Developments around basel 2


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Developments around basel 2

  1. 1. Developments around Basel IIInternational Finance CorporationJune 20-25, Moscow, Krasnodar, UfaDr. Harry StordelDirector, Group Risk ManagementThe author makes no representation as to the accuracy or completeness of the information provided. The views expressed hereare those of the author, and do not necessarily represent those of Credit Suisse Group.
  2. 2. CONTENTS1. Basel II Overview2. Credit risk guidance3. Operational risk guidance4. Basel II implications5. Basel II and governance6. Basel II costs7. Conclusion & Outlook for IFC June 2005, Dr. Harry Stordel 2
  3. 3. BASEL II OVERVIEW TIMELINE 1999 ... 2004 2005 2006 2007 FRAMEWORK DEVELOPMENT IMPLEMENTATION ROLL-OUT & CALIBRATION Consultative and working papers Conclude Basel / IOSCO Recalibrate using QIS5 or Trading Book Review; “parallel run” results Quantitative Impact Studies (QIS)BASEL Co-ordinate national QIS Evaluate further refinements June ’04: Publication of revised capital framework AIG: home/host coordination Proposed national implementation Publish first draft of national Final implementation guidance /06SFBC / FSA consultative papers implementation text in Jan 05 Dialogue with banks on approval Set up working groups to initiate Dialogue with firms on national dialogue with industry implementation Dialogue between regulators for banks with home-host issues Participate in QIS Participate in national YE 05: Start Start 07: “go implementation working group “Parallel run” live” StandardBANKS Comment consultative papers & FIRB Banks IRB / AMA dialogue with regulator Application to Define project structure and plan regulator Implement project & close gaps Complete Start 08: “go Project live” AIRB for IFC June 2005, Dr. Harry Stordel 3
  4. 4. BASEL II OVERVIEWAIMS AND BUILDING BLOCKSAims of Basel II reforms — Radical overhaul of current, out-of-date regulatory regime — Goal is to address known deficiencies in Basel I rules and reduce opportunities for arbitrage — More ‘risk sensitivity’ for credit risk (i.e. lower ratings = higher charge) plus capital for Op Risk — Roughly similar to Economic Risk Capital (ERC) style approach for capital calculationsPillar 1 - Summary of proposals: CAPITAL CREDIT RISK MARKET RISK FIXED ASSETS OPERATIONAL RISK Eligible capital • No change >=8% Standardised Approach Standardised Standard RW Basic Indicator Deduction of • simple • comprehensive + Approach + • Basel 100% • EBK > 100% + Standard Approach EL-Provision • EL = expected Internal Rating Based Internal Models Advanced Measure- loss • foundation ment Approach • advanced Change under Change under Potential change No change under New under Basel II Basel II under Basel II Basel II Basel IIPillar 2: Formalized requirements, esp. re: internal capital assessmentsPillar 3: Large increase in external disclosure, including heavy details about Basel II capital components for IFC June 2005, Dr. Harry Stordel 4
  5. 5. 2. Credit Risk Guidance for IFC June 2005, Dr. Harry Stordel 5
  6. 6. CREDIT RISK OVERVIEW QUALIFYING CRITERIA• Break-down exposures in Basel II asset classes 100% RW + Pillar 2 + ??• Use recognized external rating agency/ies forcounterparties in individual exposure classes• Risk mitigation method used for accounting for nocollateral Standardised• Limited qualitative requirements for risk mitigation Approach Mapping• Break-down exposures in B2 IRB asset classes• Methodology to estimate long-term averageprobability of default (PD), preferably over a full noeconomic cycle, by rating no• Margin of conservatism for possible errors e.g.correlation between PD and EAD yes• At least 5 years historical default/ rating modeldata Appli- Foundation IRB• At least annual refresh of ratings cation Approach• Qualitative