Transcript Document

Basel II
Impact on The Credit Worthiness
of Norwegian Banks
Per Törnqvist
Associate Director,
Financial Services Ratings
January 17 2005
Basle II Imply Sweeping Changes
Big Move Towards Self-Regulation and Own-Models
• Regulators no longer prescribe
• Regulators opine on banks’ own processes
Ultimate Goal Is To Let Markets Decide Creditworthiness
Make Capital Scheme More Inclusive of All Risks
Make Capital Scheme More Risk Sensitive
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S&P remains clearly supportive …
• Basel II an improvement because it better
differentiates credit risk
• Basel II reinforces existing trends towards
more advanced credit risk management
• Basel II will increase transparency
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S&P remains clearly supportive …but
• Basel II is still the minimum amount of
capital a regulator will require in order to
allow a bank to operate.
• The actual amount of capital in banking will
continue to differ from the minimum
requirement.
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What Is Capital?
Capital levels are like credit enhancement levels. Composed of
instruments intended to absorb losses.
•Tier 1 capital: Tangible common equity plus up to 15% qualifying hybrid
instruments
•Tier 2 capital: Subordinated debt, excess hybrid instruments, loan loss reserves
in excess of expected losses, up to .80% of Risk Weighted Assets
•Tier 3 capital: Medium-term subordinated debt instruments that can be used to
satisfy market risk capital requirements.
•Total capital needs to be 8% of Risk Weighted assets: Tier 1 minimum is 4%.
•Standard & Poor’s do not view all instruments the same way.
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What is Capital For?
1. To cover unexpected losses (UL): a function of term of loan and
correlation
2. To grant management strategic freedom. (Acquisitions & investments)
3. Expected losses (EL) are to be covered by loan loss reserves: defined
as PD x LGD for 1 year
•
Any shortfall in reserves is to be deducted 50% from Tier 1 and 50% from Tier 2
capital
•
Any surplus in reserves may be added to Tier 2 capital up to 8% of RWA
The lower the quality of the asset, the greater the proportion of reserves
relative to capital is required to support the asset.
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Overall Change in Capital
Requirement
20
15
10
12%
6%
3%
5
%
0
-2%
-5
-10
-15
-20
-22%
-25
Standardized
Source Basel
Committee –
Overview on QIS 3
IRB F
Large Banks
Small Banks
Large Banks: T1 Capital >€3bn
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IRB A
Impact on Capital Requirement
% Change in K Requirements (Large Banks)
140
%
120
100
80
60
40
20
1
0
-20
Source Basel
-40
Committee –
Overview on QIS 3-60
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3
Standardized
Corporate
SME
Securitized assets
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-2
-14
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IRB F
Sovereign
Specialized Lending
Overall Credit Risk
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Bank
Equity
Operational Risk
IRB A
Retail
Trading Book
Overall Change
What Bank Regulators Will
Look For In Pillar 2
Banks must define capital adequacy at levels above the minimum
 in relation to risk profile and appetite
 in relation to stress tests performed
Supervisors must:




review risk governance at the corporate level
review internal controls with respect to data and model quality
be prepared to intervene early in cases of deterioration
monitor adequacy of disclosure
Supervisors and banks must design and review robustness of
methods that deal with risks not covered in Pillar 1:
 interest rate risk
 concentrations of credit risk by borrower and industry
 strategic risk
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Likelihood of Changes Due to Basel II
 Depends on whether banks were arbitraging their
capital regulations or already focused on economic
capital model results
 Pricing issues will likely depend on market
competitive conditions. And BIS II will create strong
incentives for increased competition on certain risk
types (e.g. secured lending, retail lending)
 Capital volatility will depend on conservatism of PD
estimates and capital cushion maintained
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Potential Impact on Banks’ Business
Basel II will reinforce trends already in place:

Scientific portfolio risk management

Increasing use of credit mitigators and risk
transfer techniques

Increased disclosure

Underwriting then selling and trading
corporate risk
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Potential Impact on Banks’ Strategy
 Shift
to Retail Banking
 Banking


