Questions & explanations
1. How do banks estimate PD, LGD, and EAD under the internal ratings-based (IRB) approach?
Under the IRB approach, banks use their own historical data and models to estimate PD, LGD, and EAD for each borrower or loan pool. For PD, they look at past default rates for similar borrowers and adjust for current conditions. For LGD, they analyze recoveries from past defaults, considering collateral and loan type. For EAD, they estimate likely drawdowns of credit lines before default. These estimates must be conservative and based on at least 5-7 years of data for PD and a longer period for LGD. Banks must also validate their models regularly. Regulators review and approve the models to ensure they are reasonable. The IRB approach allows risk weights to be more tailored, often lower than standardized, but requires strong risk management.
2. What are PD, LGD, and EAD in credit risk?
PD stands for Probability of Default, which is the chance that a borrower will fail to pay back a loan. LGD stands for Loss Given Default, the percent of the loan amount the bank loses if the borrower defaults. EAD stands for Exposure at Default, the total amount the bank could lose when default happens. For example, if a company borrows $100 and defaults, PD might be 2% (2% chance), LGD 60% (lose $60), and EAD $100. These three values are used to calculate expected loss: PD times LGD times EAD. Banks use these estimates to set aside capital for bad loans. Under Basel rules, these parameters can be estimated by banks using internal models (IRB approach) or by regulators (standardized approach).
3. Compare the internal ratings-based (IRB) approach and the standardized approach for credit risk.
In the standardized approach, banks use fixed risk weights set by regulators for each type of loan, like 100% for corporate loans. In the IRB approach, banks use their own estimates of PD, LGD, and EAD to calculate risk weights, which can be lower for safe borrowers. So IRB can reduce capital requirements for banks with good loan portfolios. However, IRB is more complex and requires regulatory approval. The standardized approach is simpler and used by smaller banks. A key difference is that IRB uses bank-specific risk estimates, while standardized uses one-size-fits-all weights. Basel III introduced the output floor to limit how much lower IRB risk weights can be compared to standardized.
4. What is the difference between expected loss and unexpected loss in the IRB framework?
Expected loss (EL) is the average loss a bank expects over time, calculated as PD × LGD × EAD. The bank covers EL by loan loss provisions (money set aside) that are deducted from profit. Unexpected loss (UL) is the extra loss beyond average in a bad year, caused by more defaults or higher losses. Capital is held to cover UL, so the bank can survive very severe losses. In the IRB framework, the capital formula calculates the UL at a 99.9% confidence level (a one-in-a-thousand-year event). For example, if EL is 0.5% of a loan, UL might be 3% at that confidence level. The bank must hold capital equal to UL, while EL is covered by provisions. This separation helps banks manage risk better.
5. Why do regulators allow banks to use internal models (IRB) instead of just standardized weights?
Regulators allow IRB because it can better reflect a bank's actual risk. Standardized weights are rough averages and may not match the risk of a bank's specific loans. For example, a loan to a very safe large company might have almost no default risk, but the standardized weight treats it the same as a risky company. IRB lets the bank use its own data to assign lower risk weights to safe loans, so it holds less capital for those. This encourages good risk management. However, IRB models can be gamed to lower capital too much, so regulators supervise them closely. The output floor also limits the benefit. Overall, IRB aims to make capital requirements more risk-sensitive and efficient.
6. What are Systemically Important Financial Institutions (SIFIs)?
SIFIs are large, complex financial institutions whose failure could cause serious damage to the global or national economy. They are often called 'too big to fail' because their size and connections mean a collapse would spread through the financial system. Regulators identify them using factors like size, interconnectedness, and complexity. The Financial Stability Board (FSB) names Global Systemically Important Banks (G-SIBs) each year. For national SIFIs, domestic regulators like the Reserve Bank of India (RBI) designate Domestic Systemically Important Banks (D-SIBs). These institutions face stricter rules, like higher capital requirements, to reduce the risk they pose.
7. What is the role of capital planning in the stress testing process?
Capital planning is how a bank decides how much capital it needs and how it will get it, linking stress test results to actual decisions. After a stress test shows possible losses, the bank adjusts its capital plan, for example, by cutting dividends or raising new capital. In the US, the Comprehensive Capital Analysis and Review, or CCAR, directly evaluates the bank's capital plan based on stress test outcomes. The plan must show the bank can maintain capital above minimum levels even under stress. Good capital planning ensures the bank is ready for bad times and can keep lending. Regulators approve or reject the plan based on the stress test results.
8. What is bank stress testing?
Bank stress testing is a method where banks check how they would handle very bad economic conditions, like a severe recession or market crash. Banks run computer models that assume high unemployment, falling stock prices, and other shocks. They then calculate how much money they would lose and whether they would still have enough capital to keep operating. Regulators use these tests to make sure banks are strong. In the US, the Dodd-Frank Act Stress Test, or DFAST, and the Comprehensive Capital Analysis and Review, or CCAR, are two such programs. Similar tests exist in other countries, like India under the Reserve Bank of India, RBI, for large banks.
9. Compare G-SIB and D-SIB designation and requirements.
G-SIB stands for Global Systemically Important Bank, designated by the Financial Stability Board for banks with global impact. D-SIB is Domestic Systemically Important Bank, designated by a national regulator like the Reserve Bank of India (RBI) for banks important to that country. Both face extra capital surcharges, but the surcharge levels and methods may differ. D-SIB surcharges are usually lower because the risk is local. For example, India assigns D-SIBs with a surcharge of 0.2% to 0.8% of risk-weighted assets, while G-SIBs have up to 3.5%. Both designations aim to reduce systemic risk, but G-SIB rules are global and coordinated among countries.
10. Why do G-SIBs need TLAC in addition to regular capital requirements?
Regular capital requirements (like CET1) protect depositors and keep the bank operating, but if a G-SIB fails, even that capital may not be enough to cover losses and allow an orderly resolution. TLAC provides extra loss-absorbing resources beyond equity, like long-term debt that can be bailed in (converted to equity) to recapitalize the bank during resolution. This reduces the need for taxpayer bailouts. Without TLAC, a failed G-SIB might have to be bailed out with public money or cause panic. TLAC is specifically for G-SIBs because their failure would be catastrophic. It works with other rules like the G-SIB surcharge to make large banks safer.
11. How do company-run stress tests differ from supervisory stress tests like DFAST?
Company-run stress tests are done by the banks themselves using their own models and assumptions, while supervisory tests like DFAST (Dodd-Frank Act Stress Test) are run by the regulator, like the US Federal Reserve, with its own models. In DFAST, the regulator calculates the bank's losses and capital under a set of hypothetical scenarios. The bank-run tests may use different scenarios or models, so results can vary. The regulator uses both to check consistency. Company-run tests give the bank a chance to show its own risk understanding, but supervisory tests provide an independent check. Both must be passed for the bank to distribute capital.
12. What is the role of long-term debt (LTD) in TLAC?
Long-term debt, or LTD, is a key part of TLAC because it provides a buffer that can absorb losses during a bank failure. When a G-SIB fails, the regulator (resolution authority) can write down that debt or convert it to equity to keep the bank running. This protects depositors and avoids a collapse. LTD must have a remaining maturity of at least one year and rank junior to other liabilities. It gives the bank a bigger cushion than equity alone because debt is cheaper to issue than equity. So for the same amount of loss absorption, using LTD saves the bank money. Regulators set minimum LTD requirements to ensure there is enough.