Understanding Risk-Weighted Capital

This chapter provides an overview of Risk-Weighted Capital and discusses:

Risk management.
Basel II credit risk regulatory compliance.
Risk-Weighted Capital features.
Integration with Enterprise Performance Management warehouses.
Processing risk-weighted capital.
Processing credit risk (Basel II).

Risk Management

One of the roles of capital is to act as a buffer against unexpected losses, and to minimize the likelihood of an institution’s failure. Institutions typically create provisions against identified losses (loss reserves); and they allocate capital to absorb any unidentified losses. Risk-Weighted Capital (RWC) enables you to systematically assess your risk exposure, calculate your capital allocation needs, and your normalized loss (loss reserve) requirements. Normalized loss distributes your expected losses across periods and levels the income/loss streams to reduce earnings volatility. You can perform your risk analysis for your ledger accounts, products or instrument pools, and treasury positions. You can assign risk weights corresponding to different risk types that you define for your organization; or you can define functions that the system uses to calculate the risk weights. In some cases, the institution may choose to allocate excess capital, for example to support superior credit ratings, or to satisfy depositors’ requirements. Risk-Weighted Capital allows you to define a set of formulas for your risk weights corresponding to your targeted capital requirements. You can use RWC to compare book capital against your risk-weighted capital in order to determine whether your organization is over or under capitalized.

With RWC, you can manage earnings volatility in the following ways:

Link risk and return by allocating capital to the business unit or activity responsible for the creation—and ongoing ownership—of the risk.
Apply the same risk-based discipline to business units within the organization that the capital markets force upon the whole organization.
Provide a standard for calculating and reporting risk-adjusted performance.
Focus on risk control and improvement opportunities.
Level out the earnings stream by reporting a normalized loss amount instead of the actual loss events.
Provide equity protection in the event of catastrophic losses.
Provide a specialized form of risk and capital management for banking institutions interested in credit risk assessment in compliance with the Basel II capital accord.

Data structures for credit facilities, risk mitigation instruments, portfolio detail and risk ratings are available for customers to store key attributes required by the accord. The delivered credit risk application engine supports processing these inputs all the way to a final value for Risk-Weighted Assets (RWA) and required Regulatory Capital (RC).

Basel II Credit Risk Regulatory Compliance

The new Basel Capital Accord (Basel II) aims to improve the soundness of today's complex financial system by instituting regulatory guidelines that place more emphasis on banks' own internal controls for risk management. In recognition of international banks' varying levels of complexity and sophistication, Basel II provides a flexible structure in which banks can use their own systems to measure their market risks and, ultimately, to manage their businesses more effectively. Basel II offers a range of methodologies for the measurement of credit risk and operational risk in determining capital levels, so that banks can adopt approaches that best fit their risk profile. At the same time, it requires comprehensive disclosure by banks whose internal processes are subject to supervisory review and evaluation.

Risk-Weighted Capital has been adapted to help institutions to comply with Basel II requirements for credit risk management and regulatory reporting. You can use Risk-Weighted Capital to help perform risk-weighted asset and regulatory capital credit risk calculations as prescribed in the capital accords. It also enables institutions to benefit from compliance with Basel II by minimizing the amount of regulatory capital withheld, offering a significant competitive advantage. The PeopleSoft Enterprise Performance Management warehouse data structures have been expanded to store and process data in the areas of collateral, facilities, and customers. A new application engine has been created to support processing of portfolio data from end-to-end for each of four methods: standardized simple, standardized comprehensive, foundation, and advanced. You can also use delivered query reports to view online the results of the credit risk application engine, enabling you to categorize, analyze, and control your financial exposures.

Terminology

The following are commonly used terms and measurements calculated by the credit risk application engine for Basel II :

