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Disclaimer
The information, data and approaches provided herein are an outcome of our research and content expertise. Although we referred to third party materials and
analysed their impact, however the content is the outcome of CCP's proprietary knowledge and is rightfully owned by us. This work is copyright protected and
legally privileged.
Please do not distribute this presentation without the prior written consent of Capital Calibration Partners or its authorized affiliates.
CCP has made best efforts to ensure that this material is complete in its entirety. However, we does not warrant its completeness or accuracy nor do we
warrant that the results obtained will be useful or will satisfy the all requirements.
Copyright © 2014 Capital Calibration Partners Inc.
Basel II: International Convergence of Capital Measurement and Capital StandardsAddressing the requirements of
Basel II: International Convergence of Capital Measurement and Capital Standards (BCBS issue June 2006)
Regulation Self-assessment
Prepared by: Capital Calibration Partners
Nov. 2014
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Innovative approach
1. Terms and conditions apply
Capital Calibration Partners (CCP) is a management consulting firm that specializes in the financial
services content curation, content standardization and content roll-out
Regulation Self Assessment
(RSA)
Best Practice Benchmarking
(BPB)
Strategic Knowledge Transfer
(SKT)
3 practice themes
Also provide customized assistance in the following areas1:
• Production of content in MS Power Point based on client mandates
of off-site work
• Completion and rating of the Self-Assessment
• Development and design of a vision or requirements document,
e.g., User Vision Documents (UVD’s), Request for Information
(RFI), Request for Proposals (RFP’s)
For further assistance,
please contact CCP at:
Our RSA toolkits allow you to
objectively determine gaps due
to regulatory changes. We map
proven management consulting
approaches with regulatory
requirements
BPB’s self-diagnostic tools
would allow you to understand
how the ‘leading practice’
financial institutions are
influencing the changes across
the industry, and how such
changes are impacting your
organization
SKT provides you deep insights
into the “practitioners’
knowledge base”, that would
enable you to conceive complex
projects internally from design to
implementation
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Web based content distribution enables robust knowledge transfer
Helps kick-start development mandate in client organizations
Understand requirements
CCP Gap Analysis Undertake Self-Assessment
• Download CCP’s
proprietary content from
the website
• Share it with key process
owners, managers and
stakeholders
• Understand the
requirements and prepare
for the Self-Assessment
• Rate Self-Assessment to
benchmark your current
state
• CCP would collate the
results, validate the Self-
Assessment, understand
your needs and develop a
target state
Step 1Step 2
Step 3
Other optional services
include:
• Development of
implementation plan,
including a delineation of
external and internal
resources
• Development of a vision
document, roadmap or
requirements document
and Request for
Proposals (RFP’s)
CCP site downloads Separate quote
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We are uniquely well-qualified to help clients
The CCP team has experience in formative research, communication plans and
strategies, developing and disseminating materials, and utilizing traditional and
non‐traditional social marketing and communication strategies, including social
media
Our research and consulting teams undertake mandated and proprietary research,
focusing on regulatory publications (Basel, FSB), industry, academic journals and
practitioners interviews
Case Studies: CCP combines interviews, content analysis, engagement results and ‘pit-
falls’ to design content that addresses complex needs of today’s consulting, regulatory
and FS client organizations. This approach is particularly well suited to clients looking for
the “lessons learned” to avoid pitfalls since it pulls together multiple perspectives into one
“story”
Our production team creates and publishes the content on our website
In a nut shell, our proprietary web platform enables you to realize significant savings
Our consultants use a wide range of quantitative and qualitative approaches to ensure
a balance of rigor and practicality while developing the FS content
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
7
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Regulations are broadly organized around three broad dimensions: Design, Embed and Refine
We use the management consulting lens of best practices to develop approaches for the implementation of regulations
Basel II: International
Convergence of Capital
Measurement and Capital
Standards
Analyze regulation
Design dimension
Embed dimension
Process dimension
D
E
R
Map consulting approaches
Design
Embed
Refine
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Basel II represents a fundamental shift in banking regulation
Pillar 1
Minimum Capital
Requirements
Pillar 2
Supervisory Review
Of Capital Adequacy
Pillar 3
Market Discipline
Basel II Capital Accord
• Recognition of agency
ratings and internal ratings
• Recognition of internal
exposure and loss mitigation
estimates
• Explicit treatment of
Operational Risk
• Banks must assess
solvency relative to their risk
profile
• Supervisors review and
evaluate risk management
and capital management
practices
• Top 5-10 banks in each
country typically expected to
comply with IRB approach
• Improved disclosure of
capital structure and capital
adequacy
• Improved disclosure of risk
measurement and
management practices
• Improved disclosure of
risk profile
• More than ever before, risk
management is a true
competitive differentiator
• Regulators expected to
differentiate ‘add ons’ based
on quality of risk and capital
management
• Significant increase in
required regulatory role
• Banks required to release
much more information
about their risk profile
• Debt and share markets
increasingly able to
differentiate based on risk
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Basel II implications for emerging market banks
Overall, Basel II brought about a positive impact on the banking sector as a catalyst for improved MIS and better management of risks
However, there were some ‘unpleasant’ consequences as well, e.g.
• Increased capital requirements and funding costs for most emerging market (EM) banks, leading to pressure on ROE
• Significant investment requirements into compliance: IT, data, analytics, resources, etc.
• Procyclicality risk
In the post-B2 world, banks need to leverage compliance efforts into business benefits, to the greatest extent possible
This amounts to substantially upgrading the way that the bank measures and manages risk, capital, profit and value
Banks also need to be aware of common challenges and pitfalls of this long and costly process
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Basel II – Sovereign Capital Charges
Sovereigns – In a Nutshell
%
1. Inputs: average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5. (Moody’s rating applied if different from S&P)
Basel I
Type of
sovereign
Risk
Weight
OECD 0
Non-OECD 100
Basel II
Ex
tern
al
Ra
tin
gAA- or above
A
BBB
BB+ to B-
Below B-
Unrated
0
20
50
100
150
100
Standardised bank
risk weights
Co
un
try
Sample est. FIRB bank
risk weights1
Poland
Russia
Turkey
Bulgaria
Czech Republic
Hungary
25
68
141
100
24
24
Rating
A2/BBB+
Baa3/BBB-
B1/BB-
Ba1/BBB-
A1/A-
A1/A-
12Source: Text
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Basel II – Sovereign Capital Charges
Sovereigns – Standardised Banks (¶¶ 53-59)
%
Risk weights for sovereign exposures:
Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Risk
Weight0 20 50 100 150 100
Risk weights may also be based on ECA risk scores
Claims on non-central government public sector entities based on corporate exposure risk weights
Claims on multilateral development banks have 0% risk weight if conditions are met, including: (i) majority of MDB’s ratings are AAA, (ii) significant portion of shareholders are AA- or better rated sovereigns, (iii) funding is in form of paid-in equity with little or no leverage, and (iv) conservative lending criteria
At national discretion, lower risk weight for banks’ exposures to their sovereign (or central bank) in domestic currency; if adopted, other regulators may permit same risk weight
13Source: Text
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Basel II – Sovereign Capital Charges
Sovereigns – IRB Banks (¶¶ 270-272)
Formula for exposure not in default:
Capital requirement for defaulted exposure equals greater of zero and difference between exposure’s LGD and bank’s best estimate of loss
Input characteristics (applicable to all types of exposures) (¶¶ 285-325):
• PD: internally determined one-year probability of default
• LGD:
FIRB: 45% (senior)/75% (subordinated); adjusted (LGD* = LGD x (E* / E) for CRM recognition
AIRB: own estimates; adjusted for CRM recognition
• EAD: not less than sum of (a) amount by which bank capital would reduce if exposure written-off fully and (b) specific provisions and partial write-offs
• M: 2.5 years for FIRB (6 months for repos); own est. for AIRB for each exposure; max. 5 years
0.12 × (1 – EXP (-50 × PD)) / (1 – EXP (-50)) +
0.24 × [1 - (1 - EXP(-50 × PD))/(1 - EXP(-50))]
Correlation (R) =
Maturity adjustment (b) = (0.11852 – 0.05478 × ln (PD))^2
Capital requirement (K) = [LGD × N [(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] –
PD x LGD] x (1 - 1.5 x b)^ -1 × (1 + (M - 2.5) × b)
Risk-weighted assets (RWA) = K x 12.5 x EAD
14Source: Text
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Basel II – Bank Capital Charges
Banks – In a Nutshell
%
1. Using inputs of average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5.
2. Using inputs of rating agency values for PD, LGD of 10%, supervisory value for EAD and M of 2.5.
3. Internal PD estimate to be applied
Source: Text
Basel I
Type of
Bank
Risk
Weight
OECD 20
Non-OECD 100
Basel IIE
xte
rnal R
ati
ng
AA- or above
A+ to A-
BBB+ to BBB-
BB+ to B-
Below B-
Unrated
20
50
100
100
150
100
Standardised
Option 1
Standardised
Option 2
20
50
50
100
150
50
Exte
rnal R
ati
ng
BB+ to B-
Below B-
Unrated3
FIRB est.
risk weights1
14-24
24-28
38-68
100-197
226
NA
AA- or above
A+ to A-
BBB+ to BBB-
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Basel II – Bank Capital Charges
Banks – Standardised Banks (¶¶ 60-65)
%
2 options, selected by national regulator to apply for all banks in jurisdiction:
Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Risk
Weight20 50 100 100 150 100
• Option 2: At national discretion, banks risk weighted on basis of own external ratings (plus more favourable risk weight if claim maturity < 3 months)
Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Risk
Weight20 50 50 100 150 100
• Local currency reduction: National regulators may reduce by one notch risk weight of local currency bank debt having maturity of less than 3 months, subject to floor of 20%
• Exposures to securities firms treated as bank claims if regulatory arrangements comparable
• Option 1: Banks risk weighted one category below risk weights of banks’ sovereigns:
Source: Text 16
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Basel II – Bank Capital Charges
Banks – IRB Banks (¶¶ 270-272)
Formulas for bank exposures same as for sovereign exposures, but with floor for PD of 0.03%
Effective floor of 16 to 48 basis points for highest quality credits (depending on maturity assumption) under Advanced IRB
• Generally, PD for high-quality bank debt will be below 0.03% floor (so floor must be used)
• More realistic 10% LGD for Advanced IRB bank (rather than 45% supervisor-imposed LGD for Foundation IRB banks) results in significant capital reductions
• Compare to 56 basis point floor for highest quality ABS
Source: Text 17
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Basel II – Corporate Capital Charges
Corporates – In a Nutshell
%
1. Using inputs of rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5.
2. Internal PD estimate to be applied
Source: Text
Basel I
Risk
Weight100
Basel IIE
xte
rnal R
ati
ng AA- or above
A
BBB+ to BB-
Below BB-
Unrated
20
50
100
150
100
Standardised
Option 1
Standardised
Option 2
100
100
100
100
100 Exte
rnal R
ati
ng
AA- or above
A
BBB
BB+ to B-
Below B-
Unrated2
FIRB est.
