Transcript Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 Case Study: South Africa on the road to Basel II Pieter Strydom Partner,

Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
Case Study:
South Africa on the road to Basel II
Pieter Strydom
Partner, Ernst & Young, South Africa
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
Overview of presentation
Overview of presentation

Introduction: The banking sector in South
Africa

Attitude towards Basel II in South Africa

Ernst & Young survey on Basel II
readiness in South Africa

Developments in bank supervision at
SARB

Developments at Bank A

Developments at Bank B
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
1. Introduction:
The banking sector in South Africa
1.1 The banking sector in South Africa
 48 banks in SA
 15 in process of de-registering or closing down
 7 with limited operations
 19 remaining of which the big 5 represent 90%
of market
 Average Basel 1 Capital adequacy 12.6%
1.2 Total Assets of Banks
US$ bn
Absa
Firstrand
Standard Bank
Nedcor
Investec
Sub Total
Other Banks
Total
Feb
2000
23.9
21.9
24.5
24.9
8.6
103.8
29.6
133.7
%
17.8
16.4
18.3
18.6
6.4
77.6
22.4
100.0
Nov
2003
41.2
39.7
52.3
49.2
13.5
196.0
40.0
220.3
%
18.7
18.0
23.7
22.3
6.1
88.9
11.1
100.0
Staff
number
31,400
35,400
34,600
25,200
4,800
130,400
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
2. Attitude towards Basel II
in South Africa
2.1 Growing consensus
 Basel I is outdated
 Weakened link between risk and capital
 Internationally active banks will be forced
into Basel II by rating agencies
 Basel II will reward excellence
 Basel II fits in with risk management
initiatives
2.2 Standards and codes
 Standards and codes set by international
bodies, and widely adopted, will provide:
• useful basis for improved market functionality
• ‘benchmarks’ against which banks can be measured
• national practices to reduce ‘un-level playing fields’ and
regulatory arbitrage
• markets forces and peer pressure will make adoption mandatory
• ‘soft law’, which can be more effective than ‘hard law’ enshrined
in legislations
 Basel II with its close link between risk and
capital requirement is fully endorsed by
banks in South Africa
2.3.1 Basel II is complex
 Banking itself is becoming more complex
 Risk management requirements are highly
sophisticated (assigning equal risk weights
to all loans is unrealistic)
 Simplicity and greater risk sensitivity are not
mutually compatible objectives
 Banks with simpler business models have
options under Basel II to reduce complexity
2.3.2 Basel II will reinforce pro-cyclical effect
 Linking the regulatory charge to the quality of
assets will bring them in line with the business
cycle
 This can lead to an increase in volatility of
asset prices and loan interest with the potential
danger of creating a ‘boom to bust’ cycle in
credit markets
 Banks may be encouraged to stop lending at a
time when the real economy is most vulnerable
2.3.2 Basel II will reinforce pro-cyclical effect
 Pro-cyclical behaviour is already endemic and
perhaps acceptable in order to establish a
more risk sensitive capital regime
 Countermeasure is to build excess capital in
good times to have a margin of protection in a
downturn
 Capital requirements under Pillar 1 should be
augmented by the capital requirements under
Pillar 2 and Pillar 3 in order to reinforce the
incentive to maintain a cushion of capital above
the minimum
2.3.3 Involvement of rating agencies
 Limited penetration – 5%
 Unique problems with listed exposures
• Low trading volumes – volatile markets
• Duel listings – flow of funds
 Lumpy exposures – concentration risk
 Danger of herd thinking
2.3.4 Rating agency data sharing
 Problem creating statistical pool to rate Medium
Corporate Advances
 Big banks extracting information on 10 000
account for 3 years on default and non default
accounts – will provide a 90% statistical pool
 To be given to one or more agencies to
calculate the quantitative (theoretical) PD
 Banks to use this PD as the quantitative basis
to confirm their own qualitative PD
 Next phase to pool information on LGD - but
2.3.5 Required capital of 10% compared to 8%
 As a result of South Africa’s country rating of
BBB, no local exposure can be rated above
BBB before taking into consideration collateral
 Banks believe continued use of capital
adequacy of 10% don’t not make sense as
their internal models already take into
account the systemic volatility in the SA
market – resulting in double counting of
systemic risk of SA
2.3.6 Capital requirements for SMEs
 SMEs are essential to build the economy
in developing countries
 Additional capital requirements for
advances to SMEs can be used to
convince government agencies to provide
