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Implementation of Basel II in RomaniaImplementation of Basel II in Romania

Progress to date and insights

22nd February 2006

Progress to date and insights

22nd February 2006

Business & Technology Risk Services

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Overview and IntroductionsOverview and IntroductionsOverview and IntroductionsOverview and Introductions

• Basel II represents one of the biggest challenges facing the Basel II represents one of the biggest challenges facing the Romanian Banking Industry today, potentially changing the Romanian Banking Industry today, potentially changing the competitive dynamics of the industry within 3 yearscompetitive dynamics of the industry within 3 years

• To compete, an average sized Bank in Romania will need to To compete, an average sized Bank in Romania will need to invest between 1-3 million euro’s for standardized invest between 1-3 million euro’s for standardized approaches and between 5-10 million to implement more approaches and between 5-10 million to implement more sophisticated approaches of the Basel Accord sophisticated approaches of the Basel Accord

• A typical medium sized bank has between 15-25 initiatives A typical medium sized bank has between 15-25 initiatives to complete for standardized, and between 35-50 initiatives to complete for standardized, and between 35-50 initiatives for advanced approachesfor advanced approaches

• BII leaders have a rigorous BII leaders have a rigorous implementation approach,implementation approach, business buy-inbusiness buy-in and ownership, and ownership, senior sponsorshipsenior sponsorship and and ready access to ready access to scarce resourcesscarce resources

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E&Y believes Basel II/CRD will give a new competitive E&Y believes Basel II/CRD will give a new competitive dynamic to the Banking Industry in Romaniadynamic to the Banking Industry in RomaniaE&Y believes Basel II/CRD will give a new competitive E&Y believes Basel II/CRD will give a new competitive dynamic to the Banking Industry in Romaniadynamic to the Banking Industry in Romania

““Capital release” will Capital release” will allow largest players to allow largest players to price aggressively for price aggressively for market share as market share as competition intensifiescompetition intensifies

Sophisticated risk Sophisticated risk management management capabilities will act as capabilities will act as a major market entry a major market entry barrierbarrier

Non-Banks, which Non-Banks, which are not subject to are not subject to Basel II will see Basel II will see opportunities to serve opportunities to serve niche segmentsniche segments

Secondary markets Secondary markets will emerge as more will emerge as more portfolios are ratedportfolios are rated

““Data starvation” for Data starvation” for risk modelling will lead risk modelling will lead to divesture of non-to divesture of non-core portfolio’score portfolio’s

Capital / efficiency Capital / efficiency advantages allow advantages allow early adopters early adopters healthy margins healthy margins amidst increased amidst increased competitioncompetition

Capital Capital advantageadvantage

Capital Capital advantageadvantage

Data advantageData advantageData advantageData advantage

Non-bank Non-bank competitioncompetitionNon-bank Non-bank

competitioncompetition

Margin Margin enhancementenhancement

Margin Margin enhancementenhancement

New entry New entry barriersbarriers

New entry New entry barriersbarriers

Active portfolio Active portfolio managementmanagement

Active portfolio Active portfolio managementmanagement

Risk based Risk based competitioncompetitionRisk based Risk based competitioncompetition

Op. Risk Op. Risk AdvantageAdvantageOp. Risk Op. Risk

AdvantageAdvantage

IRB Compliance likely IRB Compliance likely to be a minimum to to be a minimum to compete effectively compete effectively within 5 yearswithin 5 years

Leaders with ORM Leaders with ORM will be able to better will be able to better manage profitable manage profitable growthgrowth

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Romania Basel II Readiness- E&Y AssessmentRomania Basel II Readiness- E&Y AssessmentRomania Basel II Readiness- E&Y AssessmentRomania Basel II Readiness- E&Y AssessmentMain implementation challengesMain implementation challenges

1.1. Assessment of Operational RiskAssessment of Operational Risk

• Collect and organize internal loss data Collect and organize internal loss data and supplement with external sourcesand supplement with external sources

• Comply with qualitative criteria for Comply with qualitative criteria for Standardized represents the key Standardized represents the key challengechallenge

2. Data Collection and Disclosure of Risk 2. Data Collection and Disclosure of Risk Across All Risk TypesAcross All Risk Types

• Implement IT infrastructure in order to Implement IT infrastructure in order to report consistently across all risk types report consistently across all risk types and business unitsand business units

3. Credit Risk3. Credit Risk

• Collect, organise and warehouse Collect, organise and warehouse internal credit-loss experience required internal credit-loss experience required for chosen sophistication level, on a for chosen sophistication level, on a uniform basis uniform basis

• Ensure internal credit rating processes, Ensure internal credit rating processes, governance and systems are aligned governance and systems are aligned with requirements outlined in the with requirements outlined in the Accord.Accord.

