Agenda for Day 1                   Introduction of Participants                   Introduction to Credit Risk             ...
Principal objectives of the Basel Accord II    Prudent capital regulation    Scientific principles for bank supervision   ...
Key inclusions in Basel II accord vis a vis Basel I accordof 1988  1. Credit risk: graded norms for capital adequacy  2. M...
Basel II Accord The #1 goal of Basel II Capital Accord is to align regulatory capital more closely with economic capital ....
Basel II Accord                          BASEL II CAPITAL ACCORD 1. MINIMUM CAPITAL           2. SUPERVISORY REVIEW       ...
Credit risk: graded norms for capital adequacyCapital                                                    Capital  %       ...
Basel II - Options of Pillar 1 for Credit Risk                        1. Standardised approach                            ...
Basel II Accord - Credit Risk Management Approaches                        Internal Ratings Based         Internal Ratings...
Salient features of proposed Basel II Accord…(1)  Claims on sovereigns and central banks will be risk weighted based on ex...
Salient features of proposed Basel II Accord…(2)  Retail portfolio will get a (lower) risk weightage of 75%  Fully secured...
Measuring Credit Risk Capital - Standardised Approach Minimum Credit Risk Capital requirement under Standardised Approach ...
Measuring Credit Risk Capital - The way forward The New Basel Approach   Standardised Approach    IRB Foundation Approach ...
Measuring Credit Risk Capital using IRB FoundationApproach                                    Maturity                    ...
Basel II - Options of Pillar 1 for Credit Risk Standardisedapproach  • Risk weights are calculated using external ratings ...
Basel II - Options of Pillar 1 for Credit RiskStandardised approach - some possible constraints  Are external ratings avai...
Why should Banks look at IRB approach?1    Very few companies are rated by an external agency. Many     countries do not h...
Basel II - Options of Pillar 1 for Credit RiskFoundation IRB - barriers to overcome  Does the Bank have appropriate rating...
Exercise # 1(a): Credit Risk Capital Calculation -Standardised approach (Basel II)   Situation    > Two Borrowers have app...
Solution # 1(a): Risk Capital Calculation - Standardised approach (Basel II)Computation                                   ...
Exercise # 1(b): Credit Risk Capital Calculation -Standardised approach   Situation    > Two Borrowers have approached the...
Solution # 1(b): Risk Capital Calculation - Standardised approachComputation                                              ...
Standardised Vs. Internal Model approaches                          New standardized model                                ...
What can a Bank do to cope with “Losses” arising fromCredit Risk?    Broadly, there are two types of losses arising from c...
What is Expected Loss?                    Expected LossCredit Loss (Rs.)                                                  ...
Expected Loss                            expected        loan                      Probability                100% less   ...
Credit Risk model flow     Inputs                    Outputs   Exposure     Default        Expected    Unexpected   Credit...
Expected and Unexpected Losses - FundamentalConcepts                                              Expected Credit Loss (1)...
Economic Capital                                                 Expected Credit Loss (1)Economic capital shouldcover Unex...
Stages in the IRB approach to Credit Risk ManagementSolutions                                                     Stage 3 ...
Project Background & Compatibility with Basel II normsStages in the IRB approach to Credit Risk Management Solutions - Sta...
Project Background & Compatibility with Basel II normsStages in the IRB approach to Credit Risk Management Solutions - Sta...
Project Background & Compatibility with Basel II normsStages in the IRB approach to Credit Risk Management Solutions - Sta...
Proposed Basel III GuidelinesThe key elements of the proposed Basel III guidelines include the following:  Definition of c...
Regulatory Capital Adequacy Levels—Proposed Norm underBasel III                                                           ...
DISCUSSIONS                    IM aCS 2010              Printed 11-M ay-11                         Page 35
All the contents of the presentation are confidential andshould not be published, reproduced or circulated without the   w...
