In this assignment, I am going to analyse and find out the risk of five companies for a certain period of time. I have chosen five FTSE 100 companies and assuming that Marylebone Bank invests £20million in shares for each company. I have chosen Barclays, BP, Next, M&S and Admiral. To do this, I have collected the 501 days adjusted close price from the period of 06/03/2014 till 12/03/2012. I would calculate VaR under Basel 1 and 2 by using variance covariance and historical simulation methods. For historical simulation, 500 scenarios have to be used for the values of the portfolio on 07/03/2013.
Why Regulate Banks
First of all banks need to be regulated in order to ensure they keep enough capital for the risk they take. It is impossible to eliminate the fact that a bank can fail, however, government wants to ensure that probability of default is minimized. This can be one reason for creating a stable economic environment where small companies or individual businesses have confidence in the banking system.
Bank Regulation Pre-1988
Bank regulation before 1988 focused on setting minimum levels for the ratio of capital to total assets. However because capital requirement levels and regulatory enforcement varied between countries, some countries had their own regulations, which were more diligently than other. The problem with regulation before 1988 was that they could not determine total risk in a bank, including all off-balance sheet items.
The BIS Accord 1998 (Basel I)
The 1988 BIS Accord was the first attempt to tackle these issues by setting international risk based standards for capital requirements. The Accord was signed by all 12 members of the Basel Committee and was a huge achievement. The BIS Accord however included two requirements: the ratio of the bank’s assets to its capital had to be less than 20, and second one was what is known as Cooke ratio. The cook ratio uses both on balance and off balance sheet items in order to calculate bank’s total risk exposure or in other words risk-weighted assets.
As you can see above, these are the different risk weights for all assets. These are determined by how risky they are.
For Marylebone Bank, the on-balance sheet items included:
1. Cash of £0.01m (0%)
2. Bond issued by BP plc of £5m (100%)
3. Government bond issued by China of £3m (100%)
4. Loans to Bank of Irelend £2.5m (20%)
5. Residential mortgage for £10m (50%)
6. UK Gilts of £5m (0%)
All of these were given different risk weights according to the table above. Using the appropriate risk weights, the risk-weighted assets were calculated as follows:
RWA=£0.01m*0%+£5m*100%+£3m*100%+£2.5m*20%+£10m*50%+£5m*0% = £13.50m.
The Accord required all banks to keep a minimum ot 8% capital of total risk-weighted assets. 4% of RWA to be in Tier 1 and 2% of RWA must be common equity. The capital consists of two components:
Tier 1 (core): Consists of items...