requirements: rating system / Approvalcoverage, corporate governance, credit risk control,annual audit review; validation; use test, disclosure• Methodology to estimate long-run default-weighted average loss given default (LGD) no• Methodology to estimate long-run default- noweighted average exposure at default (EAD)• At least 7 years historical LGD & EAD model data yes• Margin of conservatism for possible errors, e.g. Appli- Advanced IRBdown-turn LGD and for possible errors e.g.correlation between PD and EAD cation Approach• Additional qualitative and disclosure requirements Approvalto FIRB (e.g. collateral mgt, LGD refreshes etc.) for IFC June 2005, Dr. Harry Stordel 6
  7. 7. CREDIT RISKSTANDARDISED APPROACH RISK WEIGHTS: MECHANICS RWA = 12.5 × rw( rating ) × E Apply Apply appropriate Chose a Basel regulatory mapping Chose a Risk mitigation risk mitigation of rating classes into Rating Agency option Option specific risk weights* eligible collateral* Collateral specific Haircuts* Prescribed by Prescribed by Regulator Bank internal choice RegulatorNote: RWA = Risk weighted asset amount; rw= regulatory risk mapping; E = exposure post risk mitigation; 12.5 = 1/8%* See annex for regulatory mapping of rating classes into risk weights, eligible collateral and collateral haircuts. for IFC June 2005, Dr. Harry Stordel 7
  8. 8. CREDIT RISK FOUNDATION IRB RISK WEIGHTS: MECHANICS ⎡ ⎛ G ( PD ) R ⎞ ⎤RWA = 12.5 × EAD × LGD × ⎢N ⎜ ⎜ + G (.999) × ⎟ − PD ⎥ × MAT adj ⎢ ⎝ 1− R ⎣ 1− R ⎟ ⎠ ⎥ ⎦ Apply appropriate Apply Apply Use own RW functionregulatory EAD* Regulatory LGD* PD estimates Exposure specific Correlation(R)* Exposure specific Maturity Adj (MATadj)* Bank internal Prescribed by Prescribed by Regulator modelling RegulatorNote: N (..) = normal cumulative distribution function for a standard random variable; G (..) = inverse normal cumulative distribution function for a standard random variable; PD = probability of default; R = correlation. Correlation is a function of PD. Matadj = maturity adjustment. Maturity adjustment is a function of PD and effective maturity.* See annex for regulatory EAD, LGD, correlations and maturity adjustments for IFC June 2005, Dr. Harry Stordel 8
  9. 9. CREDIT RISKADVANCED IRB RISK WEIGHTS: MECHANICS ⎡ ⎛ G ( PD ) R ⎞ ⎤RWA = 12.5 × EAD × LGD × ⎢N ⎜ ⎜ + G (.999) × ⎟ − PD ⎥ × MAT adj ⎢ ⎝ 1− R ⎣ 1− R ⎟ ⎠ ⎥ ⎦ Apply appropriate Use own Use own Use own RW functionEAD estimates LGD estimates PD estimates Exposure specific Correlation(R)* Exposure specific Bank internal modelling Maturity Adj (MATadj)* Prescribed by RegulatorNote: see former slide* See annex for regulatory correlations and maturity adjustments. for IFC June 2005, Dr. Harry Stordel 9
  10. 10. 3. Operational Risk Guidance for IFC June 2005, Dr. Harry Stordel 10
  11. 11. OPERATIONAL RISKOVERVIEW QUALIFYING CRITERIA Gross Income α Basic Indicator Approach • Gross income break-down by business lines • Bottom-up risk identification and analysis • Assessment of OpRisk impact on solvency no • Ongoing monitoring of OpRisk with suitable tools (e.g. KPI, limits,thresholds scorecards) • Adequate reporting system, enabling mgmt to respond to exceptions yes • Define, refine and communicate operational β Standardised risk appetite based on risk assessment Approach • Inclusion of OpRisk in pricing, basis for insurance cover • Tracking of relevant OpRisk data, incl. losses• OpRisk measurement methodology• OpRisk measurement, monitoring and no control strategies no• Active oversight of OpRisk mgmt process by Senior management• OpRisk Measurement system integrated into yes Advanced day-to-day risk management process; output Appli- Measurement to be used for management decisions, incl. cation Approach capital allocation Approval• Regular audit review of risk mgmt process• Own mapping of business lines for IFC June 2005, Dr. Harry Stordel 11