risk weights1
14-24
24-28
38-68
100-197
226
NA
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Basel II – Corporate Capital Charges
Corporates – Standardised Banks (¶¶ 66-68)
%
2 options, selected by national regulator to apply for all banks in jurisdiction:
Rating AAA to AA- A+ to A- BBB+ to BBB- Below BB- Unrated
Risk
Weight20 50 100 150 100
• Option 2: At national discretion, all corporates risk weighted at 100% without regard to external ratings
• SME Adjustment: 75% risk weight for unrated SME if exposure under €1 million and either treated by bank as retail or guaranteed by individual
• Includes claims on insurance companies
• Option 1: Corporates risk weighted as set out in following chart (supervisory authority to increase 100% risk weight for unrated corporates where warranted by higher default rates):
Source: Text 19
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Basel II – Corporate Capital Charges
Corporates – IRB Banks (¶¶ 270-274)
Formulas for corporate exposures same as for bank exposures, including floor for PD of 0.03%
Source: Text
SME Adjustment for firms setting total annual sales (S) at €50 million or and €5 million or more:
• Subject to national discretion, supervisors may allow banks to substitute total assets for total sales
• SME adjustment generates approx. 20% reduction in risk weights (depending upon original creditworthiness)
Correlation (R) = 0.12 × (1 – EXP (-50 × PD)) / (1 – EXP (-50)) +
0.24 × [1 - (1 - EXP(-50 × PD))/(1 - EXP(-50))] – 0.04 ×(1 – (S-5)/45)
Effective floor of 14% risk weighting for foundation IRB banks due to minimum PD of 0.03% representing a capital charge of 112 bps
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Basel II – Retail Capital Charges
1. PD and LGD inputs provided by bank (¶ 331); PD floor at 0.03%
2. Using PD of 3% and LGD of 80% and PD of 5% and LGD of 90%, respectively
3. Using PD of 5% and LGDs of 40% and 60%, respectively
Source: Text
Basel I
Risk
Weight100
Basel II
Generally
Default
75% if conditions met
From 150% to 50% depending
on level of specific provisions
against exposure
Standardised bank risk weights FIRB est. risk weights1
Credit cards
Other Retail
70-110 2
60-90 3
Retail – In a Nutshell
%
Internally determined PDs and
LGDs under Foundation IRB
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Basel II – Retail Capital Charges
Retail – Standardised Banks (¶¶ 69-71)
Generally
• 75% risk weight if:
Exposure to individual or small business
Exposure takes form of revolving credit, line of credit, personal loan, lease, or small business facility (mortgage loan excluded to extent otherwise covered (see below))
Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one counterparty should exceed 0.2% of overall portfolio
Maximum aggregate counterparty exposure €1 million or less
• Effective floor of 600 basis points
Source: Text
Past Due
• Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows:
150% when specific provisions less than 20% of outstanding amount of exposure
100% when specific provisions 20% or more of outstanding amount of exposure
100% when the specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case
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Basel II – Retail Capital Charges
Retail – IRB Banks (¶¶ 326-338)
Formula for qualifying revolving retail exposure not in default:
Source: Text
Formula for qualifying revolving retail exposure not in default:
When only drawn balances securitised, bank must hold required capital against unfunded commitment
0.04Correlation (R) =
LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 ×
G (0.999)] – PD × LGD
Capital requirement (K) =
K x 12.5 x EADRisk-weighted assets
(RWA)
=
0.03 × (1 – EXP (-35 × PD)) / (1 – EXP (-35)) + 0.16 × [1 -
(1 - EXP(-35 × PD))/(1 - EXP(-35))]
Correlation (R) =
LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 ×
G (0.999)] – PD × LGD
Capital requirement (K) =
K x 12.5 x EADRisk-weighted assets
(RWA)
=
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Basel II – Real Estate Capital Charges
1. Subject to conditions
2. Reduced 50% risk weight possible, subject to conditions
3. Using PD of 1% and LGD of 10% and PD of 2% and LGD of 25%
4. Using PD range of 0.07% and 2.1% and LGD of 35%
Source: Text
Basel II
Standardised bank risk weights FIRB est. risk weights
Real Estate – In a Nutshell
%
Basel I
Type of
exposure
Risk
weight
Residential
Commercial
50
100
Residential
Commercial
35 1
100 2
Residential
Commercial
10-50 3
20- 90 4
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Basel II – Real Estate Capital Charges
Real Estate – Standardised Banks
Residential Real Estate (¶¶ 72-73)
• 35% risk weight for exposures fully secured by mortgages on residential property occupied by the borrower or rented
• Strict prudential criteria (including loan to value ratios) determined by national regulators
• Supervisors may require increased risk weight if data warrant
• Effective floor of 280 basis points
Source: Text
Commercial Real Estate (¶ 74)
• Generally 100% risk weight, given experience in numerous countries with troubled credits over the past few decades
• However, 50% risk weight possible in certain markets if (among other conditions): (i) tranche not greater than lower of 50% of market value and 60% of mortgage lending value, (ii) losses on tranche do not exceed 0.3% in any year, and (iii) overall losses from commercial real estate in relevant market do not exceed 0.5% in any year
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Basel II – Real Estate Capital Charges
Real Estate – IRB Banks
Residential Mortgages – Formula for exposure not in default (¶¶ 327-328):
Source: Text
High volatility commercial real estate (HVCRE) (¶¶ 280-284):
At national discretion, banks may assign preferential risk weights of 70% to “strong” and 95% to “good” where maturity is less than 2.5 years or supervisor determines bank’s underwriting criteria and other risk characteristics are substantially stronger
0.15Correlation (R) =
LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 ×
G (0.999)] – PD × LGD
Capital requirement (K) =
K x 12.5 x EADRisk-weighted assets
(RWA)
=
Supervisory Rating Strong Good Satisfactory Weak Default
Risk Weight 95 120 140 250 0
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Basel II – Covered Bonds Capital Charges
1. Italy, Portugal, Sweden, UK
2. Requires rating of AAA to AA-
3. Requires rating of A+ to A- under Option 1 and rating of A+ to BBB- under Option 2
4. LGD of 12.5% required in CRD with PD floor of 0.03%. Using inputs PD as noted, LGD of 12.5%, supervisory value for EAD and M of 2.5.
Source: Text
Basel II (CRD)
Standardised bank risk weights FIRB est. risk weights4
Covered Bonds – In a Nutshell
%
Basel I
Type of
exposure
EU Risk
Weight
UCITS
qualifying
Exceptions 1
10
20
PD of 0.03%
PD of 0.15%
4
10
Senior debt
RW
Covered bond
RW
20 2
10
50 3
20
100
50
150
100
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Basel II – Specialised Lending Capital Charges
Source: Text
Basel II
Standardised bank risk
weights (¶ 80)IRB bank risk weights (¶¶ 275-284)
Specialised Lending – In a Nutshell
%
Basel I
Risk
Weight
All 100Five Classes of Specialised Lending:
• Project finance
• Object finance
• Commodities finance
• Income-producing real estate
• High-volatility commercial real estate
Generally: For exposures other than HVCRE,
banks that do not meet requirements for estimation
of PD will map internal grades to five supervisory
categories (70% for strong, 90% for good, 115% for
satisfactory, 250% for weak and 0% for default) (¶
275)
At national discretion, supervisors may allow 50%
for “strong” and 70% for “good” if remaining
maturity less than 2.5 years or supervisor
determines underwriting or other risk characteristics
are substantially stronger (¶ 277)
All 100
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Basel II – Off Balance Sheet Items
Off Balance Sheet Items – Standardised Banks (¶¶ 82-89)
Off-balance sheet items converted into credit exposure equivalents using credit conversion factor (CCF)
Commitments
• Original maturity of up to one year: 20% CCF
• Original maturity in excess of one year: 50% CCF
• Unconditionally cancellable: 0% CCF
Source: Text
Securities lending
• Lending of bank securities or posting as collateral (including repo and reverse repo transactions): 100% CCF
Letters of Credit
• Short-term self-liquidating trade letters of credit: 20% CCF
Other commitments
• As specified in Basel I
Failed transactions
• As specified by national regulators
• Effect of failed transactions on off-balance sheet items subject to Basel/IOSCO review
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Basel II – Off Balance Sheet Items
Off Balance Sheet Items – IRB Banks (¶¶ 310-316)
Off-balance sheet items converted into exposure at default (EAD) input using credit conversion factor (CCF) under either foundation approach to EAD or advanced approach to EAD:
Source: Text
Foundation approach to EAD
• Types of instruments and CCFs same as for standardised approach (¶¶ 82-89) except for commitments, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs)
• CCF of 75% applicable to commitments, NIFs and RUFs regardless of maturity
• CCF of 0% if commitment unconditionally cancelable
Advanced approach to EAD
• Banks allowed to use own estimates of CCF if allowed to use internal estimates for EAD (¶¶ 474-478)
• But 100% CCF if required under foundation approach to EAD
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Basel II – Equity Capital Charges
1. For banking book exposures. National supervisors may exempt from IRB treatment for up to ten years particular equity exposures held at publication date of Basel II accord (¶ 267)
2. CRD has preferential treatment vs. Basel II Accord; supervisors may increase to 150% for venture capital and private equity investments (¶ 80
3. Inputs: average rating agency PDs, LGD of 90%, supervisory value for EAD and M of 5.
4. Under Basel II (¶ 353) a floor risk weight of 200% applies to listed equities
Source: Text
Basel II 1
Standardised bank
risk weights
Simple
Model 2
Equity – In a Nutshell
%
Basel I
Type of
exposure
Risk
Weight
Non-consol
equity100 Corporates
Banks
100 2
100
Securities
firms100
Co
mp
an
y
DaimlerChrysler
Siemens
Fresenius Med. Care
GE
Sony
Vivendi Universal
Bertlesmann
PD/LGD
Model 3Rating
290
290
290
290
290
290
290
92 4
81 4
264
32 4
82 4
195 4
120 4
A3/BBB
Aa3/AA-
Ba1/BB+
Aaa/AAA
A1/A
Baa3/BBB-
Baa1/BBB+
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Basel II – Equity Capital Charges
IRB Banks – Three Approaches
Simple risk method (¶¶ 344-345)
• CRD: 190% risk weight for diversified private equity exposures (not in Basel II)
• CRD: 290% risk weight for publicly traded exposures (300% in Basel II)
• CRD: 370% risk weight for all other holdings (400% in Basel II)
Source: Text
Internal models method (¶¶ 346-349)
• Taken from VaR models as 12.5 times difference between
99% percentile one-tail quarterly return and
Risk free rate over long-term sample period
• Floor: capital charge under simple risk model but using 200% (traded) and 300% (not traded)
PD/LGD method under CRD (¶¶ 350-361)
• Generally, use normal corporate exposure formulas if possible (results in risk weights substantially below 200% and 300% floor in Basel II)
If bank does not have sufficient information to use definition of default, then apply scaling factor of 1.5 to risk weights
Unfunded credit protection on equity exposure recognised, subject to LGD of 90%, with reduced LGD of 65% for private equity exposures
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Basel II – Non-Performing Loan Capital Charges
Source: Text
Basel II/CRD
Non-Performing Loans (NPLs) – In a Nutshell
%
Basel I
No uniform rules:
• In Europe –
combination of
general and specific
provisions
• In US five-tier
ranking system
derives capital
Standardised bank risk weights (¶¶ 75-78) IRB bank risk weights
• Generally: Unsecured portion of exposure
past due for more than 90 days, net of
specific provisions, risk weighted as follows:
150% when specific provisions less than
20% of outstanding amount of exposure
100% when specific provisions 20% or
more of outstanding amount of exposure
100% when specific provisions 50% or
more of outstanding amount of exposure,
with supervisory discretion to reduce risk
weight to 50% in such case
• Residential Mortgages: risk weighted at
100% net of specific provisions; at national
discretion risk weight reduced to 50% of
specific provisions 20% or greater
• Commercial Mortgages: unexpected loss
risk-weighted at 100%
• Generally: capital requirement for defaulted
exposure is equal to greater of zero and
difference between LGD (described in para.