Term	Definition
PD	Probability of Default: the likelihood that a borrower will technically default on an obligation to repay a loan or other obligation.
LGD	Loss Given Default: expected loss in the event of default.
EAD	Exposure at Default: an on-balance sheet or off-balance sheet item is defined as the expected exposure of the facility upon default of the obligor at no less than the current drawn amount, subject to recognizing the effects of on-balance sheet netting.
EL	Expected Loss: the product of PD and LGD.
IRB	Internal Ratings Based: refers to the approach which allows banks to use their internal estimates of borrower creditworthiness to assess credit risk in their portfolios. The results are translated into estimates of EL, which forms the basis of minimum capital requirements. There are two variants to the IRB approach: foundation and advanced. See Credit Risk Processing Options.
CCF	Credit Conversion Factor: Used to calculate the credit exposure or EAD of off-balance sheet transactions in both the Standardized approach and Foundation IRB approach. Banks can use their own estimates for CCF in the advanced IRB approach.
Collateral	Risk mitigation instrument, especially financial instruments. The underlying security, mortgage, or asset for the purposes of securitization or borrowing and lending activities. In the case of securitized transactions, it means the underlying cashflows.
CRM	Credit Risk Mitigation: Reduction of credit risks by taking collateral, obtaining credit derivatives or guarantees, or taking an offsetting position subject to a netting agreement.
Customer Group	An institution-defined grouping of customers or counterparties associated with a credit facility. A customer group defines a list of customers or counterparties that can draw on a specific credit facility.
Haircut	Determined by the Basel Committee. Haircuts reflect the volatility of a loan, the financial collateral, and possibly existing volatility of currency. It is the margin (expressed in percent) applied to asset or liability exposures to reflect the volatility of that exposure.
Retail banking	Banking with private individuals, but can also include some type of small businesses.
Risk Rating	Represents the assessment of an individual person's or company's creditworthiness. All borrowers are assigned to rating categories in a standardized and consistent manner. The rating provides international investors with accepted standards as a basis for their investment decisions.
Maturity mismatch	Different maturities of exposure and risk mitigation instrument. The maturity of the risk mitigation instrument is shorter than exposure's maturity.
Headroom	Difference between the commitment amount on a credit facility and the summed draws against the facility.
Limit	Commitment amount of a facility (overall fund commitment made by the bank to the customer).
Product Group	An institution-defined grouping of financial products associated with a credit facility. A product group defines a list of products that a bank customer can contractually enter into under a specific facility agreement.
Sub-limit	Commitment amount limit of a sub-facility (that falls under the overall facility).
Sub-sub-limit	Commitment amount limit of a sub-sub-facility (a further restrictive limit which falls under a sub-limit)

Credit Risk Processing Options

There are four processing options for the credit risk engine using either the standardized approach or the Internal Ratings Based (IRB) approach:

Standard simple

The bank allocates a risk weight to each of its assets and off-balance sheet positions and produces a sum of risk-weighted asset values. A risk weight of 100% means that an exposure is included in the calculation of risk-weighted assets at its full value, which translates into a capital charge equal to 8% of that value. Similarly, a risk weight of 20% results in a capital charge of 1.6% (that is, one-fifth of 8%).

In support of the standardized simple approach, the credit risk application engine relies on configurable credit risk function rules to apply different weights to various exposure classes.
Standard comprehensive

Under the standard comprehensive approach, a bank can allocate eligible financial collateral to reduce the amount of the exposure to the counterparty. You can use regulatory or bank-defined haircuts to decrease the amount of collateral or increase the level of exposure. Haircuts account for potential changes in the market prices of securities and foreign exchange rates. Like the standardized simple option, risk weight factors are ultimately applied to the resulting net exposure.

In support of the standardized comprehensive approach, the credit risk application engine relies on a combination of collateral allocation and haircut algorithms, as well as configurable credit risk function rules.
Foundation (IRB)

The bank estimates each borrower's creditworthiness through an assigned risk rating and related PD (probability of default). These results, along with other inputs supplied by bank supervisors (such as LGD or Loss Given Default), are translated into estimates of a potential future loss amount, and minimum capital requirements.

Risk mitigants such as collateral and guarantees are treated very similarly to the standardized comprehensive approach. In support of the Foundation approach, the credit risk application engine relies on a combination of engine-assigned parameter values, collateral allocation, haircut algorithms and configurable functions.
Advanced (IRB)

The bank estimates the credit worthiness of borrowers as well as other inputs for the determination of potential future loss amounts and minimum capital requirements.

RWA and capital charge formulas are generally similar to the foundation approach, but allow banks more latitude in defining exposure estimates, probability of default and loss given default. The credit risk application engine incorporates this flexibility through its ability to read tables which contain factors such as LGD and PD.

Process Flow

The following table illustrates the process flow for credit risk processing.

