Transcript Management of Capital within Wholesale

The Significance of Basel 2
How international best practices may influence
your reputation and your business
International Banking Club "ANALYTICS UNLIMITED"
Moscow, April 2, 2008
Cris van Kempen
Regional Head Central & Eastern Europe
ABN AMRO Risk Advisory Services
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Outline
 Basel 2 Framework is Good Practice Risk Management
 Basel 2 - Background
 Differences between Basel 1 and Basel 2
 Basel 2 Framework – what does it say?
 Data Requirements
 Basel 2 Challenges
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Good Practice Risk Management
Looks at risk v. reward, not just at risk
Covers all risks

Not just those easily quantifiable: Enterprise Risk Management
Integrated

Common language for all types of risk: Economic Capital
Based on the possibility of economic loss

Economic, rather than Regulatory or Book Capital
Objective rather than expert based

Risk models

Heavy data requirement
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Basel 2
=
Good Business and Risk Management Practice
In essence aligning a Bank’s capital with the
risk it currently incurs and more importantly
unexpectedly may occur
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The Strategic Value of Risk
“….The typical belief is that risk management focuses on loss
avoidance. This view is based on the history of Risk management being
control focused.
However risk management has evolved rapidly to address the more
strategic issue of optimisation of return on risk. This evolution has
been accompanied by statistical, mathematical and financial
techniques….”
David Belmont in “Value Added Risk Management” (2004)
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The Evolution of Risk Management
Capital
Allocation
Portfolio
Management
Maximise
Earnings
Potential
Measurement Across
Risks
Risk v.
Return
Earnings
Stability
Identification
TYPICAL CURRENT SYSTEM
Awareness
Protection
against
Unforeseen
Losses
STRATEGIC
ADVANTAGE
CONTROL
Risk Management sophistication
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Basel 2: Best Practices in Risk Management
– Risk Management is a key success factor for a banking strategy
Current global banking environment demands best Risk Management practices to
withstand tough competitive pressures and public scrutiny
– Risk enhancements should be driven by a strategic vision, going beyond Basel 2
compliance:
– The alignment of the business model to the formal requirements
– The alignment of the organizational structure to the business model
– The alignment of the IT structure to the business model and the formal requirements
– Basel 2 is more than a set of regulations
it is a wholly different approach towards risk management, -measurement, -monitoring
and -reporting, formalising Best Practices
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Basel 2 is more than complying with regulations
Within banks, it is highly important that Basel 2 not be
treated as a compliance exercise. It has to become part of
the management and governance of the bank with a greater
focus on risks an how those relate to the capital the bank is
holding.
Nicolas Le Pen
Chairman of the Basel Accord Implementation Group
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Behavioural changes of Banks
Detailed data requests submitted to customers
Full disclosure (e.g. financial information on clients parent
company will be required)
Credit Portfolio Management : a ‘need to have’
Short term behaviour driven by rating
Credit derivatives market booming with AAA/AA rated banks
becoming the winners
Compulsory Ratings Disclosure
Standardisation pays off (i.e. program lending under retail
approach)
No more back up / liquidity facilities and other unused
commitments
Spread widening for high capital cost portfolios, spread
tightening for low capital cost portfolios
Less willingness of local operations in emerging markets to
buy government paper
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ERM and Basel 2 can help you reach your potential
Share Price
Access to
Capital Markets
Strategy
Investments
Acquisitions
Divestments
Capital Requirement
Rating
Portfolio Management / Capital Allocation
Return Data
Risk Data
Operational Risk Management
Credit Risk Management.
Market Risk Management
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Economic Capital
99.97%
Confidence level
Probability
of Loss
Expected loss
Unexpected loss
- absorbed by
provisions and margins
- absorbed by riskbased Economic
Capital
Basel 2 capital
requirements = UL
Potential
unexpected loss
- against which it would
be uneconomical to
hold capital
Amount of
Capital Lost
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BIS 1 (1988 Accord - Basel 1 ) Background
Conclusion:
Capital
Capital is somehow
independent from risk
Regulatory capital
8%
Risk
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Limitations and Advantages of Basel 1
 “One size fits all”

causes mis-pricing of credit risk, distorted metrics

supervisors check compliance rather than risk management

false sense of security
 Risk Asset Ratio static regardless of the economic cycle

inhibits efficient credit risk management process
 No benefit for diversification, no penalty for concentration
 No differentiation for duration
 Promoted capital arbitrage