  12. 12. OPERATIONAL RISKBASIC INDICATOR APPROACH K = α ⋅ GIK Operational risk capital requirementα Multiplicator set at 15%GI Gross Income = net interest income + net non-interest incomeAssessment:• very pragmatic but not risk sensitive; for small banks for IFC June 2005, Dr. Harry Stordel 12
  13. 13. OPERATIONAL RISKSTANDARDISED APPROACH n K = ∑ β i ⋅ BLI i βi Multiplicator for Business Line i BLIi, Indicator for Business Line i i =1 i Business Line Indicator β-Factor 1 Corporate Finance Gross Income 18% 2 Trading & Sales Gross Income 18% 3 Retail Banking Gross Income 12% 4 Commercial Banking Gross Income 15% 5 Payment & Settlement Gross Income 18% 6 Agency Services Gross Income 15% 7 Asset Management Gross Income 12% 8 Retail Brokerage Gross Income 12%Assessment:• complicated and not risk sensitive; for medium sized banks for IFC June 2005, Dr. Harry Stordel 13
  14. 14. OPERATIONAL RISK THE 4 ELEMENTS OF THE AMA QUANTIFICATION A bank’s AMA OpRisk model must include the following 4 elements: (1) Internal loss data (2) External loss data (3) Scenario analysis (4) Business environment & internal control factors There are a number of practical implementation issues with each of these 4 elements: – Completeness; Accuracy; Auditability; Relevance Completeness Accuracy Auditability RelevanceInternal loss data LOW/MEDIUM (1) HIGH HIGH LOW (2)External loss data LOW (3) LOW (3) LOW/MEDIUM (3) MEDIUMScenario analysis MEDIUM/HIGH MEDIUM LOW HIGHBusiness environment & LOW LOW/MEDIUM(4) LOW/HIGH (4) HIGHinternal control factors Conclusion Some elements are auditable but not relevant Notes & others are relevant but not auditable (1) More difficult to ensure completeness for high-frequency, small-loss events “Minor” events; easier for “Major” events (2) Low rating as most firms unlikely to have suffered numerous “Major” events to provide sufficient data sample (3) Low/medium rating due to reporting bias and collection bias (4) High accuracy and auditability for factors that are countable but Low otherwise for IFC June 2005, Dr. Harry Stordel 14
  15. 15. OPERATIONAL RISK AMACSG’S FOCUS ON HIGH IMPACT–LOW FREQUENCY OpRISKGoal of OpRisk management is to reduce the frequency & severity of large, rare events Small Losses Large Losses “MAJOR” events Low Frequency (Primary challenge) Focus of CSG • Can put banks (eg. Barings) out of business or Doesn’t matter much severely harm reputation Operational Risk Management: • Difficult to understand and prioritize in advance Escalation • Similar to issues faced in several other industries: aviation, healthcare, railways, chemical processing “MINOR” events (Secondary challenge) • Generally not firm threatening, generates High Frequency efficiency savings rather than reduce material Focus of CSG risks Not Relevant • Can often be incorporated into pricing - “cost of Operational Excellence: (Otherwise would already be out of business!) doing business” (eg. credit card fraud losses) • Managed through budget process at the line level Line Mgt • Experience makes it easier to understand problems, to measure issues & to take relevant actionNote: Low frequency – high impact events have very different causal characteristics as high-frequency low-impact events: see annex for IFC June 2005, Dr. Harry Stordel 15
  16. 16. OPEATIONAL RISK AMA COMPONENTS OF CSG’s SCENARIO ANALYSISExpert judgment based: transparent documentation Mechanical 4 elements of the AMA Qualitative inference of loss severity and frequency Aggregation of for scenarios scenarios usingInternal loss data OpRISK+ Scenario severity & frequencies 500 4.00% Scenario Scenario severity amount 400 Loss Distribution definitions 3.50%External loss & 3.00% data parameter 300 s 2.50% Frequency 200 2.00% Capital Business 100 chargeenvironment 1.50% & internal control 0 1.00% Medium Medium Medium Medium factors Low Low Very High High High Low Low Low Frequency Probability 0.50% 1 in x years 50 20 10 5 3 2 0.00% Annual loss for IFC June 2005, Dr. Harry Stordel 16
