Banks provide core banking services, hold a banking license and are subject to regulatory supervision by a banking regulator

Deposit collection: accepting cash or money (deposits) from individuals and businesses (depositors) for safekeeping in bank account, available for future use. Current/Checking accounts (Bank must honor withdrawal anytime. Interest not allowed) Certificate of Deposit (CD)/Negotiable CD(NCD) (Can sell like ST bond) Fixed Deposit (FD) (Pre-mature withdrawal has interest penalties) Savings accounts (1 day maturity. Most stable and longest duration) Payment services: accepting and making payments on behalf of customers using their bank accounts Debit cards Electronic banking FX Checking accounts Loan underwriting: evaluating and deciding whether customer (borrower) eligible to receive loan/credit and then extending loan/credit. Commercial and industrial loans Consumer loans Real estate/mortgage loans Credit cards Banks in the economy [Purpose of banks] Financial intermediation: channel savings from depositors to borrowers Traditional banking is bond. When making loan, bank is buying bond (interest is paid by borrower) Asset transformation: create loans (assets) from deposits (liabilities) Asset transformation is very subtle activity Buy Bonds/Loan: Small investor cant deal with uncertainty of heterogeneous maturity/mixed denomination/ customised terms, banks can due to scale. Sell Bonds/Deposit: Banks cannot customise as many of their clients are atomistic (many separate entities) Money creation: Done through financial intermediation and Asset transformation A vital role of banking. Calibrated through reserve requirements (inverse of money multiplier) I/R on loans > I/R paid on deposits. Since deposits can be withdrawn any time, must balance goal of higher revenues with need for cash on hand reserve fraction of deposit funds This process allows bank to create money by repeatedly lending original deposit to bank 10% reserve requirement = money multiplier of 10. $ created from $100 deposit is $1,000 of which $900 is new $ and $100 is original deposit. Money creation is done through credit. Creating virtual money, not printing actual money. For policy makers (eg. QE3), easy way of killing this is if Universal Bank does not lend the $100. so money in entire banking system is zero.

QE is where buy LT bond and pump in cash into banking system. Problem is whether banks use money domestically or spend overseas. Deposit reserve requirement is monetary policy tool. A lever used to control money creation. But same issue that need bank to be supportive and willing to lend. Currently stabilise at 3% and little volatility. Fiscal policy where govt spends money (eg. Infra projects). But issue is money still goes through banking system and same problem. Why such attention on banking system in economic recovery planning M1 is real money, M2 is the new money created, etc. Systemic risk: when all deposits are to be withdrawn at same time. Liquidity risk management. Other banking services Cash management: bank handles cash collection and payment for coy and invest any temporary cash surplus. Investment and securities related activities: Providing investment products with higher returns than deposits; Brokerage svc as buy and sell securities on behalf of customers; IB svc as advise corp customers on M&A, etc. Derivative trading Bank as market maker Entity that stands ready to buy and sell. Initially, banks started to facilitate trades but now doing proprietary trading. Derivatives are frightening as they are easily created but yet have wide impact (hence, creation of volcker rule) Loan commitments: Bank receive flat fee to extend funds for period of time whether full amount drawn down or not. Used portion recorded on B/S, unused portion remains off B/S Similar to put option where bank is option writer. But options always have value when valid, so bank should charge. Letters of credit: Guarantees payment on behalf of customer and receive fee Where internationally-reputed bank acts as guarantor and sends LC to goods delivering-partys bank. Prefer to send LC to banks for back office validation as there is high fradulent rates. Typically, LC is 90 days. Goods delivering party can sell the LC at a discount to its bank in return for funds: Bankers acceptance/guarantee (derived from when banks stamped accepted on olden day physical LCs). This converts LC into negotiable instruments. However, if bank is short of funds, will re-discount to other banks. When market very active, same LC can be re-discounted 5 times, called trade bill and becomes like commercial paper. Insurance Trust services: Professionally manage customers asset for fee. (assets do not show up on banks B/S) Risk management service: offer risk management skills & tools experience to customers

Types of Banks Retail banks

Retail and consumer banks, S&Ls (thrifts, building societies) and credit unions primarily offer loans to individuals Private banking firms provide wealth mgt svc to rich individuals Postal banks offer banking svc to customers in post offices Wholesale banks Commercial banks offer loans to large biz, intermediary in fund raise, provide financial services Correspondent banks offer banking svc to other banks Investment / Merchant banks Universal Banks Banks that offer financial services (insurance) along with core banking functions Central banks Bank for International Settlements [Link] central bank of central banks

Banking Risks Regulatory reserve capital or minimum capital requirement the key approach to preventing insolvency arising from risks Banks have large amount of funds with social implication Deposits. Hence, regulators decide to focus on capital. 3 types of risk under Basel II (New Basel Accord) Credit risk Potential loss if borrower (counterparty) fails to meet its obligations according to agreed terms. Single largest risk most banks face Aggregate credit risk of assets in banking book Banking book : portfolio of assets (primarily loans) that bank holds, does not actively trade, and expected to hold until maturity when loan repaid fully. Banking starts with premise that borrowers are unlikely to default. Defaulters are exception, rather than rule. Historically, Credit Risk is ex-post. Lend and then manage account. But this means that assuming risk-free investment into bond purchase. Treasuries are only proxies to risk-free (Print $ to repay). No real riskfree. Market risk Loss arising from movements in market price as result of change in I/R, FX and equity and commodity prices. Focus on trading book (portfolio of financial assets held by bank to facilitate trading for customers or own account or hedge against risks). Usually made available for sale. Interest rate risk loss due to I/R movements. Arise as bank assets (loans and bonds) usually longer maturity than bank liabilities (deposits). If I/R rise, value of LT asset fall more than ST liabilities, reducing bank equity. If I/R rise, bank forced to pay higher I/R on deposits before LT loans mature and can replace with higher I/R loans. Equity risk loss due to adverse change in stock price FX risk loss due to adverse exchange rate fluctuations