Advantage: Easy to set up and check
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Basel 1 vs. Basel 2
Basel 1
Basel 2
•Finance content
•Quantitative
•Risk content
•Qualitative and Quantitative
•One standard for all
•Risk differentiation
Capital cost is determined by own estimates: a
bank’s history/track record determines its ultimate
capital cost
•Introduction of new asset classes (SL, SME)
•Introduction of a portfolio approach for retail assets
•Introduction of Operational Risk
•Three alternative approaches
•Three Pillars including all aspects of Risk Management
•Focus on Data
•Corporates – Banks – Sovereigns
•Exposure by exposure calculation
•Credit Risk & Market Risk
•One approach for all
•RWA calculation only
•Limited data use
Basel 1 = 33 pages
EU CRD > 500 pages + CEBS + regulator specific
The Basel regulatory capital formula for credit risk maintains the current definition of total capital and the
minimum 8% requirement:
RWA = EAD x PD x LGD x M
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Basel 2 Framework – what does it say?
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Basel 2 - Background
What is it?
 A new Capital Adequacy Framework for the Financial System
 A risk sensitive approach to capital allocation
 A new methodology to assign economic capital on risk adjusted basis

dramatic impact (at profitability level) on the Banking Industry

changes the rules of the game one of the most significant raw materials “CAPITAL”
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Basel 2 – Why ?

Needed to enhance the soundness and stability of the international
banking system (globalisation)

More risk sensitive capital requirements

Stronger risk management practices (quantitative and qualitative)

Enhanced supervision and transparency
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The 3 Pillars of Basel 2
Mutually reinforced Pillars
Pillar 1
Minimum capital
requirements
Credit risk
Market risk
Operational risk
Pillar 2
Supervisory
Review
• Tailor approach to
regulation - for risks in Pillar I
not fully taken account of, or
risks not in Pillar I
• Active dialogue between
Supervisor and Bank on
capital adequacy
Pillar
Market Discipline
• Meaningful disclosure
by Banks
• Reliance on Banks’ own
assessment requires
greater transparency
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Basel 2
The document (www.bis.org)
Mutually reinforced Pillars
Pillar 1
Minimum capital requirement
Pillar 2
Pillar 3
Supervisory Review
Market Discipline
Approaches
• Standardized
• Internal Rating Based
Foundation
Advanced
Credit
Market
Operational
•
•
Tailor approach to regulation.
Active dialogue between
Supervisor and Bank on
capital adequacy
Asset Class
Corporate
Bank
Sovereign
Retail
“Larger” Corporate
SME
Specialized Lending
“thorough evaluation of Bank’s
risks and processes”
• Meaningful disclosure
by Banks
• Reliance on Banks’ own
assessment requires
greater transparency
Project Finance
Object Finance
Commodity Finance
IPRE
HVCRE
Equity
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Three Approaches to Credit Risk
Banks may utilise one or more of the following Basel 2 Approaches to calculate Credit Risk RWA
Standardised Approach
•Based on the existing Basel I
Framework
•Incorporate external ratings
Foundation Internal
Rating Based Approach
Advanced Internal
Rating Based Approach
•Based on internal ratings (e.g.
PD)
•Based on internal ratings
•Supervisor dictates many of
the risk weight elements (e.g.
LGD)
Lower sensitivity to Risk
•Use own estimates for many
of the risk weight elements.
High sensitivity to Risk
The key difference between the Basel 1 and the Basel 2 approaches to
the calculation of the Credit RWA is the inclusion of counterparty ratings
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Credit Risk - Building Blocks
1. Probability of Default (PD)
The likelihood a debt instrument will default within 12 months
2. Exposure at Default (EAD)
Anticipated outstandings + ( (facility limit – anticipated outstandings) x Usage
Given Default %)
3. Loss Given Default (LGD)
Net Collateral Value”NCV”/Exposure at Default (EAD)
NCV = collateral value x recovery rate
4. Maturity (M)
Captures the higher/lower average risk of a credit with a tenor greater than one
year
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Pillar 1 Credit Risk (FIRB & AIRB)

For our purposes, the main requirement arising from the Pillar 1 credit risk calculation
is that we can no longer derive Credit Risk RWA directly from the balance sheet.
Instead of fixed risk weights (0%, 20%, 50%, 100%) per chart of account line, the RWA
is now a continuous function.
RWA = f (PD, LGD, EAD, M)

PD per obligor is derived from the ratings infrastructure owned by Risk.

LGD is derived from risk ratings infrastructure, and in some cases from data about
credit risk mitigants (collateral, guarantees, netting, credit derivative protection)

EAD is dependent both on risk data (limits) and data about actual outstandings (as is
M).
EAD = f (Outstandings data, Risk data)


As a result we have to integrate data originating in the bank’s booking systems with
risk data.
The Pillar 2 control framework requires us to ensure that the data used to derive RWA
is consistent with the financial statements.
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Other Basel 2 Related Requirements

A counterparty is only allowed to have one UCR bank wide.

