I’ve been tasked with implementing the Basel II IRB Capital Calculations. I was given this formula:
This is alphabet soup! Even if I could calculate this, what in the heck would I do with it? I’m going to cancel my vacation to Greece, in fear that they use these symbols on the street signs and I’ll not get a break from this madness.
Imelda, It’s all Greek to Me.
Don’t cancel your lovely Greek vacation just yet. They are just people like us, and to my knowledge you won’t be subjected to formulas during your vacation. It’s Basel, Switzerland, the home of these formulas, you might want to skip to avoid a surprise encounter.
Let’s take a quick tour of the alphabet soup.
K stands for Capital. No, not Kapital like “Das Kapital” but the capital the bank will be required to hold in the event of a serious ka-blooey in the economy. The technical term for ka-blooey is “tail event”, which I’ll explain in another post.
LGD stands for Loss Given Default. Some people refer to this as the “Oopsie” factor, the amount of money you’ll have lost if the loan goes bad. Under normal circumstances, we can have quite a few “oopsies”, which is our expected losses on the portfolio. However, once we have so many “oopsies” such as in a severe “tail event”, we have an unexpected loss, which is well past “oopsie”.
R stands for correlation. If one borrower defaults, how likely are the other borrowers to default? Typically your borrowers don’t gather in a convention and decide as a group not to pay you at the same time. However, imagine all their home prices steeply declined, or they all lost their jobs at the same time. In that case, you might see your borrowers default with high correlation to each other. Now you see why knowing the size of the potential “oopsie” becomes important.
Please enjoy your lovely vacation, spend your hard earned money in a country who has had a few “oopsies”, and we’ll go through the rest of the alphabet soup when you return!
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