Análisis Situacional del Ecuador en el Comercio Exterior

Supervisory agencies set minimum capital adequacy requirements to ensure an adequate capital endowment of financial institutions. Banks are required to calculate and con- sistently maintain a minimum capital adequacy ratio. A revised framework for capital measurement and capital standards was passed by the Basel Committee in 2004 to im- prove the coherence of capital requirements with the risk inherent in the financial positions of financial institutions and to specify balance sheet items as regulatory capital according to their ability to absorb losses. Banks are required to adopt a forward-looking approach to capital management and to set capital levels in anticipation of possible adverse events or changes in market conditions.

5 _{Structural models of credit risk typically incorporate the principle of no-arbitrage valuation, which}

involves the dynamical replication of uncertain state-dependent cash flows of an asset in a complete market using a self-financing trading strategy. By generation of a dynamically riskless position consist- ing of the risky asset and its replication portfolio, resulting cash flows are discounted at a riskless rate. The basic principles of no-arbitrage theory and risk-neutral valuation are outlined in Neftci (1996) and Baxter and Rennie (1996). A more rigorous treatment is found in Karatzas and Shreve, (1988, 1998) and Musiela (1998).

The definition of bank capital eligible for regulatory purposes is defined in the Basel Capital Accord BCBS (1988) and its Market Risk Amendment BCBS (1996a). Regula- tory eligible capital is divided into core capital (tier-I capital) and supplementary capital (tier-II capital). Core capital includes equity capital and disclosed reserves from post- tax retained earnings and is required to constitute at least 50% of regulatory capital. Supplementary capital amounts to the size of tier-I capital at most, and includes undis- closed reserves, revaluation reserves, general loan loss provisions, hybrid debt capital instruments and subordinated term debt. Goodwill and investments in non-consolidated financial subsidiaries and significant corporate investments are deducted from core cap- ital.6 _{The Market Risk Amendment establishes an additional tier-III capital consisting}

of short-term subordinated debt, which is exclusively determined to cover market risk.7

Regulatory capital is measured against risk weighted assets. This total capital ratio must not fall below the level of 8%; for the core capital ratio a minimum of 4% is obligatory.8

Specific capital requirements such as capital multipliers or position limits can be imposed by supervisory agencies on all material exposures.

Capital standards differ financial instruments into banking book exposures and trading book exposures. Banks must have clearly defined policies and procedures to determine which exposure to include and exclude from the trading book for capital adequacy pur- poses and risk management. The trading book consists of positions in financial instru- ments and commodities held either with the intent of trading or as a hedge of other positions in the trading book. Financial instruments constitute either assets or liabil- ities and involve primary financial claims and derivative instruments. Financial assets include cash, the right to receive cash or another financial asset, equity investments or the contractual right to exchange financial assets at potentially favorable terms. Finan- cial liabilities subsume contractual obligations to deliver cash or another financial asset or the exchange of financial liabilities under conditions that are potentially unfavorable. Positions held with the intent of trading are projected for short-term resale to profit from actual or expected short-term price movements or to lock-in arbitrage profits and include proprietary positions and positions arising from client servicing and market making.

The extent to which an exposure can be marked-to-market on a daily basis by means of reference to an active, liquid two-way market determines the eligibility of an expo- sure as trading position. Basic requirements to qualify positions for trading book capital

6 _{Cf. BCBS (1988), p. 3ff and BCBS (2005b), p. 10}

7 _{Cf. BCBS (1988), p. 3ff including Annex I, p. 17ff, as well as BCBS (1996a), p. 7f. for a rigorous}

definition of eligible capital.

8 _{The calculation of risk-weighted assets and the regulatory requirements for the use of internal models in}

the calculation of the market risk and the specific market risk charge are outlined in BCBS (1988) and BCBS (1996a), respectively. Numerous amendments and newsletters further detail the applications of risk weights.

treatment include (1) a clearly documented trading strategy, (2) position limits appro- priately set and monitored, (3) daily mark-to-market or at least a daily assessment of model parameters in the case of mark-to-model valuations, (4) positions actively mon- itored, managed and reported on a daily basis, (5) ability of the bank to identify and hedge the material risks of the exposure, (6) external validation of a bank’s own valuation of mark-to-model exposures.

Positions in the bank’s own eligible regulatory capital instruments are deducted from capital. Trading positions in other financial institutions’ eligible regulatory capital in- struments will be deducted from capital at the discretion of supervisory agencies. In- ternal hedges of banking book credit exposure using trading book credit derivatives do not qualify for the mitigation of capital requirements unless the bank purchases credit protection from an eligible third party. Interest rate risk in the banking book is subject to the supervisory review of pillar-II of the revised standards.

Banking book positions subject to the treatment of the revised capital standards are basically categorized into five classes of corporate, sovereign, bank, retail and equity ex- posures. Within the corporate asset class, there are five sub-classes of specialized lending (project finance, object finance, commodities finance, income-producing real estate and high-volatility commercial real estate). Bank exposures include exposures to banks and securities firms.

