Basel II Perspectives Beyond Pillar I Minimum Capital

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  • Pillar II: Supervisory Review Process Supervisors expect banks to operate above minimum regulatory capital ratios to provide a buffer against risks not taken into account or not fully captured by Pillar I Interest rate risk in banking book: Banks need to measure risks (economic value relative to capital) using a standardized interest rate shock Credit risk: stress testing, definition of default, residual risk, and credit concentration risk Operational risk: supervisor to consider whether capital requirement computed in Pillar I depicts a consistent picture of individual bank’s operational risk Liquidity risk: potential losses arising from liquidity crunches.
  • Does Basel Require A-Cyclical Capital? An overview of some fundamental arguments. Bottom of the cycle is always wrong by one time
  • Starting from the right hand side: in Pillar II we will design a process through which we demonstrate to our regulators we have enough capital using alternative views of Capital and stress testing results. Two issues: first we don’t have such a replicable, auditable “process” in place Second: Our risk appetite is not sufficiently defined. It may be as simple as a target rating + a qualitative EaR statement (don’t lose as much as the competition during a down-turn) Risk Appetite will need to be better defined including capital management and allocation policies with respect to business cycles and risk appetite with respect to downgrades (related to stress testing, I will get back to this in the next slide) Going back to stress testing, In Pillar II, we design a transparent, auditable and replicable ‘process’ to demonstrate capital adequacy using ‘alternative’ views of capital and stress testing within the context of risk appetite Need to Design the process Need to Validate ICAAP Risk appetite is currently not sufficiently well defined but will need to be well articulated in Pillar II Capital management and allocation with respect to cyclicality Stress testing and tolerance to downgrades :
  • Basel II Perspectives Beyond Pillar I Minimum Capital

    1. 1. Basel II PerspectivesBeyond Pillar I Minimum CapitalRocky IeraciVice PresidentStandard & Poor’sJune 9, 2009Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.Copyright (c) 2008 Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.
    2. 2. Agenda • An Overview of the Basel II Framework • Basel II Implementation - Common Criticisms • Closer look at Pillar II and Capital Adequacy – Dealing with Pro-cyclicality – Role of Stress Testing – ICAAP Framework • Summary Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.2.
    3. 3. Basel II Framework • The Framework consists of three reinforcing pillars: – Pillar I - Minimum Capital Requirements  Sets out rules and principals for the calculation of minimum regulatory capital required for Credit, Operational and Market Risk.  Ratio of capital (tier 1 or total) to risk-weighted assets. – Pillar II - Supervisory Review Process  National regulators to ensure compliance with minimum standards in fulfilling Pillar 1; audit internal risk rating systems, methodology, risk oversight, internal control, monitoring and reporting.  Assess overall capital adequacy – consider risks not covered by framework. – Pillar III - Market Discipline  Disclosures (e.g. in annual report) allow market participants (e.g. creditors, shareholders) to decide for themselves whether risks has been appropriately measured and managed. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.3.
    4. 4. Basel II Framework Pillar 1: Calculation of Risk Weighted Assets 1) Credit Risk • Standardised Approach – Assign risk weights using rule based method supported by external rating assessment. • Foundation IRB – Use internal risk rating system approved by regulator to produce own estimates of PD which serve as an input to calculate risk weights. • Advanced IRB – Builds on FIRB and allows the use internal risk rating system to produce own estimates of PD, LGD and EAD. 2) Oper. Risk • Basic Indicator Approach – Fixed % of 3yr avg. positive annual gross income. • Standardised Approach – Fixed % with additional granularity by business line. • Advanced Measurement Approach – Use of internal models/methodology approved by national regulator for estimation of Op Risk capital charge 3) Market Risk • Standardised Approach – The capital charge for general market risk and specific risk is determined using supervisory weights by instrument type. • Internal Models – Use own models, approved by regulator, to estimate capital. • Approaches represent a “continuum of increasing sophistication and risk sensitivity.” More advanced approaches = more accurate measure = reduced overall capital charge, all else equal. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.4.
    5. 5. Basel II Framework Pillar II: Supervisory Review Process – Four Guiding Principals • Internal Capital Adequacy Assessment Process (ICAAP): – Institutions should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. • Supervisory Review and Evaluation Process or (SREP): – Supervisors should review and evaluate institutions’ ICAAP and strategies, as well as their ability to monitor and ensure their compliance with own funds requirements. Supervisors should take supervisory action if they are not satisfied with the results of this process. • Supervisors should expect institutions to operate above the minimum own funds requirements and should have the ability to require them to hold capital in excess of the minimum. • Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular institution and should require rapid remedial action if capital is not maintained or restored. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.5.
