**1. Basel Committee Regulations:**
- Origin: The Basel Committee on Banking Supervision introduced capital requirements to address credit risk, specifically accounting for potential defaults on loans and derivatives contracts. Initially, the focus was on credit risk only.
**Example**: A bank is required to set aside a certain percentage of its capital as a buffer to cover potential losses in case borrowers default on loans or derivatives contracts.
**2. Evolution of Capital Requirements:**
- Expansion: Over time, the Basel Committee expanded the scope of capital requirements to include not only credit risk but also market risk and operational risk.
**Example**: In addition to accounting for credit risk, banks also need to consider potential losses arising from fluctuations in financial markets and operational failures, such as system breakdowns or fraud.
**3. Models for Computing Regulatory Capital:**
- Standardized Models: Basel Committee developed standardized models to calculate regulatory capital consistently across different banks.
- Internal Models: Banks also use internal models they have developed to calculate regulatory capital based on their specific risk profiles.
**Example**: Using standardized models, the Basel Committee can ensure a level playing field by providing a common framework for capital calculations. Banks may develop internal models tailored to their risk exposures, allowing for a more accurate representation of their specific risks.
**4. Basel Committee's Response to the Credit Crisis:**
- Limiting Internal Model Use: After the 2007-2009 credit crisis, the Basel Committee reduced the reliance on bank internal models, as they were criticized for underestimating risks.
**Example**: During the crisis, some banks' internal models failed to adequately account for the high default rates in mortgage-backed securities, leading to capital shortfalls.
**5. Current Use of Internal Models:**
- Standardized Model Requirement: Presently, all three risks (credit, market, and operational) must be computed using a standardized model.
- Exception: Banks approved by their national regulators can use an internal model for market and credit risks only.
**Example**: If Bank X is approved by its national regulator and has demonstrated its internal model's accuracy and risk management capabilities, it can utilize its internal model to calculate capital requirements for market and credit risks.
**6. Internal Model Capital Calculation:**
- Comparison Method: For banks using an internal model for market and credit risks, the required capital amount is calculated based on the greater of:
- The capital computed by their internal model, or
- 72.5% of the capital computed by the standardized model.
**Example**: Let's say Bank Y uses an internal model and computes a market risk capital requirement of $100 million. The standardized model calculates a market risk capital requirement of $150 million. The greater of the two values would be $108.75 million, and Bank Y must maintain at least $108.75 million in capital for market risk.
**7. Introduction of Liquidity Ratio Requirements:**
- Reason: The credit crisis revealed that liquidity shortages were significant contributors to the financial turmoil experienced by banks.
- LCR: The liquidity coverage ratio ensures banks have sufficient high-quality liquid assets to survive a 30-day period of financial stress.
- NSFR: The net stable funding ratio aims to control the maturity mismatches between a bank's assets and liabilities over a longer-term horizon.
**Example**: Bank Z must maintain a certain percentage of its assets in highly liquid forms, like cash and government bonds, to ensure it can meet its short-term obligations even during financial crises (LCR). Additionally, NSFR ensures that Bank Z has a stable and matched funding structure, reducing the risk of sudden funding shortages.
In summary, the Basel Committee's regulations have evolved over time to address various risks faced by banks. They include standardized and internal models for capital calculations and incorporate liquidity ratio requirements to ensure banks are better equipped to handle financial stress and maintain stability. Examples help illustrate how these concepts are applied in practice within the banking industry.
**Topic: Basel Regulations**
1. What was the primary focus of the original Basel Committee regulations?
a) Market risk
b) Operational risk
c) Credit risk
d) Liquidity risk
Answer: c) Credit risk
2. In addition to credit risk, which risks were later incorporated into the Basel capital requirements?
a) Market risk and operational risk
b) Market risk and liquidity risk
c) Operational risk and liquidity risk
d) Market risk, operational risk, and liquidity risk
Answer: a) Market risk and operational risk
3. What type of models are used to compute regulatory capital under Basel regulations?
a) External models developed by independent organizations
b) Standardized models developed by individual banks
c) Internal models developed by the Basel Committee
d) Both standardized models developed by the Basel Committee and internal models developed by banks
Answer: d) Both standardized models developed by the Basel Committee and internal models developed by banks
4. Why did the Basel Committee reduce the use of bank internal models after the 2007-2009 credit crisis?
a) Internal models were too complex for regulators to understand.
b) Internal models tended to overestimate risks, leading to capital shortages during the crisis.
c) Internal models were not effective in calculating market risk.
d) Internal models were deemed unnecessary after the crisis.
Answer: b) Internal models tended to overestimate risks, leading to capital shortages during the crisis.
5. What percentage of the capital computed by the standardized model is applied to the internal model capital computation for credit and market risks?
a) 50%
b) 60%
c) 72.5%
d) 80%
Answer: c) 72.5%
6. What is the purpose of the liquidity coverage ratio (LCR) introduced by the Basel Committee?
a) To ensure banks have enough funding sources to remain viable for 30 days in the event of financial stress.
b) To control maturity mismatches between a bank's assets and liabilities.
c) To measure a bank's credit risk exposure.
d) To calculate a bank's operational risk capital requirements.
Answer: a) To ensure banks have enough funding sources to remain viable for 30 days in the event of financial stress.
7. The net stable funding ratio (NSFR) aims to:
a) Ensure banks have enough funding for short-term liquidity needs.
b) Control maturity mismatches between a bank's assets and liabilities over a longer-term horizon.
c) Measure a bank's market risk exposure.
d) Calculate a bank's operational risk capital requirements.
Answer: b) Control maturity mismatches between a bank's assets and liabilities over a longer-term horizon.
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