GOING ADV ANCED - Oliver Wyman− Scope of aggregation: Risk category vs. aggregate RWA (Risk-Weighted Asset)-based floors, potential additional floors based on exposure class −

AUTHORSAdrian Murphy, Partner Rico Brandenburg, Principal

POINT OF VIEW

Financial Services

GOING ADVANCED IMPROVING ACCURACY OF RISK WEIGHTED ASSETS AND DRIVING CAPITAL EFFICIENCY IN BRAZIL

Copyright © 2015 Oliver Wyman 2

EXECUTIVE SUMMARY

Brazil’s robust banking system has been and remains a key strength for the country. To

date, regulatory capital has not been a major constraint for the largest players. Banks

pursued double-digit growth and supported robust returns allowing them to cover losses

incurred and generate sufficient capital through retained earnings to sustain future growth

and reward shareholders. Hence, over the past years, banks have focused on enabling the

front-office, through growth strategies, optimization of channel management and more

robust underwriting and fraud detection, rather than strategic capital and risk management

initiatives, such as capital efficiency improvement, stress testing, scenario planning and

management of distressed debt.

The Brazilian financial system is a high loss environment with high provisions across the

economic cycle. This is significantly driven by structural factors in the market including the

business mix (e.g. more unsecured, less real estate), segment mix (e.g. new and emerging

segments) and credit market infrastructure (e.g. positive credit bureau still in formation).

Nonetheless there have been significant losses in individual portfolios over the past

number of years that could have been mitigated with the right risk and capital management

infrastructure in place.

Exhibit 1: Cumulative net write-off percentage for top 100 global banks since 2008 (total cumulative write-offs (adjusted for write-backs) as percentage of average customer assets)*1

20%

30%

10%

40%

Ban

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Globalbanks

Brazilianbanks0%

*1 Source: Company annual reports, SNL Financial data, Oliver Wyman analysis. Ranking of total cumulative net write-offs from 2008 to 2014 normalized according to average customer assets during period. Sample consists of top 100 global banks according to asset size, plus Santander Brazil (#103) and HSBC Brazil (#256). Top 25 results shown.


Brazil is now in an economically difficult period with zero or negative GDP growth, high

inflation and fiscal pressure. Although the new finance team is taking actions to combat

inflation, control expenses and improve productivity, there are still some tough years ahead.

This will likely imply a slow-down in credit growth and increasing pressure on delinquencies

and provisions. Whilst there is some opportunity to mitigate the impact in certain segments

(e.g. through limit management, selection, pricing etc.), the effective management of risk and

capital will become an increasingly important strategic issue in the low growth environment

in Brazil over the coming years.

Brazil has signed up to the G20 agenda and as such the banks in Brazil will be impacted by

new global regulation. A significant part of this new regulation is already factored in through

the new Basel III rules, however, there are a number of outstanding proposals to tighten

up and make more conservative the standardized approaches that the majority of Brazilian

banks use under Basel III. This will likely exert downward pressure on CET11 ratios and there

is a very significant downside risk if banks do not prepare. The main changes that will impact

Brazil include:

• Basel III: Higher quality core capital, more conservative capital requirements, more stringent counterparty credit risk treatment (this is largely already in progress including the capital components and additional liquidity and leverage requirements)

• Revised standardized approach: Increased conservatism in the standardized approach for credit risk capital and potential capital floors

• Revised operational risk approach: Increased conservatism and potential removal or modification of alternative standardized approach

• Capital adequacy: Use of stress testing and additional buffers to inform capital adequacy

• IFRS 9: Move to expected loss approach for provisioning

In this context, we believe it is important for Brazilian banks to make a step change in the

sophistication of their risk and capital management capabilities towards:

• Improved accuracy: a more precise understanding of risk and capital will help guide senior management, in particular given the significant skews in returns across segments and products

• Optimized capital: tactical reductions in capital can be achieved under both standardized and advanced approaches enabling growth and returns

• Better business decisions: the new risk capabilities and capital planning processes can be leveraged to support portfolio optimization and improved business decisions

1 Common Equity Tier 1 Ratio (CET1): Measurement of a bank’s common equity compared with total risk-weighted assets as defined under Basel III.

We estimate that with a strategic capital optimization program supported by

implementation of IRB advanced, almost all of the players could realize a significant

improvement of 10-20% in capital requirements. The trend through time will be to

dis-incentivize standardized approaches, so ultimately the relative impact may be

significantly larger.

