How are BIS capital charges calculated?
3-step formula
Risk-based capital requirements set by Basel can be as high as 30%. Three formulas are applied to arrive at the regulatory capital requirement. We explore each in turn. First, we calculate “Credit Exposure”. Second, we weight that exposure to arrive at the “Risk-weighted Asset” (RWA). Then, we calculate the capital requirement against that RWA. For example, consider the capital requirement for $10 million in bank-intermediated trade finance.
First, “Credit Exposure” = Notional Amount x CCF (Credit Conversion Factor). The CCF ranges from 20% (for short-term self-liquidating instruments) to 100% at maximum. Thus, a $10 million notional can carry between $2 million to $10 million in ‘Credit Exposure’.
Second, Basel applies a risk weight to this exposure to calculate the “Risk-weighted Asset”. This could vary from 20% to 150%. At the lower bound: RWA = $2m x 20% = $400k. The upper bound: RWA = $10m x 150% = $15m.
Third, Basel requires banks to hold 8%-20% capital against RWAs. Lower bound capital requirement = RWA x 8% = $400k x 8% = $32k (0.32% of the notional). Higher bound capital requirement = RWA x 20% = $15m x 20% = $3m (30% of the notional).
Excessive capital requirements and antiquated linear calculations of default risk underpin the opportunity for capital relief via risk transfer.
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