Commodity risk loss due to adverse change in commodity price Operational risk Loss resulting from inadequate or failed internal processes, people, systems and external events. Least understood and most challenging to measure, manage and monitor. Includes legal risk Excludes strategic and reputational risk Other risk types Liquidity risk loss due to inability to meet continuing obligations Business risk loss due to loss in competitive position Reputational risk loss resulting from decrease in standing in public opinion

International Regulation for Bank Risks Bank for International Settlements (BIS) Established in Basel, Switzerland in 1930 Principal centre of international central bank cooperation Forum to promote discussion and policy analysis among central banks Centre for economic and monetary research Prime counterparty for central bank financial transactions Agent / trustee for international financial operations Basel Committee formed after Herstatt Bank closure in 1974 (causing international FX settlement problems) Forum for regulatory cooperation on banking supervision related matters Not a global supervisory authority Develops guidelines for banks and regulators Recommends statements of best practice Encourages development of common regulatory and supervisory approaches to internationally active banks Close gaps in international supervisory coverage based on two basic principles Every international banks should be subject to supervision Supervision should be substantial enough to ensure compliance Basel I Level playing field by standardising national capital requirements ROE = NI/E = (NI/A) x (A/E) = ROA x Equity Multiplier Typical bank ROA is 1% (Very low efficiency business) Japanese understood this concept and zaibatsu/keiretsu operated with bank at the core. EM of 100 (For every $100 of asset, only $1 is equity belonging to shareholder) Major concern for US when Jap banks entered market. Hence, became motivation for Basel Accord: Capital Asset Ratio (CAR) of >=8%; Riskbased Asset (same as Risk Weighted Asset) Introduction of risk-weighted assets (RWA) : assess risks across all asstes Banks have to calculate total RWAs including that of off-balance sheet (OBS) items Minimum regulatory capital requirements against RWAs Tier 1 core capital primarily banks equity

Tier 2 supplementary capital reserves, provisions, hybrid capital instruments 50% of total regulatory capital First international attempt to link risks to banks equity by setting 8% min cap requirement/ratio (ratio of RWA to regulatory capital) Regulatory Capital = Tier 1 + Tier 2 adjustments Capital adequacy achieved when capital ratio >= min cap standard Market Risk Amendment Banks became broad-based providers of financial service and trading activities began playing more sig role. Focus on banks positions in traded financial assets i.e. FX, bonds, equities, commodities and derivatives Banks allowed to use own system to measure market risk subject to supervisory approval, and capital required to cover market risk based on model effectiveness. Specifically, allowed VaR models. Weaknesses of Basel I Too simplistic to address complex bank activities Encouraged banks to lend to higher credit risks corporates since risk weights same for all Basel 1 produced regulatory arbitrage. Gains are privatised, losses are socialised In bank, shareholders enjoy while depositors suffer. Hence, banks have incentive to go for high risk projects which give high returns. No recognition of credit risk mitigation which help to lower credit risk associated with loans e.g. credit insurance Credit risk mitigation: (1) collateral (2) insurance/guarantee (3)OffSetting/diversification No recognition of diversification benefits (eg. Diverse customer groups) Basel I is one-size-fits-all. No incentive to peg investment to risk. Basel II Connect capital requirements more closely with actual risks incurred Broaden risks considerations when calculating min cap requirements Exposure Risk: Obligor Risk (Obligor Risk Rating) Temasek vs Venture Start-up [Probability of Default (PD) or Mortality Rate. PD is forward looking, MR is backward looking. PD>0] Facility Risk (Facility Risk Rating) What is the asset (eg. Hous ing for rent or stay?) [LGD = 1- Recovery Rate] Size Risk How much is loan [EAD which goes beyond amount on books] Accommodate differing complexities in operations and business Provide incentives for sophisticated internal risk management systems Reduce non-systemic risk in banking system Provide supervisors with enhanced powers to redress weaknesses in individual banks 3 Pillars Pillar 1 Minimum capital requirements Improve standardised rules established in Basel I

Should reflect 3 major types of risks i.e. Credit, Market and Operational risks Different alternatives of varying complexity to calculate minimum regulatory capital required First attempt to assign regulatory capital to operational risk Pillar 2 Supervisory process Calculation of economic capital (EC), amount of capital firm require to survive during time of distress to cover Pillar 1 risks Governance structure with Board of Directors (BoD) and senior management oversight Evaluation of banks own assessment of risk profile and processes Pillar 3 Market discipline Public disclosure of banks condition to depositors and other interested parties Use transparency to encourage sound banking practices 2 overarching objectives Improve connection between regulatory capital to underlying risks Address financial innovation effects Adopting Basel II Country adopting Basel II must adjust its own laws and regulations to incorporate requirements Implemented across EU countries Committee of European Banking Supervisors (CEBS) created to ensure Basel II uniformly interpreted, applied and implemented in all 25 member states 115 countries chose to implement Basel II National bank regulators allowed to customise certain Basel II definitions, approaches or thresholds The value of collateral differs from countries. Eg. In the US, cars and houses are viewed to have zero or low collateral value. This is not the case for SG and other countries. Hence, it is up to their discretion. Deposit insurance coverage: promise by govt/insurance system that in event of bank failure, depositors will receive deposits made with banks. Aim to reduce bank run, bank panic and contagion. Historically voluntary and offered by insurance companies, banks and governments. Insured banks should enjoy lower funding cost. Not popular and many voluntary systems failed as insurers insufficient to repay when widespread bank failure. US Federal Deposit Insurance Corporation (FDIC) set up after 1933 Great Depression. Subject to certain limits, constraints and caps. FDIC model copied by many countries Deposit insurance around the world Explicit deposit insurance system where agency appointed to guarantee deposits Implicit deposit insurance system where no specific agency but government stated willingness to guarantee deposits when needed Bank regulatory capital

