Transcript The Evolution to Basel II XBRL and the Basel II Capital Accord Donald Inscoe Deputy Director Division of Insurance and Research U.S.

The Evolution to Basel II
XBRL and the Basel II Capital Accord
Donald Inscoe
Deputy Director
Division of Insurance and Research
U.S. Federal Deposit Insurance Corporation
XBRL International, Tokyo, Japan November 8, 2005
First Basel Accord

The first Basel Accord (Basel I) was
completed in 1988
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Set minimum capital standards for banks
Standards focused on credit risk, the main risk
incurred by banks
Became effective end-year 1992
Reason for the Accord

To create a level playing field for
internationally active banks
–
Banks from different countries competing for the
same loans would have to set aside roughly the
same amount of capital on the loans
1988 Accord Capital Requirements


Capital was set at 8% and was adjusted by a
loan’s credit risk weight
Credit risk was divided into 5 categories:
0%, 10%, 20%, 50%, and 100%
–
Commercial loans, for example, were assigned to
the 100% risk weight category
Risk-Based Capital

The Accord was hailed for incorporating risk
into the calculation of capital requirements
Capital Calculation

To calculate required capital, a bank would
multiply the assets in each risk category by
the category’s risk weight and then multiply
the result by 8%
–
Thus a $100 commercial loan would be multiplied
by 100% and then by 8%, resulting in a capital
requirement of $8
Criticisms of the Accord

The Accord, however, was criticized for
taking too simplistic an approach to setting
credit risk weights and for ignoring other
types of risk
Risk Weights

Risk weights were based on what the parties
to the Accord negotiated rather than on the
actual risk of each asset
–
Risk weights did not flow from any particular
insolvency probability standard, and were for the
most part, arbitrary
Operational and Other Risks

The requirements did not explicitly account
for operating and other forms of risk that may
also be important
–
Except for trading account activities, the capital
standards did not account for hedging,
diversification, and differences in risk
management techniques
Banks Develop Own “Capital
Allocation” Models

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
Advances in technology and finance allowed
banks to develop their own capital allocation
(internal) models in the 1990s
This resulted in more accurate calculations of
bank capital than possible under Basel I
These models allowed banks to align the
amount of risk they undertook on a loan with
the overall goals of the bank
Internal Models and Basel I

Internal models allow banks to more finely
differentiate risks of individual loans than is
possible under Basel I
–
–
Risk can be differentiated within loan categories
and between loan categories
Allows the application of a “capital charge” to
each loan, rather than each category of loan
Variation in Credit Quality

Banks discovered a wide variation in credit
quality within risk-weight categories
–
–
Basel I lumps all commercial loans into the 8%
capital category
Internal models calculations can lead to capital
allocations on commercial loans that vary from
1% to 30%, depending on the loan’s estimated
risk
Capital Arbitrage


If a loan is calculated to have an internal
capital charge that is low compared to the
8% standard, the bank has a strong incentive
to undertake regulatory capital arbitrage
Securitization is the main means used by
U.S. banks to engage in regulatory capital
arbitrage
Example of Capital Arbitrage

Assume a bank has a portfolio of commercial loans with the following
ratings and internally generated capital requirements
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AA-A: 3%-4% capital needed
B+-B: 8% capital needed
B- and below: 12%-16% capital needed
Under Basel I, the bank has to hold 8% risk-based capital against all of
these loans
To ensure the profitability of the better quality loans, the bank engages
in capital arbitrage--it securitizes the loans so that they are reclassified
into a lower regulatory risk category with a lower capital charge
Lower quality loans with higher internal capital charges are kept on the
bank’s books because they require less risk-based capital than the
bank’s internal model indicates
New Approach to Risk-Based Capital

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By the late 1990s, growth in the use of
regulatory capital arbitrage led the Basel
Committee to begin work on a new capital
regime (Basel II)
Effort focused on using banks’ internal rating
models and internal risk models
June 1999: Committee issued a proposal for
a new capital adequacy framework to replace
the 1998 Accord
Basel II

