Reading 52 - QB5.3

[saritay]

Hi David, I don't understand how you came up with the answer. Can you explain the deductible part and where you get 12.5 from?

Do we have to memorize the risk weights?

Many thanks, S
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B5.3. If a bank retains the equity (junior) tranche of a securitization where the notional of
the tranche is $10 million and the tranche has a long-term “B-” credit rating, what is the
capital charge under the standardized approach for securitization exposures?
a) $400,000
b) $800,000
c) $1.2 million
d) $10 million

B5.3. D $10 million


B+ and below rated securitizations are DEDUCTED while implies a 1,250% risk weight such

that CRC = $10 MM * 12.5 * 8% = $10 million; i.e., capital equal to the full notional

 

[David Harper CFA FRM]

Hi saritay,

12.5 is the reciprocal of 8% (i.e. 1/8% = 12.5) such that 12.5 is how to require regulatory capital against the entire exposure.

It's easier to see, I think, with an example: say a bank only has one asset with exposure of $100 million which is AA-rated with risk weight of 20%. The basic (Cooke ratio) capital requirement is 8%; i.e., regulatory capital of 8% of risk-weighted assets. So, a historically common FRM question in this case has been: how much regulatory capital would need to be held against this $100 exposure with risk weight of 20%. Answer: $100 exposure * 20% * 8% = $1.6 because $100*20% =$20 million is the risk weighted asset. And [risk-weighted asset] * [regulatory ratio of 8%] is the regulatory requirement. That's the essential innovation of Basel II: to asks banks to convert, eg., a $100 booked exposure to its $20 risk-weighted equivalent, and then require regulatory capital against the risk-weighted asset rather then the booked exposure.

Now assume the bank adds a $200 securitization exposure (retained) which is BBB rated. That's a 100% risk weight.

• The bank's risk weighted assets = (100 * 20%) + (200 * 100%) = $220.0 RWA and regulatory capital = 8% * $220 RWA = $17.60. Notice that is $16.0 in capital is held against the $200 securization exposure here; that's still a lot of leverage

Now assume the bank adds a $200 securitization exposure (retained) which is C rated. That's a 1,250% risk weight.

• The bank's risk weighted assets = (100 * 20%) + (200 * 1,250%) = $2,520 RWA and regulatory capital = 8% * $220 RWA = $201.60. That's $1.6 for the AA-rated exposure plus $200 capital against the $200 exposure; i.e., fully covered. In this way, the 1,250% is a way to get back to 1.0: 1250%*8% = 100%.
• The "deduction" refers to us getting the same result if we deducted the $200 capital (and the corresponding exposure): $201.6 against both of the exposures is the same as 201.6 - $100 = $1.6 against the assets after "deducting" the securitization exposure. I hope that explains.

 

[saritay]

Thank you David