BASEL II - WHERE TO NOW?

Andrew Jennings January 2009

2

Disclaimer

Opinions expressed in this presentation are those of the speaker and do not necessarily reflect the views of Citigroup Inc or its affiliates

3

BASEL II – Where we are now?

10 years in its creation

Banks have spent about £10bn - £20bn on its implementation

Many banks have started to report under Basel II

Significant improvement over Basel I

BUT …. Still needs improvement

Greater importance of Pillar 2

Basel Committee due to release a paper shortly

4

Basel II - Enhancements

Trading book risk – inclusion of “Event Risk” Greater emphasis on Stress Testing Review of Off-Balance Sheet exposures Treatment of securitisations Counterparty risk – reducing credit default swap risk Liquidity External Audit Quality Fair value accounting Improved disclosure Others??

5

Tier 1 Capital and Stress Testing

Increased attention to Tier 1 ratios

Need to have sufficient Tier 1 capital after a severe stress event.

Increased attention to severe stress results

Raises pro-cyclicality of Basel II

Consideration of provisioning policies

More emphasis on building up capital in ‘good times’

Implications for banking returns

6

IMPACT OF PROCYCLICALITY UNDER BASEL II

20%

10%

0% 0%

-10%

-20%

Change in Tier 1 Ratio

QIS 4&5 Average Results: Tier 1 -10%

Impact of increased ECL post

stress: Tier 1 -5%

Impact of increased RWA and losses on

stress Tier 1 +17%

IMPACT OF A RECESSION ON BASEL II TIER 1 CAPITAL RATIO UNDER A-IRB

7

STRESS TESTING

Increased importance

Reverse stress test proposed

Regulators setting stress testing assumptions

Regulators set Basel II parameters if data is lacking

Cover all risks

Informs forward planning, capital requirements and risk appetite.

Contingency capital plans.

8

USE OF STRESS TESTING RESULTS

Severe but plausible stress test across whole bank.

Identify concentrations:– Single large exposures

– Large losses as a result of large moves of a specific factor (eg house prices)

– Consider secondary effects and changes in historic correlations.

Identify portfolios with ‘Fat Tails’ e.g.– Secondary mortgages and some sub-prime mortgages

– Leveraged or Bridge Loans

– Originate to distribute portfolios awaiting sale

– Basis risk of ‘well hedged’ positions.

9

DATA QUALITY

Good quality risk data vital to optimise Basel II capital requirement.

Poor quality leads to conservative capital estimates and potentially excessive capital usage.

Credit and finance data need to be, as near as possible, the same.– Settlements outstanding,

– Deferred fees

– Impaired counterparties

– Correct mark to market

10

DATA QULAITY (continued)

Include non finance data– Legal netting where available

– Full collateral data

– Risk ratings assigned

– Counterparty identified

– Comprehensive netting

– Legal vehicle used

– Identify defaults and recoveries promptly and comprehensively

11

Accurate Data for models

Exposure at Default:– Volume of data limited so changes can have a disproportionate

effect.

– Particularly noticeable for credit cards and un-drawn wholesale commitments.

– High quality risk management of use of un-drawn commitments will have a significant benefit in Basel II capital requirements.

Loss Given Default– Evidence of downturn LGD and its variation across cycle.

– Management of defaults and recoveries.

– Sectoral and geographic analysis.

12

USE MODELS WHERE POSSIBLE

Operational Risk model – very different distribution of operational risk.

Expected Positive Exposure (‘EPE’) for OTC derivatives.

Model ALPHA (below defined regulatory level x1.4)

VaR or EPE for Secured Finance Transactions (SFTs).

VaR for all aspects of Market Risk, but will include event risk.

13

POTENTIAL TO OPTIMISE CAPITAL UNDER BASEL II

More difficult than Basel I

Explore those that make sense for your bank – e.g. in Retail:– Potential to sell defaulted credits which are difficult to collect

– Reduce undrawn commitments

Explore those that make sense for your bank – e.g. in Wholesale:– Cancel swaps

– Reduced intra group exposure

– CDS hedging of higher risk exposures

– Banking book/trading book split

– Undrawn commitments – especially if under 1 year.

– Collateralised or covered by parent guarantee.

14

RETURN ON BASEL II CAPITAL:

Given previous comments there is considerable pressure on banks’ balance sheets

Most significant ratio to many banks is the Tier 1 regulatory ratio.

Need to optimise return on Tier 1 capital

Reduce assets utilisation

Risk has a vital role in helping identify opportunities.

15

16

Oh Man, I got the

BASEL II Blues !