A comparison of the Basel III capital requirement models for financial institutions

Abstract

The purpose of this report is to implement and compare the two Basel III standard methods on how to calculate the capital requirement for finan- cial institutions, related to counterparty credit risk. The models being the Standardized Approach for Counterparty Credit Risk (SA-CCR) and the Internal Model Method (IMM). The SA-CCR model is a simpler and more standardized model with prescribed methods while the IMM model is a more flexible model optimized to the specific portfolio. Because of this, the IMM model requires more work to implement. The comparison of these two models is done by looking at a small number of transactions from the Bank’s trading book and computing the Exposure At Default (EAD) that these would give. Both models are used to compute this, and these results are compared. To obtain EAD the transactions need to be priced and their Net Present Value (NPV) needs to be calculated. One need simulated interest rates to do so, which is done using Monte Carlo simulations. For this, a Hull-White process is used to simulate the interest rates and the parameters of this process is calibrated using market data.
Out of the two models, the IMM model is the more complex one. It requires both normal and stressed data as input parameters and it also needs to be validated. The validation of the model is done by doing some- thing called ”backtesting” on it, which investigates if the model created does give the expected results. Backtesting is performed by taking the interest rate for one day and then creating a confidence interval using this date, predicting where the rate will be 10 days into the future. This confidence interval is then compared with the true value 10 days into the future to see if the prediction does in fact cover the actual value. If so, the prediction does give us a credible result, so this is a way of checking how good the model is.
The result was that the usage of the IMM model, instead of the SA- CCR, would lead to the institute being required to hold 11 % less capital. However, this result is based on only one type of instrument and tested for only a fraction of the institute’s total trading book, so it would re- quire some testing on a bigger scale to really ensure this result. Another thing that could improve this work is if a different simulation process, other than Hull-White, would be used. Some alternative methods that could potentially give a better result and other future improvements are discussed.

Popular Abstract

In this work we have implemented and compared the two Basel III standard models of how to compute the capital requirement for financial institutions. These models being the Standardized Approach for Counterparty Credit Risk (SA-CCR) and the Internal Model Method (IMM). This work has been carried out working together with one of the major banks in Sweden, using their data and trades to obtain the results. The SA-CCR model is currently used by the Bank, and this model is seen as an easy way of calculating the capital require- ment, but quite blunt. The IMM model offers more flexibility and is tailored to the Bank’s trading portfolio, which means that potentially the usage of this model instead could save the Bank a sizeable amount of money. The result found was that the change of models could lower the capital requirement cost for the Bank by approximately 11 %.
The capital requirement means the amount of capital the institution is required to hold based on the counterparty credit risk. The counterparty credit risk meaning how large the exposure is towards the counterparty and how much risk the counterparty implies.
Since the IMM model enables more flexibility, it also comes with a great deal of responsibility and guidelines to follow. One of these is to backtest the model, which means that one uses historical data to predict the interest rate a certain time period into the future, and then compare this prediction with the actual value of that day. This shows how accurate the model created is, and therefore strengthens the result.
This work was done upon request of the Bank, to do a first investigation of if the change of methods would be beneficial for the Bank and something worth further looking into. This could potentially mean a lot of money saved by the Bank, money that would not be tied up and instead could be invested and hope- fully lead to a more prosperous Bank.
References on how to implement an IMM model has been difficult to find, these models are as mentioned above quite closely linked to the transactions of the portfolio and therefore confidential information most of the times. This report can therefore be seen as a brief introduction on how to implement an IMM model, and important aspects to consider.

• author: Johannesson, Sara and Wahlberg, Amanda
• supervisor: Erik Lindström
• organization: Mathematical Statistics
• alternative title: En jämförelse av Basel III standardiserade modeller för kapitaltäckningskrav för finansiella instutioner
• course: FMSM01 20221
• year: 2022
• type: H2 - Master's Degree (Two Years)
• subject: Mathematics and Statistics
• keywords: Basel III, Internal Model Method (IMM), Standardized Approch for Counterparty Credit Risk (SA-CCR), Counterparty Credit Risk, Capital Requirement
• publication/series: Master's Theses in Mathematical Sciences
• report number: LUTFMS-3452-2022
• ISSN: 1404-6342
• other publication id: 2022:E51
• language: English
• id: 9094446
• date added to LUP: 2022-06-29 14:39:07
• date last changed: 2022-07-20 12:53:48