468) and bank’s best estimate of expected
loss (¶ 272)
• Under IRB approach, for asset classes other
than securitisation, bank must compare (i)
total amount of eligible provisions with (ii)
total expected losses and deduct excess (if
any) of expected losses over provisions (¶ 43,
¶¶ 380-383)
• For securitisation exposures or the PD/LGD
approach for equity exposures, bank must
first deduct EL amounts under paras. 563 and
386, respectively (¶ 43)
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Basel II – Non-Performing Loan Capital Charges
Non-performing loans – Generally
Essentials:
• Non-performing loan under Basel II is any loan that is past due for more than 90 days, but subject to national variation
• For purposes of defining secured portion of non-performing loan, eligible collateral and guarantees will be recognised as under CRM rules for performing loans
• Capital charges depend on level of specific provisions held against loan
Source: Text 34
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Basel II – Non-Performing Loan Capital Charges
Non-performing loans – Standardised Approach
Unsecured non-performing loan:
• Unsecured portion of non performing loan will be risk-weighted as follows:
150% when specific provisions less than 20% of outstanding amount of exposure
100% when specific provisions 20% or more of outstanding amount of exposure
100% when specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case
Source: Text
Secured non-performing loan:
• Qualifying residential mortgage loans risk weighted at 100%, net of specific provisions. If such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion
• Commercial mortgages: unexpected loss risk weighted at 100%
• Non-performing loans fully secured by forms of collateral not recognized under Basel II (eligible financial collateral) risk weighted at 100% when provisions reach 15% of outstanding amount of loan
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Basel II – Non-Performing Loan Capital Charges
Non-performing loans – IRB Approach
General Rules:
• Capital charges to cover unexpected losses
• Bank must cover expected losses with specific provisions
Source: Text
Consequences:
• Fixed LGD at 45% for non-retail assets and senior exposures may result in risk weights as follows:
565% when no specific provisions of outstanding amount of exposures
400% when specific provisions 20% of outstanding amount of exposure
0% when the specific provisions 50% or more of outstanding amount of exposure
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Basel II – Non-Performing Loan Capital Charges
Non-performing loans – sample capital calculation
€100 million NPL
Source: Text
Specific Provisions 0% 30% >50% 80%
Net exposure 100 70 <50 20
Capital Charges
Basel I 8.0 5.6 3.2 1.6
Standardised Approach 12.0 5.6 1.6 0.8
IRB Approach 45.0 15.0 0.0 0.0
Advanced IRB Approach 30.0 0.0 0.0 0.0
Risk Weights
Basel I 100% 100% 100% 100%
Standardised Approach 150% 100% 50% 50%
IRB Approach 565% 270% 0% 0%
Advanced IRB Approach 380% 0% 0% 0%
Assumptions:
• Supervisory discretion allows use of 50% risk weight if exposure has specific provision of 50% or better
• LGD in Advanced IRB Approach is 30%
• IRB Approach and Advanced IRB Approach are approximated
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Basel II – Non-Performing Loan Capital Charges
Non-performing loans – Originator´s point of view and market outlook
Motivations to sell non-performing loan portfolios:
• Reduce capital supporting non-performing loans
• Reduce negative carry by eliminating financing needs
• Shift capital and resources into more profitable businesses
• Optimize bank’s balance sheet
• Improve bank’s credit ratings
• Reduce operating costs due to smaller work-out departments
Source: Text
Market outlook
• Basel II will motivate banks to sell NPLs
• German NPL market estimated between €160 billion and €300 billion (Boersenzeitung 18.2.2005)
• German NPL market development to increase to estimated €20 billion this year and possible average of €15 billion per year after 2007 (Boersenzeitung18.2.2005)
• No capital charges required if investors not banks
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Basel II – Credit Risk Mitigation
1. Same as simple approach under Basel II for standardised banks (i.e., substitution)
2. Maturity of < one year
3. Subject to considerable change due to Basel/IOSCO review, including introduction of “double default” recognition for certain exposures rather than substitution approach
Source: Text
Basel II
Credit Risk Mitigation (CRM) – In a Nutshell
%
Basel I
Type of
exposure
Risk
Weight1
OECD
sovereign0
OECD
bank20
Non-OECD
bank 220
Standardised bank risk weights3
• Simple approach: Risk weight of CRM is
substituted for risk weight of unsupported
exposure
• Comprehensive approach: Adjust value of
both amount of exposure and value of CRM
with either supervisory or own-estimate
“haircuts”; adjust for maturity and currency
mismatches
IRB banks
• Generally: CRM reduces PD or
LGD inputs
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Basel II – Credit Risk Mitigation
Credit Risk Mitigation – General Rules (¶¶ 109-210)
Protection
Buyer
• Determine capital as provided on following page, except determine capital pursuant to securitisation rules (following) if credit risk protection tranched(e.g., purchased derivatives
Protection
Seller
• Treat as cash position in underlying
Specific
Adjustments
• First to default and second to default protection (¶¶ 207-210)
• Proportional cover (¶ 190(c), ¶ 198))
• Maturity and currency mismatches: size of haircut depends on type of instrument, type of transaction and frequency of mark-to-market and remargining (¶ 135)
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Basel II – Credit Risk Mitigation
Credit Risk Mitigation – Capital Calculation Method
Standardised
Banks
• Simple Approach (¶ 129, ¶¶182-185) Risk weight of CRM substituted for risk weight of unsupported exposure
(¶ 129) Subject to floor of 20%, with exceptions, e.g., core market participant
floor is 0%, subject to certain conditions (¶ 183)• Comprehensive Approach (¶¶ 130-138)
Supervisory or own-estimate haircuts adjust both amount of exposure and value of collateral received (¶ 130)
Further adjustments for maturity mismatches (square root of time formula) and currency mismatches (¶ 135)
• Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review (¶¶ 140-142, ¶¶189-193)
• VaR models permitted subject to supervisory approval (¶ 138, ¶¶ 178-181)• On-balance sheet netting recognised (¶ 139, ¶ 188)
IRB Banks• Generally
Collateral reduces PD or LGD input (reducing required capital) (¶¶ 289-307)
• Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review (¶ 301)
• VaR models permitted subject to supervisory approval (¶ 292)• On-balance sheet netting recognised (¶ 292)
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Basel II – Credit Risk Mitigation
Credit Risk Mitigation - Eligible Financial Collateral
Eligible
Collateral
(¶¶ 145-146)
• Cash and gold
• Rated debt securities (sovereign BB- or higher; other BBB- or higher)
• Senior, unrated debt securities issued by bank if listed on recognised exchange and all other bank issues are BBB- or higher
• Equities included in main index or listed on recognised exchange
• UCITS/mutual funds where price quoted daily and UCITS/fund only invests in above instruments
• For IRB banks only: receivables, real estate and other collateral meeting minimum requirements (¶ 289)
• All items recognised as collateral in banking book can also be recognised in trading book
No
correlation
• Collateral must not have material positive correlation with underlying exposure (¶ 124)
First-to-
Default
Second-to-
Default
• First-to-default: recognised if bank obtains protection for entire basket, credit event triggers contract, and notional of underlying less than contract (¶¶ 207-208); regulatory capital relief for asset with lowest risk-weight in the basket
• Second-to-default: recognised if bank obtains first-to-default protection as above or if one asset already defaulted (¶¶ 209-210)
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Basel II – Credit Risk Mitigation
Credit Risk Mitigation - Other Criteria
Recognition of credit derivatives (¶¶ 191-194)
• Legally binding documentation; direct claim on provider; irrevocable and unconditional
• Mandatory credit events not determined solely by protection provider: (a) failure to pay, (b) insolvency and (c) Restructuring (recognition up to 60% of underlying if no restructuring)
• If asset mismatch, underlying/reference obligation must be pari passu and protection must contain cross-default/cross-acceleration
• Cash settlement permitted if robust valuation process
• If protection purchaser’s right to transfer underlying subject to obligor consent, may not be unreasonably withheld
Source: Text
Eligible protection providers (¶ 195)
• Sovereigns, public sector entities, and banks and securities firms with lower risk weighting than underlying exposure (not SPEs)
Counterparty risk charges for OTC derivatives (¶¶ 186-187)
• Counterparty credit risk charge = [(RC + add-on) – CA] x r x 8% where: RC=replacement cost; add-on= as determined under Basel I; CA=volatility adjusted collateral amount; r=risk weight of counterparty
• Being changed to model-based approach under Basel/IOSCO review
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Basel II – Securitisation Capital Charges
Source: Text
Basel II
Securitisation – In a Nutshell
%
Basel I
Type of
exposure
Risk
Weight1
Generally 100
First loss Deduct
Unfunded <
1 year0
Standardised banks
Risk weights based on rating of
position. If exposure unrated, then
deduct from capital except in case of:
• Most senior exposure (look-through to
average risk weight of pool)
• Second loss position or better (look-
through to higher of 100% and highest
risk weight of pool)
• Liquidity facilities (credit conversion
factors depending on type and length of
liquidity commitment)
IRB banks
Hierarchy of approach:
• If exposure rated must determine risk
weight based on ratings based approach
(RBA)
• If unrated exposure to ABCP conduit may
use internal assessments approach (IAA) if
conditions met
• If unrated exposure may use supervisory
formula approach (SFA) if can determine
inputs (including using top down
methodology)
• If unrated exposure and RBA, IAA and SFA
unavailable, may use exceptional “look
through” approach with regulator consent
on temporary basis for liquidity facilities
• Otherwise, must deduct unrated exposure
from capital
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Basel II – Securitisation Capital Charges
Securitisation – Standardised Banks – Ratings Based Approach
%
1. Originating banks must deduct BB+ to BB- exposures (¶ 569)
Source: Text
Long Term RatingsShort Term Ratings
Standardised bank risk weights (¶ 567) Standardised bank risk weights (¶ 567)
Exte
rnal R
ati
ng
AA- or above
A
BBB
BB+ to B-
Below B-
Unrated2
20
50
100
350 1
Deduct
Deduct
Exte
rnal R
ati
ng
A-1/P-1
A-2/P-2
A-3/P-3
All other ratings/
unrated
20
50
100
Deduct
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Basel II – Securitisation Capital Charges
Securitisation – Standardised Banks
Except as provided below, unrated securitisation exposures must be deducted (¶ 567)
Most senior exposures (¶¶ 572-573)
• If the most senior tranche is unrated, the bank that holds or guarantees that position may “look through” to the underlying pool to determine the risk weight (and may assign a risk weight equal to average of risk weight assigned to exposures in underlying pool), provided that the composition of the pool is known at all times
Second loss positions or better (¶¶ 574-575)
• Qualifying exposures provided by sponsor banks in ABCP programs that are in second loss position or better may apply a risk weight equal to the greater of (x) 100% and (y) the highest risk weight assigned to any exposure in underlying pool, but only if:
The first loss position provides significant credit protection
The associated credit risk is investment grade or better
The bank holding the exposure does not hold the first loss position
Eligible liquidity facilities (¶ 576)
• Banks may apply risk weight to eligible liquidity facilities equal to highest risk weight assigned to any exposure in underlying pool
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Basel II – Securitisation Capital Charges
Securitisation – Standardised Banks
Liquidity facilities (¶¶ 579-580)
Generally
• 20% credit conversion factor (CCF) for eligible liquidity commitments with an original maturity of one year or less
• 50% CCF for eligible liquidity commitments of more than one year
• 100% CCF for all other liquidity commitments, including rated commitments
Increase from 0% under Basel I
• Regulators believe liquidity absorbs more than just liquidity risks
Credit conversion factor of 0% theoretically possible if:
• Commitment qualifies as “eligible liquidity”
• Commitment can only be drawn if general market disruption (i.e., where more than one SPE across different transactions is unable to roll over maturing commercial paper – i.e., not as result of impairment in credit quality of specific SPE or its pool)
• Commitment must be secured by underlying assets and rank pari passu with conduit’s securities
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Basel II – Securitisation Capital Charges
Securitisation – Standardised Banks
“Eligible Liquidity” (¶ 578)
Documentation must identify and limit circumstances of draw, and amounts drawn must be limited to amount likely to be repaid from underlying assets and seller-provided credit enhancement
No incurred losses should be covered and draw should not be automatic
Asset quality test should not cover defaulted assets as defined in paragraphs 452-459 (including receivables more than 90 days past due unless extended up to 180 days by national regulators); if funding based on rating of underlying asset, it must be rated at least investment grade at time of draw
Facility cannot be drawn after all applicable credit enhancement to which liquidity facility has access has been exhausted
Repayment of draws must not be subordinated to interests of any conduit security holder
