Definition: A policy-based system where institutions pay premiums to a centralized body (like
the Central Deposit Insurance Corporation, CDIC) to guarantee depositor funds.

• Taiwan’s Specifics:

◦ Coverage: CDIC compensates up to NT$3 million per depositor per institution.

◦ Cost: Premiums are paid by the financial institutions, not the depositors.

• Primary Functions:

1. Prevents bank runs (maintains stability).

2. Protects small depositors by creating a risk-free asset.

3. Enhances public confidence in the banking system.

Part 3: The Economic Theory of Deposit Insurance

We analyze deposit insurance using option pricing theory to explain why it creates “Moral
Hazard.”

A. The Moral Hazard Problem

• Depositor Apathy: Because their money is insured, depositors have no incentive to monitor
whether a bank is being run safely.
• Bank Risk-Taking: If premiums are “flat” (fixed rate) regardless of risk, banks are incentivized
to take high risks to maximize returns, knowing the insurer bears the downside.

B. The “Put Option” Analogy

• Concept: Providing deposit insurance is mathematically equivalent to the CDIC selling a Put
Option to the bank.

• The Variables:

◦ V: The bank’s asset value.

◦ B: The liability to depositors (Principal + Interest).

• The Payoff Structure (Zero-Sum Game):

◦ If V ≥ B (Solvent): The bank pays depositors and keeps the profit (V−B). The CDIC pays
nothing.

◦ If V < B (Insolvent): The bank defaults. The CDIC steps in to pay the difference (B−V) to
depositors.

• Conclusion: The CDIC effectively promises to buy the bank’s bad assets at price if the value
drops below B. This protects the bank’s shareholders from negative liability, encouraging risk.

C. The Pricing Discrepancy

• Fair Premium: Should increase as the bank takes more risk (like car insurance costing more for
bad drivers).

• Flat Premium: Often used in practice.

◦ Result: High-risk banks underpay, while low-risk banks overpay. This subsidizes risky
behavior.

Part 4: Managing Risk – Taiwan’s Regulatory Evolution

To combat moral hazard and procyclicality, Taiwan has evolved its regulatory framework.

A. Evolution of Participation

• Pre-1999: Voluntary participation (some banks opted out, leaving depositors vulnerable).

• 1999: Amended to Compulsory insurance to ensure total coverage.

• 2007: Shifted to a strict Application and Approval system to control the quality of insured
institutions.
B. Differential Premium System
Instead of a flat rate, Taiwan now uses a differentiated rate to penalize risky banks. Premiums are
calculated based on a matrix of two factors:

1. Capital Adequacy Ratio (CAR): Is the bank well-capitalized?

2. Risk-Based Rating (CAMELS): A composite score measuring:

◦ Capital Adequacy

◦ Asset Quality

◦ Management
◦ Earnings

◦ Liquidity
◦ Sensitivity to Market Risk

• The Grid: Banks are categorized - the worse the CAR and CAMELS score, the higher the
premium rate.

C. Other Regulatory Tools

• Prompt Corrective Action (PCA): Regulators intervene early (e.g., restricting asset growth)
before a bank completely fails.

• Financial Examination: rigorous auditing to ensure data accuracy.

• Financial Restructuring Fund: Established in 2001 to handle systemic failures. It allowed for
the takeover of institutions with negative net worth to stabilize financial order and ensure "non-
disruption of financial services".

Analogy for Understanding

To solidify the “Deposit Insurance as a Put Option” concept:

Imagine a trapeze artist (The Bank) performing for an audience (The Depositors).

• The Net below is Deposit Insurance.

• If the artist performs safely and lands on the platform (V>B), they keep their salary (profit).

• If they try a dangerous triple-flip and fall (V<B), the net catches them. The audience (Depositors)
still gets a good show and doesn't see the artist go "splat."

• The Moral Hazard: Because the net is there, the artist might try dangerous tricks they wouldn't
dare attempt without it.
• Differential Premiums: To stop this, the circus owner (CDIC) charges the artist a fee to use the
net. If the artist is known for being reckless (Low CAMELS rating), the owner charges them a
massive fee to use the net, discouraging them from being too wild.