Are Crop Insurance Payments Distributed Fairly Across Crops?
Are Crop Insurance Payments Distributed Fairly Across Crops?
Essential Risk-Based Capital Concepts and
the (Not So New) Basel II Accord
FASTrack Capital Workshop
June 15, 2006
Bruce J. Sherrick
integrated Financial Analytics and Research, LLP
“The proposed new Basel II Accord is now described and
amended on over 750 pages of text, and the word ‘agriculture’
does not appear once.” (Peter Barry’s observation at the Capitalizing
for Risk in Agriculture Symposium, subsequently revised upward)
“The impact and consequences of Basel II will be immense for
financial institutions. New processes and procedures need to
be implemented, and there is a tremendous need for new data
management…. data issues are enormously complex requiring
(long histories) and external validation” (Susan Andre)
Some More Quotes…..
I aged quickly and not gracefully”
John Hawke, Comptroller of the Currency, 2002
“… these proposals on Basel II and the amended Basel I
represent substantial revisions to the regulatory risk-based
capital rules applied to U.S. banking institutions, from the very
largest to the smallest” Governor Susan Schmidt Bies, 2006
“Far better an approximate answer to the right question than
an exact answer to the wrong one – the latter of which may be
made arbitrarily precise via a redefinition of the question”
(various attributions including Sherlock Holmes)
Does Basel II ask the right questions?
Introduction to Economic Capital
Basel-II’s Role in encouraging the “right
amount” of economic (rather than
regulatory minimum) capital
Basel II and the FCS
Some Strategic Implications
Views of “Capital” differ:
Owners see as synonymous to wealth:
Financial Officers (CFO, Treasurer…):
Funding source and capacity for growth
Growth in value
Current Return (income)
Riskiness of growth and return stream
Safety and soundness: Historic View that Too Much is
Basel II – Economic Capital Aligned for Efficiency
Hold Economic Capital to Cover
Expected: loss allowance
Credit risk: borrower’s default
Market risk: effects of interest rate changes
on asset and liability values
Operational risk: failed human, performance,
processes and technology
Economic Capital Needs
Frequency: Probability of default (PD)
Severity: Loss given default (LGD)
Amount: Exposure at default (EAD)
N.B.: Separation of PD from LGD is a KEY distinction
from typical risk-rating practices in current practice.
What is Economic Capital ?
Various views including:
Amount needed to “insure” against
undesirable outcome with given tolerance
Guided by actuarial principles and market
pricing of ROE risk
Backstop for risk and growth
Includes equity capital and loss reserves
Who is this “Basel” anyhow..
Basel Committee on Bank Supervision
Committee of central banks and regulators
from major industrialized countries
Headquartered in Basel, Switzerland
Hosted by the Bank for International
What Does Basel Do?
Provides broad policy guidelines for each
country’s regulators to adopt or modify
Forum for Industry interaction
Extensive staff and research program
Fosters international monetary and
financial cooperation and serves as a bank
for central banks.
1988 Basel Accord (Basel I)
Targeted at large, international banks
Adopted by over 100 countries; applied to
all U.S. banks and other financial
institutions, including the FCS
Slots loans and securities into four risk
classes (e.g. all commercial and
agricultural loans treated the same)
The de facto standard. Period.
Basel I (1988 cited as 1st adoption)
New measures and
Crude risk classes
Not responsive to
Largely ignores passage
of time and risk
Background – Basel I to present
Basel Accord of 1988 aimed to homogenize (capital and other) practices of
internationally active banks, beginning with those in the G-10 countries.
Formally in place now in >100 countries, de facto standard for nearly all.
Represents a Minimum Hurdle view of capital
e.g., 8% with standard weights, non-responsive to changes in non-categoric risks
“The purpose of requiring banks to hold capital is to prevent 1-sided bets.”
– K. Rogoff, Journal of Economic Perspectives, 1999 special issue on
international bank regulation.
Viewed as deductible applied against implied public backstop for financial
Background – continued
Cost of excess capital not borne by public regulator
Cost of too little capital is borne by taxpayer
Rational intent to set capital requirements with high likelihood
for adequacy = low tolerance for insolvency risk
Basel II – the main idea
Basel II consultative (early warning) document in 1999 with indications
that new proposal would represent a move toward “economic” capital and
more market pricing of risk.