All counterparties must be reviewed at least annually. Dependent on UCR
and credit committee decision the review frequency can increase.

Different counterparties belonging to one group can be assigned different
counterparty ratings, because each individual credit risk (customer), is rated
on its specific merit.

Guarantors must be rated separately.

We need to have 5 years of UCR-information.

We need to have 7 years of defaulted counterparty information.

The rating models used (both UCR and LGD) must be validated annually.
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Pillar I for Operational Risk
Stage 1
Basic
Indicator
Approach
Stage 2
Standardised
Approach
-One size fits all
N
- o incentives for
better ORM
Stage 3
Advanced
Measurement
Approaches
-Risk based
I- ncentive to
manage risks
Sound Practises Paper
Simple
Low
Less reflective of actual risk
Simplicity
Granularity
Risk sensitivity
Sophisticated
High
More reflective of actual risk
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Basic Indicator
Average annual gross income over the previous three years
multiplied by 15 % . Gross Income is defined as net income plus
net non interest income – as defined by National Supervisors.
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Standardised Approach
Essentially the same approach as the Basic Indicator but more refined with an
indicator eg sales for each business multiplied by a factor ;
Line of Business
Factor (example)
Corporate finance
18 %
Trading and sales
18 %
Retail banking
12 %
Commercial banking
15 %
Payment and settlement
18 %
Agency services
15 %
Asset management
12 %
Retail brokerage
12 %
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Advanced Measurement Approach
Regulatory Requirements
Internal Data
External Data
Business Environment & Internal
Control Factors
Scenario Analysis
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AMA Qualifying Criteria
Quantitative Standards

One Year Holding Period and 99.9% Confidence Interval

Procedures for Model Development and Validation

Estimation of Correlations Allowed under Certain Conditions
Four Key Elements

Internal Data

External Data

Scenario Analysis
Business Environment and Internal Control Factors

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Basel 2 provides flexibility
Basel 1
Credit risk
weightings
Limited number of risk
weighted categories:
0%,10%,20%,100%,
Recognition of
credit risk
mitigants
Limited recognition of
collateral (cash, bank,
and OECD securities)
Specific market
risk charge
Specific
operational risk
charge
Basel 2
Standardised: Based on
external ratings from 0%
to 150%; unrated 100%
Advanced IRB:
Increased risk sensitivity with
weighting function based on
advanced internal models
Extended list of available collateral, subject to final approval from local regulator
Standardised/Internal
Models *
Not applicable
Foundation IRB: Increased
risk sensitivity with risk
weighting function based on
internal models
Standardised
Basic Indicator: 15% of
bank’s gross income
over the previous three
years
Internal Models
Standardised: Gross income
serves as a proxy for the
scale of a bank’s business
operations
Advanced Measurement
Approach (“AMA”): Internal
models are used, subject to
approval from local regulator
Supervisory
oversight
Informal
Formal evaluation of banks and risk assessment by supervisor (process, controls, models).
Additional capital requirements could be added
Disclosure
to the market
Voluntary
Requires establishment of a fully developed disclosure regime; detailed disclosures
concerning holdings, risk management methodologies, and capital adequacy assessments
“Least Advanced”
“Intermediate”
“Most Advanced”
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Data Requirements
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Data Requirements
“Consistent quality data is the key to a
successful Basel 2 implementation”
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Data Requirements
The amount and granularity of data has increased enormously since Basel 1
To calculate the Credit RWA under the IRB approaches we need granular data in the following
categories…...
SBU solvency adjustments)
2) Credit Approval Data e.g. Approved
Facilities, Internal Ratings assignment (UCR to Obligor/LGD
Class), GFID
Integrated 3) Credit Registration Data e.g.
Booked Facility, Usage Amounts, GID
Data Sets
4) Central Risk Inputs e.g Collateral
6) Results Data
1) Financial Data e.g. Outstandings, Cross-
Types, UCR relation to PD/ LGD Class to LGD %, Basel II
Specific (haircuts, CCF)
5) Standard Financial Data e.g.
Basel I codes (Risk weight % to COA), COA
7) Operational Data
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Data Sourcing – Underlying Principles
Get close to the G/L for
asset data while
maintaining required
granularity
Criteria all source systems
must meet
As part of this strategy, the choice of source systems for Basel 2 data is underpinned by two key principles
Complete
Data should give complete coverage, including applicable adjustments
Strategic
Investment in data sourcing should take account of existing strategic
change programmes & re-use possibilities
Granular
Chosen source systems must be able to meet the low level of granularity
necessary for Basel 2
Reliable & Robust
Data must be from systems that are sufficiently maintained & supported
Controlled
Data must be from appropriately controlled sources (SarbOx & B2)
Timely
Data must be available and signed off, in an appropriate time window
Reconciled
Data must be from reconciled sources
High Granularity
Adjustments
Adjustments
Ideal Sourcing
Point
Low Granularity
Booking
System
Finance
Sub-Ledger
Financial
Consol. Systems
G/L
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Data Model
Describes what data (i.e. information) does the business need to
keep track of
Describes what processes does the business need to perform.
Describes entities, attributes, relationships
linked together (i.e. Process/Entity matrix) they form a Business
Model
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Data Model
Provides a project with a consistent "language" set aligning it with
other users of the Model, both externally and internally
Starting point for construction of a Logical Data Model is
preferably (an industry) standard model

