Basel II Perspectives Beyond Pillar I Minimum Capital

Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.Copyright (c) 2008 Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.

Basel II PerspectivesBeyond Pillar I Minimum Capital

Rocky IeraciVice PresidentStandard & Poor’s

June 9, 2009

2.Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.

Agenda

• An Overview of the Basel II Framework

• Basel II Implementation - Common Criticisms

• Closer look at Pillar II and Capital Adequacy

– Dealing with Pro-cyclicality

– Role of Stress Testing

– ICAAP Framework

• Summary


Basel II Framework

• The Framework consists of three reinforcing pillars:

– Pillar I - Minimum Capital Requirements

Sets out rules and principals for the calculation of minimum regulatory capital required for Credit, Operational and Market Risk.

Ratio of capital (tier 1 or total) to risk-weighted assets.

– Pillar II - Supervisory Review Process

National regulators to ensure compliance with minimum standards in fulfilling Pillar 1; audit internal risk rating systems, methodology, risk oversight, internal control, monitoring and reporting.

Assess overall capital adequacy – consider risks not covered by framework.

– Pillar III - Market Discipline

Disclosures (e.g. in annual report) allow market participants (e.g. creditors, shareholders) to decide for themselves whether risks has been appropriately measured and managed.


Basel II Framework

Pillar 1: Calculation of Risk Weighted Assets

1) Credit Risk

2) Oper. Risk

3) Market Risk

• Standardised Approach – Assign risk weights using rule based method supported by external rating assessment.

• Foundation IRB – Use internal risk rating system approved by regulator to produce own estimates of PD which serve as an input to calculate risk weights.

• Advanced IRB – Builds on FIRB and allows the use internal risk rating system to produce own estimates of PD, LGD and EAD.

• Basic Indicator Approach – Fixed % of 3yr avg. positive annual gross income.

• Standardised Approach – Fixed % with additional granularity by business line.

• Advanced Measurement Approach – Use of internal models/methodology approved by national regulator for estimation of Op Risk capital charge

• Standardised Approach – The capital charge for general market risk and specific risk is determined using supervisory weights by instrument type.

• Internal Models – Use own models, approved by regulator, to estimate capital.

• Approaches represent a “continuum of increasing sophistication and risk sensitivity.” More advanced approaches = more accurate measure = reduced overall capital charge, all else equal.


Basel II Framework

Pillar II: Supervisory Review Process – Four Guiding Principals

• Internal Capital Adequacy Assessment Process (ICAAP):

– Institutions should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

• Supervisory Review and Evaluation Process or (SREP):

– Supervisors should review and evaluate institutions’ ICAAP and strategies, as well as their ability to monitor and ensure their compliance with own funds requirements. Supervisors should take supervisory action if they are not satisfied with the results of this process.

• Supervisors should expect institutions to operate above the minimum own funds requirements and should have the ability to require them to hold capital in excess of the minimum.

• Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular institution and should require rapid remedial action if capital is not maintained or restored.


Pillar I

Basel II Framework

• Under Pillar I Advanced approach for Credit Risk, FIs develop Internal Risk

Rating Systems to estimate PDs, LGDs, EADs.

• These parameters are inputted into a standard formula to estimate the minimum

regulatory (credit) capital.

• Under Pillar II, FIs demonstrate their capital adequacy using these parameters,

for example, in EC and stress testing estimations.

• Pillar I is a stepping stone !

Capital

Adequacy

PD, LGD, EAD

Reg Capital

EC

Stress Testing/Scenario Analysis

Risk Appetite

Pillar II


Basel II Implementation – Common Criticisms

• Since first proposal, Basel II has often been criticized. Are these criticisms

justified? Some yes and some no…

– Extensive data requirements

– Too expensive and time consuming to implement

– Issues around specific parameter estimation requirements

– Conservatism requirement and impact on resulting capital estimate

– Issues with Supervisory Capital Formula

– Stifle advances in economic capital modelling

– Inconsistent application of rules across jurisdictions

• Recent economic events led to increased pressure on framework

– No restrictions on growth during benign periods

– Too focused on Credit risk at expense of other risks

– Pro-Cyclicality


Basel II Implementation – Common Criticisms

• Implementation has not been huge success. Framework to blame?