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Basel II – Securitisation Capital Charges
Securitisation – Standardised Banks
Overlapping Exposures (¶ 581)
• For example, if conduit sponsor provides programme-wide liquidity and credit enhancement to ABCP conduit:
If funding one exposure precludes funding the other exposure, sponsor need not hold capital against both exposures
Instead, for overlapping portion sponsor should hold capital against exposure with highest credit conversion factor
• Query
How to allocate partial credit enhancement
How to allocate programme-wide credit enhancement
Eligible servicer advances (¶ 582)
• Servicers may contractually agree to advance cash to insure uninterrupted payments to investors if full reimbursement right is senior to other claims
• At national discretion, CCF of 0% for facility cancellable without prior notice
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Options
• IRB bank must calculate capital on basis of:
External ratings pursuant to ratings based approach (rba)
Inputs into supervisory formula (sf) approach
Internal assessments approach (IAA)
• Cap: If IRB would require more capital for securitisation exposure than had the position not been securitised, bank may use IRB capital requirement for underlying exposures (¶ 610)
Hierarchy (¶ 609)
• IRB bank must use ratings based approach (RBA) to calculate capital if external rating or inferred rating available
• Where RBA not available, bank may use SF or IAA if available
• Where neither RBA nor SF or IAA are available, bank may use look-through approach (see below) in paragraph 639
• Otherwise, position must be deducted
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks – Ratings Based Approach
%
Source: Text
Long Term RatingsShort Term Ratings
IRB bank ratings-based risk weights (¶¶ 616) IRB bank ratings-based risk weights (¶¶ 615)
Exte
rnal R
ati
ng
Exte
rnal R
ati
ng
A-1/P-1
A-2/P-2
A-3/P-3
All other
ratings/
unrated
7
12
60
Deduct
Most senior Base case Non-granular
12
20
75
Deduct
20
35
75
Deduct
Most senior Base case Non-granular
7
8
10
12
15
18
20
25
35
AAA
AA
A+
A
A-
BBB+
<BB- or unrated
BBB
BBB-
BB+
BB
BB-
12
20
35
20
35
50
35
35
50
60
100
250
75
100
250
75
100
250
425
650
Deduct
425
650
Deduct
425
650
Deduct
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
IRB bank may use IAA if conditions satisfied
• Only available for exposures to ABCP programmes
• Internal assessments mapped to equivalent external ratings and exposures assigned resulting risk weights
• Supervisor may suspend bank’s use of IAA until deficiencies (if any) are corrected
Conditions
• ABCP issued by conduit must be externally rated
• Internal assessment must be based on ratings criteria for each asset type and be equivalent of investment grade when exposure is funded
• Bank’s supervisors must be satisfied that internal ratings meet required criteria in paragraphs 90-108 and with relevant external ratings criteria
• Bank must show that internal criteria matches external criteria
Internal Assessments Approach (¶¶ 619-622)
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Conditions (cont’d)
• Supervisor may, if warranted, disallow any seller provided recourse, guarantees or excess spread or any other first loss enhancement
• Internal assessment must identify gradations of risk that can be mapped to external ratings gradations
• Internal assessment process, and particularly stress factors, must be at least as conservative as publicly available ratings criteria from rating agencies rating ABCP programme:
Bank must choose most conservative of two or more external criteria if two or more criteria apply
Bank must not choose only ratings agencies with less restrictive methodologies to rate ABCP programme and must keep up with methodology changes
Bank cannot use a non-public ratings methodology but may consider more conservative non-publicly available methodology
For new or unique transactions, bank may discuss applying IAA with supervisor
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Conditions (cont’d)
• Internal and external auditors, a rating agency, or bank’s internal credit review or risk management function must perform regular reviews of internal assessment process; if internal reviews are used, they must be independent of ABCP business line
• Bank must track and adjust internal processes over time
• ABCP programme must have credit and investment guidelines (which should cover issues specified by supervisor)
• Credit analysis of seller’s risk profile must be performed
• ABCP programme must have minimum asset eligibility criteria that exclude defaulted assets, limit concentrations, limit asset tenor, etc.
• ABCP programme should have collections processes established that consider operational capability and credit quality of servicer, lockbox arrangements, etc.
• All sources of risk must be considered (including credit and dilution)
• Structural features must be included such as wind down events
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Capital charge determined under supervisory formula (see following page) on basis of five inputs (with 56 basis point floor):
• Regulatory capital of exposure if held on balance sheet (KIRB
)
• Degree of credit enhancement supporting exposure (L)
• Exposure’s thickness (T)
• Effective number of exposures in the securitised pool (N)
• Pool’s exposure-weighted average loss given default (LGD)
Definition of KIRB
• KIRB
is ratio (expressed as a decimal) of
The IRB capital requirement for the underlying exposures in the pool to
The notional amount of such exposures
• For structures involving SPE, all SPE assets must be included in pool, including residual interests (such as a cash collateral account)
• Reserves against assets in pool do not reduce notional amount of the pool in determining KIRB, but can count as credit enhancement
Supervisory formula approach (¶¶ 623-636)
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
• IRB Capital charge = greater of (a) 0.0056 and (b) (S [L+T] – S [L])
• S[L] = L if L<= KIRB, else,
• S[L]= KIRB +K[L] –K[KIRB] +(d. KIRB /ώ )(1- exp(ώ *(KIRB – L)/ KIRB))
Where
• h=(1- KIRB /LGD)N
• c= KIRB /(1-h)
• v =((LGD- KIRB) KIRB +0.25(1-LGD) KIRB )/N
• f=((v + KIRB 2 )/(1-h) – c 2 ) + (((1- KIRB) KIRB – v )/(1-h) τ )
• g=((1-c)c)/f -1
• a=gc
• b=g(1-c)
• d=1-(1-h)(1-Beta[KIRB, a,b])
• K[L]=(1-h)((1-Beta[L,a,b]L+ Beta[L,a+1,b]c)
• Beta [L,a,b] refers to the cumulative beta distribution with
• parameters a and b evaluated at L,
• τ =1000 and ώ = 20
Supervisory Formula (¶¶ 624-626):
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Generally
• Eligible” liquidity facilities only drawn in event of general market disruption (as defined in ¶ 580) have a 20% CCF
• Otherwise, all liquidity facilities have 100% CCF; 100% CCF permits IRB banks to provide multi-year liquidity or “structured” liquidity without additional capital requirements
Determination of capital
• If facility is externally rated, bank may rely on rating provided it uses 100% CCF
• If facility is unrated, bank may use IAA if qualifying
• If facility is unrated and IAA unavailable, bank must determine KIRB either using “bottom-up” approach or “top-down” approach and apply SF
“Look-through” procedure
• If not practical to use “bottom-up” or “top-down”, bank may, on an exceptional basis and subject to supervisory approval, temporarily apply highest risk weight of pool under standardised approach to individual exposures covered by eligible liquidity facility
• In such a case, the bank must use 50% CCF for commitments of one year or less and 100% for commitments in excess of a year, or 20% CCF for market disruption liquidity
Liquidity facilities (¶¶ 637-639)
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Top-Down Approach (¶¶ 362-373)
• For use in determining KIRB in SF
• Generally
Top-down approach available provided bank’s programme complies with criteria for eligible receivables and minimum operational requirements
Intended mainly for asset-backed securitisation exposures, but may also be used for appropriate on-balance sheet exposures
Eligible Corporate Receivables (¶¶ 241-243)
• Eligible corporate receivables must satisfy following conditions for application of top-down approach:
Bank has not directly or indirectly originated receivables (and has purchased them from unrelated third parties)
Receivables generated on arms length basis (and not subject to inter-company contra accounts)
Purchasing bank must have claim on all proceeds from pool or a ratable interest
National supervisors to develop concentration limits
• Recourse to seller does not automatically disqualify transaction as long as cash flows from assets are primary source of repayment (plus certain other requirements)
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Basel II – Securitisation Capital Charges
Securitisation – IRB Banks
Inferred Ratings (¶¶ 617-618)
• When following conditions are met, bank must attribute inferred rating to unrated exposure:
Reference rated exposure must be subordinate in all respects to unrated exposure
Credit enhancements must be taken into account in determining subordination (for example, if reference position benefits from third party guarantee but unrated position does not, then latter may not be assigned inferred rating)
Maturity of reference position must be equal to or longer than that of unrated position
Inferred rating must be updated continuously to reflect changes in external rating of reference position
External rating must satisfy general requirements for recognition of external ratings in securitisation transactions
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Basel II – Early Amortisation Structures
Securitisation – Early Amortisation Provisions
Originating banks are required to hold capital against investors’ interests in a securitisation when
• It sells assets into a structure containing an early amortisation feature and
• The exposures sold are of a revolving nature
Banks are not required to apply the early amortisation rules to:
• Replenishment structures where the underlying exposures do not revolve and the early amortisation ends the bank’s ability to add new exposures
• Transactions of revolving assets containing early amortisation features that mimic term structures (i.e., where the risk does not return to the originating bank)
• Structures securitising credit lines where the investors remain liable to fund future draws by borrowers after amortisation events
• The early amortisation clause is triggered solely by events unrelated to the performance of the pool or the originator
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Basel II – Early Amortisation Structures
Securitisation – Early Amortisation Provisions
Applicable capital charge
• equals (1) the notional amount of the investors’ interest times (2) the applicable credit conversion factor times (3) the risk weight for the underlying credits
• But capitalised assets (such as future margin income) are treated separately and will typically be deducted from capital
Capped at the greater of:
• The capital required for retained securitisation exposures
• The capital required had the exposures not been securitised
Applicable credit conversion factor based on whether
• The amortisation is “controlled” or “non-controlled”
• The securitised exposures are (i) uncommitted retail credit lines that are unconditionally cancellable or (ii) any other type of exposure
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Basel II – Early Amortisation Structures
Securitisation – Early Amortisation Provisions
A “controlled” amortisation must meet the following conditions:
• The originator has in place a capital/liquidity plan to ensure it has sufficient capital and liquidity if early amortisation occurs
• Throughout the transaction, including the amortisation period, there is a pro rata sharing of interest, principal, expenses, losses and recoveries based on the balances of receivables outstanding at the beginning of each month
• The amortisation period fixed by the bank is sufficient for 90% of the total debt outstanding at the beginning of the period to have been repaid or to have been recognised as in default
• The pace of repayment is not any more rapid than would be allowed under straight-line amortisation over the period fixed as described above
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Basel II – Early Amortisation Structures
Securitisation – Early Amortisation Provisions
Credit conversion factors (CCF)
• For structures with controlled amortisation
0% to 40% for uncommitted retail lines (see next page)
90% for committed retail lines
90% for all non-retail lines (whether committed or uncommitted)
• For structures with non-controlled early amortisation
0% to 100% for uncommitted retail lines (see next page)
100% for committed retail lines
100% for all non-retail lines (whether committed or uncommitted)
For uncommitted retail credits
• Calculate two points:
The point at which the bank is required to trap excess spread (or 4.5% above the early amortisation trigger if no trapping)
The three month average excess spread for the transactions
• Divide the excess spread level by the trapping point and look up the CCF for the transaction on the following page
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Basel II – Early Amortisation Structures
Securitisation – Early Amortisation Provisions
3 month average excess
spread as % of trapping
point
CCF for Uncommitted
Retail Exposures in
Controlled Structures
CCF for Uncommitted
Retail Exposures in Non-
Controlled Structures
133.33% or more 0% 0%
Less than 133.33% to 100% 1% 5%
Less than 100% to 75% 2% 15%
Less than 75% to 50% 10% 50%
Less than 50% to 25% 20% 100%
Less than 25% 40% 100%
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Basel II – Trading Book Capital Charges
Trading Book – In a Nutshell 1
1. Paragraph references in materials below on trading book are to 1996 Market Risk Amendment (MRA) unless otherwise noted
Basel I (1996 Market Risk
Amendment)Basel II (MRA; Accord ¶¶ 864-718)
Minimum capital requirement:
• Credit risk requirements under regulatory capital rules, excluding debt and equity securities in trading book and all positions in commodities, but including credit counterparty risk in trading book or banking book, plus