Hence there is clear upside for banks in building in the optionality to allow an easy and cost-

effective transition to more advanced approaches as conditions merit. Banks should improve

“bottom up” approaches to identify and measure risks (e.g. credit risk, operational risk etc.)

and implement robust tools to provide an integrated view of risks across the balance sheet

and the ability to rapidly run stress testing and scenario analysis. This will ensure a robust

risk management framework and allow Brazilian banks to capture the full business benefits

of risk management upgrades, in addition to meeting regulatory requirements. In our view,

this will be an increasingly important strategic issue for senior management and the board

over the coming years, and banks that lead may realize significant competitive advantage.

RISK-SENSITIVE CREDIT RISK MEASUREMENT

Comparative analysis across banks and countries have revealed significant differences

between standardized and advanced modelling approaches in different countries as well

as between advanced approaches in different institutions in the same countries which are

not related to the underlying risk of the credit exposures. The Basel committee is seeking

to address inequalities through revision of the standardized approach and introduction of

capital floors. This in turn will be impacted by convergence in relation to the IFRS accounting

rules, per the table below:


Exhibit 2: Summary of main changes impacting credit risk capital requirements

REGULATION DESCRIPTION CAPITAL IMPACT

New standardized approach

“Consultative Document – Revisions to the Standardized Approach for credit risk”

• Main objective is to make the standardized approach to credit risk

− More risk sensitive

− More closely aligned to the AIRB (Advanced Internal Rating-Based) approach (in terms of definitions and scope)

− Less reliant on external credit ratings

• Approach is based on “risk drivers” which

− Are used to determine the standardized risk weights

− Will increase data requirements to determine risk weights in the standardized approach

Significant increase of standardized capital requirements

IFRS 9

“Consultative Document – Guidance on accounting for expected credit losses”

• IFRS 9 (International Financial Reporting Standards) will fundamentally change the level and dynamics of credit provisions and is likely to increase provision levels

• Key drivers of the increase vary by stage of the exposure

− Stage 1 (performing): Change in outcome window to 12 months from typically 3-6 months

− Stage 2 (significantly deteriorated): Move to lifetime EL (Expected Loss), i.e. lifetime default rate, lifetime expected LGD (Loss Given Default) – not most likely

− Stage3 (defaulted): Move to lifetime expected LGD rather than most likely outcome of impairment event (mean vs. median result)

Increase of provisions (alignment of provisions and expected loss under AIRB)

New capital floor

“Consultative Document – Capital floors: the design of a framework based on standardized approaches”

• New AIRB capital floor will be based on Basel III standardized approach instead of Basel I and will become an integral and permanent element of regulation (currently part of the transitional measures)

• Key elements of the capital floor under discussion

− Scope of aggregation: Risk category vs. aggregate RWA (Risk-Weighted Asset)-based floors, potential additional floors based on exposure class

− National discretion: Extent to which national discretion in Basel III standards is allowed for in the determination of the floor

− Provisions treatment: Adjustments for differences in the treatment of provisions between the standardized and AIRB approaches for credit risk

Increase of capital under advanced approaches (depending on the level)

These initiatives will result in a decrease in CET1 ratios across countries and institutions. The

latest QIS results are currently being prepared by Central Banks and so we do not provide

an actual estimate of impact here. We do, however, note that our own client discussions and

insights suggest the impact could be very significant.

Brazilian banks are still under the standardized credit risk approach and have to date faced

challenges in the implementation of advanced credit risk approaches. This is partly due to

the rigidities of the framework, and a limited focus on the optimization of credit risk capital

requirements, as well as a lack of involvement of the businesses in such programs. There is

flexibility in the advanced capital standards that can be leveraged to ensure the approach

is fit for business needs and meets regulatory requirements. This for example includes

flexibility around interpretations of data histories, the choice of modelling approaches

and the ability to reflect business practices to mitigate risk. In this context, an effective

implementation of the advanced modelling approach can deliver a sizeable (if not huge)

capital benefit due to an alignment of capital and risk, and importantly increased

transparency and improved business practices.


Exhibit 3: Potential capital impact through advanced modelling under Basel III Advanced Approaches – Emerging market example (percentage of standardized capital requirements)*1

90%

100%

110%

70%

80%

60%

120%

Currentstandardized

Reduction Shortfall AIRBimpact

InitialAIRB

Methodology OptimizedAIRB

Data Businesslevers

OptimizedAIRB impact

INITIAL CALCULATION OPTIMIZATION

100%-10% to

-15%

+15% to+20%

0% to+10%

100% to110%

-5% to-10%

-5% to-10%

-5% to-10%

80% to90%

-10% to-20%

50%

*1 Oliver Wyman analysis.

The example shows that calculations based on first generation risk models and calculation

engines are often likely to overestimate the capital under the advanced credit risk approach.