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RMPG Learning Series CRM Workshop Day 1 session 2

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RMPG Learning Series CRM Workshop Day 1 session 2

  1. 1. Agenda for Day 1 Introduction of Participants Introduction to Credit Risk Overview of Basel Guidelines Lunch Break Framework for Credit Risk Management Open Session/ Q&A IM aCS 2010 Printed 11-M ay-11 Page 1
  2. 2. Principal objectives of the Basel Accord II Prudent capital regulation Scientific principles for bank supervision Use of market discipline for better focus on risk • Better risk management • Financial Stability IM aCS 2010 Printed 11-M ay-11 Page 2
  3. 3. Key inclusions in Basel II accord vis a vis Basel I accordof 1988 1. Credit risk: graded norms for capital adequacy 2. Market risk: setting aside capital for market risk 3. Operational risk: introduced for the first time 4. More emphasis on banks’ own internal methodologies, supervisory review and market discipline. 5. Flexibility, menu of approaches, incentives for better risk management IM aCS 2010 Printed 11-M ay-11 Page 3
  4. 4. Basel II Accord The #1 goal of Basel II Capital Accord is to align regulatory capital more closely with economic capital ... #1 … using the 3 “pillars” approach IM aCS 2010 Printed 11-M ay-11 Page 4
  5. 5. Basel II Accord BASEL II CAPITAL ACCORD 1. MINIMUM CAPITAL 2. SUPERVISORY REVIEW 3. MARKET DISCIPLINE REQUIREMENTS OF CAPITAL ADEQUACY Based on 4 principles Increased disclosure of Sets minimum acceptable capital Banks must assess capital structure solvency relative to Credit risk tied to their risk profile ratings Improved disclosure of Supervisors should risk measurement and Public ratings review bank’s management practices Internal ratings assessments Explicit treatment of Banks should hold in Operational (“Event”) excess of minimum Improved disclosure of Risk level of capital risk profile Excludes Regulators will “Strategic & intervene if capital Improved disclosure of Reputation Risk” levels deteriorate capital adequacy IM aCS 2010 Printed 11-M ay-11 Page 5
  6. 6. Credit risk: graded norms for capital adequacyCapital Capital % 8.0 8.0 8.0 8.0 % AA A BBB BB AA A BBB BB • In 1988 Basel I Accord, a loan to a AA • In 2004 Basel II Accord, there are graded rated corporate requires the same amount of norms for capital adequacy capital as a loan to a B-rated corporate IM aCS 2010 Printed 11-M ay-11 Page 6
  7. 7. Basel II - Options of Pillar 1 for Credit Risk 1. Standardised approach Components - Credit ratings of the borrowers rated by ECA. Weights are defined by regulator w.r.t.to the ECA rating. Regulators defined list of authorised securities Capital Allocation 2. IRB - Foundation Components - PD, LGD, EAD PD will be defined by bank and LGD and EAD will be provided by the regulator. Regulators defined list of authorised securities. 3. IRB - Advanced Components - PD, LGD, EAD, Maturity. Based on experience and regulatory approval, Bank can define Complexity of Approach its own list of eligible securities. Subject to qualitative entry criteria IM aCS 2010 Printed 11-M ay-11 Page 7
  8. 8. Basel II Accord - Credit Risk Management Approaches Internal Ratings Based Internal Ratings BasedStandardised Approach (IRB) (IRB) Foundation Approach Advanced Approach Risk-weights set Risk weights Bank to estimate Loss differentiated by internal Given Default (LGD) based on external credit risk ratings Bank to estimate risk ratings Exposure At Default Bank estimating PD for (EAD) Treatment of their internal ratings Improved disclosure of risk measurement and collateral and management practices guarantees set by Effect of risk mitigation parallel to that in the Improved disclosure of supervisors Standardised Approach risk profile Improved disclosure of capital adequacy IM aCS 2010 Printed 11-M ay-11 Page 8
  9. 9. Salient features of proposed Basel II Accord…(1) Claims on sovereigns and central banks will be risk weighted based on external credit assessment However, at national discretion, a lower risk weightage may be applied to bank exposures to their sovereign for loans in domestic currency Basel has proposed two approaches for measuring claims on banks Option 1: assign a risk weight one category less favourable than that assigned to claims on sovereign of that country Option 2: Base the risk weights on the external credit assessment of the bank itself Claims on corporate will be risk weighted based on external credit assessments: For example AAA to AA- corporate will get a risk weightage of 20%, while A+ to A- will get a risk weightage of 50% IM aCS 2010 Printed 11-M ay-11 Page 9