– Yes, there are shortcomings in framework, but some blame must go to how Basel II was being implemented at Banks:

• Seen as ‘regulatory tax’ versus way to enhance risk management

• Divisions between ‘Risk Management’ and ‘Line of Business’

– Risk not ingrained in strategic decision making

– Energy focused on reducing regulatory capital requirements

• Relationship between Banks and Regulators

• Overwhelming focus on Pillar I minimum capital

– Pillar I seen as end in itself instead of an initial step in the development of a comprehensive capital adequacy process.

• Crisis has reinforced view that banks need more robust risk management frameworks to deal with varying economic climates.

– Key is for industry to adhere to “Spirit” of the full Basel II Framework


Closer Look at Pillar II ICAAP Pro-Cyclicality and Role of Stress Testing


Pro-Cyclicality – Role Risk Rating Philosophy

• Risk Rating Philosophy: Expected behavior with respect to the cycles. – PIT: cyclical, forward-looking – Conditional on Current Information

– TTC: a-cyclical, cycle average - Unconditional

• An Example Philosophy: PIT via– Keeping RR to PD mapping constant

– Continually re-grading the obligors based on the cycle

• Spectrum of Risk Rating Philosophies

Pure PIT, not

achievable

Pure TTC, not

achievable

More PIT Hybrid Philosophies More TTC

Continuous PD models utilizing stock market information and leading economic indicators.

Intended TTC IRRS

External Rating Agencies (i.e. S&P’s Ratings

Intended PIT IRRS

• All info related to an obligor’s default likelihood is observable,

• Frictionless re-grading system

• No changes in RR due to systematic reasons. (ie. Relative ranking does not change unless for idiosyncratic (i.e. company-specific) reasons


Pro-Cyclicality – Role Risk Rating Philosophy

Cap

ital

Bottom of the cycle

Business Cycle (time)

Bottom of the Cycle Capital reflecting the maximum capital requirement over a cycle. It is a-cyclical

PIT Capital reflecting the capital requirement over the next year. It is Cyclical.

TTC Capital, reflecting the average capital requirement over a cycle. It is a-cyclical.

• Pro-Cyclicality refers to tendency for capital held to decrease in ‘good’ times

and increase in ‘bad’ times.

• Generally not desired as it exaggerates peaks/valley of cycle.

• Rating philosophy plays big part in variability of capital under IRB.

• Trade off: Cost of Holding Extra Capital Vs. Cost of Raising Capital at the

Downturns.


Pro-Cyclicality – Built in Stabilizers

• Does Basel II Already contain built in stabilizers?

PDs It appears that either philosophy is acceptable.

LGDs Appears to be a-cyclical via “bottom of the cycle” Working Paper #14, page 71 : “.. produce the "long run default-weighted average LGD" rather that "point in time" LGD estimates. But..

Philosophy (a-cyclical vs. cyclical) vs. Calibration (expected vs. conservative)

The use test The level of correlations and

systemic risk Diversification

Correlations Unconditional

Stress Test Appears to be pushing towards an a-cyclical conservative measure: “If a bank chooses a ratings philosophy that is likely to result in rating transitions that reflect the impact of the economic cycle, its capital management policy must be designed to avoid capital shortfalls in times of economic stress - ANPR, July 11, 2003”

-

-

-

-

Looking at the Components, it can be interpreted it does…


Pro-Cyclicality – Built in Stabilizers

• Is concern over the pro-cyclicality of Pillar I capital misplaced?

– “Tier I ratio is based on Pillar I capital requirements. And Tier I is

the ratio that EVERYONE is focused on. In fact the Total Capital

ratio gets virtually no attention these days.”

• Cyclical Tier I ratio is NOT desired thus Pro-cyclicality of Pillar I

capital is not desired.

• However, why are we concerned about Pillar I capital? Pillar I is a

stepping stone - it is at best one of the building blocks of ICAAP!

– Role of Stress Testing

– Role of alternative measures of capital

– Integration of the different risk types into overall capital adequacy


ICAAP Design


ICAAP – “Earlier” Practices

• Capital Adequacy was often determined as:

– Book Value of Equity > Max (Economic Capital, Regulatory Capital, Rating

Agency Capital)

• Capital estimated for “Internal” vs. “External” audience.