Realizing the sizable benefit that is achievable through alignment of capital with risk requires

the implementation of a strategic optimization capability and toolkit that:

• Provides a strategic view of capital across the balance sheet including all of the businesses lines

• Identifies areas of capital efficiency improvement and sizes the impact of technical and strategic improvement levers

• Acts as a mechanism to engage all of the business and provide a unified view across risk and finance

The key to success is to treat this as a strategic issue involving all of the top management

and not simply as an accounting problem. This requires an integrated view across all of the

portfolios and segments coupled with a detailed understanding of the levers that can be

deployed to deliver the required impact. So for example, a low return in the SME segment

may drive actions to push the business towards safer and more efficient collateralized

lending products, or may simply encourage the collection of turnover data to benefit from

moving down the SME capital curve. The business may have enacted a real reduction in

risk appetite, mandating a forward looking risk driver analysis to justify a lower and more

relevant prediction of default rates, rather than slavishly relying on a long period of internal

historic data that is simply no longer relevant. The strategic tool and levers framework


(of which there are literally hundreds) allow these issues to be identified quickly and

proactively resolved, in a pragmatic and convincing way, achieving business buy-in and

regulatory approval.

Given the likely adoption of IFRS 9 across G20 countries, a successful delivery of AIRB credit

risk programs will also put banks at the forefront for the implementation of the revised

provisioning rules which will align provisions with expected loss and enforce an earlier

recognition of potential losses. The key advantages of implementing IFRS9 when advanced

models are already in place are:

• Avoidance of confusion around different risk measures between finance, risk and the business

• More efficient use of scarce resources (finance and risk costs, IT investment, data scientists)

• Consistency between provisioning and risk assessment philosophy, i.e. the risk model used to price the product is likely to be the most appropriate to assess whether the credit spread has materially changed

• Typically less systems and data challenges during the implementation

INTEGRATION OF OPERATIONAL LOSSES

The comparatively low capital charge imposed by the basic indicator and in particular

standardized approaches has led to a Basel review of operational risk measurement. Judging

from international precedents, the revised standardized approach is likely to be based on a

composite variable known as the “Business Indicator” rather than gross revenues or assets.

The proposed approach gives weight to activities such as gains and losses from trading, fees

and commissions from services. This is likely to increase the operational risk capital charge

for large global and investment banks and for fee heavy businesses (card issuers, payment

providers, etc.).

The Advanced Modelling Approach (AMA) introduces an operational risk measure based

on internal models using internal and external loss data as well as business expert input.

The proposed changes to the standardized operational risk framework will make the

AMA approach more attractive to a wider set of banks, including the larger Tier 2 banks.

In general, we estimate a capital impact of up to 20% in operational risk capital through

adoption of AMA compared to the revised standardized approach. In Brazil the outcome will

depend on whether a similar mechanism to the current Alternative Standardized Approach

(ASA) is allowed under the new rules.


Exhibit 4: Comparison of operational risk capital requirements under different regulatory approaches in Brazil (Sum of operational risk RWA normalized by total RWA – selected banks)*1

8%

12%

16%

4%

20%

AlternativeStandardized

Approach (ASA)

AdvancedMeasurement

Approach (AMA)

The StandardizedApproach

(TSA)

RevisedStandardized

Approach

0%

*1 Source: Annual reports, Oliver Wyman analysis. Estimated sum of operational risk RWAs normalized by total RWAs for selected Brazilian banks.

The ASA which many banks in emerging markets, such as Brazil, currently rely on in order to

derive a significantly lower capital requirement is not currently included under the proposed

new BIS rules. We expect this to be an area of significant lobbying. In our view the general

direction is nonetheless to penalize standardized approaches and there will almost certainly

be an additional incentive to move to AMA when the new rules have been established.

The major benefit of implementing AMA and the associated infrastructure and processes

comes not through capital optimization, but through improved operational risk

management in the businesses. The impact is chiefly through improved risk identification

(including “tail” and “business as usual” events), enforcing an integrated “front-to-back”

view (including business units and support functions) and focussing senior management on

the most important issues. We estimate potential to reduce expected losses by 10-20%.

To realize this benefit it is important to embed the operational risk models in an integrated

operational risk and controls framework to provide a logical structure to identify and manage

risks, and support the necessary controls and remedial actions.