  10. 10. Salient features of proposed Basel II Accord…(2) Retail portfolio will get a (lower) risk weightage of 75% Fully secured residential mortgage will get a risk weightage of 35% Off-balance sheet items under the standardised approach will be converted into credit exposure equivalents through the use of credit conversion equivalents Financial Collateral, Guarantee & Derivatives are recognised as Risk Mitigation strategies IM aCS 2010 Printed 11-M ay-11 Page 10
  11. 11. Measuring Credit Risk Capital - Standardised Approach Minimum Credit Risk Capital requirement under Standardised Approach is (E *) x Risk Weight x Regulatory capital requirement. & E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]} where: E* - Exposure value after risk mitigation; E - Current value of Exposure; He - Haircut appropriate to the exposure C - The current value of the collateral received Hc - Haircut appropriate to the collateral Hfx - Haircut appropriate for currency mismatch between the collateral & exposure IM aCS 2010 Printed 11-M ay-11 Page 11
  12. 12. Measuring Credit Risk Capital - The way forward The New Basel Approach Standardised Approach IRB Foundation Approach • Internal estimation of Probability of Default (PD) • Formula for estimation of Exposure at Default (EAD) • Regulator to provide estimate of Loss Given Default (LGD) IM aCS 2010 Printed 11-M ay-11 Page 12
  13. 13. Measuring Credit Risk Capital using IRB FoundationApproach Maturity (from Regulator) Exposure PD Risk Scores Data Data EAD Estimator (from Regulator) LGD Estimates Capital (From Regulator) Required Type Value (set by Regulator) Security Data Computed IM aCS 2010 Printed 11-M ay-11 Page 13
  14. 14. Basel II - Options of Pillar 1 for Credit Risk Standardisedapproach • Risk weights are calculated using external ratings set by the regulator • Credit Risk Mitigation Techniques (CRMT) are defined by the regulator • Mandatory standard as long as the Bank does not pass the approval for a more advanced approach [1] [2] [3] [4] PD LGD EAD Maturity M Implicitly predetermined by risk weights (RW) Regulatory No explicit set up by the regulator which are based on predetermined recognition external ratings The three approaches differ in the source of the parameters, either external/regulatory predetermined or an internal estimate IM aCS 2010 Printed 11-M ay-11 Page 14
  15. 15. Basel II - Options of Pillar 1 for Credit RiskStandardised approach - some possible constraints Are external ratings available? Will borrowers meet the requirements of rating agencies? How many borrowers are already rated? How many agencies are accredited? Are the stipulated Credit Risk Mitigants sufficient? Are default events (according to the Basel II definition) triggered in the IT system? Is all the data needed for the use of Credit Risk Mitigation Techniques available in the IT- system? IM aCS 2010 Printed 11-M ay-11 Page 15
  16. 16. Why should Banks look at IRB approach?1 Very few companies are rated by an external agency. Many countries do not have a rating agency The standardised approach only recognises financial2 collateral. While traditionally, Banks have been seeking receivables & inventory as security to finance working capital requirements3 Banks that bring in early discipline of risk pricing assets are likely to benefit in the long run IM aCS 2010 Printed 11-M ay-11 Page 16
  17. 17. Basel II - Options of Pillar 1 for Credit RiskFoundation IRB - barriers to overcome Does the Bank have appropriate rating models with sufficient granularity to distinguish shades of grey in credit risk? Availability and accuracy of Information Appropriate models for various categories of borrowers e.g. Retail, SME, Corporate, Real Estate etc. Validation of relevant Models Interfaces to IT systems to capture relevant information Regulator’s ability to provide LGD, EAD, Maturity information Is all the data needed for the use of Credit Risk Mitigation Techniques available in the IT- system? IM aCS 2010 Printed 11-M ay-11 Page 17