Methods for calculating capital Credit risk : RWA Standardised Approach (SA) Foundation Internal Ratings Based Approach (FIRB) Advanced Internal Ratings Base Approach (AIRB) Market risk: Mkt risk capital charge Standardised Approach (SA) Internal Models Approach (IMA) Operational risk: Op risk capital charge Basic indicator approach (BIA) Standardized approach (SA) Advanced measurement approach (AMA) For each risk, there are 2 to 3 levels (eg. SA is entry level for credit and market risk)RWA(Market Risk) = 12.5 x MR; RWA(Op Risk) = 12.5 x OR; RWA(Credit Risk) added with RWA(MR) and RWA(OR) = RWA(Total) Regulatory capital : min capital that regulators require bank to maintain Tier 1 (core) capital Shareholders equity (amt of capital after subtract liabilities from assets) Innovative capital (complex financial instruments with equity and debt features) under strict rules Adjusted interim annual profits can be added if auditors allow so as to support new biz w/o raising capital Tier 2 capital: Undisclosed reserves (eg. Revaluation reserves) Subordinated debt (debt issued by bank that rank lower on repayment scale than depositors in event of bank default). Reserve for loan losses up to a limit Must not exceed Tier 1 capital Tier 3 capital Wide variety of subordinated debt including profit from trading activities. Applied only to market risk in trading book. Deductions and adjustments to be removed from capital calculation Goodwill Investment in subsidiaries engaged in banking and similar activities Shares held by bank in another bank 3 pillars of Basel II Pillar 1 Minimum capital requirement RWATotal = RWACredit + 12.5(CapReqMarket + CROperational) Regulatory Capital = Tier 1 + Tier 2 + Tier 3 - Deductions Min capital requirement: RC / RWATotal 8% Additional requirements (Tier 1 + Tier 2) eligible for credit risk 8% * RWA (Tier 1 + Tier 2 + Tier 3) eligible for market risk CRMarket Reality of capital requirement for credit risk RWA = 12.5 * K

K = [LGD x N[(1 - R)-0.5 x G(PD) + (R / (1 R)0.5 x G(0.999)] PD x LGD] x (1 1.5 x b)-1 x (1 + (M 2.5) x b) RCCredit = 0.08 * 12.5 * K (assuming EAD = 1) = K => CRTotal = RCCredit + RCMarket + RCOperational independent of 8% => CAR is no longer 8% as under Basel I Under Basel I, Risk-Based Asset (Risk Weighted Asset) (Eg. 20) = Credit Exposure (eg. 100) x Risk Weight (0.2). Capital Requirement (CR) = 8%. Regulatory Capital (RC) = RWA(20) x 0.08 = 1.6. Hence, Bank can hold 0.8 of Tier 1 and 0.8 of Tier 2. Market Exposure has no risk weight. Assume exposure of 50, multiplied by 8% CR to give RC of 40. Working backwards, RWA is 40 div 12.5 = 50. Basel II states that amount of capital bank needs to keep will be 99.9% confidence level (EL is not enough as it means 50% chance of insolvent. Max not feasible as it can be very large sum). Catastrophic Loss (CL) or Worst Case Loss (WCL) 99.9% Unexpected Loss = CL Expected Loss (EL) EL = PD * LGD * No. of exposure * value per exposure Under Basel II, banks to cover EL (Tier 1) by loss reserve. UL covered by Reg Cap (which is equal to ECap). Tier 2 covered by excess of reserve after EL. Let UL = K = ECap, Define: RWA = 12.5 x K RegCap = 0.08 x RWA = 0.08 x 12.5 x K = K In this case, 8% becomes totally irrelevant, fictatious. R = correlation between defaults (usually 12-24%); M is effective maturity; G is cumulative normal; N is normal distribution; b is firm size (to be confirmed) K formula is based on single unit (eg. % loss), not $ unit Pillar 2 Supervisory review process Beyond Pillar, covers 3 areas outside of Pillar 1 scope Risk not fully covered in Pillar 1 e.g. concentration risk Risk not considered in Pillar 1 e.g. banking book interest rate risk (will be covered separately under Basel II) Factors external to bank e.g. business cycle effects Bank management responsible for internal capital adequacy assessment process (ICAAP) Supervisor assesses quality of ICAAP Supervisor can raise capital but also require other measures Set targets for improvement in risk management structure Introduce tighter internal procedures and improve staff quality through training and recruitment Curtail business activity and risk level (in extreme case) 4 key principles of supervisory review Principle 1 Banks should have a process to assess their overall capital adequacy in relation to their risk profile as well as a strategy to maintain their capital levels

Board and senior management oversight Sound capital assessment : target cap ratio should be related to banks strategic biz plan and should have transparent link between risk and capital Comprehensive assessment of risk Monitoring and reporting Internal control review Principle 2 Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of the process On and off site reviews Meetings with bank management Review work of external auditors Monitor periodic reports Review should cover Calculation of risk exposures and translation into capital requirement Quality of process and internal controls around process Capital composition appropriate for scale of business Monitoring and review of ICAAP by bank Targets are appropriate for operating environment Extreme and unexpected events taken into account for capital targets Deficiencies in ICAAP framework Principle 3 Supervisors should expect banks to operate above the minimum regulatory capital ratios, and they should be able to require banks to hold capital in excess of the minimum Banks expected to maintain buffer above minimum capital requirement due to Risks / business activities not covered by Pillar 1 Bank specific conditions requiring additional capital Local market conditions Desire for higher credit rating Avoid need to raise capital quickly if market conditions change Principle 4 Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored Dividend suspension Raising additional capital Specific issues to address during supervisory review

Banking book interest rate risk : potential loss in lending and deposit activities due to change in I/R. discretion with bank supervisors on mandatory capital requirement. Stress testing under Internal Ratings-Based (IRB) : must have suff capital to cover IRBs requirement and any deficiencies identified in credit risk stress tests carried out Definition of default when either/both events occur: Obligor unlikely to repay its credit obligation in full without recourse by the bank to actions such as taking formal possession of any collateral > 90 day delinquency Definition of default is difficult. 90 day delinquency is technical default, however, even that number is debatable. Cured Days of Deliquency starts counting from day of non-payment. At 90, becomes default. If before 90, able to pay back, then the loan is cured where DD is reset to zero (re-aged) Credit risk is risk of obligor not fulfilling obligation. Implication goes beyond not paying, there is TMV loss too. So if owe $20 and pays $5, still losing TMV on $15. Still delinquent. However, difficult for many banks to implement. Residual risk Pillar 1 allow banks to mitigate credit exposure by collateral, guarantees or credit derivatives assuming perfect execution. However, residual risk can could greater exposure than originally recorded. Credit concentration risk Significant exposures to single counterparty Exposures to counterparties in same economic region or location Exposures to counterparties dependent on same business activity or commodity Indirect exposure to credit mitigation methods e.g. single type of collateral Operational risk Use of gross income under BIA and SA to reflect op risk may underestimate risk. Supervisor should examine biz and compare with similar banks Securitisation Banks remove (sells) and transfers credit risk to investors. Brings capital relief. Should check how completely securitization has transferred risk. Accountability and international cooperation

