Transcript Overview of Supervision Approach to Credit Risk (IRB) and

CIA Annual Meeting
Session 4405
Future of Credit Risk Management:
Supervisory Approach to Basel II
Ben Gully
Director, Basel Implementation Division
Office of the Superintendent of Financial Institutions
June 29, 2005
CIA Annual Meeting
Session 4405
Basel II General Overview
OSFI Approach to IRB Implementation
Key Issues
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Session 4405
Basel II: Background
• Basel I
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“One-size-fits-all”
Market risk and credit risk
• Basel II
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Tailored approach to internationally active or significant banks
Market, credit and operational risk (all 3 risks are “explicit” in regulatory capital charges)
‘Advanced’ approach to credit risk
Supervisory Review Process
Market discipline
• Moving from CP1 (1999) to Basel II implementation (2007) and beyond
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Consultative period
Parallel reporting
Implementation
Transition period
• Implications
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Financial institutions
Rating agencies
Supervision
Market discipline
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Basel II: Structure
Basel II Framework
Pillar I
Minimum Capital Requirements
• Minimum capital level
• Credit risk (Internal Ratings
Based Approaches and
Standardized Approaches)
• Internal ratings
• External ratings
• Credit risk mitigation
• Operational risk
• Market risk
Pillar II
Supervisory Review
Pillar III
Market Discipline
• Bank internal capital
assessment (vs. risk profile)
• Comprehensiveness and
conservatism
• Internal controls
• Monitoring and
reporting
• Board and management
oversight
• Supervisory review and
intervention
• Disclosure requirements
• Risk profile
• Capital adequacy and
structure
• Risk management
practices
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Basel II: Pillar I – Minimum Capital Requirements
Minimum Capital
Credit Risk
Operational Risk
Market Risk
Standardized Approach
Basic Indicator Approach
(BIA)
Standardized Approach
Internal Ratings Based Approach (IRB)
Standardized Approach
(SA)
Internal Model Approach
Foundation IRB (FIRB)
Advanced IRB (AIRB)
Alternative Standardized Approach (ASA)
Advanced Measurement Approach
(AMA)
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Basel II: Three Approaches for Credit Risk
• Increasing levels of risk-sensitivity
Criteria
Standardized
Foundation IRB
Advanced IRB
Risk weights Determined by BIS
Based on internal
estimates and BIS
formula
Based on internal
estimates and BIS
formula
Risk
parameters*
(PD, LGD
and EAD)
Not applicable
PD – internal estimates
LGD and EAD set by BIS
Internal estimates of all
risk parameters
Credit risk
mitigation
Limited mitigation
Greater recognition of
risk mitigation defined by
BIS
Mitigation defined by
bank
Similarity with Basel 1
Risk Sensitivity
Note: “Internal estimates” means banks’ own estimates
* PD – Probability of Default; LGD – Loss Given Default; EAD – Exposure at Default
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Basel II: IRB Minimum Requirements
• Risk Rating Systems’ Design and Operations
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Broad definition of RRS
Two dimensional RRS: Borrower – PD, and Facility – LGD
Rating philosophy
Rating process - independence and replicability
Data maintenance of all material and relevant risk drives of credit risk
Stress testing and capital adequacy
• Corporate Governance and Oversight
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Board and senior management
Internal audit
Independence of Credit Risk Control Unit (CRCU)
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Basel II: IRB Minimum Requirements, cont’d
• Use of RRS
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Use of internal estimates
Track record of use
• Risk quantification – predicting credit risk metrics based on internal experience
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Probability of Default (PD)
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Long-run average of one-year default rates for borrowers in a given grade
Loss Given Default (LGD)
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LGD and economic loss
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LGD reflects downturn conditions
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Use and retention of historical experience
Exposure at Default (EAD)
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Expected gross exposure of facility upon default of the borrower
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Use and retention of historical experience
• Validation
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Integrity of validation process
Broad approach to validation
Quantitative validation tools
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Basel II: Complexity of IRB Implementation
• IRB approach uses parameters of banks’ credit risk rating systems to drive regulatory capital
• “The term “rating system” comprises all of the methods, processes, controls, and data collection
and IT systems that support the assessment of credit risk, the assessment of internal risk ratings,
and the quantification of default and loss estimates.”
Basel II
• Multiple aspects of implementation:
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Organization (risk management, corporate governance and oversight)
Credit risk processes and procedures
Data
IT systems
Business operations
Capital planning
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Basel II: Key Steps of IRB Implementation
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Organization (risk management, corporate governance and oversight)
Credit risk processes and procedures
Data
IT systems
Business operations
Capital planning
Gap Analysis
Scope Assessment
Implementation Project Plan
Rollout Plan
Implementation
Use Test
Self-Assessment
Approval
Ongoing Monitoring
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Basel II General Overview
OSFI Approach to IRB Implementation
Key Issues
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OSFI Approach: Five Phases
Phase
Description
Time
Phase 1: Monitoring Banks’
Implementation Efforts
Part A: Preliminary bank self-assessment against
AIRB minimum requirements and associated
project planning
Part B: Rollout plan for AIRB implementation
Nov. 2004 to
Jan. 2006
Phase 2: Formal Application
and Preparation for
‘Meaningful’ Parallel
Reporting
• Year 1 of parallel reporting period
• Submission of approval package to OSFI
• Review of banks’ application packages
Feb. 2006 to
Oct. 2006
Phase 3: ‘Meaningful Parallel
Reporting and Completion of
OSFI Review for Approval
• Year 2 of parallel reporting period
• Completion of monitoring of capital reporting
and any outstanding approval work
Nov. 2006 to
July 2007
Phase 4: Bank Approval for
Pillar 1 Credit Risk Capital
Purposes
Two-step approval decision
1. Conditional approval
2. Reconfirmed and final approval
July 2007 to
Dec. 2007
Phase 5: Monitoring of
Ongoing Compliance
• Post approval and ongoing compliance
After Jan.
2008
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Basel II General Overview
OSFI Approach to IRB Implementation
Discussion Points
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IRB Implementation: Discussion Points
• Overall Implementation
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Enterprise-wide implementation - business management, risk
management, IT, internal audit, finance, etc.
Implementation on a consolidated basis – all legal entities, asset
exposures and jurisdictions
Resource management
Timelines
Self-assessment
• Project Management Office
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Coordination of multiple stakeholders - business management, risk
management, finance, IT, etc.
Budget and resource planning
Change management – internal and external stakeholders
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IRB Implementation: Discussion Points, cont’d
• Corporate Governance and Oversight
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Role of internal audit
Role of board and senior management and associated training
Independence
Reporting
• Cross-border Implementation: “Home/ Host” and “Host/ Home”
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Implementation across multiple jurisdictions
Coordination of approval and ongoing supervision
Materiality
Information sharing
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IRB Implementation: Discussion Points, cont’d
• Corporate and Retail Risk Rating Systems
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RRS metrics
Rating philosophy – definition, documentation and operationalization
Validation framework
Use test
Risk mitigation
• IT
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Identification of supporting architecture
System integration and system updates
Data marts and data migration
Capital computation and management
• Data
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IRB data requirements – quality and quantity
Historical retention of loss experience and data availability
Risk quantification
Reconciliation
Data management framework
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Session 4405
Questions
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