    6. 6. Basel II Framework • Under Pillar I Advanced approach for Credit Risk, FIs develop Internal Risk Rating Systems to estimate PDs, LGDs, EADs. • These parameters are inputted into a standard formula to estimate the minimum regulatory (credit) capital. • Under Pillar II, FIs demonstrate their capital adequacy using these parameters, for example, in EC and stress testing estimations. • Pillar I is a stepping stone ! EC Adequacy Capital PD, LGD, Reg Capital Stress Testing/ EAD Scenario Analysis Risk Appetite Pillar I Pillar II Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.6.
    7. 7. Basel II Implementation – Common Criticisms • Since first proposal, Basel II has often been criticized. Are these criticisms justified? Some yes and some no… – Extensive data requirements – Too expensive and time consuming to implement – Issues around specific parameter estimation requirements – Conservatism requirement and impact on resulting capital estimate – Issues with Supervisory Capital Formula – Stifle advances in economic capital modelling – Inconsistent application of rules across jurisdictions • Recent economic events led to increased pressure on framework – No restrictions on growth during benign periods – Too focused on Credit risk at expense of other risks – Pro-Cyclicality Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.7.
    8. 8. Basel II Implementation – Common Criticisms • Implementation has not been huge success. Framework to blame? – Yes, there are shortcomings in framework, but some blame must go to how Basel II was being implemented at Banks: • Seen as ‘regulatory tax’ versus way to enhance risk management • Divisions between ‘Risk Management’ and ‘Line of Business’ – Risk not ingrained in strategic decision making – Energy focused on reducing regulatory capital requirements • Relationship between Banks and Regulators • Overwhelming focus on Pillar I minimum capital – Pillar I seen as end in itself instead of an initial step in the development of a comprehensive capital adequacy process. • Crisis has reinforced view that banks need more robust risk management frameworks to deal with varying economic climates. – Key is for industry to adhere to “Spirit” of the full Basel II Framework Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.8.
    9. 9. Closer Look at Pillar II ICAAP Pro-Cyclicality and Role of Stress Testing Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.9.
    10. 10. Pro-Cyclicality – Role Risk Rating Philosophy • Risk Rating Philosophy: Expected behavior with respect to the cycles. – PIT: cyclical, forward-looking – Conditional on Current Information – TTC: a-cyclical, cycle average - Unconditional • An Example Philosophy: PIT via – Keeping RR to PD mapping constant – Continually re-grading the obligors based on the cycle • Spectrum of Risk Rating Philosophies Intended Intended PIT IRRS TTC IRRS Pure PIT, More PIT Hybrid Philosophies More TTC Pure TTC, not not achievable achievable • All info related to an • No changes in RR due to Continuous PD models External Rating systematic reasons. (ie. Relative obligor’s default likelihood utilizing stock market Agencies (i.e. ranking does not change unless is observable, information and leading S&P’s Ratings for idiosyncratic (i.e. company- • Frictionless re-grading economic indicators. specific) reasons system Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.10.
    11. 11. Pro-Cyclicality – Role Risk Rating Philosophy • Pro-Cyclicality refers to tendency for capital held to decrease in ‘good’ times and increase in ‘bad’ times. • Generally not desired as it exaggerates peaks/valley of cycle. Bottom of the Cycle Capital reflecting the maximum capital requirement over a Bottom of the cycle cycle. It is a-cyclical PIT Capital reflecting the capital requirement over the next year. It is Cyclical. l a i pa C TTC Capital, reflecting the average capital t requirement over a cycle. It is a-cyclical. Business Cycle (time) • Rating philosophy plays big part in variability of capital under IRB. • Trade off: Cost of Holding Extra Capital Vs. Cost of Raising Capital at the Downturns. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.11.
    12. 12. Pro-Cyclicality – Built in Stabilizers • Does Basel II Already contain built in stabilizers? Looking at the Components, it can be interpreted it does… - PDs It appears that either philosophy is acceptable. LGDs Appears to be a-cyclical via • Philosophy (a-cyclical vs. “bottom of the cycle” cyclical) vs. Calibration (expected vs. conservative) Working Paper #14, page 71 : “.. - produce the "long run default- • The use test weighted average LGD" rather that • The level of correlations and "point in time" LGD estimates. But.. systemic risk • Diversification Correlations Unconditional - Stress Test Appears to be pushing towards an a-cyclical conservative measure: “If a bank chooses a ratings philosophy that is likely to result in rating transitions that reflect the impact of the economic cycle, its capital management policy must be designed to avoid - capital shortfalls in times of economic stress - ANPR, July 11, 2003” Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.12.