Basel II Requirements:Basel II Requirements:= Satisfied by = Satisfied by most banksmost banks

XX = Further work = Further work required for most required for most banksbanks

?? = Further work = Further work required for some required for some banksbanks

Risk Management Methodology ? X

Senior Management Overview / Audit X X

Data and systems X XPolicies and procedures ? XModels and methodology ? X

Organisation and governance ? XDisclosure X X X

Risk integrated into core business X X

Basel II RequirementsCredit Risk

MarketRisk

OperationalRisk

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E&Y insights into Basel II implementation in RomaniaE&Y insights into Basel II implementation in RomaniaE&Y insights into Basel II implementation in RomaniaE&Y insights into Basel II implementation in Romania

Bank’s are awaiting clear guidance Bank’s are awaiting clear guidance from NBR in a number of areas to from NBR in a number of areas to

assist their BII preparation activitiesassist their BII preparation activities

Role of Risk Role of Risk Management is Management is

changing but still changing but still requires further requires further

alignmentalignment

Pillar II and the role of the Board still needs Pillar II and the role of the Board still needs to be addressedto be addressed

Data quality and Data quality and availability remains a availability remains a

key concernkey concern

Key Romanian Basel II

implementation insights

Key Romanian Basel II

implementation insights

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Basel II implementations are raising a number of questions which now require proactive NBR guidance

Basel II implementations are raising a number of questions which now require proactive NBR guidance

NBR has rolled out a industry support program in preparation of Basel 2 implementation:

• ARB roundtables

• Translation of the European text

• Drafted the “national options”

• Began work on the model validation manuals

NBR has rolled out a industry support program in preparation of Basel 2 implementation:

• ARB roundtables

• Translation of the European text

• Drafted the “national options”

• Began work on the model validation manuals

Our clients expressed the need for increased NBR support on:

• Guidelines on the “qualitative” requirements of Basel II (i.e. Pillar II requirements)

• Setting up a “help desk” specialized in helping banks out throughout implementation on specific issues (e.g. how is financial insurance recognised as a risk mitigant)

• Provide guidance on internal model development and validation, including how to tackle the historic data shortage

Our clients expressed the need for increased NBR support on:

• Guidelines on the “qualitative” requirements of Basel II (i.e. Pillar II requirements)

• Setting up a “help desk” specialized in helping banks out throughout implementation on specific issues (e.g. how is financial insurance recognised as a risk mitigant)

• Provide guidance on internal model development and validation, including how to tackle the historic data shortage

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Data quality and availability remains a key concern and constraint for most banksData quality and availability remains a key concern and constraint for most banks

Issues• Progressive Banks are adopting a two-

pronged Basel II strategy incorporating changes for both:

– Standardized as an immediate priority– IRB as a medium term objective

• Data audits have identified a number of constraints:

– Lack of default experience and data surrounding the default event

– Lack of a market representative sample

– Immature portfolio’s create uncertainty regarding predictive qualities

– Insufficient data in specific areas such as collateral, recoveries and overall loss experience

– Lack of external or internal ratings captured

Issues• Progressive Banks are adopting a two-

pronged Basel II strategy incorporating changes for both:

– Standardized as an immediate priority– IRB as a medium term objective

• Data audits have identified a number of constraints:

– Lack of default experience and data surrounding the default event

– Lack of a market representative sample

– Immature portfolio’s create uncertainty regarding predictive qualities

– Insufficient data in specific areas such as collateral, recoveries and overall loss experience

– Lack of external or internal ratings captured

Potential Solutions

• Perform data review for IRB as well as standardized

• Use external data from vendors and adjust for Romanian circumstances, but difficult to prove applicability to NBR

• Leverage a Group model and adjust for Romanian circumstances

• Develop judgmental models to start collecting the data, calibrate based upon observations over time

