Workshop on Risk Management in Commercial Banks · Workshop on Risk Management in Commercial Banks September 3-7, 2007 Shanghai National Accounting Institute DELEGATION LIST OFFICIAL

Workshop on Risk Management in Commercial Banks

September 3-7, 2007

Shanghai National Accounting Institute

DELEGATION LIST

OFFICIAL DELEGATES

AUSTRALIA 1. Bernie Egan

Program Director Basel II-Policy Research and Statistics Australian Prudential Regulation Authority

Tel: 612-9210-3584 Fax: 612-9210-3021

E-mail: [email protected]

BRUNEI DARUSSALAM 2. Rajali Abu Bakar

Spacial Duties Officer, Grade I Financial Institution Division Ministry of Finance

Tel: 673-238-4251 Fax: 673-238-2215


CHINA 3. Hu Xuehao

Deputy Director-General Fiance Department

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Ministry of Finance 4. Zhang Ruohan

Deputy Director Finance Department Ministry of Finance

5. Xing Yingying

Financial Market Department People’s Bank of China

Tel: 86-10-6619-5819 Fax: 86-10-6601-6647

6. Zhang Lixing

Director International Department China Banking Regulatory Commission

7. Cui Yuanjian

Deputy Director Financial Institution Division II Shanghai Municipal Office of Finance Service Tel: 86-21-2311-6320 Fax: 86-21-2311-6384

E-mail: [email protected] 8. Chen Yan

Section Chief Foreign Trade Division Tianjin Municipal Finance Bureau Tel: 86-2223303740 ext. 2621 Fax: 86-22-3311489 E-mail: [email protected]

9. Gao Jie Section Chief Tianjin Municipal Finance Bureau Tel: 86-22-23321287 ext. 230 Fax: 86-22-23321287

10. Hu Jingru Section Chief Kunming Municipal Finance Bureau

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11. Yang Jianjun Kunming Minicipal Finance Bureau

INDONESIA 12. S.Y. Dewi Irmawan

Bank Supervisor Bank Supervision Directorate Bank Indonesia

Tel: 62-21-230108 ext 4722 / 62-8189-43933 Fax: 62-21-2311353

E-mail: [email protected] 13. Edi Setijawan

Bank researcher Islamic Bank Directorate Bank Indonesia

Tel: 62-21-3818451 / 62-8111-40211 Fax: 62-21-350 1989


KOREA 14. Yoo, Jae Soo

Director Banking System Division of Financial Policy Bureau Ministry of Finance and Economy

MALAYSIA 15. Aida Kasumawati Mohd Yatim

Senior Executive Financial Conglomerates Supervision Bank Negara Malaysia

Tel: 603-22635000 ext: 8256 Fax: 603-2693-4051


PHILIPPINES 16. Charissa Panlilio Hipolito

Director III Corporate Affairs Group Department of Finance

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Tel: 632-5257-427 Fax: 632-5251-313

E-mail: [email protected] 17. Restituto Cruz

Deputy Director Bangko Sentral ng Pilipinas Tel: 632-306-13-52/632-536-74-35 Fax: 632-306-14-15

RUSSIA 18. Yulia Grigorovich

Head of Subdivision Banking Regulation and Supervision Department Central Bank of Russian Federation

Tel: 7 -495- 957-84-10 Fax: 7-495- 957-84-16

E-mail: [email protected] 19. Larisa Moskovkina

Advisor Department of International Economic and Fiancial Relation Central Bank of Russian Federation

Tel: 7-495-771-91-22 Fax: 7-495-771-91-32


THAILAND 20. Aroonsri Methisariyapong

Economist Bureau of Financial System Ministry of Finance

Tel: 662-273-9020 ext 3415 Fax: 662-618-3374

E-mail: [email protected] 21. Pongrapeeporn Abhakorn

Economist Fiscal Policy Office Ministry of Finance

Tel: 6651234466 Fax: 6626183374

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VIET NAM 22. Minh Pham Hong

Expert International Cooperation Department Ministry of Finance Tel: 84-4-220 2828 ext. 7040 Fax: 84-4-2208109 E-mail: [email protected]

23. Hoa Bui Thi Phuong

Department of Banking and Financial Institution Ministry of Finance Tel: 84-4-220-2828 ext. 7094 Fax: 84-4-220-8020 E-mail: [email protected]

INTERNATIONAL ORGANIZATION

WORLD BANK 24. Arvind Gupta

Lead Specialist Finance and Private Sector Development in East Asia and the Pacific

APEC BUSINESS ADVISORING COMMITTEE 25. Ken Waller

Chair Financial Advisory Board Australian APEC Study Centre

BIS 26. Alicia Garcia-Herrero

Regional Office for Asia and the Pacific

PRIVATE SECTOR

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27. Chris Mouat Director China Partnerships Australia and New Zealand Banking Group Limited

28. Patrick Zhu Head of Retail Risk China Partnerships Australia and New Zealand Banking Group Limited

29. David Millar Chief Operating Officer Professional Risk Managers’ International Association

30. Guo Jun Secretary General Professional Risk Managers’ International Association China

Tel: 86-10-6236-7872/13120278568 Fax: 86-10-6236-6907

E-mail: [email protected]/[email protected]

31. Chen Hua Credit Risk Management Department

China Development Bank Tel: 86-10-8830-8910 Fax: 86-10-6833-7127

E-mail: [email protected] 32. Liu Ruixia

Deputy General Manager Risk Management Department Industrial and Commcial Bank of China

Tel: 86-10-6610-6026 Fax: 86-10-6610-6501

33. Sun Chongwei Regional Manager International Department Industrial and Commcial Bank of China Tel: 86-10-66106015 Fax: 86-10-66106501 E-mail: [email protected]

34. Ji Hou

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Director Auditing Center (East) Everbright Bank of China

Tel: 86-21-6252-1276 Fax: 86-21-6213-0938


35. Ren Guoqiang Auditing Center (East) Everbright Bank of China

Tel: 86-21-6252-0306 Fax: 86-21-6212-0938

E-mail: [email protected] 36. Song Xiaoping

President Jinqiao Subbranch, China Merchants Bank Tel: 86-21-50753779 Fax: 86-21-50753795 E-mail: [email protected]

37. Liu Hongfeng Manager China Merchants Bank Fax: 86-755-83195059 E-mail: [email protected]

38. Yin Li

General Manager Risk Management Department Shanghai Branch, Bank of China Fax: 86-21-50372059 E-mail: [email protected]

39. Chen Qiqi

Senior Manager Assistant Shanghai Branch, Bank of China Tel: 86-21-38824588 ext. 21410 Fax: 86-21-50372059 E-mail: [email protected]

40. Wang Shufang

President Pudong Branch, Bank of Shanghai

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Fax: 86-21-5070-1959 E-mail: [email protected] 41. Huang Haiqing

Administration Assistant Pudong Branch, Bank of Shanghai Fax: 86-21-5830-5623

E-mail: [email protected] 42. Zhang Qingxian

Manager Risk Management Department Pudong Branch, Bank of Shanghai

Tel: 86-21-5830-5232 Fax: 86-21-5830-5473

E-mail: [email protected] 43. Miao Jun

Manager Risk Management Department Pudong Branch, Bank of Shanghai Fax: 86-21-5830-5473 E-mail: [email protected]

44. YE Qingyu Senior Risk Manager Shanghai Branch, Bank of Communications Tel: 86-21-63111000 ext. 3426 Fax: 86-21-53856683 E-mail: [email protected]

45. Wang Zhuanhong

Senior Credit Extension Manager Shanghai Branch, Bank of Communications Fax: 86-21-53856005

46. Huang Wen Manager Risk Management Department Pudong Branch, Shanghai Rural Commercial Bank Tel: 86-21-50588286 Fax: 86-21-50588287

47. Liu Xiangdong

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President Chia Tai International Finance Co., Ltd.

48. Jiang Yiling

Deputy General Manager Chia Tai International Finance Co., Ltd. Tel: 86-21-63352788 Fax: 86-21-63351986 E-mail: [email protected]

49. Bao Xiaofei

General Manager Risk Management Department Daiwa SMBC-SSC Securities Co., Ltd.

Tel: 86-21-6859-8000 Fax: 86-21-6859-8030

E-mail: [email protected] 50. Tan Yonghong

Senior Manager Risk Management Department Daiwa SMBC-SSC Securities Co., Ltd.

Tel: 86-21-6859-8000 Fax: 86-21-6859-8030

E-mail: [email protected] 51. Windiartono

Senior Manager PT. Bank Rakyat Indonesia

Tel: 62-21-5713-114 / 62-8151-854335 Fax: 62-21-5713121

E-mail: [email protected] 52. Wibowo Sulistianto

AVP Risk Management Department PT. Bank Negara Indonesia

Tel: 62-21-5728-039 Fax: 62-21-2511-148

E-mail: [email protected] 53. Promod Dass

Head Financial Institution Ratings

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RAM Rating Services Berhad Tel: 6-03-7628-1790 / 60-1626-30901

Fax: 6-03-7620 8251 E-mail: [email protected] 54. Yin Ching Wong

Manager Financial Institution Rating RAM Rating Services Berhad

Tel: 6-03-7628-1717 Fax: 6-03-7620-8251

E-mail: [email protected] 55. Chu Thị Minh Hà

Deputy Director Credit Management Department The Bank of Investment and Development

56. Phùng Nguyệt Minh Specialist Capital Planning Department The Bank of Investment and Development

57. Nguyễn Kim Trang Specialist Capital Planning Department The Bank of Investment and Development

58. Phạm Quốc Trung Director Customs Service Development Department The joint stock bank - VP Bank

59. Đặng Tuấn Tú Deputy Director Customs Service Development Department The joint stock bank - VP Bank

60. Đỗ Thị Bình Giang Deputy Director ATM Center The joint stock bank - VP Bank

61. Phạm Thị Lan Ngọc

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Specialist ATM Center The joint stock bank - VP Bank

62. Phan Thị Phương Thúy Specialist ATM Center The joint stock bank - VP Bank

63. Nguyễn Thị Bịch Lộc Manager Human Resourse and Training Department The joint stock bank - VP Bank

64. Nguyễn Xuân Hùng Specialist Internal Audit Department Vietnam Bank for Ariculture and Rural Development

65. Bùi Thị Nhung Deputy Director Department of Preventing and Management Risks Vietnam Bank for Ariculture and Rural Development

66. Vũ Thị Thu Huyền Specialist Board of Management Department Vietnam Bank for Ariculture and Rural Development

67. Cao Xuân Đông Deputy Director Credit Management Department Vietnam Bank for Ariculture and Rural Development - Bac Ha Branch

68. Trần Thanh Hà Deputy Director International Currency Department

69. Võ Thị Khánh Vân An Binh Joint Stock Bank - Hanoi Branch

70. Ngô Thị Mỹ Hương An Binh Joint Stock Bank - Hanoi Branch

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71. Trương Minh Đức An Binh Joint Stock Bank - Hanoi Branch

72. Nguyễn Hoàng Sơn An Binh Joint Stock Bank - Hanoi Branch

73. Nguyễn Băng Tâm VTC

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September 3-7, 2007 Shanghai National Accounting Institute, P.R. China

Co-sponsors:

Ministry of Finance, P.R.China Australia Treasury Ministry of Finance and Economics, Korea

Co-organizers:

Asia-Pacific Finance and Development Center World Bank Institute

PROGRAM

Monday, September 3, 2007

8:30-9:00 Registration

Venue: 3rd Floor, Lecture Building III 9:00-9:10 Session 1 Opening Speech

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III 9:10-9:30 Group PhotoTaking

9:30-10:40 Session 2 Overview of Risk Management in Banking Sector

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Arvind Gupta, Lead Specialist for Finance and Private Sector Development in East Asia and the Pacific, the World Bank

10:40-10:50 Coffee Break

10:50-12:00 Session 3 The Present Situation and Ahead of Banking Risk Management in China

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Zhang Lixing, Director, International Department, China Banking Regulatory Commission

12:00-13:30 Lunch

Venue: 2nd Floor, Dinning Hall II

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13:30-15:00 Session 4 The Present Situation and Ahead of Banking Risk Management in India

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Arvind Gupta, Lead Specialist for Finance and Private Sector Development in East Asia and the Pacific, the World Bank


15:30-17:00 Session 5 Implementing Risk Management – people, process and systems considerations

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: David Millar, Chief Operating Officer, PRMIA

Tuesday, September 4, 2007

9:00-10:20 Session 6 Strategies to Enhance Risk Management and Corporate Governance in Commercial Banks

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Ken Waller, Chair of the Australian APEC Study Centre's Financial Advisory Board


10:40-12:00 Session 7 Building A Healthy Regulatory Framework for Risk Management in Commercial Banks: Commercial bank’s perspective

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speakers: Chris Mouat, Director, China Partnerships, ANZ ;Patrick Zhu, Head of Retail Risk, China Partnerships, ANZ

12:00-13:30 Lunch


13:30-15:00 Session 8 Building A Healthy Regulatory Framework for Risk Management in Commercial Banks: Regulator’s perspective

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Bernie Egan, Program Director, Basel II – Policy Research and Statistics Australian Prudential Regulation Authority, Australia


15:30-17:00 Session 9 Building A Healthy Regulatory Framework for Risk Management in Commercial Banks: Rating agency’s perspective

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speakers: Promod Dass, Financial Institutions Rating Department, Rating Agency Malaysia Bhd.; Wong Yin Ching, Manager, Financial Institutions Ratings, Rating Agency Malaysia Bhd.

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Wednesday, September 5, 2007

9:00-10:30 Session 10 Building A Healthy Regulatory Framework for Risk Management in Commercial Banks: Regulator’s perspective

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Yoo, Jae Soo, Director, Banking System Division, Financial Policy Bureau, Ministry of Finance and Economy, Korea

Q&A


10:50-12:00 Session 11 Building A Healthy Regulatory Framework for Risk Management in Commercial Banks: Commercial bank’s perspective

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Liu Ruixia, Deputy General Manager, Risk Management Department, Industrial and Commercial Bank of China

Q&A

12:00-13:30 Lunch


13:30-15:00 Session 12 Cross-border Banking and Supervisory Cooperation under Basel II

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III Speaker: Alicia Garcia-Herrero, BIS Regional Office for Asia and the Pacific

Q&A


15:30-17:00 Session 12 Break-out Small Group Discussion

Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III The participants will be divided into small groups to review and discuss the presentations during the three days and the implications/applicability in their own current financial environment.

17:00-18:00 Session 13 Group Report &Conclusion Venue: U-Shaped Classroom IV, 3rd Floor, Lecture Building III

Thursday, September 6, 2007

8:30-18:00 Site Visit-Shanghai Downtown

Friday, September 7, 2007

8:30-18:00 Site Visit-Suzhou

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Overview of Workshop

September 3, 2007Shanghai National Accounting Institute, P.R. ChinaAsia-Pacific Finance and Development Center

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Why a Program on Risk Management

Banking systems– Mobilize savings (economies of scale)– Allocate and monitor the use of society’s savings– Facilitate risk amelioration and trading

Well-Functioning Banking systems– Improve capital allocation and economic growth.– Reduce income inequality– Lower poverty & Inequality

Consequences of Banking Failures – Economic growth suffers --- output declines, entrepreneurship

gets thwarted.– Fiscal burden diverts resources from essential public goods

and public investments

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Asia has been very successful inmobilizing resources

Source: East Asia Finance, The Road to Robust Markets, World Bank, 2006

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Progress has been made in the bankingsector


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Capital Markets Are Growing


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Banking Sector Agenda Remains


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Why Risk Management? Banking Instability

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Framework for Banking Stability

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Why Risk Management?

Banks often have– Liquidity problems– Large open currency positions of private banks– Significant holdings of government debt– Low asset quality– Risk assessment and management systems weak– Lack of good corporate governance– Major macroeconomic instability– High public sector deficit– Systemic distortions created by weak banks– Weak financial disclosure rules and oversight

arrangements

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Why Risk Management?

Increase in bankruptcy in most economies as markets become more competitive --- globalization and domestic liberalization“Winner’s Curse”. More creditworthy firms have direct access to debt markets. Banks make more loans to borrowers without access to credit markets average loan quality has deteriorated.Volatile Values of CollateralMore competitive financial markets ---Interest margins have declinedThe growth of derivatives : all have credit exposures

Thus worsening of the risk-return tradeoff

BIS Risk-Based Capital Requirements: Links capital charges to external credit ratings or internal model of credit risk.

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Why Risk Management: Economic Rationale

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Why Risk Management?Macro-financial Rationale

Procyclicality of bank lending is a widespread phenomenon and not confined to specific episodesShocks to capital result in a reduction of bank loan supply (both in and outside crises and independent of structure)The effect of initial capital is stronger in crisis timesLoan losses have the potential to exacerbate macroeconomic fluctuations, that is, financial instability may have real effects (even outside of crises and absent bank defaults).Financial and monetary stability are not disjoint.Monetary policy can have powerful effects in exacerbating or alleviating financial instability. Banks’ balance sheet characteristics affect their lending activity: banks with higher provisions tend to extend less credit than their stronger competitorsThe impact of provisions on bank loan supply is stronger for banks that are poorly capitalized.Bank capital ‘matters’ more in times of low economic growth

Source: Bank weakness and bank loan supply , Erlend Nier and Lea Zicchino, 2004, Bank of England

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Why Risk Management? Corporate Rationale

Risks arising from provision of financial services such as – Market risk– Credit risk– Operational risk– Cross border risk

To set performance incentives that are not perverse and better align growth and stability Measure economic capital Allocate resources more efficientlyApply risk based pricingCustomer selection and product developmentActive management of portfolio riskEstablish an integrated risk management system to ensure consistent risk measurements / policies for each type of risk, across all businesses.

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Traditional Approaches to CreditRisk Management

Character – reputation, repayment historyCapital – equity contribution, leverage.Profitability – earnings volatility.Collateral – Seniority, market value & volatility of market value of collateral.Economic cycle and market conditions.