Step	Activity	Description
1.	Load portfolio data.	Load facility, collateral and instrument data into the warehouse.
2.	Create processing scenario.	Define a standardized, foundation or advanced processing scenario.
3.	Load assumptions.	Load risk rating, PD, LGD (advanced) and risk-weight assumptions.
4.	Pool retail exposures (optional).	Group instrument level detail records into pools with like attributes.
5.	Define or alter risk function rules.	Rules can supplement or override delivered algorithms, risk weights.
6.	Run Credit Risk application engine.	Evaluates on and off-balance sheet exposures. Applies risk mitigation such as collateral or guarantees. Applies haircuts, maturity mismatch algorithms. Calculates facility headroom, optionally at sub-limit levels. Assigns PD, LGD, EAD and RW as appropriate. Applies risk functions.
7.	Review output.	Query output table to evaluate risk-weighted assets, regulatory capital results. Adjust and rerun as necessary.

Risk-Weighted Capital Features

Risk-Weighted Capital has features that enable you to:

Define risk weighting rules for ledger accounts, products, or treasury position balances.
Define as many risk types as necessary, according to your business needs, for example credit risk, market risk, interest rate risk, deposit runoff risk.
Calculate risk weighted capital and normalized loss using one of two options: apply a set of additive risk weights that can be applied based on user-defined criteria, or define one or more risk functions that can be used to calculate a capital or normalized loss amount.
Specify risk weighted capital rules for income statement accounts, for example to cover legal risks.
Calculate risk weights and regulatory capital output for asset classes defined in the Basel II accord for standard (simple and comprehensive), foundation IRB (internal ratings-based approach), and advanced IRB approaches.
Process credit risk calculations at the overall facility, sub-facility levels and sub-sub-facility level.
Create and apply portfolio risk functions to calculate a specialized form of risk weights for credit risk processing. The credit risk engine executes the functions as a final step in its processing, and can use these calculations to override the default risk weights.
Calculate operational risk resulting from inadequate or failed internal processes, people and systems, or external events.
Query online the results of the credit risk engine to assess Basel II regulatory compliance, and to analyze portfolio credit exposures.
View online a matrix charting changes over time in instrument, facility or collateral attributes, so as to evaluate trends in selected data.
Generate reports to review, audit, and validate your risk weighting rules.
Calculate risk weighted capital and normalized losses for forecasted balances.
Use effective dating for assumptions, which provides you with a history of assumptions to help you track rules, and make inquiries concerning results.
Assign risk-weighted capital rules based on account tree nodes.

For example, if the 'other assets' node included multiple ledger accounts, you could choose to apply an RWC rule to the tree node that represents all 'other assets', rather than to each ledger account individually.

Note. RWC calculates economic capital based solely on the estimates of risk inherent in the products or activities. It does not reallocate existing book capital.

Integration with Enterprise Performance Management Warehouses

Risk-Weighted Capital draws data from Performance Warehouse for its processing, and posts results back to the warehouse for reporting. After you load the data from your source systems into the Operational Warehouse Store (OWS), the ETL process moves it into the Operational Warehouse (OWE). You can run another set of ETL maps to populate the Multidimensional Warehouse (MDW) tables, which are used by Business Intelligence reporting tools to create reports.

For a discussion of the Enterprise Performance Management warehouse tables common to all the Financial Services Industry applications, including Risk-Weighted Capital, see PeopleSoft Application Fundamentals for the Financial Services Industry 9.0 PeopleBook, “Understanding Common FSI Processes”.

Risk-Weighted Capital Output Tables

The following are output tables specific to Risk-Weighted Capital processing:

RWC_CALC_IN_F00

Stores RWC and normalized loss amounts for instruments.
RWC_CALC_AC_F00

Stores RWC and normalized loss amounts for PF ledger accounts.
RWC_CALC_PS_F00

Stores RWC and normalized loss amounts for treasury positions.
RWC_CALC_IP_F00

Stores RWC and normalized loss amounts for forecasted pools.
RWC_BS_PROD_F00

Stores instrument balances processed, their weighted average risk and normalized loss weights.
RWC_BS_TRPS_F00

Stores treasury position balances processed, their weighted average risk and normalized loss weights.
RWC_RCN_F00: stores RWC and normalized loss amounts from the RWC reconciliation process.
FI_IRWCALC_R00