Basel II consists of three pillars:
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Minimum capital requirements for credit risk,
market risk and operational risk—expanding the
1988 Accord (Pillar I)
Supervisory review of an institution’s capital
adequacy and internal assessment process (Pillar
II)
Effective use of market discipline as a lever to
strengthen disclosure and encourage safe and
sound banking practices (Pillar III)
Pillar I

In the United States, all banks that will be
required to conform to the new capital
standard will use the Advanced Internal
Ratings Based approach (AIRB)
AIRB Approach Requirements


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Collect sufficient data on loans to develop a
method for rating loans within various
portfolios
Develop a Probability of Default (PD) for
each rated loan
Develop a Loss Given Default (LGD) for each
loan
Example: Safe v. Risky Loans
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Safe loans:
– Over a 1-year period, only 0.25% of these loans
default
– If a loan defaults, the bank only loses 1% on the
outstanding amount
Risky loans:
– Over a 1-year period, 1% of loans default every
year
– If a loan defaults, the bank loses 10% of the
outstanding amount
Example: Safe v. Risky Loans
(continued)

For a $100 million portfolio of the safe loans,
the bank would expect to see $250,000 in
defaults in a year and a loss on the defaults
of $2500
–
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($100 million X .25% = $250,000)
($250,000 X 1% loss rate = $2500)
Example: Safe v. Risky Loans
(continued)

For a $100 million in a risky portfolio the
bank would expect to see $1 million in
defaults in a year and a loss on the defaults
of $100,000
–
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($100 million X 1% = $1 million)
($1 million X 10% = $100,000)
Goal of Pillar I

Although simplistic, this example
demonstrates what Pillar I is trying to achieve
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If the bank’s own internal calculations show that
they have extremely risky, loss-prone loans that
generate high internal capital charges, their
formal risk-based capital charges should also be
high
Likewise, lower risk loans should carry lower riskbased capital charges
Complexity of Pillar I

Banks have many different asset classes
each of which may require different treatment
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Each asset class needs to be defined and the
approach to each exposure determined
Minimum standards must be established for
rating system design, including testing and
documentation requirements
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The proposals must be tested in the real world
Assessing Basel II

To determine if the proposed rules are likely
to yield reasonable risk-based capital
requirements within and between countries
for banks with similar portfolios, four
quantitative impact studies (QIS) have been
undertaken
Results of Quantitative Impact Studies

Results of the QIS studies have been
troubling
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Wide swings in risk-based capital requirements
Some individual banks show unreasonably large
declines in required capital
As a result, parts of the Accord have been
revised
Operational Risk

Pillar I also adds a new capital component
for operational risk
–
Operational risk covers the risk of loss due to
system breakdowns, employee fraud or
misconduct, errors in models or natural or manmade catastrophes, among others
Pillars II and III

Progress has also been made on Pillars II
and III
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Pillar II focuses on supervisory oversight
Pillar III looks at market discipline and public
disclosure
Pillar II

Supervisory Oversight
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Requires supervisors to review a bank’s capital
adequacy assessment process, which may
indicate a higher capital requirement than Pillar I
minimums
Pillar III

Market discipline and public disclosure
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The United States is currently in the forefront of
disclosure of financial data
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SEC disclosure requirements for publicly traded banks
Bank regulators require quarterly filing of call reports for
all banks
U.S. authorities are currently considering what
banks should publicly disclose about their Basel II
calculations
U.S. Implementation of Basel II

Based on results for QIS4, which show the
potential for substantial declines in capital,
the U.S. banking regulators have proposed a
revised implementation timeline
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The revised timeline includes a minimum threeyear transition period
Revised U.S. Timeline for Basel II
Implementation
Year
2008
2009
2010
2011
Transistional Arrangements
Parallel Run
95% floor
90% floor
85% floor
U.S. Implementation of Basel II
(Continued)