Problems of consistency and subjectivity

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New Approaches to Risk Management

Role of Credit Risk Models – Support tactical credit risk management – Support decision making at the strategic level– Understand better lending implications

Credit Risk Modeling Framework– Definition of default– Aggregation of credit risk– Recovery– Exposure

Types of Models (Econometric, Equity Based, Actuarial)

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Measuring Risks

All measurements of risk incorporate not only quantitative but also qualitative elements.

– Even with good data and tools, uncertainty exists– Estimation error always exists, often difficult to quantify – Need to combine with qualitative tools and judgment

Use of sensitivity analysis, stress testing, and scenario analysis

– For analyzing potential effects not captured by static quantitative tools

– To inform use of baseline measure – When data are scarce or tools are lacking, baseline measure should

use more sensitivity analysis and qualitative factors– Should cover the major risk types (credit, market, operational)

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INTEGRATED RISK MANAGEMENT

THREE RELATED ASPECTS – Integrated risk management as having consistent

policies and methods of measurement of risk through-out the firm.

– Integrated risk management as the integration of risk measurements, particularly economic capital, as a component, into all aspects of business decisions.

– Integrated risk management as the process of centralizing certain key risk architecture functions, to ensure consistency in measurement and reporting of risk.

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Risk Management System

Risk Management Functions

Approve and monitor risk limits.Approve limit exceptions.Approve new forms of transactionsFunction as eyes and ears of senior management with regard to risk taking of business.

Risk Architecture FunctionsBuild and maintain risk infrastructure of firm:Develop methods to measure and analyze risks, including economic capital.Develop risk policies.Develop comprehensive risk reports.Develop IT based risk systems

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Risk Management

Risk Models for Individual Assets– Regression model and using simulation model

Portfolio Risk Models for Economic Capital– The Conceptual Framework: Economic Capital– Types of Portfolio models– Assessing economic capital

Basel II Capital– Basel’s Capital Rules– Assessing Basel capital

Basel II implementation process in banks

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Basics Tasks in Credit Risk Management

Professional Risk Manager’s International AssociationReview strategic credit positions:

– Any changes to largest exposures (net of collateral)?– How about changes to counterparty ratings?– Any significant credits to be approved by chief credit officer or board?

Credit limits and provisions:– Any limit excesses?– Limits to be reviewed?– Provisions still up to date?– All concentrations within limits?

Credit exposure:– All exposures covered and correctly mapped?– Any Wrong way position?

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Basic Tasks in Credit Risk Management (Cont’d)

Credit reporting:– All significant risks covered in credit report?– Report distributed to all relevant parties?– Any significant credits that must be discussed at top management/board level?

Stress and scenario analysis:– Any surprises from stress and scenario analysis at portfolio or global level?– Anything not covered by current set of scenarios?

Provisions:– Any past or anticipated changes in general loss provisions?– Any changes to specific provisions?

Documentation:– Full documentation in place for all transactions?– Break clauses and rating triggers fully recognized?

Credit protection:– Credit protection utilized and understood?– Any further possibility to exploit credit protection?

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RISK METHODS AND ANALYTICS FUNCTIONS

Risk Methods and Analytics

Operational Risk Analytics Credit Risk Analytics Counterparty Risk Analytics Market Risk Analytics Model Validation

Source: Evan Picoult, Citigroup October, 2006

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Definition of Economic Capital

Capital is held to ensure that a bank is likely to remain solvent, even if it suffers unusually large losses

– Available economic capital:– The amount by which the value of all assets currently exceeds

the value of all liabilitiesRequired economic capital:

– The amount by which the value of all assets should exceed the value of all liabilities to ensure that there is a very high probability that the assets will still exceed the liabilities in one year’s time

Typically, banks aim to have a high (e.g., 99.9%) probability of remaining solvent

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Economic Capital

EC is the amount of capital to be held to protect against low probability lossesThe building blocks of EC

– PD, LGD, EAD, correlation, (M)The key parameters describing the Credit Loss PDF

– EL and UL– Capital as percentile of PDF

Basel Capital is a stylized version of EC– A single correlation is assumed– A single systematic risk factor– “Infinite granularity”, no large loans or concentrations– No uncertainty in LGD

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Thinking about Economic Capital

Given the random amount of losses we suffer each year, how much could we lose if we are unlucky?

– Capital as an unexpected loss percentile– Capital = percentile of PDF

How much could we expect to lose in a recession?– Capital as expected loss conditional on “severe" draw of

systematic risk factor– Uncertainty in LGD and EAD assumed to be idiosyncratic, so– Conditional EAD and conditional LGD are equal to their

expected values, respectively– Capital = conditional default probability x LGD x EAD

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Use of Economic Capital & RAROC

Capital decisions– General provisions, reserves, capital allocation

Portfolio allocation decisions– Identification of opportunities and problems

Pricing and profitability decisions– RAROC: Risk-Adjusted Return On Capital

Boosting high RAROC business linesLoan pricing

– Margin = EL + H x Capital + OpRisk + OpCost

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Risk Adjusted Return on Capital

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Stress Testing

What is Stress Test? Techniques used by financial firms to gauge their vulnerability to exceptional, but plausible, events. How do you identify a plausible, stressful scenario?

– Use a historical scenario – Develop a hypothetical scenario

What is likely to be stressed?– The earnings, reserves, and capital adequacy of the

individual banks– Stress test should cover loans and other parts of the

balance sheet as well as the income statement

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Principles vs. Rules based Standards for Governance

Rules-based: detailed, rigid with little discretion, but intention can be circumventedPrinciples-based: broad principles with little structure to guide, flexible and responsive to changes, as judgment is guided by spirit/intentionObjectives-based: principles+ where objectives are clearly defined, sufficient detail and structure is given so that standard can beoperationalized and applied on consistent basis

Economies can adopt standards to reorganize bureaucracy for transparent and effective delivery of services, with accountability. These operational standards ensure that processes minimizes self-serving behaviour, turf fights and silo mindsets, and promote collaboration and unity of purpose in delivery of public services

Hence, institutional reform involves not only performance and conformance, but also transformance into a socially accountable growth

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Basel II

Will profoundly alter bank behavior

Much more complex and risk sensitiveFirst Pillar – Minimum capitalSecond Pillar – Supervisory reviewThird Pillar – Market discipline

Treats exposures very unequally depending on exposure characteristicsTreats banks very unequally depending on sophistication of risk management systems

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Basel II Scope of Application

Applied on consolidated basis to internationally active banks All banking and other financial activities (whether or not regulated) captured through consolidation Financial activities do not include insurance

Majority-owned subsidiaries not consolidated: deduct equity and capital investments Significant minority investments without control: deduct equity and capital investments Deduction of investments 50% from tier 1 and 50% from tier 2 capital

Insurance entitiesGenerally, deduct bank’s equity and other capital investments in insurance subsidiaries However, some G10 countries will retain current risk weighting treatment (100% for standardized banks) for competitiveness reasons Supervisors may permit recognition by bank of excess capital invested in insurance subsidiary over required amount

Commercial entities generally deducted significant investments in commercial entities above materiality thresholds

Significant investments in commercial entities below materiality thresholds risk weighted 100%

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Basel II – Three Pillars

First Pillar

Second Pillar

Third PillarMarket Discipline: New public disclosure requirements to compel improved bank risk management

Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management.

Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process, including supervisory power to require banks to hold more capital than required under the First Pillar

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Basel II – Capital Components

Credit risk charges– Revised

– To ensure capital charges are more sensitive to risks of exposures in banking book

– Enhancements to counterparty risk charges also applicable to trading book exposures

Operational risk charges– New

– To require capital for operating risks (fraud, legal, documentation, etc.)

Market risk charges – Initially unchanged, but Basel/IOSCO review has proposed changes to specific

risk calculations and Second Pillar stress testing

– To require capital for exposures in trading book

– Rules in Market Risk Amendment (1996)

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Basel II – Types of Banks

Standardized

Foundation IRB

Advanced IRB

• Measure credit risk pursuant to fixed risk weights based on external credit assessments (ratings)• Least sophisticated capital calculations; generally highest capital burdens

• Measure credit risk using sophisticated formulas using internally determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M).•More risk sensitive capital requirements

•Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD, EAD •Most risk-sensitive (although not always lowest) capital requirements•Transition to Advanced IRB status only with robust internal risk management systems and data

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Summary of Main Changes in the BCP

More emphasis placed on governance, transparency and accountability of supervisory agencies, and reaffirming supervisory independence and adequacy of resources and legal protections.Bank governance given more attention to ensure that there is effective control over a bank’s entire business. More details are provided on board and senior management responsibilities, set clear strategies andaccountabilities. Strengthened guidance on risk management practices. While some areas were already covered in the former BCP, these have now been brought under “standalone” CPs including (i) an integrated approach to risk management, (ii) liquidity risk (iii) operational risk and (iv) interest rate risk in the banking book.The importance of greater disclosure to enable market discipline to supplement official supervision is reinforced. New criteria have been added specifying that the supervisor “require” disclosure and not just “promote” it, as formulated earlier.The “know-your-customer” (KYC) principle expanded to better capture issues pertaining to the abuse of financial services firms by criminal elements as reflected in the revised FATF standards as far as relevant for bank supervisors.

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Credit Rating Agencies

Role of Credit Rating Agencies (CRAs) is vital – CRAs assess the credit risk of banks – CRAs attempt to make sense of the vast amount of

information available regarding a bank, its market and its economic circumstances

– They give investors, lenders to banks, and to regulators a better understanding of banking system and banking institution risks.

– A credit rating, typically, is a CRA’s opinion of how likely a bank will mange its financial obligation and operations in a timely and efficient manner.

– Under Basel II they have a special role.

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Role of Credit Rating Agencies

What Credit Rating Agencies Do for Banks?What is the Rating Process?What are the Rating Methodologies?How transparent is the ratings process public dissemination of ratings and market timing? How do they manage Conflicts of Interest?

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Perspectives on Supervision and Regulation

Objectives of regulation and supervision– Systemic Stability– Safety and Soundness– Consumer Protection– Consumer Confidence

Universal functions– Prudential regulation– Prudential supervision– Systemic Stability– Conduct of Business: Regulation and Supervision

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Perspectives on Supervision and Regulation

– Safety Net Arrangements– Liquidity Assistance– Insolvent institutions– Crisis Resolution – Market Integrity

Institutional Structure of Financial Regulation– Fragmented or Integrated

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Why Cross-Border Supervision?

Waves of large intra-nation bank mergers over the past decade have created banks of unprecedented size

– Japan credit quality problems have resulted in consolidation partially the result of government policy

– US – Drive to have truly national banks ---merger wave among larger regional banks

– Europe – Intra- market mergers created “national champions” – often with government encouragement

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Risk Based Approach In Regulatory Institutions Issues and Actions

Involvement of Senior StaffImprove communication with banks– Clearer Guidances– Clearer explanation of assessments

Training and Guidance for SupervisorsUse of IT

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Why Cross-Border Supervision?Implications of Banking Industry Globalization

Global banks may be key players in markets that are not key to the bankNational borders provide tax/regulatory arbitrage opportunities but provide little other benefit to the bankReputation/political risk may be as important as potential financial impact of adverse outcomes in the host country

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Cross- Border Banking Supervision

Basel II attempts to better promote international harmonization of regulatory environment. Goals include:

– Improve soundness and stability of the international banking system

– Insure capital is not a source of competitive inequality– Encourage stronger risk management

Home-Host CoordinationBetter Knowledge of Subsidiary ActivitiesHome-Host Supervisory ChallengesBetter Knowledge of Subsidiary ActivitiesHome-Host Supervisory Challenges: Objectives, Implementation and Expectations, Incentives Capabilities

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Thank You

1

Banking Reform and Risk Management in China

Zhang Lixing Director of International Affairs Division

International DepartmentChina Banking Regulatory Commission

3 September 2007, Shanghai

2

ContentsContents

An Overview of ChinaAn Overview of China’’s Banking Systems Banking System

Evolution of Banking Reform and Risk ManagementEvolution of Banking Reform and Risk Management

Challenges to Risk Management & Our ResponseChallenges to Risk Management & Our Response

Basel ImplementationBasel Implementation

3

4

Ten year ago: Could China avoid a banking crisis that befell others in Asia?

Seven years ago: Could China afford banking Reform?

Four years ago: Could China kick-start banking reform?

Three years ago: Could China avoid a hard landing?

Questions Frequently Asked ???Questions Frequently Asked ???

Two years ago: Could China start listing its banks above book value?

5

In history In history (Prior to 2003)(Prior to 2003)

Banks discharged with policy and social duties during the transformation from planned economy to market economy

NPLs surging as a result of weak corporate governanceand risk management, and systemic risks loomed large

Three policy banks established in 1994, marking the separation of policy finance and commercial banking

The Law on Commercial Banks enacted in 1995Issuance of RMB270 billion worth of special government bonds for purpose

of Big Four recapitalizationOff-load of RMB1.4 trillion worth of NPLs to four newly established AMCsThe credit quota policy abolished to allow banks with more credit decision

powers

6

A new round of banking reform starting with the CCB, the BOC, anA new round of banking reform starting with the CCB, the BOC, and the d the ICBC, following a roadmap of reICBC, following a roadmap of re--capitalization, restructuring and IPO capitalization, restructuring and IPO

Through partnership with foreign strategic investors, the reformThrough partnership with foreign strategic investors, the reformed banks ed banks benefiting from improved corporate governance, risk management abenefiting from improved corporate governance, risk management and nd internal internal controlscontrols

The reform package being drafted for the ABC, the last of the BiThe reform package being drafted for the ABC, the last of the Big Five, g Five, which will lean towards rural development and microwhich will lean towards rural development and micro--financing for financing for farmersfarmers

Reforms of small and mediumReforms of small and medium--sized banks rolling out steadily, featured sized banks rolling out steadily, featured by financial rehabilitation, corporate restructuring and introduby financial rehabilitation, corporate restructuring and introduction of ction of foreign strategic partnersforeign strategic partners

Numerous postal savings offices across the country consolidated Numerous postal savings offices across the country consolidated to form to form China Postal Savings Bank, officially opened for business on 31 China Postal Savings Bank, officially opened for business on 31 December 2006December 2006

A Snapshot of Major Reforming Actions A Snapshot of Major Reforming Actions Post 2003Post 2003

(to be continued)(to be continued)

7

Strategy Strategy ♦Adoption of customer-oriented development strategy♦Development of profit-driven business plan♦Pursuit of shareholder value maximization

Risk Risk Management and Management and Internal ControlInternal Control

♦More emphasis on risk and internal controls, risk pricing and business diversification

♦Adoption of IFRS, RAROC, EVA, etc. to measure credit cost and performance.

HR andHR andIT InfrastructureIT Infrastructure

♦Promoting a market-focused and performance-based human resources management and incentive program

♦Recruiting talents both at home and from abroad♦Accelerating IT infrastructure construction

Mindset Change in Corporate GovernanceMindset Change in Corporate Governance

8

In the rural areas inhabited by over a half of the nationIn the rural areas inhabited by over a half of the nation’’s s population:population:

The reforms of rural credit cooperatives accelerated, with some The reforms of rural credit cooperatives accelerated, with some being merged and some transformed into rural cooperative or being merged and some transformed into rural cooperative or commercial banks. As a result, the number of the commercial banks. As a result, the number of the RCCsRCCs reduced reduced from 35,540 to 19,348 between 2002 and 2006.from 35,540 to 19,348 between 2002 and 2006.

At the end of 2006, the CBRC released At the end of 2006, the CBRC released Guidelines on Adjusting Guidelines on Adjusting the Marketthe Market--entry Threshold for the Banking Institutions in Rural entry Threshold for the Banking Institutions in Rural AreasAreas, which highlights two breakthroughs: (1) welcome all kinds , which highlights two breakthroughs: (1) welcome all kinds of capital to the formation of new types of financial institutioof capital to the formation of new types of financial institutions in ns in rural areas;(2) welcome all kinds of banking institutions to brarural areas;(2) welcome all kinds of banking institutions to branch nch out in rural areas out in rural areas

As of JuneAs of June--end 2007, 20 township banks commenced business in end 2007, 20 township banks commenced business in rural communities.rural communities.

A Snapshot of Major Reforming Actions A Snapshot of Major Reforming Actions Post 2003Post 2003

9

Substantially Improved Capital AdequacySubstantially Improved Capital Adequacy

Banks in Compliance with Capital Adequacy RequirementsBanks in Compliance with Capital Adequacy Requirements

Source: CBRCSource: CBRC

125

100

53308

0.6%

47.5%

75.1% 77.4% 78.30%

2003 2004 2005 2006 2007Q2

Number of Banks % of Total Banking Assets

10

NonNon--Performing Loans on the DeclinePerforming Loans on the DeclineIn 2005, NPL ratio of major Chinese banks dropped to single digit for the first time.

275254

208

151 150 149

7.0%7.5%8.9%

13.2%

17.9%

23.6%

2002 2003 2004 2005 2006 2007Q1

NPL Volume(US$bn)

NPL Ratio


11

Shortfall in Loan Loss Reserves NarrowedShortfall in Loan Loss Reserves Narrowed

(Unit: US$ Billion)

200

115.972.2

57.9

2003 2004 2005 2006


12

Performance of Reformed Banks (2006)Performance of Reformed Banks (2006)

CCB BOC ICBC BoCom

0.72 0.9417.66

Large Exposure 5.88 2.38 3.24 3.24

Provisioning Coverage Ratio 85.49 97.46 73.84 98.75

Cost/Income Ratio 36.67 35.71 35.78 35.00

Capital Adequacy Ratio 12.61 13.46 14.21 11.10

NPL Ratio 3.26 4.65 3.68 2.01

HSBC

13.37

Goldman Sachs,

Allianz, AmericanExpress

ROA 0.94 1.04ROE 14.91 13.69

Foreign Investors/Strategic Partners

BOA, Temasek

RBS, Merrill Lynch, Li Ka-shing,Temasek,UBS, ADB


13

Actions to Ensure SustainabilityActions to Ensure Sustainability

Hold bank board accountable for risk limits setting

Align the incentive package with risk control performance

Underpin independent risk control functions

Covering: capital adequacy, large exposures, connected transactions, underwriting due diligence, market risk, operational risk …

Guidance onCorporate Governance

Guidance onCorporate Governance

Regulations on risk-focusedsupervision

Regulations on risk-focusedsupervision

14

Note: Government bond and financial bond are excluded from bond issuance and bond depository balance.

