Transcript Enhanced Lending Through Modern Credit Risk Management

Day 3
Basel II and Bank Risk Management
Garrett Glass
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The Revised Framework
• The original international bank capital
standards were implemented in 1988 (Basel I)
• Market risk amendments were added in 1996
• The Revised Framework has been developed to
provide more consistency to capital adequacy
regulation and to reduce competitive inequality
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The Revised Framework
• The Revised Framework provides for greater
use of risk assessments from banks’ internal
systems
• A range of options are provided for determining
the capital requirements for credit and
operational risk
• A limited degree of national discretion is
allowed but will be monitored
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The Revised Framework
• As with the 1988 Accords, the Revised
Framework sets minimum capital standards;
regulators can always set higher levels of
minimum capital or set higher standards
• Major changes are incorporated for the
treatment of expected and unexpected losses,
and for securitized exposures
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The Revised Framework
• Regulators will need to monitor banks’ progress
during the implementation period before
allowing a bank to shift over to the new capital
standards
• The revised Accords now constitute Pillar I of
the new Framework
• Pillar II has been added requiring supervisory
review; Pillar III introduces market discipline to
the process
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The Revised Framework
• Some areas require additional work, beginning
with the concept of capital for double default
risk (systemic risk)
• Instruments subject to unanticipated losses
need to be defined more precisely
• Capital applicable to trading exposure will be
studied jointly with the International
Organization of Securities Commissions
(IOSCO)
The Credit Crisis has made this work much more urgent!
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Credit and Operational Risk
• The Revised Framework expands
measurement techniques for calculating
credit exposure and regulatory capital
• A new measure of operational risk capital is
introduced
• Individual claims are expanded to provide
better detail on credit exposure to
sovereigns, public sector entities, other
banks, securities firms, corporations,
residential property holders, and
commercial real estate
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Credit and Operational Risk
• The standardized approach to calculating
capital is still allowed, and is based on risk
weights applied to notional amounts of credit
exposure
• Risk weights are 0% or somewhat higher for
AAA sovereign risk, and become progressively
steeper for commercial bank and corporate
exposures
Libyan banks may be required to use the standardized approach
rather than an internal model approach for risk management
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Credit and Operational Risk
• Investment banks and securities firms are
granted the same capital requirements as
commercial banks as long as the firm is
subject to proper regulation and supervision
• Real estate is given a concessionary weight of
35% under certain conditions (this is less likely
to be granted after the Credit Crisis)
• Risk weights progress up to 150% of exposure
for doubtful loans, corporate loans rated below
BB-, and venture capital exposures
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Credit and Operational Risk
• Off balance sheet credit exposures will continue
to have an asset-equivalency weight as well as
a risk weight under the Standardized Approach
• Acceptable credit mitigation techniques, such
as collateral, have been expanded, but banks
must meet defined legal standards in order to
take advantage of these techniques
Home mortgages as collateral will in the future be considered to
provide much less risk reduction than assumed in 2004
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Credit and Operational Risk
• The Standardized approach to capital
measurement has been considered inadequate
or even wrong by many large banks
• Since 1988 these banks have made progress
on their own internal capital measurement
systems
• The BIS will now allow such banks to measure
regulatory capital with these internal systems,
but only a few very large banks will qualify
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Credit and Operational Risk
• Banks using this Internal Ratings-Based (IRB)
approach must compute four risk components:
probability of default; loss given default;
exposure at default; and effective maturity
• In addition, to use the IRB approach banks
must have a system to determine unexpected
losses and expected losses
• All IRB assumptions are likely to be tightened
considering the Credit Crisis
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Credit and Operational Risk
• The IRB puts assets into five basic categories:
corporate, sovereign, bank, retail, and equity
• IRB risk parameters and risk weight functions
are set at a minimum level by the BIS
• If banks wish to use the IRB foundation method,
they must calculate loss given default; the BIS
will provide the other factors
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Credit and Operational Risk
• Banks which calculate on their own all four risk
components will be granted allowance under
certain conditions to use these, under the
Advanced method
• Basel II presents more detail on calculating
capital for securitized assets
• A Standardized table is provided for most such
securities, but IRB banks may use internal
measures with regulatory approval
Expect major changes in the way central banks calculate
the risk of securitized assets
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Credit and Operational Risk
• In either case, the BIS sets the appropriate
deductions from capital for credit exposures
which have been securitized
• Greater flexibility is allowed for interest only
strips, Special Purpose Entities, and other risk
techniques not covered by the 1998 Accords
This flexibility is likely to be eliminated altogether !