– “Smoothed PDs” used in estimation of “regulatory” capital requirement.

• Ad-hoc, non-standardized, non-creditable Stress Testing.

– Not formally linked to Capital Adequacy assessment

• Liquidity not formally linked to Capital Adequacy assessment.

• Insufficiently understood, defined and quantified Risk Appetite

• Lack of a comprehensive, robust and transparent framework to assess

overall capital adequacy.


Pillar II – ICAAP

• In this broader sense, it would be shortsighted to see ICAAP only as a

regulatory compliance requirement. All financial institutions need ICAAP !

• “In Pillar II, aim is design a transparent, auditable and replicable ‘process’ to

demonstrate capital adequacy using ‘alternative’ views of capital and stress

testing within the context of risk appetite.”

• Fundamental question is how do Bank’s measure and manage the ‘safety

cushion’ between available capital and the estimate of required risk capital.

• “We need to be convinced that the organizations can

convince themselves they have adequate capital using their

particular framework and process.”

• “Evolution not revolution”

• A Regulatory interpretation:


Designing ICAAP - Necessary Ingredients

• Pillar I Minimum Capital

• A good starting point and a clear improvement over Basel I constant risk

weight approach. But still a poor proxy for true economic capital required.

• Economic Capital

• Why use the proxy if we have EC?

• Proven useful as a relative measure but need to be careful when used an

absolute measure.

• Simplifying assumptions (e.g. Risk Horizon, single default point),

• Aggregation difficulties, inter-risk type correlations,

• Difficulty measuring, especially Operational and Business Risk,

• Validation challenges: Critical model assumptions are hard to validate..

• Nevertheless, certainly risk sensitive and a very useful input.



• Risk Appetite - Needs to be better understood, agreed upon and

quantified!

• Target Rating

• Incur losses less than direct competition during downturns -Be the “safe

choice” during credit downturns

• Downgrade tolerance? – Stress Testing Limits

• Capital Management policy (how dynamic?)

• Preparation via “Fire-Drills” and “War Games”

• Stress testing

• Capital and Liquidity Contingency Plans



• Liquidity formally linked to Capital Adequacy assessment

– Capital is for rainy days but Capital is held in less than perfectly liquid

assets!

– Losses → Expected CFs not materialized →Reduced Liquidity

Position

– (Magnified) Losses ← Increased Liquidity Risk Premium ←(System

wide) Reduced Liquidity


Stress Testing - Pillar II

Stress Testing

Micro Level Macro Level

Primary Purpose

Risk Identification and mitigation(Accuracy of quantification is of secondary importance)For example, as a value add for an industry review, or

when is topical or the business line generates lots of questions or there are lots of exceptions in lending.

Input into Capital AdequacyAccuracy of quantification is important

Output

Losses in general including foregone revenues

Stressed PDs, LGD, EADs, Migration Rates

CoverageAny sub-portfolio can be targeted

When not enough data expert judgment can be utilizedMacro level by country, Industry etc.

Heavy dependency on data availability

Approach

Expert JudgmentDesign a Scenario and analyze the Impact on Capital

and/or Revenue and/or ELQuantitative Methodologies

Frequency As frequently as needed Synchronized with capital planning

Methodology

Can be case specificExpert Judgment and Simpler Quantitative approaches,

like modeling the Balance Sheet or the Income Statement

Needs to be standardized

Examples

Bank’s exposure to:1. Real Estate 2. Automotive 3. Hedge Funds 4. Asset Back Commercial Paper and impact on Capital if brought into the Bank’s balance sheet

Global, Industry level or regional down-turns and recessions.