Source: CBRC/CSRC/China BondSource: CBRC/CSRC/China Bond

Scale of Bank loans, Bonds andStock in China by March 2007

14%2%

84%

Negotiable Maket Cap.Bond Depository BalanceBank Loan Balance

Annual GDP Growth of ChinaUS$ bn

13701504

1719

2023

2387

27759.1%

11.5%

10.0%10.1% 10.4%

11.1%

2002 2003 2004 2005 2006 2007Q2

GDP GDP Growth rate

Challenges & Response: Challenges & Response: Macroeconomic ChangesMacroeconomic Changes

2.93.3

3.8

4.6

5.65.9

2002 2003 2004 2005 2006 2007Q1

Total Assets of Banking Institutions(Unit: US$ trillion)

The close interaction between the banking and economic growth haThe close interaction between the banking and economic growth has s shaped the banking landscape in the past, and will reshape it doshaped the banking landscape in the past, and will reshape it down the wn the roadroad. .

15

Challenges & Response: Challenges & Response: Macroeconomic ChangesMacroeconomic Changes

Banking in China is featured with unbalanced development by regiBanking in China is featured with unbalanced development by region, on, product and client base.product and client base.

With homogeneous marketing strategy and product offering, banks With homogeneous marketing strategy and product offering, banks are in are in a tough competition and often compromise lending policies to meea tough competition and often compromise lending policies to meet t market share targetmarket share target

As ChinaAs China’’s economic cycle shows, risks in certain industries and regions,s economic cycle shows, risks in certain industries and regions,if not properly handled, will surely accumulate and concentrate.if not properly handled, will surely accumulate and concentrate.

Policy adjustments for balancing economic development may lead tPolicy adjustments for balancing economic development may lead to o new and heightened credit risk for banks.new and heightened credit risk for banks.

Response: close watching, careful scrutiny, prompt signaling andResponse: close watching, careful scrutiny, prompt signaling andwarning, and encouraging banks to open eyes for new warning, and encouraging banks to open eyes for new opportunitiesopportunities

16

Challenges & Response: Challenges & Response: Market Liberalization Market Liberalization

The urge to conduct universal banking brings banks to face not oThe urge to conduct universal banking brings banks to face not only nly credit risk, operational risk, market risk, but also conflicts ocredit risk, operational risk, market risk, but also conflicts of interest, f interest, connected transactions, inadequate disclosure and other risks. connected transactions, inadequate disclosure and other risks.

The trend towards crossThe trend towards cross--sector operations is posing new challenges to sector operations is posing new challenges to Chinese regulatory and supervisory framework as well.Chinese regulatory and supervisory framework as well.

Response: Response: Carefully reviewing each and every applicationCarefully reviewing each and every applicationLearning the experience of other countries in legislation and Learning the experience of other countries in legislation and regulation of complex financial institutionsregulation of complex financial institutionsActively promoting coordination and information sharing with Actively promoting coordination and information sharing with other regulatory authoritiesother regulatory authorities

17


As China moves towards interest rate and foreign exchange As China moves towards interest rate and foreign exchange liberalization, banks are more than ever exposed to market risk.liberalization, banks are more than ever exposed to market risk.

There is considerable demand within China by the corporate sectoThere is considerable demand within China by the corporate sector and r and financial system to hedge their market risk through derivatives.financial system to hedge their market risk through derivatives.

With abundant liquidity, the demand for investments in new finanWith abundant liquidity, the demand for investments in new financial cial products has risen significantly. products has risen significantly.

Absence of a reliable RMB yield curve makes hedging and investmeAbsence of a reliable RMB yield curve makes hedging and investment a nt a difficult task.difficult task.

Response: Response: Providing guidance on market risk managementProviding guidance on market risk managementIssuing the Notice on Establishing Reference Benchmark for Issuing the Notice on Establishing Reference Benchmark for Market Risk MeasurementMarket Risk Measurement

18


0

10

20

30

40

50

60

May-03 Sep-04 Jan-06 May-07

QFII QDII

0

5

10

15

20

May-03 Sep-04 Jan-06 May-07

QDII QFII

Source: CBRC/CSRCSource: CBRC/CSRC

With further capital account opening, qualified Chinese banks arWith further capital account opening, qualified Chinese banks are e increasingly allowed to invest in overseas markets, including boincreasingly allowed to invest in overseas markets, including both fixed th fixed income instruments and equity.income instruments and equity.

Number of Approved Institutions Amount of Approved Quota

19

Challenges & Response: Challenges & Response: Market LiberalizationMarket Liberalization

Once investing abroad, banks will directly face all types of risOnce investing abroad, banks will directly face all types of risk as well as k as well as countercounter--party risk in their international investments.party risk in their international investments.

Response: Response: Requiring banks to improve their risk identification and Requiring banks to improve their risk identification and management capability, provide sufficient training and educationmanagement capability, provide sufficient training and educationto their business and operational staff, and adequately inform to their business and operational staff, and adequately inform their customers about the risks of products they offer.their customers about the risks of products they offer.Encouraging banks to partnership with experienced international Encouraging banks to partnership with experienced international firms to learn from their partners m in risk diversification andfirms to learn from their partners m in risk diversification andmanagement.management.Entering supervisory agreement with HK SFC, FSA and SEC Entering supervisory agreement with HK SFC, FSA and SEC down the road.down the road.

20

21

Challenges & Response: Challenges & Response: Innovation ProgressInnovation Progress

Innovation improves banksInnovation improves banks’’ efficiency and creates new revenue streams, efficiency and creates new revenue streams, but it also brings a new array of risks, ranging from credit risbut it also brings a new array of risks, ranging from credit risk, market k, market risk to operational risk. risk to operational risk.

Response: Response: Strengthening onStrengthening on--site examinations site examinations Issuing rules to address risks from specific business such as Issuing rules to address risks from specific business such as derivatives, ABS, onderivatives, ABS, on--line banking, etc.line banking, etc.Requiring independent and effective audit to ensure the proper Requiring independent and effective audit to ensure the proper handling of riskshandling of risks

22

Basel II Implementation Basel II Implementation

Chinese banks with overseas presence are mandated to adopt BaselChinese banks with overseas presence are mandated to adopt Basel II II starting from the endstarting from the end--2010. Those not ready by the prescribed deadline 2010. Those not ready by the prescribed deadline may enjoy a grace period up to endmay enjoy a grace period up to end--2013. Other banks including foreign 2013. Other banks including foreign bank subsidiaries may choose to apply for adoption when they arebank subsidiaries may choose to apply for adoption when they are ready. ready.

Credit Risk: banks may start with FIRB approach though they are Credit Risk: banks may start with FIRB approach though they are encouraged to target to AIRB approach.encouraged to target to AIRB approach.

Market Risk: banks are required to adopt Internal Models approacMarket Risk: banks are required to adopt Internal Models approach, h, while those not ready may have a waiver with the approval from twhile those not ready may have a waiver with the approval from the he supervisor provided that a clear roadmap towards IM approach shosupervisor provided that a clear roadmap towards IM approach should uld be in place.be in place.

Operational Risk: CBRC will work closely with the industry for aOperational Risk: CBRC will work closely with the industry for a practical practical capital charge approach.capital charge approach.

23

Complete the ruleComplete the rule--making by the end of 2008making by the end of 2008

Launch QIS in 2009Launch QIS in 2009

Accept banksAccept banks’’ application from the beginning of 2010application from the beginning of 2010

Basel II Implementation Basel II Implementation

Tremendous efforts will be made in training Tremendous efforts will be made in training of both the supervisors and practitioners.of both the supervisors and practitioners.

24

The right time to repair the roof is while the sun is shining, not when

the weather has already turned.--- John F. Kennedy

25

Thank You

1


Overview of Indian Situation

September 3, 2007Shanghai National Accounting Institute, P.R. ChinaAsia-Pacific Finance and Development Center

2

Indian Commercial Banks

Banks continue to play a dominant role in intermediation27 government banks, 30 private banks, 33 foreign banksGovernment banks dominate in share of assets, but …. New private banks and foreign banks lead in competitiveness and quality of earnings. Two private banks in top ten banks

3

Banking Landscape

Steadily improving– Financial Liberalization commenced in 1991-92– Prudential guidelines introduced for banks– Over USD5 billion equity infused by the government during the

next 10 years– ‘New’ private banks licensed– Gradual tightening of prudential norms

Basel II guidelines from March 2007– Standardised Approach under credit risk– Basic Indicator Approach under operational risk– IRB aimed for 2010

The better performing private banks listed on the NYSE or LSE; dual reporting of financials under US GAAP

4

Prudential Norms Strengthened

From March 2004 onwards, banks moved to the internationally accepted 90-day norm for recognition of loan impairment (from the 180-day norm in place so far). To this end, commercial banks were to begin charging interest at monthly, rather than quarterly, intervals and to build up additional provisions to achieve smooth convergence.More stringent provisioning requirement on the doubtful assets introduced from March 2005. All assets classified doubtful for three years or more will have to be 100% provisioned, whereas previously they were fullyprovisioned on the unsecured portion and 50% provisioned on the secured part of the exposure.Non-performing government-guaranteed exposures treated in a similar manner to any other non-performing loan (NPL) in terms of classification and provisioning, from March 2006 onwards.Risk weightings on exposures to public financial institutions (PFIs) will be raised from 20% to 100%, while risk weightings on mortgage loansincreased from 50% to 75% (further increase significantly in 2006 and 2007) and consumer credit, including personal loans and credit card receivables from 100% to 125% from March 2005.

5

Prudential Measures

Foreign banks operating in India and Indian banks having presence outside India are allowed to migrate to the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk under Basel II with effect from March 31, 2008. All other scheduled commercial banks are to migrate to these approaches under Basel II in alignment with them but in any casenot later than March 31, 2009.For smooth transition to Basle II and with a view to providing banks in India additional options for raising capital funds, banks were advised in January 2006 that they could augment their capital funds by issue of additional instruments such as (i) innovative perpetual debt instruments (IPDI) eligible for inclusion as Tier I capital; (ii) debt capital instruments eligible for inclusion as Upper preference shares eligible for inclusion as Tier Icapital; and (iv) redeemable cumulative preference shares eligible for inclusion as Tier II capital.

6

Bank Lending Increasing Rapidly

Source: RBI

7

Rapid Credit Growth in Recent Years

8

Asset Quality

Steadily Improving– increased loan loss provisions

and write-offs using the windfall profits from trading in government securities

Slowdown in NPL accrualsImproved risk appraisal systems and focus on d loan monitoring NPL recovery facilitated by changes in debt recovery laws --The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SRFAESI) Act.Market discipline and surveillance enhanced by equity issuance to institutional and household investors.

Source: Fitch

9

Asset Quality

Source: Reserve Bank of India

10

Net Interest Margin

Net Interest Margins remain reasonable but will come under pressure as competition in the banking system increases especially from new private banks.

11

Return on Average Assets

12

Return on Equity

13

Cost to Income Ratio

14

Capital Adequacy Ratio

15

Financial Exclusion is Still High

Source: Speech by Deputy Governor RBI, June 2007

16

Access to Financial Services is Limited in Rural Areas

Out of 203 million households in the country, 147 million are in rural areas – 89 million are farmer households. 51.4 per cent of farm households have no access to formal or informal sources of credit while 73 per cent have no access to formal sources of credit.Only 49% of household savings are in Financial Assets (CSO Estimates 2004)

17

Risk Management Improving

Government banks in the midst of reengineering their business processesMarketing and credit functions are being separated in government banksRisk evaluation function is being centralizedRisk grade models are being introduced to accommodate different industries and collateralsFor consumer lending scoring models are being testedIRB approach will not be possible before 2010

A Higher Standard for

Risk Professionals

www.prmia.org

Implementing Risk Management

– people, process and systems considerations

David Millar, COO, PRMIA

Workshop on Risk Management in Commercial Banks,

Shanghai, 3rd – 7th, September, 2007

A Higher Standard for Risk Professionals www.prmia.org

Presentation contentsThe dimensions & drivers of

risk• What is risk?• What are the drivers?

The categorisation of risk • Impact of Basel II• Risk frameworks

Risk and capital • Capital• Bank capital• Basel II and risk-based capital• But capital is not all

Risk architectures • Management information• Financial risk data• Non-financial risk data

Implementation considerations

• All parts of a bank are not equal• Implementation issues• Governance• Risk cultures• Supervisors


Risk Professionals

www.prmia.org



Dimensions and Drivers of Risk Management


What is a risk?

1. a situation involving exposure to danger,

2. the possibility that something unpleasant will happen,

3. an object (person or thing) that creates or exacerbates a risk situation.

• A risk may cause a “loss event” – financial or otherwise –directly or indirectly

• A risk may not cause a loss event – it may never happen – but it could and needs protecting against

• A loss event is caused by a risk – even if the cause is out of the control of the institution

• A loss event may not cause a financial loss, it may even create a profitable situation - but it is still a loss event

A scenario that can be described (qualified, if not quantified) and that may be damaging, in any way, to an organisation.


Risk in historyEarly money lending

“Metal” money was lent – the risk was not getting paid –or getting paid late (credit risk) – but the lenders also started to act as deposit takers or took shareholders.

The age of discovery

Money lent to fund a voyage – periods were long –profits, and risk, very high – loss could be total.

1500’s Monetary inflation (market risk) appears – companies with shareholders set up to fund voyages – promissory notes appear – paper starts to replace metal, so credit worthiness of paper issuer becomes key.

18th - 19th

CenturiesBanking is primarily to support commercial trading: other risks – operational, reputational, etc – appear.

19th – 20th

CenturiesInvestors and depositors at risk – liquidity and inflation risk - also bankruptcies, corruption and insider dealing.

1920+ Regulation introduced to target market failures (systemic risk) and regulate practices.

1980+ Regulators target excessive risk taking, and investor protection – banks must now put aside capital as first line of defence against the risk of insolvency – and demonstrate risk management skills.


Drivers of risk management

• Regulatory drivers– Local– Regional– Global

• Business drivers– Increased profitability– Reduced losses– Improved reputation

(customers, public and analysts)– Credit agency ratings

Stick and

Carrot• With the objective of managing risk,

not eliminating it


Business drivers

Increased profitability

More efficiency, more productivity, increased sales, maximised return on capital.

Reduced losses

Cut out unnecessary activities and improve inefficient ones, reduce process failures, minimise non-productive overheads, avoid losses through theft or fraud.

Improved reputation

Create a valid image of positive values, reduce any negative impressions, emphasise a positive and secure future, attract investors and staff.

Credit ratings

By demonstrating the above, improve the rating given to the entity by the global credit rating agencies (Moody’s, Standard & Poors, etc).


What the rating agencies say …• “Moody's believes that the assessment of risk is becoming

increasingly central to the fundamental analysis of a rated bank. Put simply, risk management improves the quality and stability of earnings, thereby enhancing the competitive position of the bank and facilitating its long-term survival.”

• “The ongoing integration of its subsidiary banks into a single network poses challenges in terms of operational, personnel, and systems integration. Moreover, the banks purchased by XXX may have hidden operational risks.” A Standard & Poor’s Report

• “Fitch (Ratings) expects financial institutions, in their response to both regulatory and management requirements, to adopt a balanced approach to risk. This includes an emphasis on tools and techniques designed to assist the management of a financial institution in the prioritization of its risk budgets and in where to focus its efforts.”


Regulatory driversLocal regulations

• National corporate governance recommendations, i.e. Turnbull (UK), CLERP 9 (Australia), CCGC (Singapore)

• Other regulations impacting component risk areas:– Money laundering – Data privacy– Health & safety

– Anti-ageism, anti-racial or gender discrimination, etc

Regional regulations

• i.e. the EU Directives (CRD, MiFID, MAD, etc) – these are centrally defined and implemented via local regulations – MiFID requires a “risk framework”.

Global regulations

• The Sarbanes-Oxley Act of 2002 (US but global impact) requires risk controls to be put in place

• The New Basel Capital Accord (Basel II) ties risk to capital requirements – for banking institutions only (at present – risk-based capital for insurers?)

• Also accounting (IAS), trade, health, vehicle, transport regulations which impact risk considerations


Cross-border implications• There is no international jurisdiction. Regulations

(global or local) implemented by local courts or regulators.

• International implications are enforced by:

Agreement by local bodies that they will implement international regulations (i.e. Basel II but also such as transport regulations), sometimes with local variations

A local regulator imposing regulations on the local branch of an overseas company so that the implications extend to the home country and other branches, i.e. money laundering regulations, Australia’s Foreign Trade Practices Act, etc

An overseas company taking advantage of national facilities (i.e. listing on their stock exchange) which then convey obligations across the whole company, i.e. Sarbanes-Oxley


Summary of key driversFor all commercial banks

Business Improvement Drivers

• More profit• Fewer losses• Better ratings

+ local regulations

→

Plus for major global commercial banks

Basel II for all, but Sarbanes-Oxley for US banks and those that have listed in the US

…. or loss of US listing (and reputation?).


Risk Professionals

www.prmia.org



Categorisation of Risk


Can we categorise risks?

Strategic Risks

Financial Risks

Procedural Risks

• Credit• Market Pricing• Interest Rate• Liquidity• Asset &

Liability • Systemic

• Operational• Disaster• Fraud• Terrorism• Project• Contractual

• Regulatory• Reputational• Pandemic• Legal• Environment• Government

Enterprise Risk

Other Risks

Risk assessments, indicators, controls and loss event data

• Business decisions

• Poor direction• Competition• New

technology


Basel II Risk Coverage

Strategic Risks

Financial Risks

Operational Risk

• Credit Risk• Market Risk –

Pricing, Interest Rate, Liquidity

• Asset & Liability

• Systemic

• Disaster• Fraud• Terrorism• Project• Contractual /

Legal

• Regulatory• Reputational• Pandemic• Environment• Government

Enterprise Risk

Other Risks

Risk assessments, indicators, controls and loss event data

• Business decisions

• Poor direction• Competition• New

technology


Basel II Risk Coverage

• Credit Risk– The risk of a bank not receiving payment for its

assets.