additional collateral or support in order for
a bank to make these advances
2.3.7 Cross border investments in Africa
 Cross border implementation of Basel II
for SA banks with investments in various
African countries
 Not all of these African countries have the
regulatory environment or capacity to
enable local banks to reap any regulatory
benefit in line with the host country
2.3.8 Cost of implementing IRB and AMA
 Be positive – a large portion of the cost
would have been incurred in order to
enhance risk management procedures
and should not be blamed on Basel II
 Bank regulators will need to take steps as
their own additional costs (internal and
external) will escalate in order to do model
evaluation, etc.
2.3.9 Operational risk
 Infant stage AMA might result in implementing
one of the standardised approaches
 Gross income as the driver for operational risk
capital is open for debate
 The ‘double whammy’ effect of high margin
advances (to cater for high delinquency) will
cause a higher credit capital charge and a higher
capital charge on the high interest margin
 Data sharing on operational risk is problematic
2.3.10 Ability of Regulator to cope
 In order for the Big 5 banks to
implement the IRB approaches from
inception in 2007
• process from ‘Guidelines to Regulations’ to be completed
• political approval process to be completed
 Big 5 banks see little benefit in a
standardised approach as there is no fit
to their risk management structures
 Big 5 banks believe standardised
approaches can be seen as ‘Basel 1.2’
and not as Basel II
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
3. Ernst & Young survey on Basel II
readiness in South Africa
3.1 Introduction to survey
 Timing: Second quarter 2003
 Population
•
•
•
•
48 banks in SA
15 in process of de-registering or closing down
7 with limited operations
19 remaining, of which 12 participated
 Methodology first used in Luxembourg
3.2 Summary of results
 Banks are partly prepared
 Re-evaluation of the way business is
conducted
 Banks will be ready for implementation
 Technology seen as the major
problem/expense
3.3 Key challenges
 Data collection
 Improvement of credit environment
 Implementation costs
 Regulatory uncertainty
 Skills availability
 Disclosure requirements
3.4 Opportunities
 Integrated risk management approach
 Align regulatory and economic capital
more closely
 Better understanding of their business
 Improve investor relations
 Improve market discipline
3.5 Results per question
Awareness of
regulations
Organisational
structure
Reporting
Compliance with
Basel II
Capital allocation
Basel II Action Plan
Technology
Awareness
Monitor
Quantify
Integrate
Awareness
Monitor
Quantify
Integrate
Awareness
Monitor
Quantify
Integrate
Awareness
Monitor
Quantify
Integrate
Awareness
Monitor
Quantify
Integrate
Awareness
Monitor
Quantify
Integrate
Awareness
Monitor
Quantify
Integrate
3.6 Tier structure model
Capabilities
Monitor
Quantify
Integrate
Tier 1
Risk Culture/
Weak awareness of
Regulation
risk management
Awareness
issues
Organisational Individual
Structure
departments
covering various
aspects of risk (e.g.
Internal Audit)
Reporting
Ad-hoc external
reporting
Tier 2
Informed management
issues
Tier 3
Clear
understanding of
risk challenges
Credit/operational
risk function, with
head reporting to
CFO
Tier 4
Risk culture drives
decision-making
Compliance of Basic Approach
Operational
Standard Approach
Risk and Credit
Risk
Operational risk capital
allocated for each
business line.
Probability of default
calculated for each
obligor
Allocation based on
regulatory capital
Capital
Allocation
Action Plan
Technology
Awareness
Undefined capital
allocation
Credit/operational risk
committee
Risk Officer responsible
for market, credit and
operational risk reporting
to CEO!
Internal reporting driven Recurring Internal
by external reporting
reporting
Frequent internal
reporting drives decisionmaking
Advance
Regulatory capital is a
measurement for
driver for developing
operational risk
stopping and acquiring
internal rating base activities
for credit risk
Allocation based on Capital consumption
economic capital
drives strategic decisions
specific insurance, risk
transfer and activities
development
No resources
Action plan set-up)
Cost/benefit
Budget allocated
allocated
analysis for each
approach
Inadequate IT
IT action plan to meet the IT solutions
Integrated IT solutions for
solutions to meet the Basel II requirements
implementation
credit/operational/market
Basel II requirements
risk management
3.7 Methodology used
Traditional Awareness
Monitor
Quantify
Integrate
Baseline
Operatio Reliance on Operational Comprehensi Comprehensi
nal Risk internal audit Risk
ve indicators ve loss
Risk-adjusted
manager
database
return linked to
compensation
