Capital Calculation: An analytical comparison of Standardized vs. Model-Based Approaches

_OVERVIEW 

This paper provides detailed analysis and observations of the different approaches for calculating regulatory capital requirements, whether firms are considering changing their approach, planning an implementation, or monitoring the outcome of the U.S.’s Basel III Endgame. 

This paper uses Acadia’s Capital Calculation Service for the Standardized Approach and the Open-Source Risk Engine (ORE) for the Model-Based Approach, both offer firms a cost-effective choice when deciding what approach and solution is right for them. 

_INTRODUCTION 

In the wake of the 2008-09 Financial Crisis, the Basel Committee on Banking Supervision (BCBS) began developing the latest standard (Basel III), which is intended to protect the global financial industry against systemic risk by requiring banks to reserve sufficient capital to protect against losses. Basel III has been under review and is slowly being implemented into law by global regulatory jurisdictions at the time of writing. 

Insufficient bank capital was identified as the primary driver of systemic risk contagion resulting from the 2008-09 Financial Crisis. Loan loss reserves and similar accounting measures are calculated as a measure of “expected loss”, with a long history of loans made to borrowers with probability-weighted expected loss rates across similar credit profiles/ratings. There’s some measure of statistical certainty embedded in the calculation of expected loss, but what happens when those losses greatly exceed their expectation due to unforeseen circumstances or periods of extreme market volatility that hadn’t ever occurred previously (e.g. due to risks that hadn’t previously been included in the modelling of expected loss, or risks that haven’t yet presented in any recent history)? This is where bank capital comes into play as a backstop for unexpected losses. 

Ensuring that banks maintain adequate capital amounts commensurate with their underlying risk-taking activities is the single core tenet underlying the Basel Capital Accords. BCBS had to first define what counts as eligible capital, and how to consistently define and measure a bank’s risk-taking activities. The first amount (Capital) forms the numerator of the resulting regulatory capital ratio, and the latter comprises the denominator (Risk- Weighted Assets – RWAs), resulting in a ratio that dictates the bank’s minimum capital requirement commensurate with their level of risk-taking. 

Minimum Capital Ratios are the primary quantitative measure by which the Basel Capital Accords are enforced by regulators. Banks therefore must have tight internal controls and disciplined risk management governance around all their lending, trading and similar risk-taking activities, and general operations more broadly in order to accurately make the necessary calculations, which feed up into the Capital Ratios, and manage their activities in an economical way around these regulatory requirements.

There are many inputs used for calculating the RWA values for a bank’s trading activities, and two general approaches (at least in the U.S.): a simplified Standardized approach, or expanded Model-Based one, or some combination thereof. For the purposes of this paper, we provide the Standardized Approach and Model-Based Approach inputs for Market Risk RWA, Counterparty Credit Risk RWA, and CVA Risk RWA. There are others, like Operational RWA, which are out of scope here in relation to trading activities.