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Consolidation?
Capital release by acquiring a bank and ‘converting’ it from
the Standard Method to the IRB method
Banks which cannot afford investments for the most
advanced approaches may be priced out of certain markets
Improved target identification due to disclosure
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Potential Impact On Borrowers
Difficult to predict:
Some types of lending appear to benefit from Basel II:
• retail lending
• mortgage lending
• SME credit
Whereas others seem relatively disadvantaged:
• Corporate lending
• Specialized lending
• Emerging markets lending
But the discrimination will more likely be between
quality borrowers and risky borrowers.
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What Could Change?
Unintended Consequences of Basel II
Nota bene: Not all lenders are subject to Basel II (hedge funds; insurance companies)
More rational allocation and pricing of capital in the economy
 Lending margins will come under pressure for asset types that gain from BIS II.
 Higher risk commercial lending could be constrained by higher capital requirements.
 Shift in the relative price of equity capital and debt.
 Increased use of structured products such as covered bonds to isolate credit quality.
 Increased focus on risk adjusted returns beyond the financial services industry.
Banks may prefer shorter-term lending
Banks may experience capital relief
 Use reserves to satisfy capital for Expected Losses
 Use collateral to reduce capital
 Consumer loans get capital relief
 Commercial lenders and processing banks need higher capital
Capital requirements (and willingness to lend) could be more volatile.
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… but Standard & Poor’s sees the
imperfections of Basel II
1. Calibration issues
2. Operational risk elusive to measure
3. Pillar II: A heavy burden for regulators
and consistency issue
4. Complex and expensive
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1. Calibration Issues
• IRB formulas underestimate the level of
required capital for certain business lines
• Need for a Recessionary Scenario
• A narrow definition of Credit Risk
• Sufficient capital should be required to allow
bank to continue to operate after it
experiences losses
• Remaining concerns on the Standardized
Approach
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Default Rates Increase During a
Recession
Default Rates for Static Pools
1981 - 2003
Rating Category
CCC
B
BB
BBB
A
AA
AAA
1-Year Avg. Rate
30.85
6.08
1.36
0.37
0.05
0.01
0.00
3-Year Avg. Rate
45.47
19.20
7.12
1.67
0.28
0.08
0.03
Minimum (3-Year)
9.09
8.16
1.25
0.00
0.00
0.00
0.00
Maximum (3-Year)
60.36
27.81
12.50
3.84
0.86
0.29
0.55
Source: Standard & Poor’s default statistics
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A Narrow Definition of Credit Risk
• Interest- rate risk & concentration risk are not
reflected in Pillar I but are allocated to
supervisory review (Pillar II)
« National Discretion »
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A Static Approach
• Pillar I : capital aimed to cover worst-case
losses and enable entity to pay off all
liabilities
• Operating banks, not static portfolios
NEED FOR A MARGIN OF SAFETY!
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2. Operational Risk Elusive to Measure
• Definition: excludes strategic and reputational
risks
• Gross income only a proxy for O.R. measure
• Calibration: 12%? 15%? 20%? 100% ?
• Over-reliance on models
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3. A Heavy Burden On Regulators
• Validation & Supervision of Models
–
–
–
–
–
IRB
Credit Risk Mitigation
Stress Testing
Operational Risk
Securitization
• Increased Power of Intervention
• Designation of ECAIs
Combined with IFRS and covered bonds and Solvency II
and a new life insurance legislation!!!
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Consistent Supervisory Standards?
• No standardization of the supervisory
process in Basel II
• Home host issues
• Crucial areas left to national discretion
(interest rate risk, concentration risk,
business and strategic risk, stress testing,
option 1 in SA)
• Capital ratios may be LESS rather than
MORE comparable across countries
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4. Complex and Expensive
• Complex and rules-based approach
• Over-reliance on models (Model Risk?)
• Expensive: ~ €115 mn for large banks (*)
(*) Source: Forrester research
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Impact of Basel II on Bank Ratings
Choice of Approach
 Banks that choose Standardized Approach will not be penalized
 We expect smaller banks in mature markets to progressively shift to
Advanced IRB This is likely to be accentuated in the Nordic region

Much of IRB not applicable to emerging markets
Level of Capital
 In theory, if a bank were to substantially reduce capital under Basel
II, all else remaining the same, we could lower the rating
 In practice, we do not expect radical changes in capital policy –
rather, changes will be gradual, as banks incrementally adapt to the
Basel II principles

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Capital for mortgage loans should reflect risks other than credit risk:
interest rate, funding, business risk, low margin profile
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