IBM's Banking Data Warehouse Model (BDWM)
Customisation of the Model is allowed assuming:

the essential terminology of the Model remains intact

customisation is controlled centrally to ensure consistent management information
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The data inter-relationships are complex
Organization
Size Measure
Type
Ultimate
Parent
Organization
Incorporation
Country
Financial Statement
Currency
Organization
Obligor Group Id
Financial Statement Total Assets
Financial Statement Total
Individual
Residence
Turnover Country
Financial
Statement
Publication
Event
type
Period
Balance
Type
Event
Involved Party
Measure
Measure
Unit Of
Involved
Measur
Party
e
Measure
Type
Involved Party
Involved Party Unique Id ..
Involved Party Name
Involved Part Description
Basel II Counterparty
Type
Approved UCR
Grade
Standard & Poor’s Debt Rating
Grade
Moody’s Debt
Rating
Collateral
Valuation
Credit Facility Limit
Reduction
Principal Repayment
Interest Payment
Credit Related Fee Payment
End Of Period Reporting
Arrangement
Event Type
Arrangemen
t Event
Grade
Involved Party Type
Involved Party Role
Fitch Debt
Rating
Event Type
Credit
Type
Grade
Credit Derivative Provider
Organization
AAB
Global Industry
Protection
Provider
Guarantor
Unit
Classification
Counterparty
Hedge Provider
Event
Counterparty Id
AAB GAIN Reporting Entity
Equity Issuer
Issuer
Primary Currency
Primary Name
AAB GAIN
Head Office Reporting Entity
Description
Reporting Entity
Booking
Arrangement
Number
Product Arrangement
Arrangement Type
Approved Internal LGD
Effective Date
Indicator
Organization
Arrangement Unique Id
Classification
Unit
..
Credit Risk Mitigation
Product Arrangement
Committed Facility
Arrangement
Individually Managed
Primary Name
Arrangement
Type
Indicator
Measure
Credit Facility
Credit Facility
Management
Credit
Protection
Description
Credit Risk Mitigation Maturity
Account
Measure
Credit Risk
Arrangement
Type
Arrangement
Date
Debit Interest Computation
Collateral
Arrangement
Arrangement
Period
Trading Book / Banking Book
Mitigation
Arrangement
Calendar Basis
Basel II Recognised
Balance
Indicator
Arrangement
Measure
Netting
Credit Facility Arrangement
Type Unit Of
Type
Account Arrangement
Type
Basel II Recognised
Arrangement
Credit
Facility
Limit
Applied Debit Interest
Measure
Netting
Reduction
In
Credit
Facility
Credit
Credit Protection Provider
Rate
Credit
Arrangement
Limit
Equity Protection
Protection
Debit Interest Spread
Drawing
Facility
Borrowing Base Limit
Arrangement
Deposit
Protected
Arrangement
Rate
Arrangement Exposure
Arrangement
Basel II
Credit
Facility
Accrued
Fees
Arrangement
Arrangement
Measurement Category
Indicator
Product
Equity
Investment
Specific
Provision
Cash Balance
Type
Type
Exposure
Credit Facility Start Date
Deposit Maturity
Credit Protection
Exposure As Potential
Exposure As Claim
Arrangement
Credit Facility Maturity Date
Credit
Facility
Date
Arrangement
Claim Arrangement
Account
Arrangement
Collateral Arrangement
Credit Facility Term Out Date
Protection
Type
Potential Claim
Arrangement
Claim
Gross Collateral Value
Credit Facility
Arrangement
Arrangement
Potential Claim Accrued
Type
Claim Accrued Interest
Basel II Recognised
Fees
Non
Claim Accrued Fees
Netting
Guarantee Arrangement
Basel II Eligible
Retail
Premium / Discount
Arrangement
Guarantee Nominal Value
Collateral Type
Basel II
Net Present Value Total
Guarantee
Materiality
Collateral
Lease PaymentsEquity Investment Exposure
Equity
EU Financial
100% Risk
Guarantor
Threshold
Type
Investment
Eligible Collateral
Arrangement
Weight Indicator
Credit Derivative Arrangement
Category
Type
Equity Investment Book Value
Equity Investment
Potentially
Collateral
Credit Derivative Nominal Value
Drawing Arrangement
Equity Realised Result
Valuation Method
Eligible
Arrangement Type
Credit Derivative Materiality
Credit Facility Drawing Maturity
Equity Accrued Interest
Collateral
Type
Financial
Threshold
Date
Credit
Equity Specific Provision
Equity Basel II
Instrument
Credit Derivative
Credit Facility Drawing Start Date
