With the new Basel III/IV/IV and IV Accords, internationally active banks are now required to compute their own risk capital requirements using the internal ratings-based (IRB) approach. Not only is adequate risk capital analysis important as a compliance obligation, but it also provides banks with the ability to optimize their capital through the ability to compute and allocate risks, carry out performance measurements, execute strategic decisions, increase competitiveness, and enhance profitability. This chapter discusses the various scientific risk management approaches required to implement an IRB method, as well as the step-by-step models and methodologies in implementing and valuing economic capital, Value at Risk (VaR), probability of default, and loss given default, the key ingredients required in an IRB approach, through the use of advanced analytics such as Monte Carlo and historical risk simulation, portfolio optimization, stochastic forecasting, and options analysis. This chapter shows the use of Risk Simulator and the Modeling Toolkit software in computing and calibrating these critical input parameters. Instead of dwelling on theory or revamping what has already been written many times over, this chapter focuses solely on the practical modeling applications of the key ingredients to the Basel III/IV and III Accords.
To follow along with the analyses in this chapter, we assume that the reader already has Risk Simulator, Real Options SLS, and the ROV Modeling Toolkit installed, and are somewhat familiar with the basic functions of each software program. If not, please refer to www.realoptionsvaluation.com (click on the Downloads link) and watch the getting started videos, read some of the getting started case studies, or to install the latest trial versions of these software programs and their extended licenses. You can download and install the demo version of the Modeling Toolkit software from the ROV website.