• Market Risk– The risk that a banks assets lose value due to

market fluctuations.

• Operational Risk– The risk of loss resulting from inadequate or

failed internal processes, people and systems or from external events, including legal risk, but excluding strategic and reputational risk.


Risk needs to be Categorised

• Credit Risk– Counterparty categorisation, loan description,

probability of default, expected loss, loss given default.

• Market Risk– Trade details, market variables, probability

calculations.

• Operational Risk– Risk categories, event categories, probabilities,

controls (descriptions, costs, effectiveness, etc), expected losses, unexpected losses, actual losses, indicators, responsibilities and authorisations, etc.


Operational risk categorisation frameworks can be complex

+ Risk Indicators (KRIs)


Risk Professionals

www.prmia.org



Risk and Capital


AssetsInvestments

CapitalCapital

LiabilitiesLiabilities

The net worth of a business; i.e. the amount by which its assets exceed its liabilities

GearingLeverage

GearingLeverage

EquityEquity

DebtDebt

EarningsEarningsBalance Sheet

What is capital?


Capital covers risk …

Source: after Marshall, Operational Risks, 2001

Severity of Loss

Freq

uenc

y of

Los

s

ExpectedLosses

UnexpectedLosses

CatastrophicLosses

Pricing Debt/Bond Holders

EquityCapital

Risks

ReserveFinancing

Non Financial Firms – Risk Cover


AssetsInvestments

CapitalCapital

LiabilitiesLiabilities

EquityEquity

DebtDebt

EarningsEarningsBalance Sheet

Banks are very different

Bank assets are risk assets

Bank liabilities are deposits

GearingLeverage

GearingLeverage

Bank capital most exposed to asset

value changes


A different level of risk cover …

Severity of Loss

Freq

uenc

y of

Los

s

ExpectedLosses

UnexpectedLosses

CatastrophicLosses

Pricing Public

Risks

EconomicCapital

Financial Firms – Risk Cover

Debt/Bond Holders


The Public is at the End of the Road …

Greenspan: “… nor should we require individual banks to hold capital in amounts sufficient to fully protect against those rare systemic events which, in any event, may render standard probability evaluation moot. The management of systemic risk is properly the job of central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events …”

Source: Alan Greenspan, FRBNY, 1996


Bank Capital …• … differs from a non financial firm’s capital: it protects

against future, unidentified risks and losses while enabling the bank to operate at the same level.

• … strengthens the stability and soundness of the (international) banking system and, if applied universally, the competitive inequality among banks is diminished.

• So banks simply need to cover themselves against the risk of insolvency due to losses exceeding allocated capital.

• Banks manage risks; regulators decided on an arbitrary capital to risk asset ratio: there is no correct answer.

• “Capital adequacy” for banks was conceived in 1988 (the Cooke Committee, to become the Basel Committee on Banking Regulations and Supervisory Practices).


• Basel Capital Accord (Basel I),– In 1988 the Basel Committee on Banking Supervision

recommended a risk-weighted capital ratio for internationally active banks,

– This set minimum standards of capital adequacy,

• A “New Capital Accord” (Basel II) proposed in 1999,

– Extended to cover regulatory (Pillar 2) and disclosure (Pillar 3) requirements, (Pillar 1 = approaches as how to calculate regulatory capital)

– Final (reviewed) version released November 2005 (over 100 countries to implement – still some questions regarding the US implementation

– Complete Accord will take effect from 2007 (earliest participants) onwards to 2012

The BIS created standards on capital


… and decided that …• Risk-weighted assets would be basis for capital

requirements

Minimum Capital Requirements = 8% of

Risk-weighted Assets

Credit Risk-

weighting

Market Risk-

weighting

Operational Risk-

weighting+ +

Now variable& more

complex in B2 (3 approaches)

Introduced 1997, small changes in

B2

New in B2 and variable

(also 3 approaches)


8% is the minimum


Citigroup’s Capital ratios (2003)

Tier 1 capital

Common stockholders’ equity $ 96,889

Qualifying perpetual preferred stock 1,125

Qualifying mandatorily redeemable securities of subsidiary trusts 6,257

Minority interest 1,158

Less: Net unrealized gains on securities available-for-sale (2,908)

Accumulated net gains on cash flow hedges, net of tax (751)

Intangible assets:

Goodwill (27,581)

Other disallowed intangible assets (6,725)

50% investment in certain subsidiaries (45)

Other (548)

Total Tier 1 capital $ 66,871

Tier 2 capital

Allowance for credit losses 9,545

Qualifying debt 13,573

Unrealized marketable equity securities gains 399

Less: 50% investment in certain subsidiaries (45)

Total Tier 2 capital $ 23,472

Total capital (Tier 1 and Tier 2) $ 90,343

Risk-weighted assets $ 750,293

Tier 1 Capital Ratio = 8.91%

Total Capital Ratio = 12.04%

Minimum Regulatory Capital = $60,023

$M


• Commercial banks, which comply with Basel II, can decide (or their regulator can decide) which approaches to calculating regulatory capital they adopt, but …

• … regardless of capital approaches all Basel II compliant organisations must develop:

– an appropriate risk management environment,– risk identification, assessment, monitoring and

mitigation/control,– regular independent evaluation of policies, procedures

and practices, – and make sufficient public disclosure to allow the market

to assess their approach to operational risk management.

But Basel Capital Adequacy is not all


• Even if the bank goes for the simplest approach to Risk-weighted Capital:-– A risk assessment culture must be

created,– Credit and operational risks must be

monitored,– Risk must be tracked,– A risk trend history must be created,– Risk actions must be disclosed.

Regardless of Pillar 1 approach

“… additional capital would not be the only answer as capital is not a substitute for appropriate risk assessment practices or adequate internal control processes.”Nicholas Le Pan, Chairman of the Basel Committee’s Accord Implementation Group, March 2004.


Risk Professionals

www.prmia.org



Risk Architectures


Transaction Compliance –transparency, best execution, Conduct

Of Business, etc.

Transaction Processing –

quote, buy/sell, clear, settle, report,

etc.

Risk Management– capital adequacy, risk management, event repair, etc.

Business Controls –trading limits, management

processes and authorisations, etc.

MIS and Internal Audit –strategic direction and control, disclosure, etc

A similar model could be created for the retail financial business

Many interlocking parts


A risk MIS viewBoard/Senior Management

Liquidity Risk SystemMarket Risk System

Credit Risk SystemOperational Risk

System

ALM / ALCO

Capital allocation

Risk MIS

Limits and

positionsA

ccounts

HR

managem

ent

Sales systems

CR

M

Manufacturing

etc.

Days debtors

% leavers

Net sales

Response time

Partsreturned

Oil reserves

Risk indicators

Transaction or event data


An enterprise risk MIS viewBoard/Senior Management

Liquidity Risk System

Market Risk System

Credit Risk System

Operational Risk System

ALM / ALCO

Capital allocation

Enterprise Risk MIS Strategic Risk System

Limits and

positions

Accounts

HR

managem

ent

Sales systems

CR

M

Manufacturing

etc.

Days debtors

% leavers

Net sales

Response time

Partsreturned

Oil reserves

Corporate Goals

Risk Appetite

External Information

• Competitor reports• Demographics• Weather trends• Financial trends• Gartner, etc• New technologies• Political moves• Etc.

Risk indicators

Transaction or event data


A corporate MIS viewBoard/Senior Management

Accounts

HR

m

anagement

Sales systems

CR

M

Manufacturing

etc.

Liquidity Risk System

Market Risk System

Credit Risk System

Operational Risk System

ALM / ALCO

Capital allocation

Enterprise Risk MIS Strategic Risk System

Limits and positions

Days debtors

% leavers

Net sales

Response time

Partsreturned

Oil reserves

Corporate Goals

Risk Appetite

External Information

• Competitor reports

• Demographics• Weather trends• Financial

trends• Gartner, etc• New

technologies• Political moves• Etc.

Corporate MIS

Regular corporate

performance data

Risk indicators

Transaction and event data


Financial risk management environment

Daily trans-action data

5 years transaction data

Core processing

systems

Capital calculations,risk metrics,

ALM, etc

Internal ratings, etc

High-tech, fast throughput, transaction processing


Operational risk management environment

Getting risk data from the …… bottom (the point of incident) … to the top (for analysis) … is key.

EV

EN

TS

RIS

KS

MITIG

ATIO

N

ASSESSMENT

FEE

DB

AC

K

… through layers of management …


Risk management environment

Support Centre

Regulatory and Supervisory

Watching

Software updates and maintenance

notes

Risk issues support

Service Management

Hosting

SecurityInfrastructure

Support

Disaster R

ecovery and C

ontinuityRisk Data Base Management

Users

Risk Management

Risk Maintenance Facility


…. comprising ….Help desks Provides support to users on issues surrounding Risk,

e.g. new financial products, new selling processes, changes in “approved persons”, company structure changes - a ‘valued opinion’ on operational risk issues.

Regulatory “watchers”

Reports on requirements of new regulations and developing regulatory and supervisory issues and latest thinking from regulators and supervisors.

Risk database management

Maintains the risk framework and ensures that it reflects changes in company structure, responsible for the impact of regulatory and supervisory changes on organisation and risk categorisation, performance checks the data collection and risk event completion activities, verifies the completeness of the risk recording function.

Service Management

Provides technical support for all risk management systems – software upgrades, access security, new users, hardware changes, communications links, etc


Technical implicationsFinancial (credit, market, liquidity, etc) risk

•Real-time

•High availability

•High performance requirements

•Automated input, few users

•Very large amounts of relatively simple data

•Kept for a long time (5 years)

•Data comes from existing core systems

Non-financial (operational) risk

•Once a day for input, once a month for reporting

•Low performance requirements

•Manual input, many users

•Relatively small amounts of fairly complex data

•Kept for a very long time (at least five years)

•New data collection systems need to be developed


Risk Professionals

www.prmia.org



Implementation considerations


Banks are not homogeneous – with respect to risk management implementation

Front office Middle office Back office

Corporate SpeedImpactRegulated“Rule-aware”

Retail SpeedImpactRegulated“Rule-aware”

Investment SpeedImpactRegulated“Rule-aware”

… but a bank needs a view of risk which combines different departmental profiles


Implementation

Risk theories and regulations

A risk culture

Processes, tools and capital allocation

Rollout considerations

Ongoing maintenance and

improvement


From financials to processes

• Credit/market risk relatively mature (liquidity risk still causing concerns!)

– But still needs data and model validation, corrections, backdating of parameters, etc

• Operational risk still immature– Specifying it

What is it? How to recognise and classify it?

– Setting it upInvolving the users, gaining commitment, regulatory approval, etc

– Rolling it out and maintaining itCollecting accurate data - feedback – validation -correcting errors – changing classifications – renewing systems, etc


The Pillar II Maze

Risk theories and regulations

An risk culture

Pro

cess

es,

to

ols

,

cap

ital

all

oca

tio

n

an

d d

iscl

osu

re

Create the risk framework

Ensuring clean data

User acceptanceRegulatory

approval

Feedback

Updating the system

User involvement

How much data to collectCleaning

old data Risk Culture


Some implementation issuesProcesses, systems and capital allocations are easy – the problems are the “people issues”:1. Build the governance processes2. Creating the framework – consensus on risk categorisation 3. Getting user involvement – from the right people4. Achieving user acceptance – “why am I doing this? I have

better things to do!”5. Deciding on how much data to collect – too little = poor

statistics, too much = inaccurate data6. Ensuring clean data – cleaning old data, ensuring new data

is completing correctly7. Gaining regulatory approval – different

interpretations/numerics in different jurisdictions8. Building a risk culture – everyone knows what risk is9. Integrating feedback and statistics – to improve the system10.How to update the systems – validating and changing

processes, risk categories (framework) and systems upgrades


Why a governance process?

Basel II (and Sarbanes-Oxley and others) requires that the Board takes overall responsibility for risk management – and is aware of risk developments

It requires that all senior management takes responsibility for the risk processing and management within their areas, and

It mandates a “risk culture” with in the organisation.


Risk objective settingStrategic objectives

• High level goals• Support

mission/vision• Strategic choices

i.e. the mission statement, the strategic objectives and the strategies to achieve them.

Related objectives

• Operations• Compliance• Reporting• Align and support• Management decision

• Costs• Time• Resource allocation

• Acceptable variance• Unit and measure of

objective

Selected business objectives

i.e. the lower level targets for this programme

Conformation of high profile objectives and verification that they match the high level goals and missionHow the strategic choices impact the variables against which success is measured

Risk appetite

Risk tolerance

i.e. the unit variations that the organisation will tolerate in order to achieve a specific programme

Source: COSO ERM Framework


Commitment• Commitment on risk management is needed

from:– Owners/shareholders

– The Board

– Senior management

– Departmental managers

– Audit, asset and liability management and compliance

– Human resources

– Staff

– Geographies


Building a risk cultureAn internal risk culture is the sum of the individual and corporate values, attitudes, competencies and behaviour that determine commitment to and style of risk management.

• It includes both an enterprise-wide risk and an internal control culture

• It requires clear lines of responsibility, segregation of duties and effective internal reporting

• It requires high standards of ethical behaviour at all levels• Although a framework of formal, written policies and

procedures is critical, it needs to be reinforced through a strong control culture

• It is the responsibility of both the board and senior management


Examples of staff risk culture

• All staff know:What a risk control or risk event is

Why they exist

What their risk responsibilities are

Prime and alternative reporting routes

What happens to their reports

What was the result of “their” event’s mitigation

What the institution’s risk status is (overall and their part)

How it is improving (or getting worse)

What their risk training plan is


Examples of management risk culture

• All Board and senior management know:What the institution’s risk policy is

What their risk appetite is

What their own risk responsibilities are

What major risk controls have been infringed or what risk events have taken place

What cumulative risk situation have accumulated

What the institution’s risk status is

How it is improving (or getting worse)

What the business impacts are


Why are Risk Cultures important?• Risks are managed by people

• People can apply standards with greater or lesser degrees of efficiency – or they can make mistakes

• People must apply the appropriate risk management standards to the best of their ability

• Regulators appreciate that the best standards and guidelines are only effective if implemented correctly – and with diligence and enthusiasm.

• Regulators will therefore test an organisations’ risk culture along with its risk standards, best practices, capital robustness and disclosure procedures.


Attributes of a risk management culture

1. Attention is paid to quantifiable and unquantifiable risks.

2. All risks are identified, reported and quantified.

3. Awareness of risk through performance measurement, risk-adjusted pricing, pay structures and forecasting.

4. Risk management is accepted as everyone’s responsibility.

5. Risk managers have teeth.

6. The enterprise avoids what it doesn’t understand.

7. Uncertainty is accepted.

8. Risk managers are monitored.

9. Risk management is not to stop people from taking risks but to create value, by enhancing the chances of success.

10.The risk culture is defined, the risk appetite is understood. Source: Operational Risk Management, PWC, November 2003 (abbreviated)


… and finally

• Talk to the supervisors– Regulations are interpreted and implemented by

regulators, central banks and supervisors– They will have national interpretations – and

local preferences and good practices– They are responsible for cross-border

cooperation and interpretation– They will set implementation practices – rule

and regulation based – or risk and principle based

– Because commitment to the regulations is their primary function, whereas, for the bank it is a secondary activity


1. Have you identified the potential business risks to the organisation?

YY//NN

2. Have you assessed the likelihood and consequence of the significant risk being realised?

YY//NN

3. Have you assessed those risks that could:– Damage your reputation?– Affect your market position?– Result in prosecution?