    13. 13. Pro-Cyclicality – Built in Stabilizers • Is concern over the pro-cyclicality of Pillar I capital misplaced? – “Tier I ratio is based on Pillar I capital requirements. And Tier I is the ratio that EVERYONE is focused on. In fact the Total Capital ratio gets virtually no attention these days.” • Cyclical Tier I ratio is NOT desired thus Pro-cyclicality of Pillar I capital is not desired. • However, why are we concerned about Pillar I capital? Pillar I is a stepping stone - it is at best one of the building blocks of ICAAP! – Role of Stress Testing – Role of alternative measures of capital – Integration of the different risk types into overall capital adequacy Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.13.
    14. 14. ICAAP Design Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.14.
    15. 15. ICAAP – “Earlier” Practices • Capital Adequacy was often determined as: – Book Value of Equity > Max (Economic Capital, Regulatory Capital, Rating Agency Capital) • Capital estimated for “Internal” vs. “External” audience. – “Smoothed PDs” used in estimation of “regulatory” capital requirement. • Ad-hoc, non-standardized, non-creditable Stress Testing. – Not formally linked to Capital Adequacy assessment • Liquidity not formally linked to Capital Adequacy assessment. • Insufficiently understood, defined and quantified Risk Appetite • Lack of a comprehensive, robust and transparent framework to assess overall capital adequacy. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.15.
    16. 16. Pillar II – ICAAP • A Regulatory interpretation: • “We need to be convinced that the organizations can convince themselves they have adequate capital using their particular framework and process.” • “Evolution not revolution” • In this broader sense, it would be shortsighted to see ICAAP only as a regulatory compliance requirement. All financial institutions need ICAAP ! • “In Pillar II, aim is design a transparent, auditable and replicable ‘process’ to demonstrate capital adequacy using ‘alternative’ views of capital and stress testing within the context of risk appetite.” • Fundamental question is how do Bank’s measure and manage the ‘safety cushion’ between available capital and the estimate of required risk capital. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.16.
    17. 17. Designing ICAAP - Necessary Ingredients • Pillar I Minimum Capital • A good starting point and a clear improvement over Basel I constant risk weight approach. But still a poor proxy for true economic capital required. • Economic Capital • Why use the proxy if we have EC? • Proven useful as a relative measure but need to be careful when used an absolute measure. • Simplifying assumptions (e.g. Risk Horizon, single default point), • Aggregation difficulties, inter-risk type correlations, • Difficulty measuring, especially Operational and Business Risk, • Validation challenges: Critical model assumptions are hard to validate.. • Nevertheless, certainly risk sensitive and a very useful input. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.17.
    18. 18. Designing ICAAP - Necessary Ingredients • Risk Appetite - Needs to be better understood, agreed upon and quantified! • Target Rating • Incur losses less than direct competition during downturns -Be the “safe choice” during credit downturns • Downgrade tolerance? – Stress Testing Limits • Capital Management policy (how dynamic?) • Preparation via “Fire-Drills” and “War Games” • Stress testing • Capital and Liquidity Contingency Plans Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.18.
    19. 19. Designing ICAAP - Necessary Ingredients • Liquidity formally linked to Capital Adequacy assessment – Capital is for rainy days but Capital is held in less than perfectly liquid assets! – Losses → Expected CFs not materialized →Reduced Liquidity Position – (Magnified) Losses ← Increased Liquidity Risk Premium ←(System wide) Reduced Liquidity Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.19.
    20. 20. Stress Testing - Pillar II Stress Testing Micro Level Macro Level Risk Identification and mitigation (Accuracy of quantification is of secondary importance) Input into Capital Adequacy For example, as a value add for an industry review, or Accuracy of quantification is important Primary when is topical or the business line generates lots of Purpose questions or there are lots of exceptions in lending. Losses in general including foregone Stressed PDs, LGD, EADs, Migration Output revenues Rates Any sub-portfolio can be targeted Macro level by country, Industry etc. Coverage When not enough data expert judgment can be utilized Heavy dependency on data availability Expert Judgment Design a Scenario and analyze the Impact on Capital Quantitative Methodologies Approach and/or Revenue and/or EL Frequency As frequently as needed Synchronized with capital planning Can be case specific Expert Judgment and Simpler Quantitative approaches, Needs to be standardized like modeling the Balance Sheet or the Income Methodology Statement Bank’s exposure to: 1. Real Estate Global, Industry level or regional down-turns and 2. Automotive recessions. 3. Hedge Funds Macro level impact of historically observed or 4. Asset Back Commercial Paper and impact on plausible hypothetical scenarios Examples Capital if brought into the Bank’s balance sheet Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.20.
    21. 21. Stress Testing - Pillar II Stress Scenarios Historical Stress Current Regulatory (Historical stress periods - PIT Economic (Event driven, determined by management) High PD and LGD Periods and Risk Capital Capital the corresponding Macro- economic factors) Appetite the Economics Translated by Department Historically driven TTC Capital Adequacy Capital Adequacy Economic Capital Adequacy Capital Adequacy Capital Stressed Stressed Macroeconomic Factors Regulatory Should consistently apply to all risk types and factors Capital Stressed Economic Stressed PDs, LGDs, EADs, Capital Migration Rates and Stressed Default Rates/ Portfolio Losses MTM Losses Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.21.