• Adopt a test-and-learn approach particularly for immature segments e.g. SME

Potential Solutions

• Perform data review for IRB as well as standardized

• Use external data from vendors and adjust for Romanian circumstances, but difficult to prove applicability to NBR

• Leverage a Group model and adjust for Romanian circumstances

• Develop judgmental models to start collecting the data, calibrate based upon observations over time

• Adopt a test-and-learn approach particularly for immature segments e.g. SME

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Pillar II and the role of the Board in “Risk Governance” still needs to be addressedPillar II and the role of the Board in “Risk Governance” still needs to be addressed

Issues• Many Bank’s believe Norm 17 compliance

is a proxy for Basel II compliance when it comes to governance requirements of the Accord

• Banks need to shift from formal compliance to really embedding the changes into the organization and decision-making processes

• Governance changes often left out of Basel II programs due to “political sensitivities”

• Most Boards currently do not demonstrate that they have effective processes for capital adequacy assessment and management

• Some need to revisit the mix of skills and experience on the Board

Issues• Many Bank’s believe Norm 17 compliance

is a proxy for Basel II compliance when it comes to governance requirements of the Accord

• Banks need to shift from formal compliance to really embedding the changes into the organization and decision-making processes

• Governance changes often left out of Basel II programs due to “political sensitivities”

• Most Boards currently do not demonstrate that they have effective processes for capital adequacy assessment and management

• Some need to revisit the mix of skills and experience on the Board

Potential Solutions

• Hold Board Risk Management Training

• Perform a formal governance review against leading practices and BIS/ CEBS guidelines

• Establish Board Level committees (e.g. risk committee) to focus on the risk profile of the Bank

Potential Solutions

• Hold Board Risk Management Training

• Perform a formal governance review against leading practices and BIS/ CEBS guidelines

• Establish Board Level committees (e.g. risk committee) to focus on the risk profile of the Bank

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The role of risk management within the organisation is changing, but still requires further work to comply with Basel II

The role of risk management within the organisation is changing, but still requires further work to comply with Basel II

Issues• Risk management functions in many

banks are still young and finding their mandate within the organization, particularly for credit and operational risk

• Traditional model of risk management often observed, with risk management being part of the credit process in full or in part leading to a lack of independence

• Often a lack of transparency and awareness within the organization as to what RM’s role is

• Skills often lacking with a lack of experience and background for key risk mgt roles

• Operational risk units often do not have mandates or a clear role within the organization

Issues• Risk management functions in many

banks are still young and finding their mandate within the organization, particularly for credit and operational risk

• Traditional model of risk management often observed, with risk management being part of the credit process in full or in part leading to a lack of independence

• Often a lack of transparency and awareness within the organization as to what RM’s role is

• Skills often lacking with a lack of experience and background for key risk mgt roles

• Operational risk units often do not have mandates or a clear role within the organization

Potential Solutions• Establish a clear charter for risk

management and communicate across organization

• Modify credit processes to remove RM from decision-making/ approvals

• Review skills and recruit externally as required

• Establish an operational risk framework, including an operational risk policy, with clear governance and reporting structures defined

Potential Solutions• Establish a clear charter for risk

management and communicate across organization

• Modify credit processes to remove RM from decision-making/ approvals

• Review skills and recruit externally as required

• Establish an operational risk framework, including an operational risk policy, with clear governance and reporting structures defined

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Final thoughts …Final thoughts …

• Keep the Board and NBR notified as to progress towards Basel II

• Manage the dependencies and risks in implementation

• Use the opportunity to question the role of risk management across the organization

• Tackle the “softer” areas of the Accord (e.g. governance) as well as the “hard” (e.g. IT systems)

• Keep the Board and NBR notified as to progress towards Basel II

• Manage the dependencies and risks in implementation

• Use the opportunity to question the role of risk management across the organization

• Tackle the “softer” areas of the Accord (e.g. governance) as well as the “hard” (e.g. IT systems)

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Thank you!Thank you!Andrew McCartney, PrincipalErnst & Young Southeast EuropeAndrew.McCartney@ro.ey.com

Andrew McCartney, PrincipalErnst & Young Southeast EuropeAndrew.McCartney@ro.ey.com

Ernst & Young RomaniaPhone: (21) 402 4000Fax : (21) 410 7046

Ernst & Young RomaniaPhone: (21) 402 4000Fax : (21) 410 7046