  17. 17. 4. Basel II Implications for IFC June 2005, Dr. Harry Stordel 17
  18. 18. BASEL II IMPLICATIONSCAPITAL IMPACT GOES BEYOND PILLAR 1 CREDIT RISKILLUSTRATIV Basel II Total CapitalBasel I RequirementsTotal CapitalRequirements Ignoring OpRisk Pillar 2 & Pillar 2 leads to OpRisk underestimating Pillar 1 regulatory capital requirements x 1.06* BIS B1 B2 pre B2 post B2 post scaling scaling Pillar 2* Preliminary factor, subject to change on the basis of QIS5 / or economic downturn LGDs calibration Market risk Credit risk Operational risk Fixed assets / non counterparty related risk Pillar 2 add on for IFC June 2005, Dr. Harry Stordel 18
  19. 19. BASEL II IMPLICATIONSPILLAR 1 AND COUNTERPARTY SELECTION FOCUS IRBF Risk Weights for Corporates (senior, 3y) IRB Banks: Competitive Standard Banks: Competitive If regulatory capital requirementRisk Weight Standardised is fully charged through pricing IRBF Senior & not considering the OpRisk charge150%100% Basel I 50% 20% PD : .03% 0.11% 0.83% 2.07% 5.9% 10% Rating : AA+ A- BBB+ BB- B for IFC June 2005, Dr. Harry Stordel 19
  20. 20. BASEL II IMPLICATIONSPILLAR 1 AND PRODUCT MIX FOCUS Basel II Risk Weight vs. Basel I ILLUSTRATIVE Higher Unchanged-Lower • Short-term financing (CCF 0% abolished)Standardised • High quality (better than A) corporate lending • Commitments (<1 year) and LCs (CCF=20%) • SME & Retail (resid. mortgages) lending • Commodity financing • Unconditionally cancellable commitments • Securities lending (e.g. bonds<BB-/unrated) • Commercial NIG / EMG lending • Past due loans (prov<20%) • Collateral lending as in para 145 • Low quality securitization • Guarantees and credit derivatives • Low quality (below BB-) corporate lending • Fixed assets & intangibles (100%) • Short-term financing (interbank, treasury) • Retail: residential mortgages, revolving, other • Commitments and LCs • SME lending (except for non-perfoming) • NIG / EMG lendingIRB • Securities lending (e.g. repos with blue chips • Loans with longer maturities • Derivatives for IG • FX counterparty exposures • IG securitization • NIG securitization • Fixed assets & intangibles (100%) • Other (e.g. Specialized Lending; equity…) Note: LC = letter of credit; NIG = non investment grade; IG = investment grade; SME = small & medium sized enterprise for IFC June 2005, Dr. Harry Stordel 20
  21. 21. BASEL II IMPLICATIONS: PILLAR 1 WINNERS AND LOOSERS: WHAT TO DO? OpRisk Charge ILLUSTRATIVEBIA/STA: Large Higher totalGross Income risk charge AMA IRB Bank Large Retail IRB Bank Portf. Large high risk Asset Corporate IRB Bank Mgt Portf. Corporate Portf. STD Bank Lower total Private Large high risk Banking Corporate risk charge Portf. STD Bank STD Bank Large Retail SME / Corporate Portf. Portf.BIA/STA: SmallGross Income lower higher Credit Risk IRB: Retail / SME STA: IG Lending STA: NIG lending IRB: NIG, Equities Charge Basel I High quality corporates Collateralized lending Short term lending Non-Performing Starting Point for IFC June 2005, Dr. Harry Stordel 21
  22. 22. 5. Basel II and Governance for IFC June 2005, Dr. Harry Stordel 22
  23. 23. BASEL II AND GOVERNANCE SYSTEMATIC CONTROL TASKS REQUIRED Basel II Pillar 1 quantification of Pillar 2 minimum capital requirements additional capital Pillar 3 requirements Disclosure Market Risk (potential change) + Credit Risk Supervisory (market + Review discipline) OpRisk Resulting control tasksAdherence to Adherence to Adherence to Adherence to•Credit policies •OpRisk policies •Capital mgt policies • Disclosure policies•Operating requirements •Sound practices • Part of new SFBC•Eligibility requirements Guidelines for IFC June 2005, Dr. Harry Stordel 23