YY//NN

4. Have you established controls to manage significant business risks?

YY//NN

5. Have you established a positive culture for controlling the risks? YY//NN6. Have you established a contingency plan to mitigate disaster? YY//NN7. Have you established continuity management control

arrangements?YY//NN

8. Do you regularly audit compliance with control arrangements? YY//NN9. Do you regularly review these arrangements with respect to their

adequacy and effectiveness?YY//NN

10. Do you report annually on your risk and control measures? YY//NN

Ten questions for risk management

From the “Turnbull Guidance” on Internal Control in the Combined Code of the Committee on Corporate Governance


Risk Professionals

www.prmia.org

PRMIA – The Global OrganisationThe Professional Risk Managers’ International Association (PRMIA) is the world’s leading risk professional’s association.43,000+ risk professionals from all segments of the financial services industry in 179+ countries (both free and paid membership)Members from 4,000+ organisations, 200+ members meetings annually in 60+ chaptersA quarterly journal and a monthly newsletterThe Professional Risk Manager’s HandbookThe PRM exam – the world’s most comprehensive risk manager’s examMember-led (400+ volunteers), grass-roots organisation with its own Code of Risk EthicsA “not for profit” organisation governed and owned by its members


Risk Professionals

www.prmia.org

Thank you

David Millar Chief Operating [email protected]

mailto:[email protected]

CHINA AUSTRALIA GOVERNANCE PROGRAMCHINA AUSTRALIA GOVERNANCE PROGRAM

Presentation to AFDC Presentation to AFDC Workshop on Risk Management in Commercial BanksWorkshop on Risk Management in Commercial Banks

33--7 September 2007, Shanghai7 September 2007, Shanghai

By Ken WallerBy Ken WallerDirector, Melbourne APEC Finance CentreDirector, Melbourne APEC Finance Centre

Melbourne, July 2007

POSTPOST--PROGRAM REVIEWPROGRAM REVIEW

2

BackgroundCollaboration between the Asia Pacific Finance and Development Centre, Shanghai and the Melbourne APEC Finance CentreAim – to improve risk management and governance in China’s banking system

3

Background (cont…)Intensive dialogue between Chinese and Australian regulators, bankers, officials, and regional and international agenciesSite visits by the Chinese delegation to major Australian financial, policy and regulatory institutions

4

Objectives of the ProgramTo build durable relations between Australian and Chinese institutionsTo identify capacity building needsTo develop a five-year capacity building program

5

Key Outcomes of the DialogueA deeper understanding of issues involved in improving governance and risk management in ChinaA sharing of experiences of successes and challenges in implementing Basel IIA deepening of relations between the Australian and Chinese institutions

6

Key Outcomes (cont…)A solid review of banks’ market, credit and operational management and challengesStrategic options that could be pursued in building capacities

7

Findings and RecommendationsThe following are some of the identified priorities:

RISK MANAGEMENT:Some of these will be discussed in further detail in the second presentation

Organisational structures for risk managementAn appropriate risk management cultureData Gathering and cleansing issuesRetaining skilled risk-management staffMeasuring and reporting risk managementIT systems and the collection of relevant dataCalculation and allocation of economic capital

8

Findings (cont…)CORPORATE GOVERNANCE:

Roles and responsibilities of the Board of DirectorsDirectors relationships with Senior ManagementThe role of Supervisory Boards in ChinaAppointment of Directors; qualifications; training and evaluation of performance

9

Findings (cont…)CAPACITY BUILDING:

Capacity building should be ongoing, principles-based and should draw on issues and key lessonsThe sharing of mutual experiences The focus is to build a good corporate governance culture and developing policy in line with best practice

10

Summary of the Site VisitsVisits to: 11 banks, a policy department and 2 regulatory agenciesThe key discussions were about:

Financial / regulatory policies and structuresAustralia–China relationsThe history and development of Australia’s banksPrivatisation and deregulation Specific risk & operational management frameworksTransition from Basel I to Basel II

11

Major Discussion PointsDeregulationCompetition Good practices in risk management and corporate governance Impacts of implementing Basel IIChina’s financial reformChallenges for China’s banks posed by Basel II

12

ConclusionsSound risk management and corporate governance practices are preconditions for a healthy finance systemBanking is about managing risk soundly and profitably Governance arrangements are integral for effective risk managementCharacteristics are reflected in Basel II

13

Conclusions (cont…)Capacity building is vital Well skilled and motivated people are criticalDeveloping good governance and risk management capacities is a journey that is different for each bank and for different countries

14

The FutureA report to the Australian and Chinese governmentsThe AFDC and the MAFC will conclude an agreement to intensify their cooperation The agreement will identify a number of joint projects, subject to appropriate funding sources

15

Future Joint ProjectsHigh level dialogues Risk management and/or governance training programsJoint research on key issues of common interest to support training in the banking sectors of both China and AustraliaBuilding an alumni network to promote exchanges

16

~~~~~~~THANK YOU

~~~~~~~

RISK MANAGEMENT ISSUESRISK MANAGEMENT ISSUES

Presentation to AFDC Presentation to AFDC Workshop on Risk Management in Commercial BanksWorkshop on Risk Management in Commercial Banks

33--7 September 2007, Shanghai7 September 2007, Shanghai

By Ken WallerBy Ken WallerDirector, Melbourne APEC Finance CentreDirector, Melbourne APEC Finance Centre

IN BANKING IN BANKING SYSTEMSSYSTEMS

2

Agenda for this presentationTo discuss specific issues of risk management arising from:

I. The recent China-Australia Governance Program that was held in Melbourne

II. Australia’s banking system – from a public policy perspective

3

I. Risk management issues for banksThree main issues emerged from the recent China-Australia Governance Program held in conjunction with MAFC and the AFDC:

a. Organisational structuresb. Culturec. Measuring and reporting risk management – the key issues for smaller banks

4

I.a. Organisational structuresAn integrated approach – fundamental Basel IIComprehensive across the whole business –including business unitsgovernance is integralmore urgency to integration –conglomeration/cross-border activities/risk diffusion

5

I.b. CultureCulture starts at the top (the Board level)

It is increasingly important as banks shift from rules-based to risk-based supervision

Requires greater participation / transparency / communication within banksGeneration of comprehensible and reliable dataBusiness Units shift from passive compliance to proactive disclosure and self-assessment

6

I.c. Measuring and reportingCredit risk

data often inadequateheavy costs/inadequate expertisebalance model results/ expert judgment

Operational riskrequires management / Business Unit supportbusiness continuity stress testing – disaster recovery plans

Cultural change – biggest challengerequires devising sound strategic approaches

Issues for smaller banks

7

II. Australia’s banking systemRisk management in Australia’s banking –the four main issues from a public policy perspective:

a. Banks’ risk management policiesb. Banks’ performancec. Assessment of banking system stabilityd. Handling current threats

8

II.a. Banks’ risk management policiesIntegrated risk managementStrategic in concept and in applicationIndependently reviewed – and policies totally integrated with system of governance and with cultureApproved and monitored by boardCritically assessed and disciplined by regulator, rating agencies, business analysts and ultimately by markets

9

II.b. Banks’ performance – 2006Strong profitability / asset growth / housing and businessFalling cost-to-income ratioNPL’s – 0.4% of on-balance sheet assets; low arrearsWrite-offs - 0.20% of outstanding loansOverseas exposure – 29% of total assetsRegulatory capital ratio 10.4%VaR – of unhedged positions / 0.04% of shareholder funds

10

II.c. Banking system stability More reliance on funding from wholesale markets – offshoreBanks’ foreign liabilities 28% of total liabilities – mainly $US and hedgedLiquidity risk well managed – securitisationS&P upgraded 4 largest banks to AA+Over recent period strong growth in share prices

11

II.d. Handling current threatsFSAP IMF reviewCrisis management arrangements – quasi deposit insuranceStress testingCentral bank response to current tightening of credit and liquidity – money market operations to maintain official cash rate

12

~~~~~~~THANK YOU

~~~~~~~

0

Workshop on Risk Management in Commercial BanksChris Mouat, Director China Partnerships ANZ

Patrick Zhu, Head of Retail Risk China ANZSep 2007

Australia and New Zealand Banking Group Limited

1

Established in 1835One of the 5 largest and most successful companies in AustraliaThe leading bank and the largest company in New ZealandThe leading bank in the South PacificAustralia’s leading bank in Asia31,000 employeesOver 6 million customers, across 28 countriesStrong performance

− Top quartile global performance− Cost/Income ratio 45.6% − 2006 NPAT $3.688 billion − Return on equity 20.7%− 252,000 shareholders

Rated AA

Some background on ANZ….

2

ANZ’s Asia Network operates in 12 markets, supporting corporate customers who invest and trade across the region

TAIWANsince 1980 • Taipei

40 peopleA$1.7B Assets

SOUTH KOREAsince 1978 • Seoul


1. 85% ANZ owned, trading as ANZ Panin Bank. Excludes ANZ Panin cards business which reports as part of Asian Partnerships2. ANZ formerly owned ANZ Grindlays which operated throughout South Asia/Middle East. In 2000, ANZ sold Grindlays to Standard Chartered Bank

INDIA

Non-Bank FinCo

since 19842 • Mumbai5 people

Malaysia & Thailand1971 1985Representative Offices

3 people • Kuala Lumpur

2 people• Bangkok

INDONESIA1

since 1973 • Jakarta71 people

A$1.6B Assets

JAPAN since 1969 • Tokyo

56 people • OsakaA$10.5B Assets

SINGAPORE (ASIA HQ)

since 1974 • Singapore127 people

A$9.1B Assets

THE PHILIPPINESsince 1990 • Manila


HONG KONG

A$5.6B Assets33 people

• Central, HK Is.since 1970

MAINLAND CHINA

A$3.1B Assets• Beijing77 people• Shanghaisince 1986

ANZ in Asia

Asia Network

VIETNAM

• Can Tho (Rep)A$0.6B Assets• Ho Chi Minh113 people• Hanoisince 1993

http://www.flags2000.com.au/flag.htm?cref=N5,N297

http://www.flags2000.com.au/flag.htm?cref=S79

3

• Branch commenced operations in 1970

• Leading Australian/NZ bank

• Commercial banking services focusing on Trade Finance &

regional/global MNCs

• 40 employees

• Branch established 1980

• Full commercial banking services

• Client base largely global Multi-national companies based in Taiwa

• 35 employees

n

• Correspondent bank for Bank of China (1948)

• Beijing Rep. Office (1986)

• Branches in Shanghai (1993) & Beijing (1997)

• Sole Australian bank with full range of services

• License to provide RMB & FX business

• ~60 employees

ANZ has a strong history across Greater China

• Mainland China (Shanghai & Beijing)

• Hong Kong• Taipei

ANZ China

4

Asia NetworkANZ Branches

• 12 markets

• Larger customers investing and trading across Asia

• Trade Finance, Project Finance, FX, Capital Markets

• 606 employees

Asia Partnerships

• 6 countries, 7 banking partnerships

• Equity and value-add

• New markets for ANZ capability

• Retail and small business focus

• 96 ANZ employees

Pacific NetworkANZ Branches

• 11 countries

• Market shares upwards of 30%

• Expanding into French and US territories

• 1,520 employees

ANZ’s Asia Strategy has two components: Servicing global relationship customers through ANZnetwork and local markets through local partners

ASIA: Mainland China, Hong Kong, Taiwan, South Korea, The Philippines, Singapore (+HQ), Japan, Vietnam, Indonesia, Cambodia, Malaysia (Rep), Thailand (Rep)

PACIFIC: Papua New Guinea, Timor Leste, Solomon Islands, Vanuatu, New Caledonia (Rep), Fiji, Tonga, Cook Islands, Samoa, American Samoa, Kiribati

Asia Partnerships

5

Partnership provides benefits to both partners through effective combination of strengths

Agreed outcomes • Agreed business strategy• ANZ expertise available • Active development of local staff

Practical governance • Investment and trust in relationship• Agreed Board and management positions• Agreed participation in governance

Sharing the upside • Alignment of decisions and consequences• Target medium term 30-49% equity position

AN

ZLo

cal

Part

ner “world class skills”

• World-class products

• Risk Mgmt expertise

• Sales Mgmt and training

• Leading technology

“home team advantage”

• Customer franchise

• Strong distribution

• Local experience

• Government relationships

Workingtogether

Practical Approach to Partnerships

Partnership Model

6

ANZ Journey

•Financial sector deregulation

•Speculative property exposures, with significant concentrations

•1989 – interest rates at 18%

Engage the competition

(1986 – 92)

• Economy in recession

• Decline in property prices accelerated

• 1992 NPLs - 6% across the industry

• ANZ close to insolvency- no government bailout

Ride out the crunch

(1992 – 98)

•Specialisation strategy - develop capability in targeted segments

•Be Lean – eliminate road blocks and cost

•Exploit optimum risk return customers and segments

•Risk management restructure & alignment with business

Refocus on profit &

virtuous cycle

(1998 - Now)

7

Today’s Risk Governance Structure

Group Asset & Liability Committee

(GALCO)

• Balance Sheet Risk

Operational RiskExecutive Committee

(OREC)

• Compliance

• Payments/operational risk

• Security

Project & Initiative Review Committee

(PIRC)

• Project risk

• Project governance

• Project priorities

Risk Committee

• Oversees policy, strategy / processes

• Authorises Group’s Limits framework

• Authorises limit approvals of the CTC

ANZ Board

Credit & TradingRisk Committee

(CTC)

• Policy

• Major Lending Decision

• Asset Writing Strategies

• Portfolio

• Traded Risk

Executive Management Committees

Board AuditCommittee

8

Independence and Segregation of Risk – Risk Functional Structure

CEO/ President

Risk Business

• Set framework, assure framework• Approve transactions• Provide risk reporting and analysis• Specify risk measurement tools (eg. statistical risk grade models)• Manage problem loans (workout strategies, collections)

• Assess risk of transactions within framework set by Risk

• Document and manage loans according to Risk policyOther Risk Area (eg. Market Risk, Operational Risk)

• Clear checks and balances• Effective working relationships

Credit Risk

Policy & Framework

Reporting & Analysis

Risk Grade Modelling & Validation

Transaction Structuring

& Credit Approval

Problem Credit

Management

Portfolio Management

Key Risk Functional Features:• Clearly defined accountabilities and authorities• Functional experts• Collaboration with regions and business units• Independent reporting

9

Level 4 – Operating procedures

Level 1 – Risk Principles

Level 2 – Group Risk policies

Level 3 – Product/Business policies

Key control policies

Specification of core products & businesses

Detailed description of how to undertake a business activity and the aspects of credit risk management to consider

GLO

BA

L

ScopePolicy Levels

The risk policy architecture enables clearly defined responsibility and authority

GLO

BA

LLO

CA

LLO

CA

L

Each

po

licy

level

is s

ub

ord

inate

to

the ‘u

mb

rell

a’o

f th

e l

evel

ab

ove

10

Increase scale & efficiency

When and what to centralise and automate?

CENTRALISED CREDIT ASSESSMENT

Headquarters

Regional branches

2nd level branches

DECENTRALISED CREDITASSESSMENT

AUTOMATED PROCESS

Complexity of risk*

MANUAL PROCESS

ANZ before(Manual &

Decentralised)

ANZ Small Business

(Automated* & Centralised)

Smaller scale & mid-level loan complexities

ANZ Medium Business

Banking (Manual & Centralised)

Ensure consistency & manage complexity of transactions

ANZ Large Corporates (Manual

and Centralised)

ANZ Personal(Automated* &

Centralised

* Automated processes do not imply 100% automation. There is a % of transactions that are referred out for manual assessment for various reasons.

As a pre-condition to deliver an automated & centralised process, a Line of Business

platform that enables consistent sales proposition

is required

11

Retail Credit Process – Automated and Centralised

Collect Customer

Info

Collect Customer

Info

Info StorageInfo Storage

Analyse InfoAnalyse Info

Recommend Decision

Recommend Decision

Process Loan

Process Loan

Account Mgmt

Account Mgmt

Sales

Centralised

80% Scorecard20% Credit

80% Scorecard20% Credit

Centralised & Sales

Centralised Credit

• Sales: Collect customer information• Centralised: Definition of information required

• Centralised: Information shared by authorised staff

• Credit system or credit manager: Analyse transaction • Credit system (scorecards) monitored closely by the

centralised Modelling Decision Validation team

• Credit system or credit manager: Recommends a decision• Internal Quality Assurance randomly review recommended

decisions

• Centralised: Opening of accounts, printing Letter Of Offers and loan draw downs

• Sales: Post loan checking and all other functions (eg. loan settlement)

• Centralised:o Periodic reviewo Maturity of loan o Make pay or no-pay decisions for NSF

WHO WHATPROCESS

Enter InfoEnter Info Sales • Sales: Real-time input of information into system

12

Fax, Email& Intranet

AutomatedDecision Model

front end input

Back OfficeInput

Decline

Offer

Applicants

AcceptedApplication

Loaded

Offer to applicants

Verification

Bureau

Scoring Model

Policy Rules

Referred for manual

assessment

Approve

Decline

Re-Submit

Decline

Approve

Offer Accepted

Retail Credit Process – Automated and Centralised

13

Business Banking Credit Process – Manual and Centralised

Analyse InfoAnalyse Info

Recommend Decision

Recommend Decision

Process Loan

Process Loan

Account Mgmt

Account Mgmt

CentralisedCredit

CentralisedCredit

Centralised Operations &

Sales

Sales

• Credit manager: Analyse transactiono Use scorecardo Apply policy ruleso Cross-check with credit bureau

• Credit manager: Recommends a decision• Internal Quality Assurance randomly review recommended decisions

• Centralised: Opening of accounts, printing Letter Of Offers and loan draw downs

• Sales: Post loan checking and all other functions (eg. loan settlement)

• Sales:o Periodic reviewo Maturity of loan o Make pay or no-pay decisions for NSF

WHO WHATPROCESS

Collect Customer

Info

Collect Customer

Info

Info StorageInfo Storage

Sales

Centralised

• Sales: Collect customer information• Centralised: Definition of information required

• Centralised: Information shared by authorised staff

Enter InfoEnter Info Centralised• Sales: Send information to centralised team• Centralised: Receive, check and enter information into shared

computer system

14

Fax, Email& Intranet

Back OfficeInput

Decline

Offer

Applicants

AcceptedApplication

Loaded

Offer to applicants

Verification

Bureau

Scoring Model

Policy Rules Manual assessment

Decline

Approve

Offer Accepted

Business Banking Credit Process – Manual and Centralised

15

Corporate process – manual and centralised

Business Unit Group Risk

Independent Risk FunctionSales Relationship

CreditCredit

Decision

Dual ApprovalHas

responsibility for customer relationship

Prepares credit

submissions

Customer pricing, taking into

account risk, capital allocation, relationship costs

Industry expertise

Financial analysis

Credit scoring

Rating agencies

KMV

Sound judgement

Deal structuring & security/covenants

Separate from relationship team

Remuneration not linked to deal flow

Experienced practitioners

Largest deals approved by CTC

& Board RMC

Single Customer Concentration Limits

Portfolio Caps

Credit Training

Portfolio Modelling

16

Segmentation of Sales and Credit – Example: ANZ Institutional Banking

Institutional Financial Services

Natural Resources

Group

Financial Institutions & Government

Food, Beverages & Agribusiness

Property & Construction

Finance

Manufacturing

Telco, Media & Entertainment

Utilities & Infrastructure

Trade & Transaction

Services

Business Services, Health

& Education

Group Risk

Credit Executive

Credit Executive

Credit Executive

Credit Executive

Bank & Country Risk

Credit Executive

Real Estate Credit Unit

Retail, Transport & Distribution

Relationship Credit Group

CAD below CRO

Discretion excludes:• Country & Bank Limits

• Intra ANZ Exposures

• Investment & Trading Limits

• Private Equity Funding

• Underwriting Transactions

• Breaching SCCL Levels







17

Credit Governance and Lending Discretion Structure

Requirements for mandatory escalation of lending decisions provides quality assurance

Sales / Asset Writing

Skill

and

expe

rienc

e

Risk in transaction(incl. size and quality)

HighLowLow

High

Low

Len

din

g

dis

creti

on

HighCreditDual Approval

Clear Delegation of Credit

Authority to Individuals

Alignment ofSkills &

Capabilities

Recognition ofCredit Risk Variation

• Size• Complexity

Assurance ofQuality in

Credit Assessment

• Upward flow

Separation ofcredit & sales

• Asset Writing• Credit

Assessment

18

Benefits for the Bank

Independence and segregation of risk has proven to be beneficial to the sales and credit teams, as well as the greater organisation

Greater focus on sales= Higher commission

Sales

Specialist risk assessment skills

= Improve loan quality

Credit Risk

Sustainable asset growthLower NPL

Increased efficiency= Higher profit

Bank

Higher Revenue

Low

er C

ost &

Los

s

19

The Aim of Financial Market Risk Controls:-

To monitor and control market risk exposures to ensure that management are not surprised by losses resulting from changes in market risk factors.