January 2001 “package” reflecting comments on proposals and indicating
additional details on risk classes, rating and so forth. First attempt at
timeline for implementation – since delayed formally at least 5 times.
Outlines 3-pillar approach
minimum capital calculations
explicit and more homogenized role of supervisory review
reliance on increased market discipline through increased disclosure
Basel II - continued
Early 2002 began development and distribution of QIS
materials – intent to assess the implications for aggregate and
specific capital under new guidelines. Current version is QIS5
Some important information about use of QIS results:
calibration during phase-in
same total capital in system (more later about this point…)
incentive to use more risk-sensitive internal ratings systems
working example: loan asset with .7% probability of default and 50%
LGD and 3 year maturity would require 8% capital.
Basel II - continued
Interest rate risk moved toward “operational risk” and treated
in pillar 2.
Sophistication in funding can transform interest rate risk to counter
party credit risk (W. Staats).
Increased granularity – more finely disaggregated risk
categories in principle leads to better risk-pricing opportunities
– has been bane to FCS Banks – conflict with existing bond
rating categories and Rating Agency tables.
Requires formal evaluation of PD, EAD, LGD, and some
measures of “relatedness” (correlation).
Basel II – Major issues for Ag involve
credit and operational risk
---- Credit Risk ---Evaluation
adapted from PWC and BIS
Credit Risk Options – the pecking order
Broad categorizations required (no choice); institution assigns ratings
linked to PD calculations. Other inputs set by supervisor/regulator
Similar in concept to BASEL I with a few additional risk ranges and
In addition to PD calculations, institution uses model-based estimates
of LGD and EAD, subject to regulatory approval.
FCS Institutions are planning to be FIRB and AIRB – some
are getting pretty good infrastructure…..
The Basel II Proposed Accord
Basel’s Role: To Standardize Economic
Capital and encourage Efficient Deployment
Allow Market Price of Risk to be determined
Respond to changes in risk through time
Simplify and Homogenize Safety and Soundness
Basel II is both following and leading
Following “best practices” of the top tier of
banks world wide
Major developments in management, measurement,
Leading/stimulating wider adoption and
tailoring to institutional size and
Basel II Process
First draft - 1999
Second draft - 2001
500 + pages
Too complicated; trades off complexity and refinement
First “Final” version - 2003
Scaled back with calibration for phase in
Implementation: end of 2006 or later
2nd through 5th Final Versions include QIS studies
and templates for “parallel” calculations and
Basel II – Current Timeline
2005 - prelim
2006 - final
2009 – 95% floor
2010 – 90% floor
2011 – 85% floor
Minimum capital requirements (our focus)
More intense as an institution uses its
internal systems to measure risk
Goal attainment and management quality
Increased disclosure and market discipline
Accord contains a spectrum of approaches
Institutions can choose the appropriate
approach, subject to documentation
Incentives (lower capital) are provided for
better risk management
Minimum Capital Requirements
for Credit Risk – 3 approaches
1. Standardized Approach
Similar to existing capital regulations
More risk weighting categories for commercial
loans (0%, 50%, 100%, 125%, 150%)
Mapped to external credit ratings or not
Applicable to “community banks” or those
approved by regulator
2. Internal-Ratings Based Foundation
Institution estimates the probability of default
(PD) for at least eight risk classes and five years
Retail loans: Estimate PD by customer segment
Regulator provides severity of default (LGD)
Regulator approves institutions methodology
Applicable to “regional banks” or those
approved by regulator
Advanced IRB Approach
Commercial loans: Institution estimates PD,
LGD, and EAD
Retail loans: Same as Foundation approach
Adjustments for loan maturity,
concentration, and risk enhancements
More rigorous documentation
Applicable to “Large, Internationally active
banks”, or those approved by regulator
Failed human practices, processes, and
technology: Enron, WorldCom, Tyco
Employment practice and work place safety
Clients, products and business practices
Damage to physical assets
Execution, delivery and process management
Percent allocation: 20% - 12%
Build a database for adverse events (type, frequency,
Risk in trading book
Addressed in several amendments to
Basel I, using VaR approaches
Interest rate risk not yet included in
minimum capital requirement, yet explicit
in FAMC, OFHEO regulations
Much Left to supervisory review
Rating the Customer
Probability of default by class
Rating the loan facility
Seniority of claim
3rd party guarantees
Loss-given default by attribute
The Dual Rating Idea
Economic Capital includes UEL or the Unexpected Loss as well.