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The Trading Book
• Trading assets are given a new definition
under the Framework: financial instruments
and commodities held in a trading book
must be intended to be traded or to hedge
other instruments in the book
• These assets must be free of restrictive
covenants on their tradability
• Mark to market of the book must take place
frequently and actively (at least daily), and
the portfolio must be actively managed
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The Trading Book
• A financial instrument is any contract that gives
rise to both a financial asset and liability of an
entity or equity
• Primary financial instruments have cash
characteristics; derivatives are secondary
financial instruments
• Trading intent means the positions are held
intentionally for short-term resale or for the
purpose of benefiting from expected short-term
price movements
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The Trading Book
• A trading book must have a clearly
documented trading strategy set by senior
management; this strategy must include a
holding horizon
• Policies and procedures for the trading book
require that it be managed on a trading desk,
have position limits, be subject to daily mark to
market or mark to model, and be assessed
regularly for liquidity availability
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The Trading Book
• Prudent valuation policies must give
management confidence that the values are
reliable, the sources of market information are
identified and appropriate, closing prices are
chosen when available, and that the valuation
be done independent of the front office
• The more prudent side of the bid/offer must be
chosen for mark to market purposes
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The Trading Book
• Where mark to market is not possible, mark to
model is permitted if prudent
• Mark to model is any valuation which has to be
benchmarked, extrapolated or otherwise
calculated from a market input
• Extra conservatism is required for marking to
model
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The Trading Book
• Senior management should know at all times
which books or components are being marked
to model, and the materiality should be
identified
• The market inputs must be sourced as much as
possible from market sources
• Generally accepted valuation methodologies
must be used if known
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The Trading Book
• If the institution develops the model on its own,
the assumptions should be appropriate and
assessed by a party independent from the
developers
• The front office should not participate in the
development or testing process of a model
• Change control procedures for models should
be clear and independent
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The Trading Book
• The model should be reviewed periodically for
performance, including analysis of P/L against
the risk factors
• Valuation adjustments should be made to cover
the uncertainty of model valuation
• Dealers may perform daily mark to market, but
price verification must be done independently
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The Trading Book
• The independent verification need not be done
daily, but at least monthly or coinciding with
valuations done for purposes of the bank’s
books and records
• Reserves may be necessary when a third-party
is providing valuation
• Reserves are required for unearned credit
spreads, close-out costs, operational risks,
early termination, investing and funding costs,
future administrative costs, and model risk
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The Trading Book
• Less liquid positions may also require reserves;
reserves may also be necessary for stale
positions or concentrated positions
• Banks must consider the volatility of market
prices in close-out situations
• All valuation adjustments must be reflected in
regulatory capital
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The Trading Book
• Internal models have been found to be a major
source of financial loss in the Credit Crisis
• Securitized assets and derivatives have been
poorly modeled, with inadequate reserves for
loss of liquidity in the market
• The problem for regulators is that some
products demand such high reserves against
loss that they are no longer profitable
• On the other hand, these products should never
have been traded in the first place
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Operational Risk
• One of the recognized weaknesses of Basel
I was the lack of capital charges for
operational risk
• Operational risk is defined as the risk of
loss from inadequate or failed internal
processes, people, or systems, or from
external events
• Legal risk is included but operational risk
excludes strategic and reputation risk
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Operational Risk
• The Framework now provides for a capital
charge for operational risk; banks may use
one of three methods, but may not revert to
a simpler method without supervisory
approval
• The Basic Indicator approach assesses a
15% capital charge on the past 3 years of
gross annual income (net interest plus noninterest income)
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Operational Risk
• The Standardized approach is similar
except that eight businesses are identified:
corporate finance, trading and sales, retail
banking, commercial banking, payments
and settlements, agency businesses, asset
management, and retail brokerage
• Regulators provide a table of capital
charges to be applied to the past 3 years
average gross annual income for these
businesses
• The charges range from 12% to 18%
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Operational Risk
• The Advanced Measurement Approach is
allowed for those banks with their own
internal operational risk measurement
systems
• Typically, such banks have extensive
internal data available on their operational
losses
• These banks will be allowed
diversification benefits across businesses
where such benefits can be justified
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Pillars II and III
• Pillar II emphasizes supervisory review
processes and is intended to encourage
banks to continue to improve their risk
management processes
• Pillar II recognizes that Pillar I capital
requirements are only minimum standards
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Pillars II and III
• Pillar II is intended to capture risks not
considered in Pillar I, and risk factors not
taken into account in Pillar I
• These would include business cycle effects
and other recurring loss phenomena
• Banks can mitigate these additional capital
charges through strengthened risk
management, improved internal limits and
controls, and higher provisions and reserves
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Pillars II and III
• Pillar III recognizes the weaknesses of the
regulatory capital approach: banks may pay
more attention to regulatory requirements than
to market discipline
• Accordingly, under Pillar III banks are judged on
the quality and type of information they disclose
publicly, subjecting themselves to market
discipline
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Pillars II and III
• Banks can enhance their exposure to market
discipline with greater disclosure about their risk
management practices, the capital assigned to
their businesses, capital assigned to risk
categories (credit, market, operational,
strategic, etc.), and capital resulting from IRB or
Advanced Method approaches
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Pillars II and III
• Supervisors will assess publicly disclosed
information against accounting requirements
(including materiality and frequency
considerations), proprietary standards, and
legal requirements
• Banks are expected to disclose sufficient
information on their Tier 1, 2 and 3 capital
levels, and capital ratios
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