Market risk factors include:

FX rates,

Interest rates,

Equity prices,

Credit spreads and

the volatilities of these prices

Operational Risk is also implicit within all Business Units with a key element of Operational Risk being the integrity of the data contained within the system.

20

Applicability of Market Risk to Chinese Commercial Banks

1. Financial Market assets constitute a material percentage of assets

2. Financial Market assets generate a material percentage of bank income

3. Financial Market assets represent the banks’ liquidity portfolio

4. The financial markets environment in China is relatively benign (eg PBoCinterest rate controls limit volatility and this provides an ideal opportunity to introduce more sophisticated financial market risk controls as their introduction will not require a major change to current treasury practices and/or operations

5. This will then enable all relevant areas (Treasury, Finance, Risk, Audit etc) to become familiar with these controls in a “less stressed” environment.

6. This contrasts with having to introduce controls at a time of stress (eg sharp deregulation, unforeseen circumstances, liquidity problems)

7. This also enables gradual increased sophistication of existing market risk controls, as market conditions become more deregulated, thus ensuring that the business develops in concert with the controls and not in possible opposition to them.

21

The risks arising from day to day operating activities which may result in direct or indirect loss. These losses may result from failure to comply with policies, procedures, laws and regulations, from fraud or forgery, from a breakdown in the availability or integrity of services, systems and information, or damage to the bank’s reputation:

Applicability to Market Risk:

1. Dealers undertake transactions which are outside limits or controls

2. Transactions are not settled correctly resulting in loss (late settlement fees, payments to incorrect counterparty, receipt of incorrect securities etc)

3. Transactions are processed incorrectly (eg wrong coupon rate recorded resulting in accrual of income that may be too low/high and thus P&L suffers sharp movement when corrected)

Possible Mitigants:1. Segregation of duties 2. Transaction authorisation 3. Financial & managerial reporting 4. Monitoring

Operational Risk Management

22

• Balance sheet interest rate risk management involves minimising fluctuations in net interest income and market value that may occur over time as a result of changes in market interest rates.

• Much of this risk arises when the repricing characteristics of the assets and liabilities making up the balance sheet are not matched. The greater the extent of such mismatching, the greater will be the potential for volatility in future net interest income and market value.

• 3 key risk measures:

• Value at Risk (VAR): Quantifies the risk to market value of an overnight movement in rates. The size of the shift is calculated from the most recent 500 days of actual rate movements (using a 97.5% level of confidence).

• Earnings at Risk (EAR): Quantifies the risk to mismatch income over the next 12 months from an overnight, parallel shift in the yield curve. The size of the shift is based on a statistical analysis of movements in the 1 month point on the yield curve.

• Market value limits: Limits absolute and relative falls in market value due to market price movements over a set period.

Balance Sheet Risk – Interest Rate Risk:

23

Value at Risk

Value-at-risk is the estimated total loss that may be sustained on a financial instrument (or portfolio of instruments) from an adverse market movement, estimated for a given level of confidence over a specified holding period

Function of 4 factors:

1. Market Price

2. Standard deviation in market value

3. Confidence interval

4. Holding Period

Example:

•Bank might report that its portfolio has a 1-day VaR of $5 million at the 95% confidence level.

•This implies that provided usual conditions will prevail over the 1 day the bank can expect that, with a probability of 95%, the value of its portfolio will fall by 5 million or less during 1 day,

•or in other words: it can expect that with a probability of 5% (i. e. 100%- 95%) the value of its portfolio will fall by more than 5 million during 1 day.

•Stated yet differently, the bank can expect that the value of its portfolio will decrease by 5 million or less on 95 out of 100 usual trading days

24

Assets

MonthsAmount (Million) -1.00% 1.00%

Loans Floating Rate avg term to repricing 2 1,300 -10.8 10.8Fixed Rate avg term to repricing 12 2,400 0.0 0.0

Bonds Floating Coupon avg term to repricing 4 1,800 -12.0 12.0Fixed Coupon avg term to maturity 19 900 5.3 -5.3

Buy/Sell Repo * Floating Coupon avg term to repricing 3 870 -6.5 6.5

Total Assets avg term to mat/repricing 8.0 7,270 -24.1 24.1

Liabilities

MonthsAmount (Million)

Customer Deposits Floating Rate avg term to repricing 0.5 2,900 27.8 -27.8Fixed Rate avg term to repricing 2.5 1,450 11.5 -11.5

Other FI Deposits Floating Rate avg term to repricing 0.5 950 9.1 -9.1Sell/Buy Repos Floating Coupon avg term to repricing 1.2 1,100 9.9 -9.9

Total Liabilities avg term to mat/repricing 1.1 6,400 58.3 -58.3

Net Assets / Equity 870 34.2 -34.2

NII Impact of 1% fall in interest rates Higher NII over next 12 months of 34.2m

NII Impact of 1% rise in interest rates Lower NII over next 12 months of 34.2m

EAR Impact - next 12 month NII

* Reverse repo

EAR (example: assumed balance sheet and assumed numbers):

25

• The primary aim of liquidity management is to ensure that the Bank can in all circumstances meet its commitments to customers as they fall due.

• This includes a desire to avoid being forced to liquidate assets in a distressed market (thus suffering large losses) in order to meet commitments (eg current US sub-prime crisis).

• Several factors contribute to the overall level of liquidity risk, these include:

The level of mismatching between projected cash inflows and outflows.

The diversity (eg, by type, customer, currency, geography) of the balance sheet's funding base.

The capacity to raise funds in the wholesale market.

The volume and quality of liquid assets.

Balance Sheet Risk – Liquidity Risk

26

Standard Treasury Processes:

Balance Sheet Mgt RMB Trading FCy Trading New Products

Liquidity Profit Profit Profit

Banks Own Profit

Customer Margin Income

Treasury Support Unit(s)

Operations / Branch (Payment) Finance (P&L) Mgt / ALCO / Risk

(Limits)

At Risk Not at Risk

1

APEC Workshop on Risk Management in Commercial Banks

27 April 2005

Building a Healthy Regulatory Framework for Risk Management in Commercial Banks: Regulator’s Perspective

September 2007

Bernie EganProgram Director, Basel IIAPRA

2

Summary

To introduce the regulatory framework, practices and main challenges under Basel II in Australia and the role of the Government

(There is some duplication with the presentation given in July in Australia)

3

Australian Prudential Regulation Authority (APRA)

Australia has a ‘deregulated’ banking system – a government decision

APRA is a risk-based integrated prudential regulator

Institutions supervised by APRA are subject to APRA’s ‘rules’, known as prudential standards, which are legislative instruments and subject to Parliamentary disallowance. (Note the difference to other jurisdictions where the legislature ‘makes’ the rules)

4

Governance and risk management and capital

Governance provides incentives for boards and management to pursue objectives that are in the interests of banks and their shareholders

To prudential supervisors, governance is an essential element in the safe and sound functioning of a bank

“… risk management process (including Board and senior management oversight) to identify, evaluate, monitor and control or mitigate all material risks and to assess their overall capital adequacy in relation to their risk profile. These processes should be commensurate with the size and complexity of the institution” (Core Principles for Effective

Banking Supervision October 2006)

Note: the important concept of proportionality and the ‘link’ to capital rather than Basel II specifically

This also reflects Australia’s approach

5

Capital regulation

Banks are in the business of taking risks

Banks want to hold capital

as protection against unexpected loss (and expected losses where provisions are insufficient)

to provide them with financial flexibility

as a sign of strength to their customers

But there is also a need for regulatory capital

for systemic reasons

statutory obligations eg depositor insurance or in Australia’s case the Australian Banking Act states “It is the duty of APRA to exercise its powers and functions ….. for the protection of depositors …..”

6

Different perspectives on capital

Regulatory Capital

Depositor protection and system stability

Economic Capital

Maximisation of stockholders wealth - the maximum amount of unexpected losses potentially arising from all sources that could be absorbed while a bank remains solvent, with a given level of confidence over a given time horizon.

Rating agency capital

The minimum level of capital the credit ratings agencies require a bank to hold in order for the bank to maintain its desired credit rating.

7

Sharing Basel II experiences

Each jurisdiction must make its own Basel II implementation decisions

With the benefit of hindsight would APRA implement Basel II differently?

Are there lessons (for China) from Australia’s experiences?

(Common) challenges following the introduction of Basel II

But: each banking supervisor has its own legal responsibilities

8

Basel II implementation considerations

Timing

Staggered or simultaneous implementation of all (the various) Basel II approaches

Tailoring Basel II

Greatest scope for purely domestic banks adopting the standardised approaches

Limited scope for internationally active banks adopting the advanced approaches

Process for approving advanced approaches

9

Basel II supervisor and bank relationships

Form and basis of the existing relationships – prescriptive?

- risk-based?

Especially for banks adopting the advanced Basel II approaches, supervisors must develop a better understanding of how banks govern themselves and how they measure and manage their risks

“…. move towards a system of risk-based supervision, developing skills in assessing the quality of a bank’s risk management and its ability to assess risk exposure.” Jaime CaruanaJune 2004

Issues of consolidated (domestic and cross-border) supervision of international banking groups through home/host supervisory arrangements

10

Basel II governance and risk management

Bank supervisors have long pushed banks to improve governance and risk management

Basel II strengthens the link between regulatory capital and risk management

Especially for banks adopting the advanced Basel II approaches under which banks use their own risk estimates (and some models), ‘best practice’ governance and risk management becomes even more critical

11

The Australian Basel II timeline

All Basel II approaches will be made available in Australia from January 2008

All Australian banks and other authorised deposit-takers will adopt the Basel II standardised approaches unless accredited by APRA to adopt the Basel II advanced approaches

Basel II is a journey, not a destination

12

Three pillars of Basel II

• Basel

II

consists

of

three

mutua

Standardised Advanced

Pillar 1 Minimum capital requirements for credit, market and operational risk

Credit risk: greater granularity + ratings (where applicable)

Operational risk: ‘crude’ and ‘mechanistic’

Credit risk – use of own risk estimates –probability of default, exposure at default, loss from default

Operational risk – use of own risk estimates and models

Pillar 2 Supervisory review: banks demonstrate they have capital targets consistent with their overall risk profile and current operating environment, with supervisors ensuring that banks have sound internal processes in place to assess the adequacy of their capital

a ‘cruder’approach than that expected of the advanced ADIs

Internal capital adequacy assessment process + supervisory ‘review’

Pillar 3 Market discipline Easily provided capital and credit quality information

Detailed qualitative and quantitative disclosures on capital and risk estimates

13

Basel II implementation challenges

Basis of application for approval to adopt the advanced Basel II approaches

Supervisory approval process

Use and experience

Dealing with the varying state of Basel II readiness of applicant banks – qualitative, quantitative, data, documentation – ‘supervisory challenge’

Basel II reporting

Estimating/dealing with potential changes in the level of regulatory capital

Implementing Pillars 2 and 3

Home/host issues

14

IRB/AMA accreditation issues

Level of robustness

Lag in documentation for model development and validation

Senior management information

Low default portfolios

Greater risk sensitivity is being achieved

Definition of default issues

Operational risk

Emerging discipline

Measure capital + manage risk

15

Some thoughts on Pillar 3

For the banks adopting the advanced Basel II approaches there will be detailed disclosure of risk estimates. That will highlight

Differences in risk estimates between banks

Differences in supervisory approaches

The Basel Committee and its working groups are committed to assisting with ‘educating’ the market

16

The implementation of Basel II in Australia

APRA’s prudential standards

Drafts have been released (mostly two drafts of each standard)

Little change expected in final standards

No approval required for ADIs adopting the standardised approaches

Advanced approaches challenging and require APRA approval – limited scope for transitional arrangements

Some interim arrangements

Margin lending

Advanced approaches - downturn LGDs on residential mortgage loans

Reporting – draft forms to be released shortly

17

Risk management

(As previously discussed) banking is about risk-taking

Basel II requires that risks be understood and managed and capital held commensurate with the risks

Australian examples of Basel II leading to better risk management

Standardised approaches – residential mortgage lending ‘grid’

Advanced approaches – risk estimates that are more robust and reflective of the risks

Pillar 2

Capital to be held against all risks

APRA to add transparency and structure to its existing process of supervisory review

ADIs adopting the advanced approaches are working cooperatively to improve their understanding and management of risks

18

Governance

Basel II requires an ADI’s Board of directors to provide oversight of its capital adequacy

For ADIs adopting the advanced approaches, the Board should also provide oversight of material aspects of the risk estimation process

APRA requires board sign-off on applications to adopt the advanced approaches

The strength of the Board structure and how expertise is brought to the Board

APRA ‘rules’ on governance “… ensure that regulated entities are managed in a sound and prudent manner by a competent board of directors …”

APRA ‘rules’ on fit and proper “Persons who are responsible for the management and oversight of an authorised ADI need to have appropriate skills, experience and knowledge …”

Boards (and senior management) are able to bring a holistic approach to risk oversight

19

Bringing it all together

Benefits to banks from the improved risk management and corporate governance arising out of the Basel II Framework

Identifying risk

Pricing risk

Managing risk

Holding adequate capital against risk

Transparency of the risk process

1

2

3

CORPORATE RAM RATINGS

Request for a Credit Profile Rating

Provides information Team of analysts studies the information

Analysts conduct site visit and management meeting

Analysts prepare rating report for Internal Rating Committee

Corporate accepts ratingor

Corporate rejects ratingor

Corporate appeals for reconsideration Rating is assigned and corporate notified

Corporate may choose to make the rating public or remain confidential

Rating is kept under surveillance

Rating Process

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

Benefits of Basle II?

Brought Risk Management and International Best Practices to the forefront

Forced banks to clean-up and organise the databases

“Cost-of-risk” on capital assessed up-front

Has allowed domestic banks to narrow the gap with foreign banks with respect to risk management

Foundation for risk-based pricing

27

28

Evolving Market Dynamics

New types of banking entities / products – the market is moving faster than risk management ideas!

Risk Management is as good as “2020-Hindsight”

Risk based pricing not easily applied in the market place

Non-bank financial institutions entering the market

29

30

31

32

33

34

35

36

37

No 19-G, The Boulevard, Mid Valley City, Lingkaran Syed Putra,

59200 Kuala Lumpur, MalaysiaTel : (603) 7628 1000Fax : (603) 7628 1700

Website: http://www.ram.com.my

Thank you

Building A Healthy Regulatory Framework for Risk Management in the Korean

Commercial Bank

Jae-soo Yoo

Director of Banking DivisionMinistry of Finance and Economy, KOREA

1

Table of ContentsTable of Contents

I. Korean Banks: Where do they stand ?

II. Macro Economic Risk Management System

III. New Basel II : Challenges & tasks

2

I. Korean Banks: Where do they stand? (1)I. Korean Banks: Where do they stand? (1)

After the Financial Crisis in 1997, the landscape of the Korean banking industry

has been dramatically changed: High Profitability, Low NPL

Major Indices of Korean Banks (As of March 31. 2007)(100mil KRW. %)

Shareholder’s Equity Substandard and bellow

Paid-incapital %

Shinhan 1,852,913 1,030,417 1,052,913 99,439 75,281 8,278 9,037 0.74 12.01* 2.04 33.86

Woori 1,883,635 1,101,728 1,059,082 112,745 31,798 8,066 10,893 0.86 11.60* 1.94 28.67

SC-cheil 607,860 324,637 334,359 27,658 12,366 1,128 5,423 1.44 10.86* 0.76 16.92

Hana 1,265,018 709,189 835,021 71,013 9,872 4,555 7,547 0.89 11.34* 1.69 26.13

KEB 822,419 381,390 461,584 59,229 32,245 2,384 3,175 0.64 12.45* 1.36 15.53

Citi 559,564 240,646 280,702 33,826 13,099 1,385 2,046 0.70 14.02* 1.06 16.50

Kook min 2,138,502 1,345,147 1,384,229 145,188 16,819 11,825 15,590 1.00 14.17* 2.39 32.08

Total 9,129,911 5,133,154 5,407,889 549,098 191,479 37,622 53,711 0.89 12.41 1.84 27.40

BIS ROA ROENetIncomeBank Total Asset Loans Deposits

3

I. Korean Banks: Where do they stand?(2)I. Korean Banks: Where do they stand?(2)

Trend of Net Income97 98 99 00 01 02 03 04 05 06 07.3

Domestic Banks - - -5.4 -4.1 4.6 5.0 1.8 8.8 13.6 13.6 6.5- Commercial Banks -3.9 -12.5 -5.9 -2.8 3.5 3.4 0.8 6.4 9.2 9.1 4.0- Special Banks - - 0.5 -1.3 1.1 1.6 1.0 2.4 4.4 4.5 2.5

(100 billion KRW)

Trend of ROA (%)

97 98 99 00 01 02 03 04 05 06 07.3Domestic Banks - - -14.4 -11.0 12.8 10.9 4.0 15.2 18.4 14.9 26.9- Commercial Banks -14.2 -52.5 -23.1 -11.9 15.9 11.7 3.2 18.0 20.3 16.1 27.0- Special Banks - - 4.2 -9.5 7.8 9.6 5.6 10.7 15.4 13.0 26.7U.S. Commercial Banks 14.7 13.9 15.3 14.0 13.1 14.5 15.3 14.4 12.9

Profitability (1)

Trend of ROE (%)

