Industry-focused Compliance - Governance, Risk, and Compliance Topic for Oracle Applications - page 386

The first pillar—Minimum capital requirements
In the first pillar of the accord, the calculation of the total minimum capital
requirements for credit, market, and operational risks is explained. The capital
ratio is calculated using the definition of regulatory capital and risk-weighted
assets. It boils down to having enough money in reserve to cope with the vagaries
of being in business. There are a number of methods discussed in the accord.
The objective here is simply to give you a sense of what the methodologies are
for assessing risk and valuing it:
• Credit risk is the risk of not being paid by a borrower.
• Market risk is the risk that the value of a marketable asset decreases.
The risk factors include stock prices, interest rates, exchange rates, and
commodity prices.
• Operational Risk is the risk inherent in participating in a given industry
or market. It includes the risk of human and procedural failures and errors.
Credit risk
In order to assess the capital requirements to cover the credit risk, the institution is
required to have classified their marketable assets for their risk weighting. The risk
weighting is a multiplier that is applied to a class of assets in order to arrive at a
"value" for the exposure. Very risky assets have a high multiplier. Very safe assets
have a low multiplier. An institution is required to have qualifying capital reserves
that cover a percentage of that exposure.
Market risk
Market risks are broken down into:
• Interest rate risk : The way that the interest risk is valued is based on the net
balance of what is owed and owing within maturity bands. For example, if
a bond is expected to mature within the next year, it represents less of a risk
than the one that will mature after 20 years, because the amount by which
prevailing interest rates can change is commensurably less. The way you
turn that into a value for the risk is that each maturity band is given a risk
weighting to factor it up or down.
• Currency risk : You can calculate the net present value of the projected cash
flows in each currency and convert it back to the reporting currency at the
current spot rate. The standard assumption is that you should provide eight
percent of the exposure to foreign exchange rate variation.