    22. 22. ICAAP Design - Managing Capital Adequacy Capital Management Framework Available Capital Available Capital Integrated Stress Testing Framework Stress Capital Limits (Capability for Immediate Planned Growth Liquidity Risk Risk reduction) Credit Risk and Risk Taking Risk Capital & change Market Risk Stress Stressed Integrated in EL/Earnings Capital Earnings Retention Macro Scenario Scenario Safety and Dividend Policy (Hypothetical Economic Effect Operational MTM Losses or Historical) Factors Risk Cushion Business Pro-cyclicality Downgrade Risk Management - Dynamic Tolerance adjustment of capital and/or risk levels Stress Event Current Risk Capital Business Cycle & Risk Capital Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.22.
    23. 23. ICAAP Design - Managing Capital Adequacy • Risk is PIT! • PIT view provides a clearer picture of capital available relative to risk taking. Capital Management Framework Available Capital Available Available Capital Capital ? Capital Safety Cushion Current Current Risk Stress Event Risk Capital Capital Smoothed Risk Capital Business Cycle & PIT Risk Capital Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.23.
    24. 24. Managing Capital Adequacy under Pillar II • Understanding current and planned risk taking in a PIT view and then managing the Available Capital in a more stable (less cyclical) manner should be desirable • We are in fact managing the capital safety buffer (‘shock absorber)’. • TTC Risk Capital would distort understanding of true safety buffer between risk taking and Available Capital. • Effective capital management can be achieved by managing the safety buffer proactively: • Balancing view of risk taking and Available Capital, • Consider effect of stress events and ensure capital buffer can absorb the potential impact, • Incorporating planned growth and dividend policies Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.24.
    25. 25. Summary Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.25.
    26. 26. What’s Next for Basel II? • The Basel Committee have listed key lessons they have learned from the banking crisis*: – strengthen risk capture, especially trading book and Off-B/S exposures – enhance quality of Tier 1 capital – build “shock absorbers” into the framework to dampen pro-cyclicality evaluate the need to supplement risk-based measures with simple gross measures of exposure – strengthen supervisory frameworks to assess liquidity at cross-border banks – strengthen risk management and governance practices at banks – strengthen counterparty credit risk capital, etc. – promote global exercises to ensure implementation of supervisory and industry sound principles *Source: “Comprehensive Strategy to Address the Lessons of the Banking Crisis announced by the Basel Committee”, Basel Committee, 20 November 2008 Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.26.
    27. 27. What’s Next for Basel II? • Fundamental premise of Basel II – putting it into perspective – Making more reliable estimations of key risk parameters. – Designing a ICAAP framework to manage capital adequacy. – Disclosing more information to the market. • Need to maintain perspective that Pillar I is a stepping stone – Designing a comprehensive framework to assess and manage capital adequacy is the real purpose. • Run the risk of killing sprit of Basel II Framework – Imposing punitive restrictions (top down capital requirements) would leave little incentive for Banks to develop better Risk Management capabilities. – Don’t want to turn ICAAP into an ‘external’ adequacy process. Big upside in developing robust internal capital adequacy program. – Basel II should provide the necessary framework and tools to bring sound risk management to financial institutions. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.27.
    28. 28. www.standardandpoors.comThis material was prepared by Standard & Poor’s Fixed Income Risk Management Services group. This group is analytically and editorially independent from any otheranalytical group at Standard & Poor’s, including Standard & Poor’s Ratings.The material contained in this document is subject to change without notice and is for informational purposes only. Standard & Poor’s cannot guarantee the accuracy,adequacy or completeness of the information and is not responsible for any errors or omissions or for results obtained from use of such information. STANDARD &POOR’S MAKES NO WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. In no event shall Standard & Poor’s be liable for direct,indirect or incidental, special or consequential damages resulting from the information here regardless or whether such damages were foreseen or unforeseen.This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategiesmentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correctas of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this material may fall against the interests of the investorand the investor may get back less than the amount invested. The information contained in this material does not constitute advice on the tax consequences of makingany particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as arecommendation of particular securities, financial instruments, strategies to you nor is it considered to be investment advice. Before acting on any recommendation in thismaterial, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Copyright © 2009 by Standard & Poors Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved. None of this information may be copied or otherwise reproduced, repackaged, further transmitted, transferred, disseminated, redistributed or resold or stored for subsequent use for any purpose, in wholePermission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. or in part, in any form, by any person, without Standard & Poor’s written consent.28.

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