97 98 99 00 01 02 03 04 05 06 07.3

Domestic Banks - - -14.4 -11.0 12.8 10.9 4.0 15.2 18.4 14.91 26.90

- Commercial Banks -14.2 -52.5 -23.1 -11.9 15.9 11.7 3.2 18.0 20.3 16.08 27.01

- Special Banks - - 4.2 -9.5 7.8 9.6 5.6 10.7 15.4 13.01 26.73

U.S. Commercial Banks 14.7 13.9 15.3 14.0 13.1 14.5 15.3 14.4 12.9

4

Profitability (2)


Trend of NIM* (Net Interest Margin)(%)

99 00 01 02 03 04 05 06 07.3

Domestic Banks 2.5 2.4 2.6 2.7 2.6 2.6 2.8 2.64 2.47

- Commercial Banks 2.9 2.7 3.0 2.9 2.8 2.8 3.1 2.90 2.74

- Special Banks 1.6 1.7 1.9 2.2 2.1 2.1 2.2 2.04 1.85

U.S. Commercial Banks 4.0 3.9 3.9 4.0 3.8 3.7 3.6

* NIM = Net Interest profit (interest revenue – interest cost)/interest bearing assets

Trend of Interest Spread** (Won denominated)(%)

99 00 01 02 03 04 05 06 07.3

Domestic Banks(Loan)(Deposit)

3.310.67.3

3.19.76.6

3.49.05.6

3.57.74.2

3.37.03.7

3.56.83.3

3.76.73.0

3.56.83.3

3.36.83.5

- Commercial Banks 3.6 3.3 3.7 3.5 3.4 3.6 3.9 3.7 3.4

- Special Banks 2.8 2.6 2.8 3.4 3.2 3.0 3.0 3.0 2.9

** Interest Spread = average interest rate of loans – average interest rate of deposits

5


Soundness

97 98 99 00 01 02 03 04 05 06 07.3Domestic Banks(Corporate)(Retail)(Credit Card)

----

----

12.9---

8.0---

3.4---

2.32.71.16.3

2.62.61.710.0

1.91.91.55.1

1.21.31.02.4

0.80.90.71.3

0.91.00.81.3

- Commercial Banks 6.0 7.4 13.6 8.8 3.3 2.4 2.7 1.9 1.3 0.9 0.9- Special Banks - - 11.2 6.1 3.6 2.1 2.3 1.7 1.1 0.7 0.8

Trend of ‘Substandard and bellow’(%)

Trend of NPL Ratio (%)

99 00 01 02 03 04 05 06 07.3Domestic Banks - - 2.8 1.9 2.0 1.6 1.0 0.7 0.7- Commercial Banks 8.3 6.6 2.8 1.9 2.2 1.7 1.1 0.8 0.7- Special Banks - - 2.7 1.7 1.6 1.2 0.8 0.6 0.7U.S. Commercial Banks - - - 1.4 1.1 0.9 0.8

Trend of Delinquency Ratio (%)

97 98 99 00 01 02 03 04 05 06 07.3Total(Corporate)-conglomerate-SME(retail)(Credit card)

------

------

5.14.3--

3.77.8

2.82.9--

2.57.5

2.11.91.81.91.37.3

2.01.81.21.91.511.9

2.01.90.62.11.810.5

1.71.80.22.11.75.5

1.21.30.11.61.13.2

0.81.00.51.10.71.6

1.01.00.61.20.81.7

- Commercial Banks 6.7 8.7 4.8 3.3 2.1 2.0 2.1 1.9 1.3 0.9 0.9- Special Banks - - 5.7 1.6 2.2 1.7 1.6 1.3 1.0 0.7 0.9

6


Capital AdequacyTrend of BIS

(%)

97 98 99 00 01 02 03 04. 05 06Domestic Banks - - 11.7 10.6 11.7 11.3 11.2 12.09 13.00 12.75- Commercial Banks 7.0 8.2 10.8 10.5 10.8 10.5 10.5 11.29 12.43 12.31- Special Banks - - 13.9 10.7 13.6 13.2 12.8 13.73 14.09 13.60U.S. Commercial Banks - - - 12.1 12.7 12.7 12.7 12.6 12.33 -

Trend of ‘Tier 1’ and ‘Tier 2’ ratio (%)

97 98 99 00 01 02 03 04 05 06Domestic Banks - - - 6.7 7.7 7.2 7.0 8.0 9.3 9.2- Commercial Banks- Special BanksU.S. Commercial BanksDomestic Banks- Commercial Banks- Special BanksU.S. Commercial Banks

3.9 4.9 6.8 6.3 6.7 6.3 6.2 7.1 8.7 8.5- - - 7.8 9.8 9.3 8.7 9.8 10.4 10.4- - - 9.4 9.9 10.0 10.0 10.0 9.9 -- - - 3.9 4.0 4.1 4.2 4.1 3.7 3.6

3.1 3.3 4.0 4.2 4.1 4.2 4.3 4.2 3.7 3.8- - - 2.7 3.8 3.9 4.1 4.0 3.7 3.2- - - 2.7 2.8 2.7 2.6 2.6 2.4 -

Tier 2

Tier 1

Trend of Coverage Ratio (%)

-170.5174.6145.7127.1131.0149.2178.0U.S. Commercial Banks200.8216.6162.1125.789.2108.480.354.343.9- Special Banks160.0159.0119.396.482.183.274.061.144.1- Commercial Banks171.7173.9131.3104.584.089.676.159.544.1Domestic Banks07.30605040302010099

7

II. Macro Economic Risk Management System (1)II. Macro Economic Risk Management System (1)

What’s Early Warning System ?

1. An Expansion the EWS on external factors developed in 1999 to cover

overall economic areas :

Financial market, Raw materials, Property market, labor

2. A comprehensive and systemic risk management system for early

detection and resolution of economic crisis(2004.9)

Participation : relevant institutions (MOFE, FSC, BOK)

- Working group in charge of financial sector are setting up to exchange

information, detect warning signals and come up with policy measures

8

II. Macro Economic Risk Management System (2)II. Macro Economic Risk Management System (2)

When Risks are detected, level of alert will be triggered

Five triggers of different level of alert

Financial Policy Council : Coordinate policy among MOFE, FSC and BOK

Types of risk: unstable financial (stock) market, disruption of financial

intermediation functions, contagion effect from overseas market

MOFE: in charge of the general crisis management plan such as

monitoring market trend, identifying cause/route of crisis, stabilizing

investor sentiment ete

9

III. Basel II Challenges and tasks1. Implementation process of New BIS Accord

Overview2002 2003 2004 2005

「New Basel Accord Implementation plan」(March)

Prepare 1st

draft (October)

∧

∧

Issue 1st draft and workshop (December)

∧

2nd T/F

(Oct~Feb)3rdT/F

(Jan~ )

Launch「New BIS Accord T/F」

(January)

∧

launch「New BIS Office」

(April)

∧

Issue domestic guidelines and

workshop(October)

∧

Decide timeline and method for New BIS

implementation (December)

∧

IRB approval process · formulate pre-run requirements and request submission of

implementation plan (January)

: Organization building

: Guideline documentation

: Adoption : T/F in place

1st T/F

(Apr~July)

Formulate credit risk control structure and

public hearing(March)

∧

Detailed AMA guidelines

(1st draft)(May)

∧

Detailed guideline on capital

adequacy(draft)(July)

∧

Detailed IRB Guideline(draft)(August)

∧∧

10

III. Basel II Challenges and tasks 2.「New BIS Ratio Calculation Guideline(draft)」

■ National guideline on New BIS Accord

A need for domestic guideline to assure smooth domestic implementation of New BIS AccordA need for domestic guideline to assure smooth domestic implementation of New BIS Accord

Full utilization of national discretion granted to national supervisors to reflect the domestic financial marketFull utilization of national discretion granted to national supervisors to reflect the domestic financial market

8 pending items will be addressed through empirical analysis and in-depth research.8 pending items will be addressed through empirical analysis and in-depth research.

1. Expanded scope of SMEs1. Expanded scope of SMEs

Under IRB, total asset as well as total sales(60 bil.) can be used to classify SMEs.Under IRB, total asset as well as total sales(60 bil.) can be used to classify SMEs.

Expanded scope of SMEs in light of the nature of the industry

Expanded scope of SMEs in light of the nature of the industry

2. <Option 1> applicable for bank exposure2. <Option 1> applicable for bank exposure

to retain stability of the banking system and avoid a radical increase in risk weights of banksto retain stability of the banking system and avoid a radical increase in risk weights of banks

ㅇ The Basel Committee announced New BIS Accord in late June, 2004.

ㅇ The regulator and banks form joint T/F to collect market feedback.

ㅇ A decision was made on applicability of 67 items out of 75 national discretion items in total■ Use of national discretion

ㅇ Example of national discretion

11

III. Basel II Challenges and tasks3. Implementation timeline

■ Implementation timeline – FSS decides timeline and method for New BIS implementation in the national market

in December, 2007.– As our nation is not a member country of the committee, global trend and domestic

financial · economic conditions are considered in decision making process.■ Timeline for domestic implementation

– An impact of New BIS implementation on the financial sector · economy, readiness of domestic banks and overseas trend are considered.

– Global trends are accommodated, and domestic banks are given time.– Potential issues due to phased adoption of risk measurement approaches are avoided.

■ Scope of application for banks– Risk management skills and competitiveness are enhanced across the banking

industry.– Banks are treated fairly in competition.

■ Imposition of risk measurement approach– Banks are granted a right to choose their risk measurement approach (considering

risk characteristics and management ability)– Global trends are accommodated.

collective implementation in early 2008 irrespective of risk measurement approachcollective implementation in early 2008 irrespective of risk measurement approach

applied to all banks operating in the domestic marketapplied to all banks operating in the domestic market

autonomous choice of banksautonomous choice of banks

12

III. Basel II Challenges and tasks 3. Implementation timeline (con'd)

■ Scope of application of New BIS Accord in the national market

Diversified Financial

Group

Diversified Financial

Group

Holding CompanyHolding Company

Internationally Active

Bank


Bank


Bank


BankInternationally Active

Bank


Bank

Domestic

Bank

Domestic

Bank

Securities

Firm

Securities

Firm

(1)

(2) (3)

(4)

(1) ~ (4) : consolidated accounting for all banks operating in the national market

(1) ~ (4) : consolidated accounting for all banks operating in the national market

Not applicable to a holding companyNot applicable to a holding company

13

III. Basel II Challenges and tasks 4. IRB approval process · use-test requirements

■ IRB and AMA approval process

■ Use-test requirements

2005 2006 2007 2008

Late March

ApplicationApplication

Late June

Review and decisionReview and decision

Preliminary discussion and previewPreliminary discussion and preview

New BIS implementation

New BIS implementation

CommonCommon

Pre-run of a rating system(for 2 years before application)

Pre-run of a rating system(for 2 years before application)Retail and F-IRBRetail and F-IRB

A-IRBA-IRBPre-run of a rating system

(for 3 years before implementation)

Pre-run of a rating system(for 3 years before implementation)

AMAAMA Pilot of a rating system(2 years before implementation)Pilot of a rating system(2 years before implementation)

Construction of a rating system in line with New BIS standards and estimation of risk components such as Probability of Default, Loss Given Default

Rating system construction and validation in line with

New BIS standard Validation of a rating system and risk components

A rating system should be used not only for calculation of regulatory capital but also for other banking activities.Utilization of rating systems

Examples of key application areas such as loan approval, pricing and provisioning

Board and management approval required for key decisions on credit rating and risk componentsManagement understanding

and reporting The management should fully understand design and operation of a rating system, and continuously ensure that the system is running properly.

14

III. Basel II Challenges and tasks 5. Credit risk control structure

■ Credit risk control structure principles- The following principles are designed to maintain check and balance of credit risk functions

in order to ensure adequacy of a rating system.

■ Credit risk control structure overview

Independence of rating assignmentIndependence of rating assignment

Independence of credit risk control functionIndependence of credit risk control function

Review by an independent 3rd partyReview by an independent 3rd party

Bigger role of the board and the managementBigger role of the board and the management

Board and management

Risk management

functionReview function

Exposure originationg

(risk generated)

Marketing Credit risk control function

reporting reporting

15

III. Basel II Challenges and tasks 5. Credit risk control structure (con'd)

■ Independence of rating assignment and review by an independent 3rd party

■ Independence of credit risk control function– Credit risk control function is responsible for design, implementation and performance

of a rating system.– Credit risk control function is independent from sales function that has a direct stake in

loan increase.

■ Bigger role of the board and the management– The board (including relevant committees) and the management should approve key

decisions on a rating system and risk components.– The management is responsible for understanding and continuous review of a rating

system.

SalesSales Independent functionIndependent function

Grade assignedGrade assigned

Final decisionFinal decision

Review Review

Grade recommendedGrade recommended

Grade assigned *Grade assigned *

Review by an independent 3rd partyReview by an independent 3rd party

Is the same grade is granted

according to the documented procedures? **

Is the same grade is granted

according to the documented procedures? **

Compare performance

* Exceptions considering size and materiality(i.e. loan approved by the delegated authority of the branch** Sampling to review consistency and timeliness of ratings for management reporting

16

III. Basel II Challenges and tasks 6. Quantitative impact study (QIS) (con'd)

■ Key items for Quantitative impact study

Risk weights of unrated exposures (standard approach)

CCF of unused committed credit line (F-IRB)

Adjustment of effective maturity(F-IRB)

Risk weights of equity exposures(IRB)

Risk weights of unrated securitisation exposures

Risk weights of unrated exposures (standard approach)

CCF of unused committed credit line (F-IRB)

Adjustment of effective maturity(F-IRB)

Risk weights of equity exposures(IRB)

Risk weights of unrated securitisation exposures

BIS ratioBIS ratio

Risk weights of unrated exposuresRisk weights of unrated exposures

A big impact on BIS ratio under standard approach

Adjustment of risk weights within 100 ~ 150% range

(existing : 100%)

A big impact on BIS ratio under standard approach

Adjustment of risk weights within 100 ~ 150% range

(existing : 100%)

CCF of unused committed credit lineCCF of unused committed credit line

An increasing burden of equity capital expected due to application of a high CCF

Credit lines are divided into four, and assigned different CCF.

An increasing burden of equity capital expected due to application of a high CCF

Credit lines are divided into four, and assigned different CCF.

Risk weights of equity exposuresRisk weights of equity exposures

An increasing burden of equity capital against equity exposures under IRB approach

Compare impact of standard approach and IRB approach on BIS ratio

An increasing burden of equity capital against equity exposures under IRB approach

Compare impact of standard approach and IRB approach on BIS ratio

Risk weights of unrated securitisationexposures

Risk weights of unrated securitisationexposures

An impact of deducting unrated securitisation exposures from regulatory capital

Compare deduction approach and investor grade

An impact of deducting unrated securitisation exposures from regulatory capital

Compare deduction approach and investor gradeAdjustment of effective maturityAdjustment of effective maturity

All exposures are assigned a maturity of 2.5 years under F-IRB.

Compare a maturity of 2.5 years and nominal matyrity

All exposures are assigned a maturity of 2.5 years under F-IRB.

Compare a maturity of 2.5 years and nominal matyrity

17

III. Basel II Challenges and tasks7. Current Status of Korean Banks in implementing Basel II

■ Korean Banks launched Task Force Team and set up detailed road map for Basel II implementationㅇ (commercial banks and some policy banks) collect long-term default/loss data

for risk estimation and develop Credit Rating Systemㅇ (regional banks and others) targeting the standardized Approach , which doesn’t

require FSS approval, examine on the adequacy of current collateral & guarantee system for New BIS Accord.

■ For those tasks that an individual bank is not able to deal with, inter-bankcooperation is under way.ㅇ running “Korea Operational riskdata Exchange Committee (KOREC) ” in order

to solve the shortage of operational risk loss data

18

III. Basel II Challenges and tasks8. Difficulties in implementing Basel II

■ Insufficiency in preparation

ㅇ Lack of credibility and validation on risk components such as PD(probability of Default),LGD(Loss Given Default), EAD(Exposure at Default)

ㅇ Short on pre-running of Risk Rating System-adequate rating system

ㅇ Insufficient corporate governance and oversight - Lack of independence in validation of risk rating system*U.S. is also running across the problem, and decided to reschedule the timeline ofimplementation (Jan 2008 -> Jan 2009)

■ Possibility of high volatility in BIS CAR after New Basel Accordㅇ Applying strictly the New Basel Accords would lower the BIS CAR mainly due to

strict application of credit conversion factor on unused committed line as well asautonomous estimates on LGD in the A-IRB

19

III. Basel II Challenges and tasks9. Reaction of Financial Regulators (FSS)

■ Adjustment of timeline for Basel II implementation ㅇ For the A-IRB, defer implementation date by one year(early 2008->early 2009)ㅇ For the F-IRB, alleviate requirements for data during transition periods(3 years)

■ Mitigating shock of implementationㅇ Exercising national discretion according to the New Basel Accords in order to alleviate

burdens of banks.* For equity exposure in IRB, applying the standardized approachFor the F-IRB, replacing effective maturity of 2.5 years with measured effective maturity

ㅇ Reducing Credit Conversion Factor for unused committed line in F-IRB during grace periods75% -> 20~50%(the standardized Approach)

■ Facilitating inter-bank cooperation

ㅇ In order to produce credible LGD estimates, collecting loss data across banks andanalyzing them

ㅇ Running “Korea Operational riskdata Exchange Committee (KOREC) ” in an effort to solve the lack of operational risk data

20

III. Basel II Challenges and tasks10. Current Status of Korean Banks in implementing Basel II

■ To implement Basel II in 2008 early, banks must submit application for IRB approval by July 2007.*submission of application should be made six months before the implementation date

ㅇ (application for the theIRB) Four banks(KB, KEB, KDB, IBK) submitted applications for approval- The IRB would be in effect as of January 1, 2008 if an application is approved

ㅇ (Application of the standardized Approach) other commercial banks and NACF(originally targeted for the IRB) and regional banks, NFFS, KEXIM(initially targeted for standard method) are planning for the standardized Approach

■ The final approval for those four applicants to the the IRB would be processed during the second half of the year based on scrutinized review on insufficiency and improvement matters

21

III. Basel II Challenges and tasks10. Potential Concerns under Basel II in Korea

■ Impacts of the New Basel Accord on SME lending in Korea

ㅇ The impact of Basel II on capital requirements for SMEs is not substantial (Korea Development Institute, 2007)

■ Impacts of the New Basel Accord on Housing Finance Market in Korea.