Reliance on Top-down
Consolidated Risk-based
quality of
eco-nomic
reporting
economic
Insurance linked
people and capital
model
with risk analysis
culture
models
and capital
Credit
Current
Current
Potential
Potential
Risk
exposure
exposure
exposure
exposure
only based
based on
simulated at simulated at
on MtM or
expected
transaction portfolio level
book values loss
level
Static limit
based on
nominal
amount
Static limit
based on
expected
loss
Multidimensional
hierarchy
Dynamic limit
borrowing
and lending
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
Developments in
bank supervision at SARB
(Website resbank.co.za)
4.1 SARB structured workgroups
Accord Implementation Forum
Steering Committee *
Risk Management
Sub-Committee
Pillar I
Credit Risk
Group
Market RIsk
Group
Regulatory Framework
Sub-Committee
Operational Risk
Group
Disclosure
Sub-Committee
Pillar III
Economic Impact
Sub-Committee
4.2 SARB Implementation Plan
 4.2.1Strategic plan
• To address issues regarding work streams, project plans,
implementation measures, regulation approval process,
staffing, funding, etc.
 4.2.2 Position paper
• Due February 2004 to indicate the approach SARB will take in
implementing Basel II in SA
• Comments to be coordinated through workgroups
4.2 SARB Implementation Plan
 4.2.3 Compilation of Regulations
• Use the regulatory work group to give guidance on the content
of the regulations
• Legal department of SARB will write regulations
• First draft regulations for standardised approaches submitted
for approval by end of 2004
• In the interim work with banks on the IRB and AMA
approaches to develop regulations at a later stage
 4.2.4 Readiness assessment
• First one in November 2003 on Basel II
• To be repeated after June 2004
• Basel II readiness subject of all trilateral meetings
4.2 SARB Implementation Plan
 4.2.5 Test data
• Gave 5 banks the names of 10 corporate clients (includes high
quality and volatile) and the description of a retail portfolio
• Requested the PD for each corporate loan, the PD for the
retail portfolio, the capital requirement for both portfolios and a
description of models
• Results were consistent PD’s for high quality corporate
exposures
• However, PD’s for volatile corporate exposures and the retail
portfolios were not sufficiently consistent
• Next phase to investigate reasons for inconsistent results
4.2 SARB Implementation Plan
 4.2.6 Model validation
• Believe will be able to go a long way in doing model
validation by
o getting information from the various banks
o benchmarking the results
o requesting banks to use different assumptions in their model
• Model evaluation will start early
o based on sensitivity testing
o using different assumptions
o on different models
o of different banks
• Coordinate the model validation with other Regulators
4.2 SARB Implementation Plan
 4.2.7 Economic impact
• An economic impact study will be initiated under the
Economic Impact Workgroup to evaluate the effect on
the economy to use Basel II – looking at
o The effect of the lower capital requirement on residential
mortgages
o The effect of the SA 10% capital requirement versus the
international minimum of 8%
o Capital requirement for lending to SMEs
o The extent of ‘Double whammy’ on high margin lending
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
5. Developments at Bank A
5.1 Attitude towards Basel II
 Bank already has an economic capital
model in line with Basel II principles
 Started internal credit rating models from
1999
 As bank operating internationally it needed
an investment rating which makes
implementation of Basel II compulsory
 Performance bonuses are based on return
on economic capital above a hurdle rate
5.2 Goals for Basel II
 Advance IRB for retail credit
 Foundation IRB for corporate credit
 Advance measurement approach for
operational risk – if at all possible
5.3 Responsibility for Basel II
 Basel II falls under capital management
 Operating division is responsible for own economic
capital management
 Economic capital is calculated on Basel II principles
 Bonus is based on economic capital – divisions
therefore already optimising their economic capital
by using Basel II principles for credit risk
 Divisions fully aware that they manage risk and that
capital management only measures risk
 Basel II not a project but the day-to-day
responsibility of business units as it adds value to
the risk management process
5.4 Initiative - Operational risk
 Don’t agree with basic indicator approach or use of
gross income to calculate the capital charge
 Developed qualitative and self assessment
information
 Created lost data base for purposes of optimising
insurance cost
 Data base to combine all these under development