• Capital charges for specific risk and general market risk under either standardised measurement method or internal models method (or combination thereof)
Essentially unchanged, except for revisions to:
• Definition of trading book: “positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book”
• Basic requirements for trading book treatment: clearly documented trading strategy; positions actively monitored and managed on trading desk; position limits set and monitored; positions marked to market at least daily; positions reported to senior management
• Capital charges for specific risks in connection with interest rate risk (see below)
• Specific risk capital charge offsets for positions hedged by credit derivatives (see below)
• New counterparty credit risk charges for OTC derivatives, repo-style and other transactions booked in trading book, and adjusted add-on factors for single name credit derivatives (see below)
Basel/IOSCO review will change trading book treatment significantly
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Basel II – Trading Book Capital Charges
Capital Requirement
Definition of Capital (MRA Intro., II.1 – I.2)
• At discretion of national regulators banks may employ third tier of capital for sole purpose of meeting proportion of capital requirements for market risks
• Tier 3 capital limited to 250% of bank’s tier 1 capital required to support market risks; tier 2 capital may be substituted for tier 3 capital up to same 250% limit subject to overall limits for tier 2 capital in Basel II Accord
• For subordinated debt to be eligible as tier 3 capital it must be available to absorb losses in event if insolvency and must at minimum:
Be unsecured, subordinated and fully paid up
Have original maturity of at least two years
Not be repayable prior to maturity date unless bank’s supervisor agrees
Be subject to lock-in clause stipulating that neither interest nor principal may be paid at maturity if payment would cause bank to fall below minimum capital requirements
Calculation of Capital (MRA Intro., II.3 – I.4)
• Bank must first calculate capital for credit risk, and only afterwards calculate market risk requirement
Capital requirement to be met on continuous basis – at close each business day (MRA Intro., I.14)
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Interest rate risk
Specific risk (MRA Part A.1.I; Accord ¶ 710)
• Specific risk charge:
Source: Text
• Offsetting restricted to matched positions in identical issue (including positions in derivatives); no offsetting if issuer same but not same issue
• “Government” category includes all forms of government paper
• “Qualifying” category includes securities rated investment grade by at least two recognised rating agencies or (subject to supervisory approval) unrated but either of comparable investment quality (standardised banks) or rated equivalent by bank’s internal systems and exchange listed (IRB banks) (Accord ¶ 712)
• National regulatory may impose higher specific risk charge on “other” category and/or disallow offsetting
Government:
AAA to AA- 0.00%
A+ to BBB-
0.25% (residual term to final maturity 6 months or less)
1.00% (residual term to final maturity between 6 and 24 months)
1.60% (residual term to final maturity exceeding 6 months)
Other rating 8.00%
Qualifying
0.25% (residual term to final maturity 6 months or less)
1.00% (residual term to final maturity between 6 and 24 months)
1.60% (residual term to final maturity exceeding 6 months)
Other 8.00%
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Interest rate risk
Generally
• Two methods: maturity method and duration method
• Capital charge is sum of four components: net short or long position; small proportion of matched positions in each time band (vertical disallowance); larger proportion of matched positions across different time bands (horizontal disallowance); net charge for positions in options
Maturity method
• Opposite positions of same amount in same issue may be omitted from framework
• Positions weighted by prescribed price sensitivity factor
• Partial offset (10% capital charge) for weighted longs and shorts in each time band
• Two rounds of horizontal partial offsetting between time bands pursuant to prescribed scale
Duration method
• Calculate price sensitivity on basis of prescribed interest rate change depending on maturity
• Slot resulting sensitivity measures into duration-based ladder within time bands
• Subject long and short positions to 5% vertical disallowance
• Carry forward net positions for horizontal offsetting as above
Source: Text
General market risk (MRA Part A.1.II)
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Interest rate risk
Interest rate derivatives (MRA Part A.1.III)
• Convert derivatives into positions in relevant underlying subject to specific and general market risk charges as above
• Futures: treated as combination of long and short position in notional government security
• Swaps: treated as two notional positions in government securities with relevant maturities
• No specific risk charge for most interest rate derivatives
• General market risk charge generally same as for cash positions, subject to exemption for very closely matched positions in identical instruments
Counterparty credit risk charge add-on factors for single name credit derivative (Accord ¶ 707)
• If reference asset is qualifying: 5% for protection buyer and 5% for protection seller
• If reference asset is not qualifying: 10% for protection buyer and 10% for protection seller
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Interest rate risk
Offsetting for interest rate derivatives (MRA Part A.1.III)
• Banks may exclude long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity, and may fully offset a matched position in a future or forward and its underlying
• If choice of underlying deliverable instruments (e.g., cheapest-to-deliver), offset only permitted if future or forward move in close alignment
• Offset may be allowed for opposite positions in same category of instruments if same underlying, same nominal value and same currency – e.g., futures (identical products maturing within 7 days of each other); swaps and forward rate agreements (identical reference rate and coupon within 15 basis points); limits on next interest fixing date
• No offsetting for positions in different currencies
But modified by Accord (see next page)
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Interest rate risk
Specific risk capital charges for positions hedged by credit derivatives (Accord ¶¶ 713-718)
• No specific risk capital charge for either side of the position if values of full legs always move in the opposite direction and generally to the same extent (e.g., identical instruments; long cash position hedged by total rate of return swap with exact match between reference obligation and underlying)
• 80% specific offset recognised when value of two legs always moves in opposite direction but not broadly to same extent (e.g., long cash position hedged by credit default swap or credit-linked note with exact match between reference obligation and underlying); to extent that transaction transfers risk, 80% risk offset for side with higher capital charge and zero specific risk requirement on other side
• Partial allowance where value of two legs usually moves in opposite direction (e.g., asset mismatch between reference and underlying)
• Otherwise, specific risk capital charge for both sides of transaction
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Equity position risk
Specific risk and general market risk (MRA Part A.2.I)
• Specific risk charge
Defined as bank’s gross equity position, calculated on national market-by-market basis
8% unless portfolio both liquidity and well-diversified, in which case 4%
• General market risk charge
Defined as difference between sum of longs and sum of shorts, also calculated on national market-by-market basis
8%
Equity derivatives (MRA Part A.2.II)
• Convert derivatives into positions in relevant underlying
• Matched positions may be fully offset
• Index risk: Further capital charge of 2% against net long or short position in index contract comprising diversified portfolio of equities to cover factors such as execution risk
• Arbitrage: Additional 2% capital charge in qualifying futures-related arbitrage strategies may be applied only to one index with opposite position exempt from capital charge
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Foreign exchange risk
Two processes (MRA Part A.3)
• Measure exposure in single currency position
• Measure risks inherent in mix of long and short positions in different currencies
Measuring positions in single currency (MRA Part A.3.I)
• Measured by summing: net spot position (including interest earned but not received, expenses accrued, and expenses not yet accrued but certain); net forward position; guaranties certain to be called and likely to be irrevocable; net future income/expenses not yet accrued but already fully hedged (at bank discretion); net delta-based equivalent of total book of foreign currency options
• Positions taken to hedge capital ratio may be excluded if “structural” (non-dealing) nature, applied consistency, does no more than protect bank capital ratio
Measuring foreign exchange risk (MRA Part A.3.II)
• Two alternatives:
“shorthand” method treating all currencies equally – capital charge is 8% times overall net open position determined by converting nominal amount (or net present value) of net position in each currency into reporting currency
internal models approach (see below)
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Commodities risk
Generally (MRA Part A.4)
• Defined as physical product which is or can be traded on a secondary market
• More complex and volatile, and less liquid
• Variety of additional risks, including basis risk (risk that relationship between prices of similar commodities varies over time); interest rate risk (risk of cost of carry); forward gap risk (risk that forward price may change other than due to interest rate changes)
• Three options: models (see below); measurement system; simplified approach
Measurement system (maturity ladder) approach (MRA Part A.4.II)
• Express commodity position in standard unit of measurement (barrel, etc.)
• Convert net position at current spot rates into national currency
• Assess capital charge against matched long and short positions in specified time bands and specified spread rates
• Residual net positions in nearer time banks may be carried forward to offset exposures in later time bands, subject to surcharge equal to 0.6% of net position carried forward
• 15% capital charge against resulting long or short position
Simplified approach (MRA Part A.4.III)
• Same capital charge for directional risk as under measurement approach
• Additional capital charge of 3% of gross positions in each commodity for basis risk, interest rate risk and forward gap risk
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Basel II – Trading Book Capital Charges
Standardised Measurement Method – Options
Generally (MRA Part A.5)
• Banks with purchased options only permitted to use simplified approach
• Otherwise, use either one of the intermediate approaches (see below) or internal model (see below)
Simplified approach (MRA Part A.5.I)
• Long cash and long put, or short cash and long call: Capital charge is market value of underlying multiplied by sum of specific and general market risk charges for underlying less amount option is in money (if any) bounded by zero
• Long call or long put: Capital charge is lesser of (a) market value of underlying multiplied by sum of specific and general market risk charges for underlying and (b) market value of option
Delta-plus (intermediate) approach (MRA Part A.5.II)
• Options reported as position equal to market value of underlying multiplied by delta
• Delta-weighted capital charge: Determined pursuant to Parts A.1 through A.4 depending on whether option underlying is debt security or interest rate instrument (Part A.1), equity (Part A.2), foreign exchange and gold (Part A.3) or commodities (Part A.4)
• Additional capital charges for gamma (measuring rate of change of delta) and vega(measuring sensitivity of value of option to change in volatility)
Scenario (intermediate) approach (MRA Part A.5.II) (for more sophisticated banks)
• Capital charge determined by calculating changes in option value at various points along “grid” of ranges of changes in option portfolio’s risk factors
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Basel II – Trading Book Capital Charges
Internal models method (MRA Part B)
Generally (MRA Part B.1)
• Conditional upon explicit approval of supervisor
Conditions to use of internal model (MRA Parts B.2 – B.7)
• Qualitative standards: independent risk control unit; integration with day-to-day risk management of bank; trading limits; compliance function; stress-testing; back-testing; external validation; independent review
• Quantitative standards: value-at-risk calculated daily (to 99th percentile, one-tailed confidence interval; with instantaneous price shock equivalent to 10 day movement in prices); update data sets no less frequently than every three months; no particular type of model prescribed (but must accurately capture option risks); discretion to recognise empirical correlations within broad risk categories; daily calculation of capital requirement; multiplication factor based on supervisor judgment of quality of bank’s risk management system
• Market risk factors: risk measurement system that models yield curve (interest rate risk), foreign exchange exposures (foreign exchange risk), market movements in equities (equity risk), convenience yield (commodities risk)
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Basel II – Operational Risk Charges
Defined as risk of loss from inadequate or failed internal processes, people and systems, or from external events (¶ 644)
Examples of risks covered
• Internal and external fraud
• Legal risks
• Damages to customers
• Losses arising out of labour, health and safety, diversity, personal injury, etc.