ㅇ Under the new Basel II, loans secured by residential properties are treated more favorably and thus the loan-to-value ratio for housing loans is likely to increase. The Korean government carefully watch the trend of housing loan and its size. If needed, policy measure will be taken place immediately.

■ Implementing the External Credit Assessment Institution of the Basel II Accord in Korea.

ㅇ Korean Credit rating agencies has short history and lacks available resources.ㅇ The new combined Act for Capital markets (will be enforced by 2008) will help to develop

Korean Credit rating agencies.

■ Procyclicality problem.

22

End of Documents

1

The Basel II implementation in ICBC

2

(1)set up the Enterprise-wide risk management system 。 It is represented on the four aspects of risk policy and system building, risk measurement, information system, data consolidation.

1.The preparation work to implement Basel II

3

4

(2)set up the risk measurement system covering all kinds of customers and realized the scientific measurement on credit risk, market risk, liquidity risk and operational risk.

5

Establish the IRB methodology and system. Referring to has developed a series of rating models covering corporate business, inter-bank business, retail business and sovereign exposures. The data indicates that the corporate rating model has the good performance with AR 0.55 which has entered into the international standard (0.5-0.7).

6

(3)Build up the IT system for IRB project. ICBC has developed the obligor rating system which is embedded with the rating methodology and rating models and realized the whole process IT management from obligor rating, credit line approval to post-disbursement management. ICBC also developed the financial report checking system, the collateral appraisal management IT systems to supply the data basis for facility rating and the industrial analysis system to supply the technology support for regional and industrial risk rating and portfolio analysis.

7

8

(4) Build up the IRB data foundation.

In 2002, ICBC conducted data consolidation project which enables centralized and real-time processing of credit risk management and to further enhance customer rating, credit limit, 12-grade loan classification, middle and long-term facility rating functions.

In 2003, ICBC developed the CIIS, PCM2003 systems which improved the credit risk management efficiency and accumulated the data for credit risk quantification. Until now ICBC has accumulated six-year loan information covering all kinds of customers including the basic information, financial information, trading and rating information, which satisfied the 5-year data accumulation requirements of the F-IRB.

9

(5)Set up the policy basis of the IRB implementation and train the internal rating staff.

10

2.The main developments and advances of Basel II project.

Project Name Time

ICBC EWRM Project 2004

ICBC Capital Management Project 2005

ICBC Interest Rate Risk Management Project 2005

ICBC Non-retail Credit Risk IRB Project 2005-2006

ICBC Market Risk Management Project 2006

ICBC Internal Audit Project 2006

ICBC Retail Credit Risk IRB Project 2007

ICBC Risk Management Projects List

11

3、The problems and the challenge

The existing problemsA. The loss data cannot meet the 7-year data requirement. B. The obligor rating and facility rating models need to be validated and calibrated.C. Need to develop the retail-business approval and performance monitoring risk quantification models.D. Need to enhance the application of IRB results on portfolio management.

12

4、The work plan of next step

A. Expedite the application of the IRB results on the whole process of risk management. B. Advance the retail IRB project to improve ICBC retail risk management. C. Expedite the data warehouse establishment and improve the facility rating system to lay the foundation for A-IRB. D. Enhance the establishment of risk culture.

CrossCross--border banking and Supervisory border banking and Supervisory Cooperation under Basel IICooperation under Basel II

Alicia Garcia HerreroAlicia Garcia HerreroBank of International SettlementsBank of International Settlements

AFDC 2007AFDC 2007Shanghai September 5, 2007Shanghai September 5, 2007

1. History of cross-border supervision until Basel I

2. Some basics of Basel II and home-host issues

3. High-level principles for the cross-border implementation of Basel II

4. The Asian case5. Concluding remarks

Overview

1. The history of cross-border supervision until Basel I

From the Basel Concordat – 1975

No foreign banking establishment should escape supervisionSupervision of foreign banking establishments calls for contact and co-operation between host and parent supervisory authoritiesSupervisory authorities should seek to remove restraints on transfers of information

Revised Basel Concordat – 1983Established principle of consolidated supervisionHost authorities responsible for subsidiaries

Recognition of differences inSupervisory methodologies and resourcesCharacteristics of local banking systemsSupervisory cultures (eg mutual reliance)

Revisions followed …

Leading to Basel Minimum Standards – 1992

International banks should be supervised by a home country that performs consolidated supervisionCreation of cross-border bank should receive the prior consent of both host and home country authoritiesHome country authorities should have the right to gather information from their cross-border banking establishmentsHost country responsible for determining the compliance with these three standards

It could impose restrictive measures or prohibit the establishment of banking offices

Cross-border consolidated supervision requires cooperation and information exchange* between home supervisors and the various other supervisors involved, primarily host banking supervisors. Banking supervisors must require the local operations of foreign banks to be conducted to the same standards as those required of domestic institutions.

* Information exchange is covered in more detail in CP 1(6), which underpins the standards set out in CP 25.

The Core PrinciplesCore Principle 25 – home-host relationships

Core Principle 25 – essential criteria

Information exchanged should be adequate for both home and hostIdentify relevant supervisors for material cross-border operations and establish informal/formal arrangements for information sharingHome to host:

Supervisory approach for overall groupGroup-wide context for host operationsGroup-level problems likely to impact hostSignificance of sub to group

Core Principle 25 – essential criteria (2)

Host to home:Non-compliance with host requirementsAdverse developments in local operationsAdverse assessments of risk management, controlsSignificance of sub to host financial sector

Foreign subs subject to similar rules as domesticHost consults home before licensingHome allowed access to group’s operations in host

2. The basics of Basel IIBasel Committee created as a forum for supervisors to address issues related to cross-border supervision

Members are G-10 bank supervisors Build trust and supervisory network, encourage others (eg regional groups of supervisors) to do so as well Three major agreements in history

1988 Basel Accord1996 Market Risk Amendment2004 Basel II (updated in Nov 2005)

Basel II sets International convergence of capital measurement and capital standards

Scope of application: all levels of ownership structure of internationally active banksThree mutually reinforcing pillars

The pillarsPillar 1: Minimum capital requirements

Three risks: credit, operational and marketFive asset classes for credit risk: corporate, sovereign, bank, retail and equityTwo approaches to credit risk: standardised and internal ratings-based (IRB)

Pillar 2: Supervisory reviewFour principlesSpecific issues: interest rate risk, stress tests, concentration risk, counterparty risk

Pillar 3: Market disciplineDisclosure requirements

Pillar 1: Assessing capital for credit risk

Basic principle of Pillar 1: capital should cover unexpected loss (UL) with high probabilityWith perfectly diversified loan portfolio and correct estimates of probability of default (PD), loss given default (LGD) and exposure at default (EAD):

UL will be zeroExpected loss (EL) should be covered by provisions

In uncertain world, actual losses may be higher than expected

UL will be positive and should be covered by capitalEL should be covered by provisionsCapital (K) + (Provisions – EL) ≥ UL with 99.9% prob

How the two approaches apply the UL principle

Standardised approach relies on support of external credit assessment (ECA):Asset → ECA → risk weights (UL) → K

Internal ratings-based (IRB) approach relies on parameter estimatesAsset → { PD, LGD and EAD } → UL → K

Foundations IRB: bank estimates PD, supervisor provides LGD and EADAdvanced IRB: bank estimates PD, LGD and EADFor retail loans, only advanced IRB allowed and UL smaller than for corporate loans

Pillar 2: The four principles

P1. Overall capital: Banks should have process for assessing overall capital adequacyP2. Supervisory response: Supervisors should evaluate banks’ internal capital adequacy assessmentsP3. Excess capital: Supervisors should expect banks to operate above the minimum regulatory capital ratiosP4. Early intervention: Supervisors should intervene at early stage to prevent capital from falling below minimum

Basel II and home-host – issues

… under Basel II, home-host issues have received more attention than they had in the pastOptions introduced for credit, op risk calculations

No real change from Basel I re standardised approach (credit), other than issues associated with ECAIsBut for more advanced approaches – significant variation in banks’ approaches is likely across jurisdictions

For advanced approaches, bank-wide information requirements are substantial

Basel II and home-host – issues (2)

Supervisory review process under Pillar 2 – initial and ongoing supervisory approvals, validation

Supervisory reliance: Host prepared to accept home’s review/approval processes at the group level? Home prepared to rely on host’s review of significant subs?Supervisors expect separate ICAAPs at parent and sub levels?

Models and processes require scale to function and be cost-effective

Further scope/demand for supervisory cooperation


No international standards exist for ‘other’ Pillar 2 risksInterest rate risk in the banking book, liquidity risk, reputational and strategic risk, credit risk concentration

Supervisors’ attitudes toward treatment of diversification benefits (across risk types, business lines, legal entities) likely to vary across jurisdictions


Different implementation timing in different jurisdictionsMany combinations possible:

Home implements advanced Basel II – host Basel IHome implements advanced Basel II – host standardisedBasel IIHome remains on Basel I – host Basel II

Overall approach to Pillar 2 likely to vary across jurisdictionsSome supervisors focusing on capital requirements for individual risk components, others placing more emphasis on totality of Pillar 2 assessments

Consolidated reporting

Reporting tohost regulator

Reporting to home regulator

Internationallyactive bank

Head officeCountry XFIRB/AMA

BranchCountry A

SubsidiaryCountry B

SubsidiaryCountry C

Only simplerapproaches

Only AIRBAnd AMA Basel I

Basel II and home-host – an example

Basel II and home-host – a work in progress

Pillar 2 currently major focus of Accord Implementation Group (AIG)

Case studies key aspect of that workInformation-sharing helps identify key issues/challenges and promotes discussion about resolution

Supervisory colleges are an effective forum for addressing Pillar 2 issues on a bank-by-bank basis

Not a panacea, as not all hosts are involvedInformation-sharing, not decision-makingBilateral relationships are important complement to colleges

Basel II and home-host – a work in progress (2)

Each jurisdiction must decide how best to deal with differences, based on

Significance/proportionalityImpact on regulatory capitalBanks’ motivation – gaming?Legislative constraintsPragmatism (eg hosts allowing subs to rely on data and systems from the parent, provided it is adapted to local circumstances)

Pillar 2 having positive impact on supervisory practicesSignificant in some jurisdictions (eg increased transparency of processes), refinement in others

3. High-level principles for cross-border implementation of Basel II

Facilitate practical cooperation and information exchangeIntended to strengthen the quality of banking supervision across countriesExisting cross-border responsibilities will generally continue to apply Enhanced cooperation for supervision of internationally active banking groups will be necessary under Basel II

Legal responsibilities

Principle 1Basel II will not change the legal responsibilities of national supervisors for

the regulation of their domestic institutions or the arrangements for consolidated supervision already put in place by the Basel Committee on

Banking Supervision

Basel Concordat continues to applyHome supervisor = consolidated supervisionHost supervisor = sub-consolidated supervisionBuild on existing arrangements without imposing undue burden

Home supervisor

Principle 2The home country supervisor is responsible for the oversight of the

implementation of Basel II for a banking group on a consolidated basis

Home supervisor makes final determinations, including Pillar 2, on a consolidated basisHome supervisor may seek input from host supervisors, especially for material subsidiariesBanks need to communicate their implementation plans internally

Host supervisors

Principle 3Host country supervisors, particularly where banks operate in subsidiary

form, have requirements that need to be understood and recognised

Banks must satisfy legal requirements in host jurisdictionsBeneficial if host supervisors accept methods and approval processes used at the consolidated levelThere may be legitimate reasons, however, not to recognise approaches used at the group level

Practical cooperation

Principle 4There will need to be enhanced and pragmatic cooperation among supervisors with legitimate interests. The home country supervisor

should lead this coordination effort

Look for ways to enhance cooperation and information exchangeHost country information requests should be reasonableWork plans should be coordinated as much as possibleCommunication between home and host, home and bank, hosts and subsidiaries Arrangements can be formal or informal

Reduction of burden

Principle 5Whenever possible, supervisors should avoid performing redundant and

uncoordinated approval and validation work in order to reduce the implementation burden on the banks, and conserve supervisory resources

Cooperation especially important where different techniques used in different jurisdictionsIdeally, supervisory work will reflect the organisation and management structure of the bankHome country will need sufficient information to conduct consolidated supervision

Communication with banks

Principle 6In implementing Basel II, supervisors should communicate the respective roles of

home country and host country supervisors as clearly as possible to banking groups with significant cross-border operations in multiple jurisdictions. The home country supervisor would lead this coordination effort in cooperation with the host

country supervisors.

Home supervisor should develop an implementation plan (in cooperation with host supervisors) and communicate the plan to the bankClarify that supervisory legal responsibilities remain unchangedPlan should be flexible and tailored to the bank

4. The Asian case

Implementing Pillar 1 of Basel II in AsiaTransitional burden on foreign banksThe race for dataHome-host issues with internal ratings-based approaches

Dealing with systemic risk and regional contagion

Incentives for banks under Pillar 2Supervisory assertivenessHome-host issues and Pillar 3

Foreign banks in Asia have a small presence although growing

Cross-border banking in emerging Asia

Asian crisis in 1997 a defining eventValue of total cross-border bank credit to non-banks in region contracted by more than 10% in 1997Foreign bank presence has remained low: foreign bank credit < 10% of totalRetrenchment by Japanese banks; dominant foreign banks now Citibank, HSBC, Standard Chartered, Deutsche and ABN Amro

Still foreign banks have made their presence feltIn certain market segments, foreign banks are aggressive, including in credit cardsIn Philippines, Indonesia, Thailand, credit cards, mortgages up

Asia and Basel II

Basel II as measure to bolster reforms after Asian crisisMove from collateral-based lending to “risk management”Timetables for implementation are ambitious

The quick: Indonesia to implement AIRB in 2010Quicker: Malaysia, Philippines, Thailand in 2009Quickest: Australia, Hong Kong, New Zealand, Singapore in 2007-08Even China: Basel 1 ½ by 2007 -- Basel 1 plus Pillars 1 and 2 of Basel II

Pillar 1 and home cost issues in Asia

During transition, foreign banks need to calculate capital twice, imposing regulatory burdenPossible advantage of advanced IRB for mortgage and consumer loans leads to race for dataComplexity of Basel 2 puts premium on home-host cooperation on information, including validationOver 100 discretionary items in Pillar 1 call for regional harmonizationRequired amount of information sharing may be burdensome to home and host supervisors

Contagion and systemic risk in Asia

Lessons of 1997 crisisAlba et al (1998): Pro-cyclical capital flows and macro policy led to Asian crisisCorrelated collateral leads to regional contagion

Acharya and Yorulmazer (2002): Banks have incentive to ignore systemic riskInadequacy of Pillar 1

It focuses on individual assets of individual banksBorio, Furfine and Lowe (2001): It underestimates risk in booms and overestimates risk in busts

Pillar 2 to the rescue?Under Pillar 2, banks internally assess overall risks and capital – but may have little incentive to assess systemic riskPowerful supervisors may just tell banks what to doBut weak supervisors reluctant to evaluate bank assessments

Banks may belong to powerful families or major industrial groupsStress tests for systemic risk heavy on discretion and judgmentResearch may give supervisors ammunition

Home-host issues: Hong Kong and New Zealand

Hong Kong is big as both home and host supervisorRegional hub for large UK, Chinese banksCoordinate on entry criteria, cooperate on validationApply simpler approach to operational risk but use Pillar 2 to offset burden of double calculation

New Zealand is ultimate hostAustralians own 85% of New Zealand’s banksRequire big banks to incorporate locallyHarmonize Basel II with APRA in move to “seamless”regulation

Cross-border supervisory cooperation in dealing with crisis

Supervisors may have different mandates – one to protect depositors, the other to maintain soundness of financial systemIn times of stress, two supervisors may differ on whether the problems are systemic Foreign bank may be systemically important in host country but not at homeFor lenders of last resort, if support is required, who provides it?

Dilemmas in resolving crisis cooperation issues

Trade-off between ring fencing and cross-border supervisory cooperationWhat information to share? Easy to underestimate amount of information needed to be shared by home and host supervisors How to resolve lender-of-last-resort issues without undermining Pillar 3 – need to give up transparency?

5. Concluding remarks

Effective supervision of international banking groups depends on effective supervision at both the local and consolidated levelEffective cooperation and coordination between home and host supervisors will be key to success of Basel IIBasel II offers an opportunity to develop pragmatic arrangements for enhanced collaboration and information sharing

5. Concluding remarks (cont’)

More effective and efficient cooperation and information flow combined with supervisory mutual trust and confidence in their respective assessment processes will

Enhance the supervisory processHelp to conserve scarce supervisory resourcesHelp to reduce overall regulatory burden on banksPromote a comprehensive and sound implementation of Basel II

Beyond principles and formal arrangements, at the end of the day what matters is having the right person at the end of the line

5. Conclusions (cont’)For the Asia case:

Transition between standardized and advanced IRB imposes burden on foreign banksPossible advantage of advanced IRB leads to race for dataComplexity of Basel II multiplies home-host issues

Dealing with regional contagionUnder Pillar 2, banks may have little incentive to assess systemic riskCan supervisors be assertive enough to evaluate overall capital adequacy?Can home and host supervisors reconcile approaches to dealing with crisis?

Appendix: Useful References

Principles for home-host supervisory cooperation and allocation mechanisms in the context of Advanced Measurement Approaches (AMA) – consultative paper (Feb 2007)Core principles for effective banking supervision / Core principles methodology (October 2006)Home-host information sharing for effective Basel II implementation (June 2006)Principles for the home-host recognition of AMA operational risk capital (Jan 2004)