Basel 2 Question(Securitization)

[monsieuruzairo3]

Hi @David Harper CFA FRM CIPM

Came across the following question from Scheweser

The standardized approach to estimating the risk arising from asset securitization:
A) requires a reduction of capital for unrated positions.
B) is more commonly known as the external Ratings-Based Approach (RBA).
C) treats securitized assets consistently regardless of credit rating until a default occurs.
D) has stricter requirements than the IRB approach for transferring of risk through securitization.

The Answer is A
Explanation: Under the standardized approach, unrated positions entail a deduction of capital, so that issuers have no incentive
to avoid ratings of high risk tranches. Note that the standardized approach gives riskier assets higher risk rates.

I am not able to make much sense out of it, unrated positions are risky so why should there be a deduction. Would you kindly help me decipher the meaning?

KR
Uzi

 

[David Harper CFA FRM]

Hi @monsieuruzairo3

Under Basel II, unrated securitizations are assigned a weight of "Deduction" (it's minor, but: "deduction" in the explanation is more precise than "reduction" in the answer). While the question intends Basel II, it is basically correct about Basel III also. (Basel III is more complicated as it did update the rules for securitizations; i.e., http://www.bis.org/publ/bcbs269.htm)

Deduction in regulatory capital is tantamount to a capital charge of 100% (indeed, you are correct, deduction is for the risky assets of all!). Some tables show Deduction, alternatively, as a risk weight of 1,250%. Say, for example, we refer to a $10.0 million exposure:

• A risk weight of 100% (e.g., Basel II unrated corporate exposures) implies a capital charge of 100% RW * $10.0 MM exposure * 8% capital charge = $800,000; classic FRM question
• A risk weight of 1,250%--aka, Deduction--(e.g., Basel II unrated securitization exposures) implies a capital charge of 1,250% RW * $10.0 MM exposure * 8% capital charge = $10.0 million such that covering the exposure is equivalent to a deduction in the regulatory capital. Maybe the bank had $200 MM in regulatory capital but it only gets to count $190 MM because it has a unrated $10 MM securitization exposure that must be covered with regulatory capital equal to the notional amount (an extremely conservative approach considering the true exposure is typically much less than notional!) which is equivalent to "deducting" $10 million from qualifying regulatory capital of $200 million. The 1,250% = 1/8%, by design. I hope that explains!

 

[monsieuruzairo3]

Thanks @David Harper CFA FRM CIPM

On another note there is a question from P2.T5.17. Lookback options
Are the following statements about lookback options TRUE or FALSE:
1) The payoff of a fixed lookback requires a MAX() function but the payoff of a floating
lookback does not need MAX()

Your answer is TRUE, but as far as I understood the True applies only for Call options. If you are evaluating Lookback put options, equations are reversed.
Fixed Lookback put : K- Min(S0,S1,...St)
Floating lookback put: Max (S0,...St) - St

So the answer to the statement should be false!
What do you think?

KR
Uzi

 

[David Harper CFA FRM]

Hi @monsieuruzairo3

That's 17.b right? It's my mistake, I had to correct it, sorry, see https://forum.bionicturtle.com/threads/l2-t5-17-lookback-options.3420/#post-9285