Pillar 3 Market discipline Disclosure focuses on capital information. Dissemination of material info that allows proper evaluation of banks biz. Capital structure Risk exposures Capital adequacy Possible exceptions to 6-monthly disclosures Small banks with stable risk profiles can make yearly disclosure Global banks must publish information quarterly on Tier 1, total cap adequacy ratio and ratios components Qualitative disclosure of principles and procedures of assessment on annual basis Regulatory reports separate from annual report and financial statements if possible Quantitative and qualitative disclosures cover Bank, group and subsidiary structure: consolidated Capital structure Tier 1, Tier 2 and Tier 3 capital Deductions from capital Total regulatory capital Capital adequacy How assess cap adequacy and cap requirements for 3 risks, total capital and Tier 1 capital ratio Risk exposure and assessment disclosures Qualitative Risk management objectives and policies RM structure and organisation Use of hedging and risk mitigation strategies Quantitative Credit risk Gross and average exposure by major products Geographic, industry and maturity distribution by major products Loans, provisions and write-offs by industry, counterparty and geographic region Market risk Capital requirement by 4 main types of general market risk ie interest rate, equity, FX and commodity risks High, average and low VAR values during reporting period and reliability of estimations I/R risk on banking book Qualitative assessment of models used (assumptions on prepayments and withdrawal of deposits)

Effects I/R changes have on earnings or value of bank

Beyond regulatory capital Economic capital: capital level bank must maintain to withstand large but unlikely losses to survive in long term. Measures potential but unexpected losses to be covered by cap. Calculating EC Estimate prob distribution of credit losses for particular period Obtain expected loss (average loss over next period) Find unexpected loss at confidential interval 99.97% where losses =< amount. Economic Capital = Unexp Loss Exp Loss Under Basel II, ECap is ultimate objective (confidence). Hence, a shift from RegCap to ECap 1-year loan = 10,000 at interest rate r T-bill rate = 4% PD = 2% with zero recovery(LGD100%) in event of default Expected payoff = 0.98[10,000(1+r)] + 0.02(0) = 10,400 if bank is risk-neutral to loan payoff and investment in T-Bill r = 6.12% (compensation for risk of default) At 6.12%, with 100 independent loans, expected loss is ($200*100) $20,000, which corresponds to 32.33% c.i. To ensure capital exceeds loss level 99.97%, must cover at least 8 defaults (99.98%) which is $80,000 (each loan is $10,000). EC = $80-20 = $60L EL of 200 reflected in pricing Risk-neutral Assumption: No preference between 100% possibility and less than 100% choices. Given perfect competition, generally assume that expected return is equal to risk-free rate (note: NOT that r = risk-free rate) Formula includes expected loss of (0.02*0) which results in required r greater than 4% risk-free rate. If thats so, why need loss reserves? Economic approach says UL becomes ECap (not whole CL) because EL is taken care of through the pricing. Regulatory approach says EL is covered by loss reserves Risk-adjusted performance measure: use EC to support capital allocation and evaluate profitability consistently across biz lines. Risk-adjusted return on capital (RAROC) : (Profit EC*r) / EC where r is risk-free rate. Higher is better. Return on risk-adjusted capital (RORAC): Profit / (EL + UL) (EL + UL = Capital at risk) Risk-adjusted return on risk-adjusted capital (RARORAC) Risk-adjusted Perf Started by bankers trust. Higher risk comes with higher return. Hence, if focus only on nominal return, will always take riskier transaction. Want to adjust for risk, however, dont have sigma on firm level. Hence, come up with the idea of confidence level by pegging credit risk to bond rating. Lower rating = higher volatility. From concept of bond: when volatility go up, premiums (i/r) go up, value of bond will go down. Pioneered concept of ECap to absorb potential economic loss

Traditionally, RAROC does not deal with defaults (assume no defaults), only focus on change in risk premiums (volatility) Now, can set EC as K to account for defaults where will need PD to obtain K.

Basel III Comprehensive set of reforms measures to strengthen regulation, supervision and risk management of banking sector Aims Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source Improve risk management and governance Strengthen banks' transparency and disclosures Reform targets Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress Macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time Tier 1 capital Basel II Tier 1 4% Core Tier 1 2% Basel III Tier 1 6% Core Tier 1 4.5% (Common Equity after deductions) 3.5% by 1/1/13 4.0% by 1/1/14 4.5% by 1/1/15 Capital Conservation Buffer (for stress conditions) Basel II (n.a.) Basel III 2.5% 0.625% by 1/1/16 1.25% by 1/1/17 1.875% by 1/1/18 2.5% by 1/1/19 Countercyclical Capital Buffer Basel II (n.a.) Basel III 0% - 2.5% Common equity or fully loss absorbing capital Banks will less than 2.5% face restrictions in dividends, share buybacks and bonuses Same escalation timeline as Capital Conservation Buffer Capital for Systematically Important Banks Basel II (n.a.)