The capital standards differ between expected loss (EL) and unexpected loss (UL) of exposures.9 _{Unexpected loss is defined as the amount by which the incurred credit loss}

exceeds the expected loss. The amount of available regulatory (economic) capital is specified by supervisory agencies (banks) to cover unexpected credit loss. In order to assess the adequacy of capital, the capital endowment of financial institutions is compared to the experienced credit loss. Economic capital constitutes the capital available to achieve a target insolvency rate and to cover the predicted unexpected losses.10 The majority of banks handle economic and regulatory capital requirements independently, however, a few banks include the cost of regulatory capital in their credit pricing methodology, thereby increasing the expected loss.

The revised capital standards enable banks to choose between four approaches to de- termine the capital requirements for their credit risk. First, financial institutions may stick to the established capital requirements set forth in the original Basel Accord of 1988 and its amendments. Second, under a standardized approach, risk weights of defaultable exposures refer to obligor ratings provided by external rating agencies. The two internal- rating-based (IRB) approaches rely on banks’ internal assessment of the risk components

9 _{Cf. BCBS (2006c), p. 86f.} 10_{Cf. BCBS (1999a), p. 14.}

PD, LGD and EAD in determining the capital charges of exposures. The foundation IRB approach requires that banks use internal PD estimates derived for obligors of a partic- ular rating class, whereas supervisory agencies provide estimates of LGD, EAD and the effective maturity of exposures. A reference LGD of 45% for senior unsecured claims and 75% for subordinated claims is mandatory. The effective LGD of collateralized exposures is calculated by adjusting the reference LGD to the exposure net of the collateral. Under the advanced IRB approach, the bank’s own estimates of PD, LGD and EAD from an internal credit assessment process are used and an effective maturity is calculated for each exposure. PD must refer to a one-year time period and will be set to 100% for obligors in default. LGD estimates must refer to specific EAD estimates.

Partial use of the IRB approach to cover only a few particular asset classes is permissible. The percentage capital requirement (CR) of an exposure is defined as the eligible capital required per monetary unit of a single exposure and takes into account PD, LGD, the correlation of defaults and a maturity adjustment.11 _{The risk-weighted assets (RWA) are}

calculated by RWA = CR ·EAD· 12.5. For small and medium size corporate borrowers, an RWA discount is incorporated using a reduced correlation assumption. The total risk-weighted assets aggregate the market risk, operational risk and credit risk RWA of exposures. An additional scaling factor at the discretion of supervisory agencies generates the aggregate level of minimum capital requirements.

Risk-weight functions provide capital requirements for UL, whereas EL is covered by credit loss provisions. A loss provisioning methodology identifies exposures to be evaluated for impairment on an individual basis. Impairments of individual loans result in specific loan-loss provisions, whereas collective impairments induce general-loss provisions. Loss charge-offs and recoveries must be carried out in accordance with the applicable accounting framework.

The total eligible provisions include specific provisions, partial write-offs, discounts on defaulted assets and portfolio-specific provisions, such as country risk or general-loss pro- visions. A positive difference between total eligible provisions and total expected loss can be allotted to tier-II capital under the IRB approach, whereas the standardized approach allows only the to inclusion of general provisions in tier-II capital.

Loans not subject to individual impairment must be grouped and impaired collectively. Factors likely to alter credit loss as compared to historical loss experience such as (1) changes in lending policy, (2) changes in relevant economic, business or market conditions, (3) changes in trend, volume and severity of past-due and low-quality loans, and (4) changes in the quality of the loan review system, should be considered in collective loss provisions.

Instruments of credit risk mitigation can be used to adjust PD, LGD or EAD estimates in a consistent way to lower capital requirements. Instruments of credit risk mitigation include third-party guarantees, collateral, securitization, credit derivatives and netting agreements and may generate types of risk that make risk reduction less effective. Credit mitigation risks include the inability to seize pledged collateral in a timely manner, refusal or delay by a guarantor to pay as well as legal, documentation and liquidity risk. The counterparty risk of trading exposures is covered as specific market risk under provisions of the market risk amendment (BCBS (1996a)).

On- and off-balance sheet exposures must be measured gross of specific provisions or partial write-offs. The EAD of facilities must not be less than the amount currently drawn. For on-balance sheet items, the netting of loans and deposits is recognized, with special adjustments for currency and maturity mismatches.12 _{For off-balance-sheet items,}

the exposure is calculated as the committed but undrawn amount multiplied by a credit conversion factor depending on the type of instrument.13 _{Effective maturity is set to 2.5}

years using the foundation approach. Using the advanced IRB approach, the effective maturity calculates as McCauley-Duration given a zero yield-to-maturity. If contracted payments are not specified explicitly, the time-to-cash flow of the last payment is used as an alternative.