Question 1: [5 marks]
Using the Basel II Internal Ratings Based (IRB) the formula for corporate exposures, describe each of the key input variables and their impact on regulatory capital and risk-weighted assets (RWA).
Question 2: [5 marks]
Beyond the regulatory requirement to maintain adequate capital reserves, what other goals does Basel II/III strive to achieve? Discuss in terms of impact on regulatory capital calculations (credit risk only) and an ADI’s risk management culture.
Question 3: [10 marks]
Consider a $300m portfolio comprising 50 unsecured corporate loans. Assuming individual exposures default with probability 3% and LGD=25% and EAD=100%
a) Derive the mean and standard deviation of portfolio loss assuming loans default independently.
b) Construct the portfolio loss distribution [Hint: use a normal distribution]
c) Derive portfolio VaR and economic capital at the 99th percentile level
Question 4:[15 marks]
Repeat 3 assuming a uniform joint default probability of 0.2%. What is the impact on portfolio risk as a result of correlation?
Question 5:[5 marks]
Define the key differences between regulatory and economic capital modeling methodologies.
Question 6:[10 marks]
Economic capital and AIRB Basel II regulatory capital are both measures of a bank’s credit loss probability density function. Explain the key differences between these approaches and suggest why a bank would invest the effort in measuring Economic Capital when it must calculate RWA using Basel II.