  24. 24. BASEL II AND GOVERNANCE BANK SPECIFIC ORGANISATION OF CONTROL TASKS Basel II control tasksAdherence to Adherence to Adherence to Adherence to•Credit policies •OpRisk policies •Capital mgt policies • Disclosure policies•Operating requirements •Sound practices • Part of new SFBC•Eligibility requirements Guidelines Specialists before generalists? Owner of control task? • Credit Risk Mgt • Head Accounting • Product control • CFO • OpRisk Mgt • Disclosure Com. • Internal control • Capital Mgt Com. • Audit (int. or ext) • BoD Audit Com. • Audit (int. or ext) • Audit (int. or ext) • Compliance • Audit (int. or ext) • Compliance • Compliance • Compliance for IFC June 2005, Dr. Harry Stordel 24
  25. 25. 6. Basel II costs for IFC June 2005, Dr. Harry Stordel 25
  26. 26. BASEL II COSTS ALL BANKS LIKELY TO FACE A GAP TO CLOSE IRB Advanced State in 2005 Typical Profile for aiming at: IRB Advanced in 2008: 0.1% of banks (Group A) Me thods Proce sse s Syste m s Da taBasel 2 Requirements Ra ting Risk Mitiga tion IRB Foundation Pa ra m e te rs ? ? OpRisk ? ? ? ? Re porting ? IRB Foundation in 2007-8: 9.9% of banks (Group F) Me thods Proce sse s Syste m s Da ta Standardised Ra ting ? ? Risk Mitiga tion ? ? Pa ra m e te rs ? ? OpRisk X ? X X ? ? Group S Banks Group A Banks Re porting Group F Banks Standardised in 2007: 90% of banks (Group S) Me thods Proce sse s Syste m s Da ta Ra ting ? ? ? X Risk Mitiga tion ? ? ? X Pa ra m e te rs X X X X OpRisk X X X X Note: = existing for all material portfolios; ? = existing for some portfolios; X = not existing for most material portfolios for IFC June 2005, Dr. Harry Stordel 26
  27. 27. BASEL II COSTSCRITICAL COST DRIVERS FOR BASEL II COMPLIANCELarge institutions in G10 countries (IRB/AMA banks)1. System complexity2. Requirements on data quality (the devil lays in the detail)3. Frequency and detail of review4. DisclosureSmall institutions in G10 countries (standardised banks)1. Minimal changes vs. today2. Extent of Pillar II review for IFC June 2005, Dr. Harry Stordel 27
  28. 28. 7. Conclusion & Outlook for IFC June 2005, Dr. Harry Stordel 28
  29. 29. CONCLUSION AND OUTLOOKWHAT CAN BANKS AND THEIR STAFF DO? At organisation level – Prepare risk management processes & systems for Basel II compliance – Substantial changes in oversight & governance of those processes – Closer integration of risk management & financial control functions – Closer integration of risk & capital management, e.g. capital allocation by product/counterparty At the risk-MIS level – Correct/timely capture of all transactional and counterparty dimensions – Correct exposure measurement a) for internal purposes and b) regulatory purposes – Pricing systems more integrated with risk assessments (use test) At the individual risk staff level – Work on making data/rating more appropriate, timely and of sounder quality – Trades are entered correctly in the MIS for IFC June 2005, Dr. Harry Stordel 29
  30. 30. CONCLUSION AND OUTLOOKBASEL II IN GENERALSubstantial benefits from aligning regulatory and economic capital – Improved acceptance of capital allocation – Enhanced market perception, process efficiency and risk-based pricing – Increase number of variables to influence capital requirementsNew balancing of strategies – Drive to expand retail business likely to increase competition (e.g. retail, mortgages, SME’s) – Drive to reduce non-investment grade business likely to increase specialization – Drive to push corporate/bank clients to enhance governance/disclosure set-up – Potential of consolidation for banks focused on corporate, SL, SF businessThe industry/supervisory dialogue must go on … to Basel III? – Build a common understanding – Clarification of interpretation issues – Concrete examples and suggestions for IFC June 2005, Dr. Harry Stordel 30