• Damage to physical assets
• Business interruption
Examples of risks not covered
• Reputational risk
• Strategic errors
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Basel II – Operational Risk Charges
Basic Indicator Approach (¶¶ 649-651)
• 15% of bank’s average annual gross income over previous three years
Standardised Approach (¶¶ 652-654, ¶¶ 660-663)
• Capital charge for each of 8 business lines calculated against average annual gross income for business line times:
18% for corporate finance (15% transitional charge within EU if major activity)
18% for trading and sales (15% transitional charge within EU if major activity)
12% for retail banking
15% for commercial banking
18% for payment and settlement
15% for agency services
12% for asset management
12% for retail brokerage
Advanced Measurement Approach (¶¶ 655-659, ¶¶ 664-679)
• Calculated on basis of internal operational risk management system approved by national regulator
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Basel II – Supervisory review
Source: Text
Four key principles of supervisory review (¶¶ 725-760)
Principle 1
Banks should have process for assessing overall capital adequacy in relation to risk profile and strategy for maintaining capital levels. Five main features of rigorous process:• Board and senior management oversight• Sound capital assessment• Comprehensive risk analysis (credit risk, operational risk, market risk, interest
rate risk in banking book, liquidity risk, other risk)• Monitoring and reporting• Internal control review
Principle 2
Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied.
Principle 3 Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum
Principle 4 Supervisors should seek to intervene at early stage and require rapid remedial action
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Basel II – Supervisory review
Specific issues (¶¶ 761-778)
• Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk
• Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach, definition of default used to determine PD and/or LGD and EAD, residual risk, credit concentration risk and operational risk
Other issues (¶¶ 779-783)
• Supervisory transparency and accountability: Supervisors should make publicly available criteria used in review of banks’ internal capital assessments
• Enhanced cross-border communication and cooperation: Basel Committee supports pragmatic provision of close and continuous dialogue between industry participants and supervisors, as well as between supervisors (without changing legal responsibilities of national regulators).
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Basel II – Supervisory review
Economic substance: Supervisory capital requirements may vary from those specified in First Pillar if would not adequately and sufficiently reflect risks of exposure
Maturity: Supervisors will review documentation to ensure that maturity mismatches not artificially created to reduce capital requirements
Correlation: Supervisors may review banks’ assessment of actual correlations between assets in pools and how that is reflected in capital calculation; with ability to increase capital if correlation not appropriately reflected
Significant risk transfer: Although securitisation may occur for reasons other than risk transfer (i.e., funding), where risk transfer is insufficient or non-existent supervisors can deny capital relief
Market innovations: Supervisors can take account of new features either through First Pillar changes in minimum capital requirements or Second Pillar supervisory action
Implicit Support: If banks engage in implicit support more than once, supervisors must require disclosure and may apply one or more of (a) refusing further capital relief for securitised assets, for period of time or permanently, (b) applying conversion factor to all securitised assets so as to hold capital against them, or (c) requiring banks to hold capital in excess of minimum requirements
Source: Text
Supervisory review process for securitisation (¶¶ 784-807)
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Basel II – Supervisory review
Residual risks: Supervisors will expect banks to consider expected losses in economic capital, as those losses not usually transferred in securitisation
Call provisions: May not be used to absorb losses or asset deterioration; supervisors may require review of bank’s decision to call prior to exercise
Early amortisation: Supervisors should review how banks internally measure, monitor and manage risks associated with securitisations of revolving facilities; following factors should be considered when analysing excess spread triggers:
Interest payments by borrowers on underlying receivables
Other fees and charges to be paid
Gross charge-offs
Principal payments
Recoveries on charged-off loans
Interchange income
Interest paid on investors’ certificates
Relevant macro-economic factors
Source: Text
Supervisory review process for securitisation (¶¶ 784-807)
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Basel II – Disclosure (Securitisation)
Objective (¶¶ 809-810)
• Impose market discipline on banks by requiring disclosure of key information relevant to banks’ risks and capital
Qualitative Disclosures for Securitisation (¶ 820, Table 8)
• Bank’s objectives for, and roles played by it in, securitisation process
• Bank’s accounting objectives for securitisation
Whether treated as sales or financings
Whether bank recognises gain on sale
Key assumptions used by bank for valuing retained interests
Bank’s treatment of synthetic securitisations
• Names of rating agencies used by bank and types of exposures rated by each agency
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Basel II – Disclosure (Securitisation)
Quantitative Disclosures for Securitisation (¶ 820, Table 8)
• Total outstanding exposures securitised by bank subject to securitisation framework
• For exposures securitised by bank subject to framework (in each case broken down by exposure type):
Amount of impaired/past due assets
Losses recognised by bank during current period
• Aggregate amount of securitisation exposures retained or purchased by bank, broken down by exposure type
• Aggregate amount of securitisation exposures retained or purchased by bank, broken down by “reasonable number” of risk bands (deducted exposures disclosed separately)
• Aggregate amount of securitised revolving exposures segregated by originator’s interest and investors’ interest
• Summary of current year’s securitisation activity, including aggregate amount of exposures securitised and gain or loss on sale, by asset type
Source: Text 87
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Stakeholder selection
The self assessment is a bottom up process, aiming to reach bank-wide convergence on key compliance topics, providing assurance to senior management and the supervisor
Several groups of participants & stakeholders are therefore relevant to the process: Total outstanding exposures securitised by bank subject to securitisation framework
• Risk / rating / credit managers on the ground to do the leg-work on gathering strengths and weaknesses
• Risk / policy owners and business line risk managers to sign off on the content for individual compliance items
• Group Risk (or equivalent) to challenge the output
• Internal audit to challenge the process (including the list of participants)
• CRO to acknowledge and sign off on the outcome
• CEO / CFO / CRO to sign the Basel 2 application file
Source: Text 89
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Stakeholder selection credit risk compliance (I)
• Common standards applied across client
Harmonised default definition
Rating philosophy (calibration, downturn)
Segmentation (hierarchy, mapping methodology)
• Perimeter complete and systematic, coverage sufficient
• Adequate PD model design and development
Data used for model development
Model design / methodology
Model performance
• Adequate LGD / EAD model design and development
Data used for model development
Model design / methodology
Model performance
• Model validation and backtesting defined and rolled out
Process defined, documented, rolled out
Technical procedures defined, documented, adhered to
Source: Text
Split by
function
Methodology & Models
• Common standards applied across client
• Perimeter complete and systematic, coverage
sufficient
• Adequate PD model design and development
• Adequate EAD/LGD model design and
development
• Model validation and backtesting defined and
rolled out
Systems & Data
• Model infrastructure in place and working
• Adequate data management and storage
• Adequate data processing (and reconciliation)
Model use and policies
• Rating policies complete & enforced
• Models used, no systematic gaming
• Model output used in management
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Split by
function
Methodology & Models
• Common standards applied across client
• Perimeter complete and systematic, coverage
sufficient
• Adequate PD model design and development
• Adequate EAD/LGD model design and
development
• Model validation and backtesting defined and
rolled out
Systems & Data
• Model infrastructure in place and working
• Adequate data management and storage
• Adequate data processing (and reconciliation)
Model use and policies
• Rating policies complete & enforced
• Models used, no systematic gaming
• Model output used in management
Stakeholder selection credit risk compliance (II)
• Model infrastructure in place and working
Models correctly coded, deployed, accessible
• Adequate data management and storage
Data accuracy and consistency is ensured
Data is stored such that both auditability and future model development ensured
• Adequate data processing (and reconciliation)
Global policies on data cleaning / treatment exist and enforced
Systems in place to ensure completeness of data submitted for the calculation
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Split by
function
Methodology & Models
• Common standards applied across client
• Perimeter complete and systematic, coverage
sufficient
• Adequate PD model design and development
• Adequate EAD/LGD model design and
development
• Model validation and backtesting defined and
rolled out
Systems & Data
• Model infrastructure in place and working
• Adequate data management and storage
• Adequate data processing (and reconciliation)
Model use and policies
• Rating policies complete & enforced
• Models used, no systematic gaming
• Model output used in management
Stakeholder selection credit risk compliance (III)
• Rating policies complete & enforced
Policies on the use of models and the use of model ratings exist and are adhered to
• Models used, no systematic gaming
Rating models are used, leading to high rating coverage
Rating overrides are acceptable, signalling user acceptance
There is no systematic “gaming” of the rating systems
• Model output used in management
Risk parameters (PD, EAD, LGD) are used in the management of the bank, through some or all of the following applications:
� Credit decision
� Delegation of authority
� Pricing
� Monitoring
� Limit setting
� Provisioning
� Economic Capital
� Internal Credit Reporting
� Other
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Stakeholder selection credit risk capital calculation (I)
• Clear assignment of responsibilities between departments
Formal agreements in place
Governance structure in place and working
• Completeness of sourcing ensured
Material entities are included in the calculation
Gaps in product / geographical coverage are actively followed up
Adequate parameter coverage
• Clear policy on data format, adhered to
A clear policy in place and communicated
Sourcing entities adhere to policy
• Data quality control exists and is enforced
Problems in the data are reliably detected
Corrections are made (in good time)
• Full audit trail exists along the calculation chain
Source: Text
Complete and accurate sourcing
• Clear assignment of responsibilities between departments
• Completeness of sourcing ensured
• Clear policy on data format, adhered to
• Data quality control exists and is enforced
• Full audit trail exists along the calculation chain
Complete and working calculation chain
• Fully industrialised process, with acceptable run time
• Operated by adequately trained internal resources
• Documentation in place
• Fully defined integrity and DQ standards in place and enforced
– sufficient data storage
• Effective error handling in place – ensuring system stability
• Results are of a quality that allows sign off
• Sign-off process defined and working
Ability to reconcile risk and accounting
• Technical link exists, with functioning mapping
• Ability to make visible and explain differences
• Ability to fully reconcile using conservative placeholders
Ability to produce the required internal and external reporting
• Systems / templates in place and working
• Results are of a quality that allows sign off
• Sign-off process defined and working
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Stakeholder selection credit risk capital calculation (II)
• Fully industrialised process, with acceptable run time
Chain architecture clearly defined
Calculation process clearly defined and communicated
Run-time suits business needs
• Operated by adequately trained internal resources
• Documentation in place
• Fully defined integrity and DQ standards in place and enforced – sufficient data storage
Calculation problems are reliably detected
Corrections are made (in good time)
Data storage is sufficient
• Effective error handling in place – ensuring system stability
• Results are of a quality that allows sign off
• Sign-off process defined and working
Acceptance of results clearly defined
Sign-off process defined and timetabled
Source: Text
Complete and accurate sourcing
• Clear assignment of responsibilities between departments
• Completeness of sourcing ensured
• Clear policy on data format, adhered to
• Data quality control exists and is enforced
• Full audit trail exists along the calculation chain
Complete and working calculation chain
• Fully industrialised process, with acceptable run time
• Operated by adequately trained internal resources
• Documentation in place
• Fully defined integrity and DQ standards in place and enforced
– sufficient data storage
• Effective error handling in place – ensuring system stability
• Results are of a quality that allows sign off
• Sign-off process defined and working
Ability to reconcile risk and accounting
• Technical link exists, with functioning mapping