Basel III More capital than standards announced Total regulatory capital required = Tier 1 + Capital Conservation Buffer + Countercyclical Capital Buffer + [Capital for Systematically Important Banks] Conversion / write-off Mechanism where subordinate debtholders will suffer loss if bank is close to insolvency or has to be rescued Known as bail-in Deductions from capital Including deferred taxes, minority interests, goodwill and other intangibles Have to be from Tier 1 only (formerly from both Tier 1 and Tier 2) Increasing by 20% from 2015 to 2018 Risk weightings stressed counterparty risk capital charge (based on stressed inputs) Capital charge for credit value adjustment risk (risk associated with deterioration in a counterpartys creditworthiness); Capital charge for specific wrong way risk (where exposure to a counterparty is positively correlated with the probability of default of that counterparty) Wrong Way Risk Insurance company is highly correlated to the event (not necessarily the insurer). Eg. Insurance company based in Lousiana and Hurricane hits that, will also affect Singapore consumer. Banks need to prove that absence of positve correlation (stress correlation). Incentives to use central counterparties to clear over-the-counter (OTC) derivatives Interconnectedness multiplier of 1.5% will also be applied to exposures to large regulated firms (with assets of at least US$100bn) and all non-regulated firms Tougher collateral, valuation, margining and stress-testing requirements Leverage ratio Banks capital to its total exposures 3% of common equity Parallel run period from 2013 to 2017 Leverage ratio regression from weighted exposures (ie. $100 invested into Apple is different from $100 invested into Zimbabwe) to total exposures Credit Risk What is credit risk Potential of borrower / counterparty failing to meet obligations according to agree terms Not limited to not repaying Default is failure to repay or meet existing obligations Counterparty risk is contracting party failing to perform under terms of agreement Credit rating agencies Evaluate creditworthiness of borrowers AAA / Aaa highest rating Investment grade AAA to BBB Noninvestment (junk) grade below BBB

Risk is always about relative. Higher rating indicates lower MR. key is to maintain the order. Characteristics of credit products Maturity: date the final payment on loan or other financial instrument becomes due. Short term Less than 12 months Temporary or seasonal financing needs Medium-term 1 to 5 years Ongoing financing and cyclical needs Long term More than 5 years Capital projects Cash produced primary source of repayment Commitment specification Committed facilities: earn margin above own cost of funds and include facility, commitment and fee for amount of loan extended Formal loan agreement Amount not used termed undrawn commitment Cost of funds reflects prevailing i/r in market, banks own cost to secure funds to be lent, margin to cover costs of asset transformation Facility fee for creation of facility Commitment fee for commitment to making credit available Uncommitted facilities Less formal arrangement Funds available on demand but solely on lenders discretion Usually short term in nature e.g. overdraft Cheaper than committed facility E.g. Bankers Acceptance and line of credit Compensating balance (non interest bearing account) may be required as collateral require borrower to deposit money with lending bank for duration of loan commitment. Purpose Normal business needs Finance inventory Purchase equipment Production process Working capital requirements Strategic opportunity May cause credit quality decline Riskier purposes Buy back stock Leveraged buyout Pay dividend Other shareholder friendly activities

Repayment source Asset conversion loans (self-liquidating loans) Repayment by conversion of collateral to cash Inventory financing Agricultural loans Cash flow based loans Repayment from borrowers operations Collateral requirements Asset pledged by borrower to secure loan Cash, property etc Loan to value (LTV) ratio which is loan divided by collateral value usually 75% 80%. Higher LTV gives borrower more incentive to walk away. Covenant requirements One-way Commitment by borrower to honor obligation Control mechanism to restrict borrowers ability to repay Possible additional features Dividend payment cap Management compensation Ability to dispose of certain assets Requirement to purchase particular assets Repayment characteristics Fixed rate interest rate does not change Floating rate interest rate tied to based / reference rate Sinking fund amortization predetermined amount of principal and well as interest repaid each time Level amortisation Balloon payment large payment at maturity Types of credit products Agricultural loans For farming and other agricultural needs Asset-based or revolving facility Asset-based or secured lending Lending specifically against borrowers assets e.g. stock, stock-in-trade, items for sale, receivables Repayment out of operational cash flow Automobile loan Direct automobile loan loan to car buyer Indirect automobile loan loan through automobile dealer Main retail loan products Commercial paper (CP) Short term unsecured note Generally issued by large and sound companies Considered low risk investment Factoring

Specialist FI or bank to help company meet cash requirements and reduce potential credit losses. Coy better able to manage assets (cash position) but will not receive full amount due as FI/Bank takes haircut (% of assets). Maturity factoring Takeover of AR, collect payment and receive commission for what is collected Finance factoring Funds advanced to company with goods / services funded as collateral Discount factoring Percentage of AR ( usually 85%) advanced with full responsibility for collection thereafter Undisclosed factoring Company itself appointed as collecting agent under discount factoring => outsiders not aware of factoring arrangement Home equity credit lines and loans Credit line revolving line of credit collateralised by borrowers property Loan pays up front maximum allowable according to home value and existing mortgages Leasing Lessee (individual or firm) has right to use asset it does not own Lessor (asset owner) receives regular payment May include option for lessee to acquire asset at end of lease Mortgages Borrowing to purchase real estate asset with asset as collateral Commercial mortgage for office buildings, factories etc. Residential mortgage for houses and apartments Overdraft facilities Borrowing in excess of checking account deposit. Expensive financing option as I/R significantly higher. Bank generally has no control over how long and for what purpose funds are used => greater credit risk Project or infrastructure finance For long term infrastructure and industrial projects Usually involve more than one lender Repayment usually from funds generated by project Revolving lines of credit Generally for businesses with temporary or seasonal needs Credit card and home equity line of credit e.g. of retail form Syndicated loans Loan provided by consortium Allows small banks to participate in large loans Reduce overall credit exposure for consortium members

Loan Losses & Loan Loss Reserves Interaction between loan loss and loss reserve Banks dont have to set aside loss provision as over time, losses even out. However, they do so in the spirit of conservatism.