Financial Instrument
Derivativ
Standard Equity Maturity Date
Product Type
Arrangement
Eligibility
Type
Principal Repayment Amount
Collateral Arrangement
e
Loss Given Default % For Equity
Eligible Hedge
Interest Payment Amount
Provider
Standardised
Credit Derivative
Hedge
Indicator
Financial Instrument
Credit
Related
Fees
Amount
Standard
&
Poor’s
Debt
Rating
Grade
Securities Identifier
Restructuring
Hedge
Provider
Standardised Securities
Write-Off
Type & Poor’s Debt Rating
Clause
Arrangement
Standard
Drawing Basel II
Id
Financial Instrument
Moody’s
Debt
Rating
Hedge Amount
Grade
Product Type
Standardised Securities
Grade
Hedged
Moody’s Debt Rating
Financial
Fitch Debt Rating
Id
Financial
Grade
Instrument Issue
Grade
Fitch Debt Rating
Equity
Instrument
Standardised
Public Type
Grade
Issuer
DebtInstrument
Security Instrument
Arrangemen
Securities
Financial
Issue
Financial
Equity
Debt Security Maturity
t
Identifier Type
Instrument Product
Exchange
Organization
Instrument Product
Instrument
Date Mutual Fund
Type
Issuer
Debt Security Instrument
Type
EVCA Industry
Equity
Deduct Regulatory
Highest Collateral Haircut
Debt Security Maturity
Category
Issuer
Capital Indicator
Equity Issuer Stage
Date
Type
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ABN AMRO’s Basel 2 Approach
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ABN AMRO Bank has chosen the Advanced Approach
Strategic aim to qualify for the advanced approaches as soon as possible:
 Credit Risk - Advanced Internal Ratings Based (IRB)
 Market Risk - Internal Models Approach
 Operational Risk - Advanced Management Approach
Main reasons for this decision:
1. Advanced approaches are more sophisticated and risk sensitive -
gives lower capital requirements
2. Peer group/competitive positioning
3. Perception of the markets/rating agencies
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Basel 2 Project Blueprint
Audit
Involvement
Project
Governance
Communi
cations
Project
Management
Overall
Coordination
Communication
Plan
Regulators
banking ass.
peers
Risk
Management
Finance
Scope of
Application
ICT
Models &
Policies
Data
Reports
Processes
Architecture
Infrastructure
Development
Validation
Risk Data
Requirements
Requirements
risk reports
Capital
calculation
Calculation
requirements
Finance Data
Requirements
Requirements
regulatory rep.
Disclosure
Disclosure
requirements
Architecture
design
Develop &
Integrate
Operating
Model
Operate &
Support
Regulators
banking ass.
peers
Vendors
Operations
Business
Unit(s)
Data Model
Implementation
Management
Management
staff
local regulators
Development
Application
Collect & Store Local reporting
Ensure Integrity requirements
Application
Implement
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Basel 2 – Challenges
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Basel 2 - Challenges for Banks

Skills shortage - scarce specialised knowledge

New Risk Management culture and new business model

High implementation costs - especially technology

Increased disclosure requirements - risk to competitive
advantage

Increased data collection and IT requirements
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Basel 2 - Challenges for Supervisors

Supervision and consultation

Model validation - technical expertise and budgets

Institutional strength - independence and discretion

Approval - ensure consistency and fairness

Risk focused supervision v compliance

Pro-cyclicality - economic cycles exacerbated
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Basel 2 - Conclusion
Links regulatory capital allocation with risk exposure

economic capital becomes more important
Greater flexibility for banks

can choose different approaches to credit and operational risk capital
requirements

can apply their own risk models with regulatory approval
Greater onus on supervisors
Increases disclosure requirements

more information on risk processes and approaches
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Questions and Answers
Thank you !
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