• Ability to make visible and explain differences
• Ability to fully reconcile using conservative placeholders
Ability to produce the required internal and external reporting
• Systems / templates in place and working
• Results are of a quality that allows sign off
• Sign-off process defined and working
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Stakeholder selection credit risk capital calculation (II)
• Technical link exists, with functioning mapping
Process covers all material portfolios
Accounting and risk data can be mapped to each other
• Ability to make visible and explain differences
Differences between the risk and the accounting data are flagged
The source of these differences can be traced and explained
• Ability to fully reconcile using conservative placeholders
All missing exposures receive a placeholder
Placeholders lead to a conservative outcome
Source: Text
Complete and accurate sourcing
• Clear assignment of responsibilities between departments
• Completeness of sourcing ensured
• Clear policy on data format, adhered to
• Data quality control exists and is enforced
• Full audit trail exists along the calculation chain
Complete and working calculation chain
• Fully industrialised process, with acceptable run time
• Operated by adequately trained internal resources
• Documentation in place
• Fully defined integrity and DQ standards in place and enforced
– sufficient data storage
• Effective error handling in place – ensuring system stability
• Results are of a quality that allows sign off
• Sign-off process defined and working
Ability to reconcile risk and accounting
• Technical link exists, with functioning mapping
• Ability to make visible and explain differences
• Ability to fully reconcile using conservative placeholders
Ability to produce the required internal and external reporting
• Systems / templates in place and working
• Results are of a quality that allows sign off
• Sign-off process defined and working
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Stakeholder selection credit risk capital calculation (IV)
• Systems / templates in place and working
Systems and templates are in place to generate the required reporting
• Results are of a quality that allows sign off
• Sign-off process defined and working
The process of accepting and signing off the results is worked out and timetabled
Source: Text
Complete and accurate sourcing
• Clear assignment of responsibilities between departments
• Completeness of sourcing ensured
• Clear policy on data format, adhered to
• Data quality control exists and is enforced
• Full audit trail exists along the calculation chain
Complete and working calculation chain
• Fully industrialised process, with acceptable run time
• Operated by adequately trained internal resources
• Documentation in place
• Fully defined integrity and DQ standards in place and enforced
– sufficient data storage
• Effective error handling in place – ensuring system stability
• Results are of a quality that allows sign off
• Sign-off process defined and working
Ability to reconcile risk and accounting
• Technical link exists, with functioning mapping
• Ability to make visible and explain differences
• Ability to fully reconcile using conservative placeholders
Ability to produce the required internal and external reporting
• Systems / templates in place and working
• Results are of a quality that allows sign off
• Sign-off process defined and working
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Stakeholder selection Operational risk compliance dimensions (I)
• All 4 key elements integrated
Internal data
External data
Scenario analysis
BEICFs
• Perimeter and coverage sufficient
Perimeter definition includes all material entities
Sufficient actual coverage against target
• Sound mapping methodology
Ability to map loss / accounting data to business lines
• Clear and harmonised definitions and classifications
Guidelines and policies provide clarity around the definition of all ORM toolbox elements
• Sound and consistent governance and policy
Source: Text
Overall framework
• All 4 key elements integrated
• Perimeter and coverage is sufficient
• Sound mapping methodology
• Clear and harmonised definitions and classifications
• Sound and consistent governance and policy
Risk Self Assessments
• Adequate approach to risk self assessments
• Consistent and effective implementation
• Management use of the RSAs
Data collection
• Comprehensive collection of internal and external data
• Staff adequately trained
• Use and follow up processes in place
IT infrastructure
• Robust systems in place
• Systems rolled out, with interfaces to other systems
Capital model
• Well reasoned modelling philosophy
• Validation approach exists and is implemented
• Model implemented, easy to use, transparent
• Stable output, appropriate allocation, buy-in from business
• Model output used for management purposes
KRIs
• Clearly identified for major risks, explicit links to risks
• Embedded in business, triggering actions
Mitigation
• Effective risk mitigation activities in place
• Reporting enables management use of ORM framework
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Stakeholder selection Operational risk compliance dimensions (II)
• Adequate approach to risk self assessments
RSAs fully reflect the organization structure and the nature of its operational risks
Adequate use of multiple data sources
Control factors taken into account
Sound methodology for assessing extreme scenarios
• Consistent and effective implementation
Comprehensive identification and understanding of biggest risks
Consistent and correct classification
The level of detail is balanced and reflective of the business complexity
Effective control of output
• Management use of the RSAs
Reporting in place
Management actions triggered
Source: Text
Overall framework
• All 4 key elements integrated
• Perimeter and coverage is sufficient
• Sound mapping methodology
• Clear and harmonised definitions and classifications
• Sound and consistent governance and policy
Risk Self Assessments
• Adequate approach to risk self assessments
• Consistent and effective implementation
• Management use of the RSAs
Data collection
• Comprehensive collection of internal and external data
• Staff adequately trained
• Use and follow up processes in place
IT infrastructure
• Robust systems in place
• Systems rolled out, with interfaces to other systems
Capital model
• Well reasoned modelling philosophy
• Validation approach exists and is implemented
• Model implemented, easy to use, transparent
• Stable output, appropriate allocation, buy-in from business
• Model output used for management purposes
KRIs
• Clearly identified for major risks, explicit links to risks
• Embedded in business, triggering actions
Mitigation
• Effective risk mitigation activities in place
• Reporting enables management use of ORM framework
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Stakeholder selection Operational risk compliance dimensions (III)
• Comprehensive collection of internal and external data
Internal loss data being gathered and stored in a detailed format for subsequent re-use
Data gathering is carried out as a continuous process and with limited time from discovery to reporting
• Staff adequately trained
Data collection staff have received sufficient training to ensure high-quality data collection
• Use and follow up processes in place
Recorded losses are reported, brought to the managements’ attention and trigger management action
Source: Text
Overall framework
• All 4 key elements integrated
• Perimeter and coverage is sufficient
• Sound mapping methodology
• Clear and harmonised definitions and classifications
• Sound and consistent governance and policy
Risk Self Assessments
• Adequate approach to risk self assessments
• Consistent and effective implementation
• Management use of the RSAs
Data collection
• Comprehensive collection of internal and external data
• Staff adequately trained
• Use and follow up processes in place
IT infrastructure
• Robust systems in place
• Systems rolled out, with interfaces to other systems
Capital model
• Well reasoned modelling philosophy
• Validation approach exists and is implemented
• Model implemented, easy to use, transparent
• Stable output, appropriate allocation, buy-in from business
• Model output used for management purposes
KRIs
• Clearly identified for major risks, explicit links to risks
• Embedded in business, triggering actions
Mitigation
• Effective risk mitigation activities in place
• Reporting enables management use of ORM framework
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Stakeholder selection Operational risk compliance dimensions (IV)
• Robust internal systems in place
Data collection systems run in a stable production environment
Access rights are clearly defined
• Systems rolled out, with interfaces to other systems
Data collection systems are linked with each other to avoid manual duplication of inputs
Source: Text
Overall framework
• All 4 key elements integrated
• Perimeter and coverage is sufficient
• Sound mapping methodology
• Clear and harmonised definitions and classifications
• Sound and consistent governance and policy
Risk Self Assessments
• Adequate approach to risk self assessments
• Consistent and effective implementation
• Management use of the RSAs
Data collection
• Comprehensive collection of internal and external data
• Staff adequately trained
• Use and follow up processes in place
IT infrastructure
• Robust systems in place
• Systems rolled out, with interfaces to other systems
Capital model
• Well reasoned modelling philosophy
• Validation approach exists and is implemented
• Model implemented, easy to use, transparent
• Stable output, appropriate allocation, buy-in from business
• Model output used for management purposes
KRIs
• Clearly identified for major risks, explicit links to risks
• Embedded in business, triggering actions
Mitigation
• Effective risk mitigation activities in place
• Reporting enables management use of ORM framework
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Stakeholder selection Operational risk compliance dimensions (V)
• Well reasoned modelling philosophy Mixture of bottom-up calculation and
allocation to suit formal group and BU upfront goals
Assumptions understandable to non-technical staff and signed off by senior management
• Validation approach exists and is implemented Full, ongoing validation of all framework
elements, documented Assumptions behind key parameters
independently reviewed Quantitative output subject to validation
• Model implemented, easy to use, transparent Top-down build structure that encompass
specific bottom-up collected data Model can reflect (quickly) any business
practice changes Model clearly documented Run-time suits business needs
• Stable output, appropriate allocation, buy-in from business Full sensitivity analysis documented and
audited Appropriate allocation / diversification Drivers of capital formally agreed with BUs
and linked to modelling• Model output used for management purposes
Reporting in place to share output with management
Source: Text
Overall framework
• All 4 key elements integrated
• Perimeter and coverage is sufficient
• Sound mapping methodology
• Clear and harmonised definitions and classifications
• Sound and consistent governance and policy
Risk Self Assessments
• Adequate approach to risk self assessments
• Consistent and effective implementation
• Management use of the RSAs
Data collection
• Comprehensive collection of internal and external data
• Staff adequately trained
• Use and follow up processes in place
IT infrastructure
• Robust systems in place
• Systems rolled out, with interfaces to other systems
Capital model
• Well reasoned modelling philosophy
• Validation approach exists and is implemented
• Model implemented, easy to use, transparent
• Stable output, appropriate allocation, buy-in from business
• Model output used for management purposes
KRIs
• Clearly identified for major risks, explicit links to risks
• Embedded in business, triggering actions
Mitigation
• Effective risk mitigation activities in place
• Reporting enables management use of ORM framework
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Stakeholder selection Operational risk compliance dimensions (VI)
• Clearly identified KRIs for major risks, with explicit links to them
Picked to represent the Bank’s biggest risks
Limited number, maintaining focus
• Embedded in business, triggering actions
Reporting in place, processes in place to ensure certain results trigger management action
• Effective risk mitigation activities in place
Business continuity planning complete
• Reporting enables management use of ORM framework
Source: Text
Overall framework
• All 4 key elements integrated
• Perimeter and coverage is sufficient
• Sound mapping methodology
• Clear and harmonised definitions and classifications
• Sound and consistent governance and policy
Risk Self Assessments
• Adequate approach to risk self assessments
• Consistent and effective implementation
• Management use of the RSAs
Data collection
• Comprehensive collection of internal and external data
• Staff adequately trained
• Use and follow up processes in place
IT infrastructure
• Robust systems in place
• Systems rolled out, with interfaces to other systems
Capital model
• Well reasoned modelling philosophy
• Validation approach exists and is implemented
• Model implemented, easy to use, transparent
• Stable output, appropriate allocation, buy-in from business
• Model output used for management purposes
KRIs
• Clearly identified for major risks, explicit links to risks
• Embedded in business, triggering actions
Mitigation
• Effective risk mitigation activities in place
• Reporting enables management use of ORM framework
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Contents
1 Why Capital Calibration Partners (CCP)?
Executive Summary
Basel II – First Pillar: Credit Risk Capital Charges
Basel II – First Pillar: Operational Risk Capital Charges
Basel II – Second Pillar: Supervisory Review
Basel II – Third Pillar: Market Discipline
Stakeholder selection for self assessment
Self assessment
Credit Risk
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
2
3
4
5
6
7
8
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Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
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Key to Graphics
Graphic Description / Notes
• Basic (B) → Industry Standard (IS) → Best Practice (BP) scale
• Current positioning of your Group.