Loan loss reserves built over years should be suff to off-set future charge-offs. When write down or charge off loan, loan loss reserves reduced first. Since provision for loan loss has previously reduced income & equity, no immediate impact on assets and equity. recoveries added back to reserves. Loss Reserve (Cumulative Allowance) It is he remainder after write-off (defaults) are paid out from loss provision. A large loss reserve does not mean bank is doing worse. Reason being that it depends on the loss provision the bank sets aside and how much is written off. Beginning balance for loan loss reserves = 10m + provision for loan losses (P/L) = 2m Ending balance for loan loss reserve = 12m Increase in loan loss reserve > more losses + specific reserve for Mega Construction loan (P/L) = 1m - write-down of Mega Construction loan = 1m Ending balance for loan loss reserve = 12m - charge-off of Mega Construction loan = 4m Ending balance for loan loss reserve = 8m => decrease in loan loss reserve can be due to real losses (charge-offs) + recovery on Mega Construction loan = 2m Ending balance for loan loss reserve = 10m Charge-Off : needs permission from Central Bank. Ie. Taken out from books. These are real losses. Also, when recovery, doesnt add to profit, but goes back to loss reserve. For Banks, losses show up not in P/L but in B/S. Even in B/S, cant really see how the changes occur. Loan losses always pass through B/S

Market Risk Market risk General or systematic market risk Across the board adverse movement in market prices Specific risk Adverse impact on price of individual asset Basics of financial instruments Currencies Foreign exchange (FX) rate reflect value of one currency relative to another Currency regime is government management of its currency relative to others Fixed income instruments Most common are loans and bonds Coupon rate or nominal rate is interest rate on principal or face value Rate may be fixed or floating Value of bond is determined by Interest rate of risk-free fixed income instrument Creditworthiness of borrower Time to maturity (more correctly duration)

Link between interest rates and maturity is called Term Structure of Interest Rates producing Yield Curve (refer to figure 6.4) Yield Curve rate known as Spot Rate Preferred Stock another type of common fixed income instrument Interbank loans Banks lending to each other Usually based on benchmark like London Interbank Offer Rate (LIBOR) or Singapore Interbank Offer Rate (SIBOR) Interbank rate [unsecured and usually through brokers] Repurchase Order (REPO), Reverse REPO [Collateralised, Secured. 3rd option to more costly interbank or securitisation. Sell securities with promise to buy back in specified time period] Transaction usually done between exchange-clearing banks (can clear cheques). Title of securities is transferred electronically but any payments on the security goes back to borrower. Lender earns implicit interest on buy-back price. International Swaps & Derivatives Association (ISDA) Master Agreements between banks. Equities Shares or stock Residual claim instrument Commodities Homogeneous product irrespective of geography or physical market Price determined by demand and supply Derivatives Value determined by value of underlying commodity traded Forward nontransferable contract defining asset, price, quantity and future date (fixed period from transaction date e.g. 1 month, 3 month) for settlement Futures standardised and transferable contract defining asset, price, quantity and future date (fixed date in future e.g. 3rd Thursday of contract month) for settlement Options right but not the obligation to buy / sell (Call / Put) at specified time (specific future date or period) and price (termed strike or exercise price) European option exercise only on maturity day American option exercise anytime between activation and maturity dates Payoffs (refer to figures 6.5 and 6.6) Swap : fixed for floating

Trading Fundamental trading positions Long bought the instrument and will benefit from price rise Short sold the instrument and will benefit from price fall Speculation Trading with aim to profit from price fluctuation Distinguished from hedging Bid-ask spread

Bid best price offered to buy Ask best price offered to sell Indicator of market liquidity. Narrower the spread, higher liquidity market has. Liquidity Ability to enter or reverse position without significant price effects Exchange and Over-the-Counter (OTC) markets Exchange Centralised marketplace where brokers and traders meet Standardised financial instruments Requirements imposed by exchange regulator Historically involve trading floors Trading information usually displayed publicly Has clearinghouse or central counterparty affiliated to exchange Clearinghouse requires members to post margin Margins Initial margin percentage of trade deposited as collateral e.g. 40% Variation margin adjustment to margin using marking-to-market Maintenance margin percentage of exposure triggering margin call Margin call notice to post more collateral (usually to bring back to initial margin) OTC No physical location or marketplace Direct transaction between long and short positions Trade through phone or computer networks Contracts and collateral usually not standardised Distinction between exchange and OTC (refer to figure 6.10) Market risk measurement and management Types of market risk FX risk loss due to adverse change in FX rates Interest rate risk loss due to adverse change in interest rates Equity risk loss due to adverse change in price of stocks. Commodity risk loss due to adverse change in commodity prices Value-at-risk (VAR) Potential loss at (or up to) a specific confidence level e.g. 99% Usually applied at portfolio level Graphical interpretation (refer to figure 6.11) Some shortcomings Measured with estimation error Does not consider loss beyond confidence level (bad tail distribution) EVT Not for worst case scenario but worst case up to confidence level EVT Extreme Value Theory When plot normal distribution, it is always smooth even down to the tailends (rep losses). Var stops at the 1% tail-end.

Another school of thought highlight need to look at extreme values, high frequency and high severity events (EVT) which are not necessarily smooth. Probability over threshold (POT) is empirical model of EVT. Stress testing and scenario analysis What-if under extreme conditions e.g. natural disaster, war etc. Now essential part of risk management Hedging Position to reduce or cancel out a risk Opposite of speculation Simple e.g. Long position can be hedged with Put Short position can be hedged with Call

Operational Risk Operational risk events Basel II considers 5 categories Internal process risk e.g. processes, procedures and control environment Lack of controls e.g. failure to audit recorded transactions Marketing errors e.g. feature offered not included Money laundering e.g. concealing source and target of funds flowing through bank Documentation or reporting e.g. inaccurate or insufficient Transaction error e.g. adding extra zeros Internal fraud e.g. transaction by employee at expense of customers and bank People risk e.g. employee error, fraud High staff turnover e.g. frequent hire and fire and placing of staff untrained for position Poor management practices e.g. unclear reporting structures, functions, conflicting practices and policies Poor staff training e.g. new hire put into position immediately Overreliance on key staff e.g. burnout of overworked staff Systems risk e.g. computer, technology, business continuity planning (BCP) Data corruption e.g. power failure during processing Inadequate project control e.g. deficient risk reporting due to inadequate planning Programming errors e.g. wrong criteria Overreliance on black box e.g. assumption that vendor algorithms / models are certainly correct Service interruption e.g. power failure System security weakness e.g. virus, hacking, System suitability e.g. crashes, incompatibility Business resumption planning needed External risk e.g. terrorist attack, natural disasters Events at other banks which impact banks countrywide

External fraud and theft Terrorist attacks Transport, communication interruption Legal risk e.g. uncertainty in rule and regulation applicability Laws passed in other regions may restrict international banking operations VaR developed on the basis of what if Low probability catastrophic (very large) loss. Requires comprehensive distribution (biggest problem now), Stress Testing (Corruption of Var). If captured comprehensive data, dont need to do stress testing. If impose, internal inconsistency as the idea of VaR is already about stress, thats why got loss. Operational Risk different from insurance as it not only looks at failed, but also inadequate. Difficulty: Can define risk but cant define the cause.

