April 2005 Q1 (iii)

Hi

The Q asks to:

(a) calculate total capital required under current Basel regulations
(b) calculate capital allocation to each division.

The Examiners Report calculate

(a) 8% of the risk-weighted assets as the total capital requirement (24m)

This is only the requirement for credit risk?? What about interest rate risk?

(b) the EAR for each division as (the std dev of profit):
Mortage = 5.5m
Advisory = 2m
Then they divide by 10% (the Target return on capital) to get the capital requirement. Should you not use the risk-free rate for the EAR method?
Then they say the total required capital is 55+20 = 75 and that the bank actually has a deficit (as the bank has only 50m capital).
I would just use the 5.5 and 2 to ratio the total calculated in (a) between the two divisions (a top down approach).

Please let me know where I make a mistake.

 

Perhaps only Basel 1 is being used. The notes do not explain any standardised method (or IRB method for that matter) for interest rate risk for Basel 2.

I used R_F = 8% (suck thumb)

I also ratioed the available capital and allocated to the 2 divisions.

Basically I did what you did. :0) Will the examiner see things the same way.... I don't know.

Wait till you get to question 2.....

If you have any comments on my april 2007 post please advice.

Thanks!

 

Another thing...

As I understand it EAR is the std dev of net profits. The notes also say (under "the method in practice") that 1.96 times EAR often used - so this is what I did. I suppose 5/6 % for R_F would have been a better suck thumb. The answers one gets are way off from the examiner though!

I take it that VaR method not used because the figures aren't really useful.