Stores RWC rates for instruments.
FI_POOLRWC_R00

Stores RWC rates for forecasted pools.
FI_RWC_CR_F00

Stores credit risk engine final output. Includes final fields for risk-weighted asset and regulatory capital results.
FI_IBAL_R00

Stores balance amounts related to the instrument.
FI_POOL_CF_R00

Stores balance amounts related to financial instrument pool cash flows.
FI_POOLINST_F00

Primary table for the Financial Instrument Pool family of tables. Contains a row for each Pool created as the result of the Stratification Engine process. An instrument pool is a single entity that acts as a proxy for a group of financial instruments. The Stratification Engine provides a way to programmatically group and summarize Financial Instruments into a Pool that can be used as a data source for the Financial Calculator and Cash Flow generators.
FI_POOLHDR_R00

Stores balance amounts related to pooled instrument records.

Processing Risk-Weighted Capital

With increased competition, financial managers are recognizing the limitations of the traditional focus on asset growth, market share, or interest earnings per share—all of which ignore the inherent business risks and can be misleading performance indicators. The emphasis is shifting to risk adjusted return on capital (RAROC), which recognizes the importance of capital adequacy—too little capital could lead to a liquidity crisis (in the event of unexpected losses), and too much capital lowers the return on shareholders’ equity.

To illustrate, let us assume that a mortgage has been on the books all month, the accrual factor is 30/360, and the loan amount is 100,000 USD. Use Risk-Weighted Capital to calculate normalized loss and allocate capital for the credit risk inherent in the loan:

Item	Calculation
Risk weight for capital	500 basis points
Risk weight for normalized loss	15 basis points
Allocated capital	5,000 USD (100,000 USD * .05)
Normalized loss	12.50 USD (100,000 USD * .0015 * 30/360)

Assume that the net interest margin on the loan is 158 USD and the funds transfer charge for allocated capital is 6 percent:

Item	Calculation
FTP charge for allocated capital	25 USD (5,000 USD * .06 * 30/360)
Net income	133 USD (158 USD − 25 USD)
RAROC	31.92% (133 / 5,000 * 360/30)

Processing Credit Risk (Basel II)

Basel II prescribes specific algorithms for the calculation of risk-weighted assets and subsequently the capital that needs to be reserved against those assets. Generally these calculations take as inputs the probability of default for the asset class, the expected exposure to the bank at the time of default, and the loss given a default (after recovery) as a percentage of the outstanding credit.

To illustrate, this is an example of the calculation for risk-weighted assets defined by Basel II. (PD and LGD are measured as decimals, and EAD is measured as currency, except where explicitly noted otherwise):

Correlation (R) = 0.12 * (1 − EXP (− 50 * PD)) / (1 − EXP (− 50)) + 0.24 * [1 − (1 − EXP (− 50 * PD)) / (1 − EXP (− 50))]

Maturity adjustment (b) = (0.08451 − 0.05898 * log (PD)) ‸ 2

Capital requirement (K) = LGD * N [(1 − R) ‸ − 0.5 * G (PD) + (R / (1 − R)) ‸ 0.5 * G (0.999)] * (1 − 1.5 * b (PD)) ‸ − 1 * (1 + (M − 2.5) * b (PD))

Risk-weighted assets (RWA) = K * 12.50 * EAD

Risk-Weighted Capital delivers these packaged algorithms for the calculation of risk-weighted assets:

Item	Description
RWC_BCR1 (PD, LGD, M)	Calculates the capital requirement K with maturity adjustment.
RWC_BCR2 (PD, LGD, M, S)	Calculates the capital requirement K with firm-size adjustment.
RWC_BCR3 (PD, LGD)	Calculates the capital requirement K for residential mortgage exposures.
RWC_BCR4 (PD, LGD)	Calculates the capital requirement K for qualifying revolving exposures.
RWC_BCR5 (PD, LGD)	Calculates the capital requirement K for other retail exposures.

For example, if you have a corporate loan with an exposure at default of 1,000,000 USD with these characteristics, the risk-weighted assets and regulatory capital under Basel II are computed as illustrated:

Item	Calculation
PD (probability of default)	5%
LGD (loss given default)	50%
M (maturity in years)	2
K (capital requirement)	0.153055762
RWA (risk-weighted assets)	1,913,197 USD = 0.153055762 * 12.5 * 1,000,000 USD
Regulatory capital (RWA * 8%)	153,056 USD = 1,913,197 USD * .08