Macro level impact of historically observed or plausible hypothetical scenarios


Stress Testing - Pillar II

Stress ScenariosStress Scenarios(Event driven, determined by

management)

Historical StressHistorical Stress (Historical stress periods -

High PD and LGD Periods and the corresponding Macro-

economic factors)

Stressed Macroeconomic FactorsStressed Macroeconomic FactorsShould consistently apply to all risk types and factors

Tran

slated b

y th

e E

con

om

ics D

epartm

ent

Histo

rically d

riven

PIT

Ec

on

om

ic

Ca

pita

l

Capital A

dequacyC

apital Adequacy

Capital A

dequacyC

apital Adequacy

Cu

rren

t R

eg

ula

tory

C

ap

ital

Stressed Economic

Capital

Stressed Regulatory

Capital

TTCEconomic

Capital

MTM Losses

Stressed PDs, LGDs, EADs, Stressed PDs, LGDs, EADs, Migration Rates Migration Rates and and Stressed Default Stressed Default

Rates/ Portfolio LossesRates/ Portfolio Losses

Risk Risk AppetiteAppetite


ICAAP Design - Managing Capital Adequacy

Capital Safety

Cushion

Capital Management Framework

Stress Event

Business Cycle & Risk Capital

Available Capital

Planned Growth and Risk Taking

Pro-cyclicalityManagement - Dynamic

adjustment of capital and/or risk levels

Earnings Retention and Dividend Policy

Liquidity R

isk

AvailableCapital

Current Risk

Capital

Stress Scenario

(Hypothetical or Historical)

Stressed Stressed Macro Macro

Economic Economic FactorsFactors

Integrated Scenario

Effect

Business Risk

Risk Capital & change in EL/Earnings

Stress Capital Limits(Capability for Immediate

Risk reduction)

Downgrade Tolerance

Integrated Stress Testing Framework

Market Risk

Operational Risk

Credit Risk

MTM Losses


ICAAP Design - Managing Capital Adequacy

• Risk is PIT!

• PIT view provides a clearer picture of capital available relative to risk taking.

Capital Management Framework

Business Cycle & PIT Risk Capital

Stress Event

Available Capital

Capital Safety

Cushion

AvailableCapital

Current Risk

Capital

?

AvailableCapital

Current Risk

Capital

Smoothed Risk Capital


Managing Capital Adequacy under Pillar II

• Understanding current and planned risk taking in a PIT view

and then managing the Available Capital in a more stable (less

cyclical) manner should be desirable

• We are in fact managing the capital safety buffer (‘shock absorber)’.

• TTC Risk Capital would distort understanding of true safety

buffer between risk taking and Available Capital.

• Effective capital management can be achieved by managing the

safety buffer proactively:

• Balancing view of risk taking and Available Capital,

• Consider effect of stress events and ensure capital buffer can absorb

the potential impact,

• Incorporating planned growth and dividend policies


Summary


What’s Next for Basel II?

• The Basel Committee have listed key lessons they have learned from the banking crisis*:

– strengthen risk capture, especially trading book and Off-B/S exposures

– enhance quality of Tier 1 capital

– build “shock absorbers” into the framework to dampen pro-cyclicality evaluate the need to supplement risk-based measures with simple gross measures of exposure

– strengthen supervisory frameworks to assess liquidity at cross-border banks

– strengthen risk management and governance practices at banks

– strengthen counterparty credit risk capital, etc.

– promote global exercises to ensure implementation of supervisory and industry sound principles

*Source: “Comprehensive Strategy to Address the Lessons of the Banking Crisis announced by the Basel Committee”, Basel Committee, 20 November 2008


What’s Next for Basel II?

• Fundamental premise of Basel II – putting it into perspective

– Making more reliable estimations of key risk parameters.

– Designing a ICAAP framework to manage capital adequacy.

– Disclosing more information to the market.

• Need to maintain perspective that Pillar I is a stepping stone

– Designing a comprehensive framework to assess and manage capital adequacy

is the real purpose.

• Run the risk of killing sprit of Basel II Framework

– Imposing punitive restrictions (top down capital requirements) would leave little

incentive for Banks to develop better Risk Management capabilities.

– Don’t want to turn ICAAP into an ‘external’ adequacy process. Big upside in

developing robust internal capital adequacy program.

– Basel II should provide the necessary framework and tools to bring sound risk

management to financial institutions.


This material was prepared by Standard & Poor’s Fixed Income Risk Management Services group. This group is analytically and editorially independent from any other analytical group at Standard & Poor’s, including Standard & Poor’s Ratings.

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Economy & Finance

Basel II Perspectives Beyond Pillar I Minimum Capital