Reference no: EM132173209
Question - A FI has Division 1 and Division 2. Important financial characteristics of the two divisions appear in the table below where all the figures are reported in billions of dollars. Note for clarity operation costs reflect operating expenses to run the business.
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Division
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Assets
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Revenues
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Funding Costs
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Operational Costs
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Expected Losses
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1
|
100
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16.5
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7.5
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2.5
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6
|
|
2
|
200
|
20
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7
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2
|
9.5
|
Variance - Covariance matrix for Division 1 and 2 losses as shown below where variances are reported on the diagonal and co variances are off diagonal. The bank faces only two risks for which it needs to measure its risk exposure against the Board tolerance; credit and operational. You may assume that the matix below is the same to apply for credit losses as it is for total (credit plus operational) losses of each division.
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Variance-Covariance Matix
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Division 1
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Division 2
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Div 1
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1.5
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4
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Div 2
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|
30
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The bank has an established hurdle rate of 15% and the Board of Directors requires the bank to maintain its risk positions within a 97.5% level of confidence. You know that a value of plus or minus 1.96 standard deviations accounts for about 5% if all outcomes under the standard normal distribution while a value of plus or minus 1.65 standard deviations accounts for about 10% of all outcomes. The bank as a regulated entity must comply with Basel capital standards and faces a required capital charge of 4% of assets in each division. In addition, Division 1 and 2's operational risk capital are estimated to be $3B and $7B, respectively. You also determine that expected operational losses are $1B and $2B for Division 1 and 2, respectively. Along with that you find that the correlation between credit and operational losses for Division 1 is .833 and the correlation between credit and operational losses for Division 2 is .75.
Q1: What is the highest credit loss the bank would be willing to take for each division given the information above?
Q2: What amount would you need to put aside for each division for credit risk based on the information above?
Q3: How do the two divisions compare in terms of financial performance unadjusted for risk? Specifically which division is better?
Q4: Provide 2 measures for each division adjusting for risk and describe the performance differences between the divisions and state what these measures are.
Q5: What is the total risk capital that should be assigned to Division 1 separately and to Division 2 separately? What inference can you make with respect to any diversification benefit?