![]() ![]() Risk Weighted Assets $2500 (Mortage * Risk Weight) It was 50% for mortgages and 100% for non-mortgage exposures (like credit card, overdraft, auto loans, personal finance etc). In Basel I, fixed risk weights were set based on the level of exposure. Tier 2 capital : Subordinated loans, revaluation reserves, undisclosed reserves and general provisions.It includes shareholders' equity and retained earnings Tier 1 capital : Primary funding source of the bank.Capital is an aggregation of Tier 1 and Tier 2 capital. It means capital should be more than 8 percent of the risk-weighted assets. Banks needed to maintain ratio of at least 8%. It is the ratio of a bank's capital to its risk. It focused on credit risk and introduced the idea of the capital adequacy ratio which is also known as Capital to Risk Assets Ratio. Basel Iīasel I accord is the first official pact introduced in year 1988. The committee was expanded in 2009 to 27 jurisdictions, including Brazil, Canada, Germany, Australia, Argentina, China, France, India, Saudi Arabia, the Netherlands, Russia, Hong Kong, Japan, Italy, Korea, Mexico, Singapore, Spain, Luxembourg, Turkey, Switzerland, Sweden, South Africa, the United Kingdom, the United States, Indonesia and Belgium. They meet regularly to discuss banking supervisory matters at the Bank for International Settlements (BIS) in Basel, Switzerland. It is to ensure that banks have minimum enough capital to give back depositors’ funds. Basel RegulationsĪ committee was set up in year 1974 by central bank governors of G10 countries. The whole economy can be in danger if current and future credit losses are not identified or estimated properly. You may have understood now why credit risk is so important. US Government bailed out many big corporate houses during recession. ![]() In simple words, people had a very little or no money to spend which leads to many organisations halted their production. Even non-financial firms were impacted badly because of either their investment in these funds or impacted because of a very low demand and purchasing activities in the economy. Banks, investors and re-insurers faced huge financial losses and bankruptcy of many financial and non-financial firms. Many financial institutions globally invested in these funds resulted to a recession. The real estate bubble burst and a sharp decline in home prices. In 2004-2007, these CDOs were considered as low-risky financial instrument (highly rated).Īs these home loan borrowers had high chance to default, many of the them started defaulting on their loans and banks started seizing (foreclose) their property. The process of selling them to investors is a legal financial method which is called Collateralized debt obligations (CDO). Banks funded these loans by selling them to investors on the secondary market. To compensate risk, banks used to charge higher interest rate than the normal standard rate. Poor credit score indicates that one is highly likely to default on loan which means they are risky customers for bank. Hence it is essential that banks have sufficient capital to protect depositors from risksĭo you remember or aware of 2008 recession? In US, mortgage home loan were given to low creditworthy customers (individuals with poor credit score). Serious honest borrowers with good credit history (credit score) would have to suffer. High NPAs lead to huge financial losses to the bank which turns to reduction of interest rate on the deposit into banks. In news, you might have heard of Kingfisher Company became non-performing asset (NPA) which means the company had not been able to pay dues. It's not restricted to retail customers but includes small, medium and big corporate houses. Remaining unpaid installments are worth USD 30,000. ![]() You paid a few initial installments of loan to the bank but stopped paying afterwards. For example, you took a personal loan of USD 100,000 for 10 years at 9% interest rate. ![]() Sometimes customers pay some installments of loan but don't repay the full amount which includes principal amount plus interest. In Method 2, both the spread and bond return are assumed to be simple, which may not be accurate, but, at least, consistent.In simple words, it is the risk of borrower not repaying loan, credit card or any other type of loan. Obtain the probability of default from a hazard rate (instantaneous conditional probability of default) Assuming 0 recovery and a risk free rate of 5%.ġ year conditional (on no prior defaults) probability of default: Given two methods to calculate the 1 year conditional probability of default of a zero coupon bond, I've come up with slightly different but close results.įrom my approaches below, is it reasonable for the results to be off? Is the amount they are off considered large? Am I missing something?ġ year zero coupon bond with a face value of 1 million trading at 80% of face value. ![]()
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