  18. 18. Exercise # 1(a): Credit Risk Capital Calculation -Standardised approach (Basel II) Situation > Two Borrowers have approached the bank for a line of Credit · Borrower ‘X’ - Amount Rs. 5,000,000 · Borrower ‘Y’ - Amount Rs. 5,000,000 > Risk ratings of the Borrowers ‘X’ is “A” and ‘Y’ is “BBB” > Risk Weights as per Basel II are : Credit assessment AAA to AA- A+ to A- BBB+ to B- Below B- (or Un-rated) Risk Weights 20% 50% 100% 150% > The Bank has taken collateral from Borrower ‘Y’ of: > Foreign Currency deposit (US Dollar) - 50,000 ≅ Rs.2,250,000 (USD=Rs.45/) > Compute the following: (a) Risk Weighted Exposures (taking account of applicable haircuts) and (b) Credit risk capital for each of the exposures of the Bank IM aCS 2010 Printed 11-M ay-11 Page 18
  19. 19. Solution # 1(a): Risk Capital Calculation - Standardised approach (Basel II)Computation Borrower ‘X’ Borrower ‘Y’Q.1. Risk Weighted Credit Exposures to the Banka. Loan Amount 5,000,000 5,000,000b. Borrower Credit Risk Rating A BBBc. Collateral N/A Obtainedc.1. Estimated value of eligible financial collateral: 2,250,000 Foreign currency deposit (FCD): 2,250,000d. Risk Weights (as per Basel II and Regulator) 50% 100%e. Current value of exposures (E) d*a 5,000,000 5,000,000f. Applicable Hair cuts N/A 8% for FCDe.1. Adjusted Exposure after Haircuts (E*) (ie., max {0, [E x (1 + He) 5,000,000 2,930,000Basel II - 8% haircut for F.C.deposits as collateral – C x (1 – Hc – Hfx)]})Q.2. Credit Risk Capitalf. Risk weighted exposure e*d 2,500,000 2,930,000g. Regulatory Risk Capital 8% 8%h. Credit Risk Capital f*g 200,000 234,400 IM aCS 2010 Printed 11-M ay-11 Page 19
  20. 20. Exercise # 1(b): Credit Risk Capital Calculation -Standardised approach Situation > Two Borrowers have approached the bank for a line of Credit · Borrower ‘X’ - Amount Rs. 5,000,000 · Borrower ‘Y’ - Amount Rs. 5,000,000 > Risk ratings of the Borrowers ‘X’ is “A” and ‘Y’ is “BBB” > Risk Weights as per Central Bank are : Credit assessment AAA AA A BBB& below Unrated Risk Weights 20% 50% 100% 150% 100% > The Bank has taken collateral from Borrower ‘Y’ of: > Foreign Currency deposit (US Dollar) - 50,000 ≅ Rs.2,250,000 (USD=Rs.45/) > Compute the following: (a) Risk Weighted Exposures (taking account of applicable haircuts) and (b) Credit risk capital for each of the exposures of the Bank IM aCS 2010 Printed 11-M ay-11 Page 20
  21. 21. Solution # 1(b): Risk Capital Calculation - Standardised approachComputation Borrower ‘X’ Borrower ‘Y’Q.1. Risk Weighted Credit Exposures to the Banka. Loan Amount 5,000,000 5,000,000b. Borrower Credit Risk Rating A BBBc. Collateral N/A Obtainedc.1. Estimated value of eligible financial collateral: 2,250,000 Foreign currency deposit (FCD): 2,250,000d. Risk Weights (as per Basel II and Regulator) 100% 150%e. Current value of exposures (E) d*a 5,000,000 5,000,000f. Applicable Hair cuts N/A 8% for FCDe.1. Adjusted Exposure after Haircuts (E*) (ie., max {0, [E x (1 + He) 5,000,000 2,930,000Basel II - 8% haircut for F.C.deposits as collateral – C x (1 – Hc – Hfx)]})Q.2. Credit Risk Capitalf. Risk weighted exposure e.1 * d 5,000,000 4,395,000g. Regulatory Risk Capital 9% 9%h. Credit Risk Capital f*g 450,000 395,550 IM aCS 2010 Printed 11-M ay-11 Page 21
  22. 22. Standardised Vs. Internal Model approaches New standardized model Internal rating system 16 12 8 1.6 0 AAA AA A+ A- CCC BB- BB+ BBB B ICRA : 1 2 3 4 4.5 5 5.5 6 6.5 7 RATING Illustration: Risk weight for AAA rating is 20%. And regulatory capital is 8%. So, the percentage of exposure to be set aside for capital is 20% * 8% = 1.6%. IM aCS 2010 Printed 11-M ay-11 Page 22
  23. 23. What can a Bank do to cope with “Losses” arising fromCredit Risk? Broadly, there are two types of losses arising from credit risks: Expected loss Unexpected loss IM aCS 2010 Printed 11-M ay-11 Page 23
  24. 24. What is Expected Loss? Expected LossCredit Loss (Rs.) Range of Loss Expected Loss Time (years) IM aCS 2010 Printed 11-M ay-11 Page 24
  25. 25. Expected Loss expected loan Probability 100% less = X X loss exposure of default recovery rate Quality of Calibration of Industry bank’s data internal ratings benchmarksExpected loss (loss rate) Unexpected loss • expected default prob • recovery rates • default correlation time IM aCS 2010 Printed 11-M ay-11 Page 25