We highlight six key “lessons learned” that should be considered by banks when developing

and implementing the operational risk measurement approach:

• Be clear about the role of each component in the capital model and risk measurement framework – this should be part of a shared, detailed vision for the overall framework

• Spend time evaluating many different options for how to structure measurement process rather than just “plunging in” – there is no “one size fits all” approach

• Ensure close and continuous coordination across risk measurement elements, capital modelling and other elements of the operational risk management framework, e.g. governance, policies, Risk Control Self-Assessments (RCSAs), Key Risk Indicators (KRIs), Business, Environmental and Internal Control Factors (BEICFs)

• Focus on business relevance and buy-in, take top-down sanity check view and pilot approaches within one or two “friendly” businesses and refine them before group-wide roll-out

• Know expectations of your regulator for operational risk measurement – ideally your approach should be discussed with the regulator before you implement it

• Use all available data sources to reduce subjectivity and generate robust results, including internal, external data, scenario analysis, BEICF and anecdotal evidence in addition to expert opinion

Exhibit 5: Integrated operational risk and controls framework*1

Co

rpo

rate

Bu

sin

ess

area

s

Governance

Risk appetite/loss tolerance

Auditing

Validation

Systems and infrastructure

Veri

ficat

ion

Documentation

Policies,standards,

concepts andmethodologies

External loss data

Risk identification

Op

risk

even

t

Inte

rnal

loss

dat

a

KR

Is

Ince

nti

ves

Cu

ltu

re

Use

test

Key

con

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sd

efin

itio

ns

Con

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test

an

das

sess

men

t

Capitalmodelling

Scen

ario

an

alys

is

BEICFs

Responses

Management,mitigation,

transfer,outsourcing,

etc.

Reporting

Rel

atio

n w

ith

reg

ula

tor

Identity Assess Respond Reporting andmonitoring

Enablers Tools Cycle

Ris

k as

sess

men

t

Products and processes approval

Project approval

*1 Example of Oliver Wyman integrated operational risk and controls framework.


STRESS TESTING AND SCENARIO PLANNING

Central banks and regulators globally are mandating that banks undertake macroeconomic

and portfolio specific stress tests. In the United States and Europe this was driven by a crisis

situation and with the focus very much on regulatory response. By embedding stress testing

and scenario analysis into the strategic capital planning processes, Brazilian banks have the

opportunity to capture the full business benefits of risk management upgrades, in addition

to meeting regulatory requirements.

Exhibit 6: Strategic capital planning processes

INTEGRATED SCENARIOPLANNING

PERFORMANCE MANAGEMENT

BOTTOM-UP CREDIT RISKSTRESS TESTING

Requires input on…

• Projected loss parameters

• Loan balance evolution (performing/NPL)

Assesses and provides feedback on…

• Projected business volumes and overall bank-strategy

• Modelling of other P&L elements(e.g. NII, fees, costs, provisions) and capital components (capital req./avail.)

• Integrated financial performance results (P&L/B-S/Capital)


• Macroeconomic scenariosand bank strategy underthose scenarios

• Impact of risk drivers on bank's bottom-line (P&L/Capital)


• Projected loss parameters (PD/LGD/EAD/EL/Provisions)

• Loan balance evolution (performing/NPL)


• Detailed budget and planning forecasts

• Scenario analysis and stress testing results

• Actual granular performance data


• Comparison of actual and projected business volumes,P&L and capital results

• Analysis of drivers for planning and stress testing deviation

• Implementation of corrective actions


An integrated planning, stress testing and scenario analysis framework improves decision

making across a number of key dimensions:

• Better understanding of key strategic “bets and threats” and overall P&L, B-S and Solvency impacts

• Embed risk and scenario-based considerations into strategic planning (vs. focusing too much on base case)

• Real-time impact evaluation around business plans and performance levers (including mitigation strategies) supporting informed management discussions

• Enhanced consistency, transparency and transversality across individual risk drivers and

stakeholders involved in the strategic planning value chain

In our global client work we regularly observe low to mid-single digit RoE impacts

following the introduction of such capabilities. The impact is driven in part by the improved

transparency and discipline through implementation of the new tools and in part by the

knock-on changes in behaviors and business-led initiatives that this encourages.

CONCLUSION

In conclusion, banks in Brazil are entering a more challenging market and regulatory

environment. There has to date been limited focus on improving RWA accuracy and

efficiency of capital. There is an opportunity to make a step change in the sophistication of

risk and capital management capabilities to meet regulatory requirements, sustain returns

and enable competitive growth strategies. In our view, this will be an increasingly important

strategic issue for senior management and the board over the coming years, and one that

banks should be planning for now.


www.oliverwyman.com

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ABOUT THE AUTHORS

Adrian Murphy is a Partner in the Americas Finance & Risk Practice.

Adrian can be reached at:

[email protected]

Rico Brandenburg is a Principal in the Americas Finance & Risk Practice.

Rico can be reached at:

[email protected]

Copyright © 2015 Oliver Wyman

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Documents

GOING ADV ANCED - Oliver Wyman− Scope of aggregation: Risk category vs. aggregate RWA (Risk-Weighted Asset)-based floors, potential additional floors based on exposure class −