After 2011, an institution’s primary federal
supervisor will assess the institution’s
readiness to operate under Basel II
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Institutions will be assessed on a case-by-case
basis
Further revisions to the floors are anticipated
Both Prompt Corrective Action and leverage
capital requirements will remain
Basel I-A: The Search for Equal
Capital Treatment
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
In the U.S., concerns that Basel II could give
those banks operating under it a competitive
advantage over other banks has resulted in a
proposal called Basel 1-A
Basel 1-A is designed to modernize the way
all U.S. banks and thrifts calculate their
minimum capital requirements
Implications

The practices in Basel II represent several
important departures from the traditional
calculation of bank capital
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The very largest banks will operate under a
system that is different than that used by other
banks
The implications of this for long-term competition
between these banks is uncertain, but merits
further attention
Implications

Basel II’s proposals rely on banks’ own
internal risk estimates to set capital
requirements
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This represents a conceptual leap in determining
adequate regulatory capital
For regulators, evaluating the integrity of
bank models will be a significant step beyond
the traditional supervisory process
Implications

The proposed Accord will elevate the
importance of human judgment in the
process of capital regulation
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Despite its quantitative basis, much will depend
on the judgment of banks in formulating their
estimates and of supervisors in validating the
assumptions used by banks in their models
Work Continues

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During the past 3 years the FDIC has
expressed its concern that the proposed
Accord will result in banks having too little
risk-based capital
Work continues on recalibrating the
proposals and a workable solution is
expected
Implications
Additional Data Needed to Counterbalance to Changes in
Environment
• Changes in environment
necessitate changes in risk
Higher
analysis for banks and
Leverage
supervisors/insurers
Unproven
Rating
Systems
Evolving
Control
Structures
Improved Risk
Management
Three Year
Floors/Leverage
Ratio
• Additional information will be
needed to:
Inform policy development.
 Supplement other sources of
risk information used in
supervisory resource planning
and overall risk assessments
 Serve as an input into deposit
insurance pricing and overall
insurance funds adequacy
analyses
Why XBRL ?

Internal ratings based and standard approach
measures require complex data model
–
Common data requirements flow from Accord and
Quantitative Impact Studies (QIS I – IV)
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Domestic and international comparisons needed to ensure
consistent application
–
Taxonomy needed to compare banks’ internal ratings of
similar and diverse risks
Common Data Elements Flow from Accord:
Standardized Internal Risk Estimates
Data Types
Reporting Granularity
Internal Risk
Estimate
Wholesale
Retail
Securitization
Equity
Market Risk
Operational
Risk
Other
M
EAD
LGD
PD
Exposure
X
X
-
X
X
-
X
X
-
X
-
X
X
- - - - X
- - - - X
Summary
Data
Portfolio
Level Data
Individual
Exposure Data for
All Transactions
Why XBRL ?

Internal ratings based measures and standard approach require
complex data model
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Supervisors need detailed information to qualify banks for
advanced approaches (IRB, AMA, and Market Risk)
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Data can be shared across different supervisory regimes
- Independent of systems, platforms, geography and language
translation
Consistent data needed to help identify risk estimates
that may be inconsistent with peer estimates.
% of Wholesale Exposures
40
Bank’s PD Distribution Mapped to S&P Rating Scale
35
Peer Banks’ PD Distribution Mapped to S&P Rating Scale
30
25
20
15
10
5
0
AA or better
A to AA
BBB to A
BB to BBB
B to BB
>B
Follow-up: Can differences between Bank’s PD and benchmark be adequately
explained by differences in risk?
Why XBRL ?
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XBRL provides a framework for complex data
model
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Open standard facilitates reuse and innovation
Analysts can spend more time analyzing data
Reduced reporting burden, especially for
organizations operating in multiple jurisdictions
Why XBRL ?

A standard is needed in any case.
Why XBRL ?
FINIS