___% capital should be adequate ___% of
How Safe – How many vote for:
50% of the time
95% of the time
99% of the time
99.97% of the time
100% of the time (don’t lend)
Now answer as a borrower…
Greater safety = more conservative =
Basel’s Risk Rating Factors
At a minimum, methods and data should account
Historical and projected cash flow repayment ability
Quality of earnings
Quality of information
Financial flexibility: Liquidity
Position in industry: Peer group standing
Correlations and Concentrations
Very real effects
Correlations: How returns and losses move
together; lower the better
Concentrations: Dominating portfolio positions
by commodities and loan sizes
Basel adjusts for concentration and assumes
an average correlation
Ag Losses unlikely to satisfy best principles for
low correlation, low concentration, and easy
Basel II in Pricing…
Expected loss: provision and allowance
Unexpected loss: risk premium covers the cost
of holding equity capital (see C8.xls)
Explicit cost of capital in loan pricing against
actual RBC requirement for that loan exposure
Shocking the model with significant
downgrades of credit quality (increases
in PD and LGD) and assessing capital
Could be linked to changes in borrower
conditions, or macro conditions
Stress testing is an inherent part of
enterprise-wide risk management
Economic capital models and measures
should be designed to include stress
To Qualify an IRB system…
Portfolio broken into 9 or more groups: Corp, Retail, Bank,
Sovereign, Equity, Project, etc., – not clear where ag fits
Must demonstrate ability to estimate PD and backfit (out of
sample validation) – very tough for small community banks,
small commercial banks with limited ag loans
Collect, store, and update key borrower/loan characteristics –
very tough for ag loans, esp. mortgages
Board and Management Qualifications
Distinctions for credit risk that are “meaningful”
(i.e., cannot use scale where all loans get same score)
Development of IRB Risk Rating systems involves tradeoff
between high fixed development cost and (potentially) lower
flow costs. Favors large lenders with good data (FCS, a few
Increase pressure to consolidate.
Data becomes increasingly valuable.
Pay to play? Some may opt out, or contract for coordinated
Successful == more accurate risk pricing as well.
RBCST parallels (tries to reflect Basel II ideas)
Markets are brutally efficient in long run – capital will seek its
Operational risk – much larger issue than in past.
Regulator are more “on the hook” in any case.
Basel and FFSC documents have some similar intent to
“promote the standardization in capitalizing, reporting, and
Less data availability makes those that are available more
valuable, and increases potential for more “overfitting”.
Disclosure pillar reduces distance (insulation) between
management and boards.
Market discipline – embarrassment of non-compliance will be
Regulated vs. unregulated lenders (i.e., how will Deere react?).
Top Ten Discussion Points
Regulators much more involved.
Incentive to avoid interest rate risk or convert to
Pro-cyclicality (not good news for ag-lenders).
Flow advantages to IRB methods.
Fixed cost advantages of non-compliance and
Ostrich strategies will fail.
Top Ten Discussion Points – cont’d
Different effects on different types of lenders (coops vs. mutual, vs. stock
vs. vendors) New opportunities for packaging/partnering with different
firms if easier to lend to vendor than to customer.
Calibration to current “total on average, but not individual lenders”
strongly favors IRB approaches, very scary for standard approaches.
Current QIS4 and QIS5 Calibration examples seem extreme for ag loans
with good collateral.
Catch-22 of establishing new compliant data systems with length of history
Extremely data dependent/model driven – strong likelihood for overfitting
with existing ag data sets. Good potential for increased risk delineation.
“Lead or Follow” a meaningful strategic decision – especially for FCA
FCA Issues …
Huge benefits to standardized reporting, updating financials on
current loans, and development of data warehousing.
Chance for System to manifest “demand for regulation” (ala
Stigler, ADM,….) to suit comparative advantages
Additional pressures for historic data consolidation.
New more complicated incentives and payoffs to capital
arbitrage – and new forms (e.g., w/FAMC).
BIS studies of effects of Basel I found few cases of credit
rationing, likely to be worse with Basel II.