Operational loss events Usually classified by frequency and severity Risk / heat map (refer to figure 7.2) High Frequency / Low Impact (HFLI) Individually minor Collectively important enough for attention Petty fraud, process failures most common Generally managed to improve business efficiency Low Frequency / High Impact (LFHI) Difficult to model and explain Rogue trading, terrorist attack becoming key concerns Can cause insolvency Operational risk management (ORM) Steps in ORM Risk identification Risk control and self assessment (RCSA) questionnaire common approach Risk in people, processes, systems and external events Risk assessment Effectiveness of existing controls Good indication of banks risk profile and enterprise and business unit levels Highlights areas of deficiency Risk measurement Quantifying potential losses from each risk Usually involves simulation, organisation size, frequency etc. Risk mitigation and control Risk avoidance Risk assumption Risk reduction

Risk transfer (insurance) Risk monitoring and reporting Concise and timely information to managers, employees and regulator Functional structure of ORM *** Common organisational structure Central risk function all risk management (RM) in bank Business line risk function evaluation of individual business lines Business unit risk function ORM in business unit supported by central RM group Analysis and monitoring Risk analysis usually centralised at HQ or risk analysis by business unit but validated by HQ Risk monitoring at business unit Approaches Top down approach Portfolio => Business line => Business unit Usually involves allocation of operational risk capital derived at enterprise level Bottom up approach Risks assessed at business unit (RCSA) and aggregated upwards Has become the preferred in many banks Best practices Audit oversight Review of business processes by external auditors Supplement bottom up approach Critical self-assessment Checklist and questionnaires Bottom up approach Risk mapping Relates process flows, organisational units, business units to operational risk types Help understand location of operational risk Bottom up approach Causal network Map of factors that directly or indirectly cause operational risk event Complex model to estimate magnitude and distribution of losses Bottom up approach Key risk indicators (KRI) Measures change in risks over time due to risky activity Usually uses statistical methods E.g. of early warning signals Increased staff turnover Higher trading volume Increased no. of failed trades Bottom up approach

Actuarial method Frequency and severity of losses based on internal and external data and information Usually involves mathematical models Top down approach Earnings volatility Volatility of earnings analysed and assumed to be caused by operational risk events and not change in business environment Shortcoming is that improvements in ORM not recognised Top down approach

Basel II and Operational Risk Operational risk framework principles Development of ORM environment internally Risk identification, assessment, monitoring and mitigation / control Role of bank supervisors Role of disclosure Operational risk capital required to absorb operational losses 3 approaches Banks need to start with BIA. Then after assigning to the lines, then can look at SA. However, most have problem classifying as (1) many businesses cross lines (2) political issue where want to lower operational risk capital. BIA and SA are meant as stepping stones. Final is AMA. Basic Indicator Approach (BIA) Average positive gross annual income over past 3 years (any year of 0 income excluded) Capital charge (K)= 15% Simplest to comply with Unfair as regardless of size, all banks get 15% capital charge. Hence, refined to SA. Standardised Approach (SA) All activities assigned to 8 business lines Average non-negative gross annual income over past 3 years for each business line (any year of loss excluded) Capital charges as follows Corporate finance 18% Payment & settlement 18% Trading & sales 18% Agency services 15% Commercial banking 15% Asset management 12% Retail banking 12% Retail brokerage 12%

Comparing 8% for capital risk, why is operational risk so high? 8% was based on unexpected loss as expected loss covered by reserves. There is no reserves under operational risk, hence higher %. Advanced Measurement Approach (AMA) Bank uses own experience and loss history Capital charge as 99.9% UL (Unexpected Loss) Simulation of operational losses using Loss Distribution Approach (LDA) (bring laptop with MS Excel if possible) No expected loss in operational risk(not the same as EL=0). (1) unlike credit and market risk where losses largely driven by causes beyond control (eg. Obligor defaults, market price turn bad), operational risk is theoretically within control. Hence if do everything right, expected loss is zero. (2) everything else remaining constant, if focus on operational risk, loss should be getting smaller.

Liquidity Risk Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses (Basel II) Global financial crisis was not because of subprime as studies showed even if all default, small % of market. The problem was collateral, derivaives and the capital requirements choking of the banks. Basel III Liquidity Coverage Ratio (LCR) Ensure that a bank maintains an adequate level of unencumbered, high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30 calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors LCR standard (Stock of high quality liquid assets / total net cash outflows over next 30 calendar days ) 100% Stress scenario for LCR The run-off of a proportion of retail deposits A partial loss of unsecured wholesale funding capacity A partial loss of secured, short-term financing with certain collateral and counterparties Additional contractual outflows that would arise from a downgrade in the banks public credit rating by up to and including three notches, including collateral posting requirements Increases in market volatilities that impact the quality of collateral or potential future exposure of derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs Unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to its clients

The potential need for the bank to buy back debt or honour non-contractual obligations in the interest of mitigating reputational risk Characteristics of high-quality liquid assets Fundamental characteristics Low credit and market risk Ease and certainty of valuation Low correlation with risky assets Listed on a developed and recognised exchange market Market-related characteristics Active and sizable market Presence of committed market makers Low market concentration Flight to quality Operational requirements for high quality liquid assets Must be unencumbered Not co-mingled with or used as hedge on trading positions, designated as collateral or credit enhancements Under control of specific liquidity risk management function Level 2 high quality liquid assets 40% of total (Level 1 + Level 2) Level 1 assets Cash Central bank reserves (can be drawn under stress) Marketable securities that are claims on sovereign, central banks, nongovernment Public Sector Enterprises (PSE), BIS, IMF, EC and multilateral banks meeting certain conditions Non-0% risk weighted host country sovereign or central bank domestic currency securities Non-0% risk weighted host country sovereign or central bank FX currency securities needed for operations Level 2 assets (15% haircut(discount) applied) 20% risk weighted marketable securities by sovereigns, central banks, nongovernment PSEs and MDBs Non FI (or affiliated) issued corporate bonds of at least AA- (or equivalent) rating Total net cash outflows Total net cash outflows over the next 30 calendar days = outflows Min {inflows; 75% of outflows} Cash outflows Retail deposit run-off Stable deposit run-off ( 5%) Less table deposit run-off ( 10%) Retail fixed term deposits 30 days with no premature withdrawal rights Unsecured wholesale funding run-off From non-natural persons Not collateralised