 Will keep operational capital charge centrally and
allocate by transfer pricing system
 Operational risk only monitored centrally but
managed by individual business units
5.5 Regulator – positive view
 The Regulator has various methods to
evaluating models
• Benchmarking
• Comparisons of assumptions
• Same data through different models
 No need to verify detailed workings of
models
5.6.1 General
 Banks in non-investment rated countries
should consider the benefit to implement
Basel II other than on a standardised
approach (benefit in risk management
measures not in Capital savings)
 Banks should be allowed a maximum of
15% of group assets not to be subject to
the IRB approach, subject to confirmation
by the Regulator to prevent cherry picking
of assets
5.6.2 General
 A staged rollout period to allow for credit
portfolios to be measured under IRB from
2007 to 2010 (in line with the UK proposal)
 In the interim Basel I would be used on the
portfolios not yet rolled out
 The requirements in terms of IAS 39 on
provisions are not in line with Basel II
although they have some common data
requirements
5.7 Warning
 Concerned that a false confidence in
statistically quantification of risk can cause
potential market distortions
 The bank will continue to use its internal
ratings and only use external ratings as a
point of reference and investigate any
differences more than three notches
 Basel II only measures risk – risk must
continued to be managed at operational
level
5.8 Negotiation with Government
 The bank also believes that Basel II will
assist in negotiations with Government
regarding the extension of credit to certain
sectors of the economy as the ‘black box’
effect of pricing of credit risk can be
reduced
 The bank used the principles of Basel II to
calculate credit risk price as the basis of
negotiations with Government for the
purchase of a portfolio of advances from a
bank in distress
5.9 Disclosure under Pillar III
 This bank is very active in the Disclosure
Workgroup
 Already completed discussion documents
to:
• compare disclosure requirements under Basel II with the
accounting disclosures required under the various bankingrelated GAAP statements
• compile a suggested disclosure model for banks in order to
comply with both Basel II and with GAAP
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
6. Developments at Bank B
6.1 Attitude towards Basel II
 Fully supports Basel II and sees it as a
natural development of risk management
 Integrated Basel II in the business plans of
business units in order to use
• advance IRB for retail credit
• foundation IRB for other credit risk
• standardised approach for operational risk
• migrate to advance operational risk approach in future
6.2.1 Project - Risk rating models
 Model development and validation
 Scorecard development and validation
 Approval by Regulator
6.2.2 Project - Data collection and integration
 Default data
 Exposure data (for EAD)
 Collateral data (for LGD)
 Default data (for PD)
6.2.3 Project - Operational risk
 Framework
 Tool selection and implementation
 Risk assessment
 Key risk indicator
 Incident management
 Capital calculation (AMA methodology)
6.2.4 Project - Regulatory relationship management
 25 regulators
 Various countries
 Varied satisfaction levels
6.3.1 Challenge - Program management
 Sustaining momentum given negative
international utterances on Basel II
 Co-ordinating complex initiatives
 Getting budget approval for initiatives
 Getting sufficient specialised skills (risk, IT
and programme management)
 Other priorities – specifically anti-money
laundering
6.3.2 Issue - Non-South African operations
 Strategy for implementation
 Approval process duplication with other
regulators
 Alignment of systems
 Is group-wide system feasible?
6.4.1 Concerns Regulator
 Will Regulator allow
• capital to go below 10%
• deviation between big banks
• Some of the big 5 banks to use models and others not
(only 1 bank has a market risk model approved)
 Time available to
• Approve credit models
• Development of regulations
o Regulations for standardised approach developed first
o Later development of regulation for advanced approaches
o Both to be completed long before 2007
 Number of resources at Regulator
6.4.2 Concerns General
 SA was an early adopter of IAS39 (Recognition
and Measurement of Financial Instruments) –
substantial problems were experienced with this
 The combined volatility effect of IAS 39 and
Basel II on capital should be considered
 Are we underestimating the effect of
implementing Basel II considering the spend by
international banks?
 Are we arrogant to think that we will be able to
do the same with a substantially smaller spend?
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004
END OF PRESENTATION