  26. 26. Credit Risk model flow Inputs Outputs Exposure Default Expected Unexpected Credit Risk rates Loss Loss Capital Recovery rate Default correlations Portfolio concentration IM aCS 2010 Printed 11-M ay-11 Page 26
  27. 27. Expected and Unexpected Losses - FundamentalConcepts Expected Credit Loss (1)(1) Pricing should Frequencycover this element Unexpected Credit Loss (2)(2) Capital shouldbe held against this Magnitude of loss Maximum Credit loss Potential unexpected loss against which it is too expensive to hold equity IM aCS 2010 Printed 11-M ay-11 Page 27
  28. 28. Economic Capital Expected Credit Loss (1)Economic capital shouldcover Unexpected credit losses Frequency Unexpected Creditand non-priced / under- Loss (2)provisioned part of expectedloss Economic Capital IM aCS 2010 Printed 11-M ay-11 Page 28
  29. 29. Stages in the IRB approach to Credit Risk ManagementSolutions Stage 3 Portfolio Stage 2 Reporting Obligor - Estimate regulatory capital Stage 1 Risk Mgmt - Measure RAROC - Reporting to Senior Management Data & - Build Internal Ratings systems Infrastructure - Estimate Default Probabilities - Facility ratings/transaction rating with LGD measures - Collect & Organize Customer Data - Introduce data infrastructure - Train Staff IM aCS 2010 Printed 11-M ay-11 Page 29
  30. 30. Project Background & Compatibility with Basel II normsStages in the IRB approach to Credit Risk Management Solutions - Stage 1 Data & - Collect & Organize Customer Data Infrastructure - Introduce data infrastructure Key Issues: Clearly articulate what data to collect Identify the best source of the data Build interfaces to pick-up data IM aCS 2010 Printed 11-M ay-11 Page 30
  31. 31. Project Background & Compatibility with Basel II normsStages in the IRB approach to Credit Risk Management Solutions - Stage 2 Obligor - Build Internal Ratings systems Risk Mgmt - Estimate Default Probabilities Key Issues: Understanding credit behaviour Ability to identify variables that predict default IM aCS 2010 Printed 11-M ay-11 Page 31
  32. 32. Project Background & Compatibility with Basel II normsStages in the IRB approach to Credit Risk Management Solutions - Stage 3 - Estimate regulatory capital Portfolio - Measure RAROC Reporting - Reporting to Senior Management Key Issues: Understanding Basel recommendations and RBI requirements Knowledge of business, regulatory and reporting requirements IM aCS 2010 Printed 11-M ay-11 Page 32
  33. 33. Proposed Basel III GuidelinesThe key elements of the proposed Basel III guidelines include the following: Definition of capital made more stringent, capital buffers introduced and Loss absorptive capacity of Tier 1 and Tier 2 Capital instrument of Internationally active banks proposed to be enhanced Forward looking provisioning prescribed Modifications made in counterparty credit risk weights New parameter of leverage ratio introduced Global liquidity standard prescribedThe Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the minimum corecapital requirement of 4.5%) be created by banks. Although the committee does not view the capitalconservation buffer as a new minimum standard, considering the restrictions imposed on banks and alsobecause of reputation issues, 7% is likely to become the new minimum capital requirement. IM aCS 2010 Printed 11-M ay-11 Page 33
  34. 34. Regulatory Capital Adequacy Levels—Proposed Norm underBasel III Proposed Basel -III Norm Common equity (after deductions) 4.5% Conservation buffer 2.5% Countercyclical buffer 0-2.5% Common equity + Conservation buffer + 7-9.5% Countercyclical buffer Tier I(including the buffer) 8.5-11% Total capital (including the buffers) 10.5-13%Regulatory Capital = Core Capital + Capital Conservation Buffer + Countercyclical buffer (if any) IM aCS 2010 Printed 11-M ay-11 Page 34
  35. 35. DISCUSSIONS IM aCS 2010 Printed 11-M ay-11 Page 35
  36. 36. All the contents of the presentation are confidential andshould not be published, reproduced or circulated without the written consent of IFC, Bangladesh Bank and IMaCS. IM aCS 2010 Printed 11-M ay-11 Page 36
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