Not related to derivative contracts From small business customers ( 5% or 10%) With operational relationships (25%) Institutional bank network deposits (25%, with criteria) Non-financial corporates, sovereigns, central banks and PSEs (75%) Unsecured wholesale funding provided by other legal entity customers (100%) Secured funding run-off Additional requirements Derivatives payables (100%) Increased liquidity needs related to downgrade triggers embedded in financing transactions, derivatives and other contracts (100%) Increased liquidity needs related to the potential for valuation changes on posted collateral securing derivative and other transactions (20% of the value of non-Level 1 posted collateral) Loss of funding on asset-backed securities,21 covered bonds and other structured financing instruments (100%) Loss of funding on asset-backed commercial paper, conduits, securities investment vehicles and other such financing facilities Drawdowns on committed credit and liquidity facilities Draw-downs on committed credit and liquidity facilities to retail and small business customers (5%) Draw-downs on committed credit facilities to non-financial corporates, sovereigns and central banks, public sector entities and multilateral development banks (10%) Draw-downs on committed liquidity facilities to non-financial corporates, sovereigns and central banks, public sector entities, and multilateral development banks (100%) Draw-downs on committed credit and liquidity facilities to other legal entities (100%) Contractual obligations to extend funds within a 30-day period (100%) Other contingent funding obligations (Supervisory discretion) Unconditionally revocable "uncommitted" credit and liquidity facilities Guarantees Letters of credit Other trade finance instruments Non-contractual obligations such as Potential requests for debt repurchases of the bank's own debt or that of related conduits Structured products where customers anticipate ready marketability Managed funds that are marketed with the objective of maintaining a stable value Increased liquidity needs related to market valuation changes on derivative or other transactions

Other contractual cash outflows (100%) Cash inflows Contractual inflows from outstanding exposures that are fully performing and for which the bank has no reason to expect a default within the 30-day time horizon Capped at 75% of total expected cash outflows as calculated in the standard Reverse repos and securities borrowing (0% for Level 1 assets, 15% for Level 2 assets and 100% for not rolling over) Lines of credit (0%) Other inflows by counterparty Retail and small business customer inflows (50%) Other wholesale inflows From financial institution counterparties (100%) From non-financial wholesale counterparties (50%) Operational deposits (0%) Other cash inflows Derivatives receivables (100%) Other contractual cash inflows

Net Stable Funding Ratio (NSFR) To promote more medium and long-term funding of the assets and activities Structured to ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles NSFR standard (Avail amt of stable funding/ Required amt of stable funding) > 100% Available stable funding (ASF) Capital Preferred stock with maturity of equal to or greater than one year Liabilities with effective maturities of one year or greater That portion of non-maturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period in an idiosyncratic stress event The portion of wholesale funding with maturities of less than a year that is expected to stay with the institution for an extended period in an idiosyncratic stress event Availability factor 100% Tier 1 & 2 Capital Instruments Other preferred shares and capital instruments in excess of Tier 2 allowable amount having an effective maturity of one year or greater Other liabilities with an effective maturity of one year or greater Availability factor 90% Stable deposits of retail and small business customers (non-maturity or residual maturity < 1yr) Availability factor 80%

Less stable deposits of retail and small business customers (nonmaturity or residual maturity < 1yr) Availability factor 50% Wholesale funding provided by non-financial corporate customers, sovereign central banks, multilateral development banks and PSEs (nonmaturity or residual maturity < 1yr) Availability factor 0% All other liabilities and equity not included above Required stable funding (RSF) for assets and off-balance sheet exposures Assets and liabilities with a remaining maturity of less than one year Off-balance sheet exposures Required factor 0% Cash Short-term unsecured actively-traded instruments (< 1 yr) Securities with exactly offsetting reverse repo Securities with remaining maturity < 1 yr Non-renewable loans to financials with remaining maturity < 1 yr Required factor 5% Debt issued or guaranteed by sovereigns, central banks, BIS, IMF, EC, non-central government, multilateral development banks with a 0% risk weight under Basel II standardised approach Off balance sheet undrawn amount of committed credit and liquidity facilities Required factor 20% Unencumbered non-financial senior unsecured corporate bonds and covered bonds rated at least AA-, and debt that is issued by sovereigns, central banks, and PSEs with a risk-weighting of 20%; maturity 1 yr Required factor 50% Unencumbered listed equity securities or non-financial senior unsecured corporate bonds (or covered bonds) rated from A+ to A-, maturity 1 yr Gold Loans to non-financial corporate clients, sovereigns, central banks, and PSEs with a maturity < 1 yr Required factor 65% Unencumbered residential mortgages of any maturity and other unencumbered loans, excluding loans to financial institutions with a remaining maturity of one year or greater that would qualify for the 35% or lower risk weight under Basel II standardised approach for credit risk Required factor 85% Other loans to retail clients and small businesses having a maturity < 1 yr Required factor 100% All other assets National Supervisory Discretion Other contingent funding obligations

What is the basis of risk models credit, market, operational Basel backtesting: allows for validated model based on sample period. After which must implement model over implementation period. After that, back-test. If Risk Grade order not maintained, fail. Model needs to have 3 years of // run. In Academic, Out-of-Sample Validation: Take 70% of data for training (build model) and 30% for testing (validate model). Also used in pharmaceutical. Basel II find it insufficient. When role out model, often doesnt work.