• Basel II compliance assessment: This should be used to indicate, whether at this point in time your Group is not compliant (NC), partially compliant (PC) or fully compliant in comparison to the targeted approach (i.e. Standardised, IRB Foundation, IRB Advanced for credit risk) regarding a certain category
• For asset classes where X-Bank holds few or no positions, N/A signifies that not meeting compliance criteria would not jeopardise the overall compliance position
• Explicit Basel II requirement based on the Internal Ratings Based Approach for Credit Risk and the Advanced Measurement Approaches for Operational Risk {Key for paragraph references: without code = The New Basel Capital Accord, November 2005; Code PMCR = Principles for the Management of Credit Risk (September 2000); Code PMSIRR = Principles for the Management and Supervision of Interest Rate Risk (July 2004), Code SPMSOR = Sound Practices for the Management and Supervision of Operational Risk (February 2003), Code AMR = Amendment to the Capital Accord to Include Market Risk (1998 update to January 1996)}
NC PC FC
B IS BP
Bold text
N/A
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Credit Risk: Methodology & Measurement
Customer/
Counterparty
Evaluation
NC PC FC
Group PositioningIndustry Standard Best PracticeBasic
• Judgement-based or simple
quantitative grading tools
• Ordinal grades have meaning
within segments, but not across
(i.e. no calibration to master
scale)
• 5-6 performing grades per
segment
• No empirical or statistical
validation or back-testing
• Mainly quantitative scorecards,
often using vended rating
models
• Ordinal rating mapped
individually to PD or external
ratings
7-8 performing grades (404)
• Judgmental validation by expert
panel in addition to statistical
validation
• Ad hoc migration analysis and
back-testing
• Sometimes calibrated to Group-
wide master scale
• Corporates
• Tailored internal rating model with both
quantitative and qualitative inputs (411)
• Development based on actual default
history, expert input or external ratings as
benchmark
• Possibly complement with vended
solutions, e.g. EDF model when
appropriate
• Specialised Finance
• Internal rating tool possibly using a
simulation-based approach (411)
• General
• Separation of borrower (PD) and facility
(LGD, EAD) (396)
• Model results are mapped to cardinal
scale (PDs) (397)
• Central tendency calibration (461-463)
• Extensive statistical validation during
development phase (420)
• Routine migration analysis, back-testing
and revalidation of model power (417 &
441)
• Master scale, with at least 15 performing
grades
• Customisation of rating model to reflect
local market conditions and accounting
conventions (389)
NOTE: Basel II
effectively making
current best practice
industry standard
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Credit Risk: Methodology & Measurement (Cont’d)
Exposure
Measurement
NOTE: Basel II
effectively making
current best practice
industry standard
Industry Standard Best PracticeBasic
• Ad hoc manual measurement of
aggregate exposure
• Limited treatment of overdraft
facilities / uncommitted lines
• Current value of derivatives
exposures only
• Notional measurement with
basic/ regulatory credit
conversion factors
Some validation with
internal experience
• Explicit treatment of EAD for overdrafts
and uncommitted lines (474 - 479)
• Expected exposure and maximum likely
exposure profiles for derivatives
incorporating netting and collateral effects
(309, 317)
• Values validated with historic data (478)
NC PC FC
• No consistent grouping of
collateral into types
• Generic values used for LGD
with no validation to bank
experience
• Crude LGD estimate, typically
based on collateral value at
origination (not at default) or
only using collateral type, but
not collateral amount
• Some validation to bank
experience
• Guarantees and covenants incorporated
into analysis (332, 480)
• LGD calculation based on economic loss
(468)
Write-off amount, time to recover and
administrative costs all used in
calculation
Based on internal data (431, 470)
• Spreadsheet-based portfolio
aggregation
Questionable quality /
aggregation of input data
Data cohorted at BU level
Little / no recognition of
correlation and
concentration effects
• Minimal portfolio analysis,
typically confined to exposures
and ‘quality’ monitoring
• Incomplete Group view
• Central Portfolio Model (CPM)
(spreadsheet or vended)
Bottom-up measurement on
customer / transaction level
Recognition of correlation
and concentration effects
• Complete Group view
(incorporating interaction effects
between portfolios)
• Rudimentary sensitivity /
scenario testing capabilities
(434–437)
• Vended or in-house bespoke
parameterised CPM
Detailed cohorting by risk
characteristics
Thorough treatment of correlations
between counterparties, industries
and geographies
Ability to ‘condition’ losses based on
macro-economic scenarios
Incorporation of securitizations
Explicit treatment of interest rate risk
Option to use value based modelling
NC PC FC
Credit
Mitigation
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
Portfolio
Analysis
Group Positioning
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Credit Risk: Data, IT & Reporting
Data Availability/
Capture
NOTE: Basel II
effectively making
current best practice
industry standard
Group PositioningIndustry Standard Best PracticeBasic
• No firm-wide counterparty ID
• Aggregate exposures manually
compiled at business unit level
• Limited availability of / access
to historical data
• Ad-hoc data capture
• Firm-wide counterparty ID
• Relevant data are available on a
customer / product level
• Historical data available for part
of customer base
• Basic risk information
systematically captured;
connection between
customer/transaction data and
collateral/recovery data is only
partially possible
• Firm-wide risk data warehouse with
consistent counterparty ID
• Automatic aggregation (quasi-online) of
exposure for all customers, products,
divisions etc
• Historical data available across entire
portfolio (429, 430)
• Full customer / risk information
systematically captured and stored for
central analysis (429, 430):
Customer data
Transaction data
Collateral and recovery information
which are connectable to transactions
/ customers
Financial data (e.g. from annual
reports, tax authorities)
Segment specific data
NC PC FC
• Limited reporting of exposure
below portfolio level
• Firm wide write-offs and
delinquencies reporting monthly
• Segment-level EL reporting
• Monthly reporting of business
unit risk and exposure
• Monthly reporting of product
level write-offs and arrears
• Cohort-level EL reporting
• Quarterly risk reports containing
concentration analyses
• (Monthly) reporting of product level
exposure, risk and concentrations (439,
440, 743)
• (Monthly) reporting of product level write-
offs and arrears
• EL/ economic capital reporting to senior
management (743)
• Systematic stress test reporting
Reporting
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
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Credit Risk: Processes & Policies
Portfolio
Management/
Limit Setting
Group PositioningIndustry Standard Best PracticeBasic
• Simple exposure limits in place,
based on subjective judgement
• No formal sector limits
• Passive portfolio management
• More complex exposure limits
based on simple quantitative
analysis for:
Counterparties
Countries
Sectors
• Passive portfolio management
• Exposure limits based on sophisticated
analysis of full portfolio effects (770-777)
• Intra BU limits backed up by BU portfolio
model
• Active portfolio management capabilityNC PC FC
Corporate
Governance
NC PC FC
NOTE: No specific
Basel II requirements
regarding this area
• Risk and price incorporated
subjectively into approval
decision
• No formal risk based pricing
• Pricing linked to counterparty
rating (linked to PD), often
based on ‘pricing grid’ - paper
based
• Basic economic capital-based
pricing tools
• Strictly enforced price floors
• Risk-based pricing using EL, economic
capital and fully loaded costs
• Full relationship-based pricing
• Detailed process guidelines, explicit
‘override’ structure
Pricing
• Responsibility for the design or
selection, implementation and
performance of the internal
rating systems lies with an
independent credit risk control
unit (441,442)
• Internal audit performs annual
reviews on the system and
independent checks on
processes and numbers (443)
• The credit policy, rating system
and its uses are approved by
the Board or subcommittee
(438)
• Senior Management needs to
demonstrate understanding and
needs to work with credit control
function to discuss and improve
the rating process (439)
• Same as Industry Standard
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Credit Risk: Processes & Policies (Cont’d)
Credit Approval
Process
Group PositioningIndustry Standard Best PracticeBasic
• Fully subjective underwriting
process
• No clear delegation process
• No real collateral valuation as
part of credit approval process
• Incomplete relationship view
• Committee-intensive process
with some delegation
• Process differentiated by facility
size
• Analysis of value of collateral in
approval process
• Business unit level aggregated
view taken
• Extensive documentation of
process and procedures
• Internal ratings and other credit
parameters must play an
essential role in the credit
approval process and bank
must have a credible track
record of their use (444, 445)
• Completion or approval of rating
assignment and review
conducted by a unit that does
not directly stand to benefit from
the extension of credit (424)
• Industry Standard as outlined to the left
and:
• High delegation of decision authority;
strict definition of overrides etc.
• Process differentiated by risk
• Detailed analysis of collateral by type in
the credit process
• Full relationship view of economic capital
/ economic profit used for larger
exposures
Counterparty
Credit
Monitoring /
Provisioning
NC PC FC
NOTE: Basel II largely
in line with current
industry standard
NC PC FC
• No automatic customer credit
monitoring after initial approval
process
• Some monitoring for larger
customers
• Qualitative assessment for
general provisioning
• Passive treatment of delinquent
credits
• At least annual review of
customer credit quality and
portfolio delinquency rates (425,
427)
• Specific provisioning based on
qualitative assessment
• Monthly analysis of delayed
payments for certain products
• Recovery process optimised to
ensure maximum recovery
rates.
• Early warning systems of deteriorating
credit quality
• Active management of watchlist using
specialised personnel
• Dynamic forward-looking provisioning
based on EL driven by output from rating
distributions / portfolio models
• Specific provisioning triggered by rating
(linked to PD) downgrades
• Recovery process treated as profit centre
110
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Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
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Credit Risk: Methodology & Measurement
Customer/
Counterparty
Evaluation
Group PositioningIndustry Standard Best PracticeBasic
• Judgement-based or simple
quantitative grading tools
• Ordinal grades have meaning
within segments, but not across
(i.e. no calibration to master
scale)
• 5-6 performing grades per
segment
• No empirical or statistical
validation or back-testing
• Mainly quantitative scorecards,
often using vended rating
models
• Ordinal rating mapped
individually to PD or external
ratings
7-8 performing grades (404)
• Judgmental validation by expert
panel in addition to statistical
validation
• Ad hoc migration analysis and
back-testing
• Sometimes calibrated to Group-
wide master scale
Mid market / SME
• Tailored internal rating models with both
quantitative, qualitative as well as
behavioural inputs (411)
• Development based on actual default
history
General
• Separation of borrower (PD) and facility
(LGD, EAD) (396)
• Model results are mapped to cardinal
scale (PDs) (397)
• Central tendency calibration (461-463)
• Extensive statistical validation during
development phase (420)
• Routine migration analysis, back-testing
and revalidation of model power (417,
441)
• Master scale, with at least 15 performing
grades
• Customisation of rating model to reflect
local market conditions and accounting
conventions (389)
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
112
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Credit Risk: Methodology & Measurement (Cont’d)
Exposure
Measurement
NOTE: Basel II
effectively making
current best practice
industry standard
Industry Standard Best PracticeBasic
• Ad hoc manual measurement of
aggregate exposure
• Limited treatment of overdraft
facilities / uncommitted lines
• Current value of derivatives
exposures only
• Notional measurement with
basic/ regulatory credit
conversion factors
Some validation with
internal experience
• Explicit treatment of EAD for overdrafts
and uncommitted lines (474 - 479)
• Expected exposure and maximum likely
exposure profiles for derivatives
incorporating netting and collateral effects
(309, 317)
• Values validated with historic data (478)
NC PC FC
• No consistent grouping of
collateral into types
• Generic values used for LGD
with no validation to bank
experience
• Crude LGD estimate, typically
based on collateral value at
origination (not at default) or
only using collateral type, but
not collateral amount
• Some validation to bank
experience
• Guarantees and covenants incorporated
into analysis (332, 480)
• LGD calculation based on economic loss
(468)
Write-off amount, time to recover and
administrative costs all used in
calculation
Based on internal data (431, 470)
• Spreadsheet-based portfolio
aggregation
Questionable quality /
aggregation of input data
Data cohorted at BU level
Little / no recognition of
correlation and
concentration effects
• Minimal portfolio analysis,
typically confined to exposures
and ‘quality’ monitoring
• Incomplete Group view
• Central Portfolio Model (CPM)
(spreadsheet or vended)
Bottom-up measurement on
customer / transaction level
Recognition of correlation
and concentration effects
• Complete Group view
(incorporating interaction effects
between portfolios)
• Rudimentary sensitivity /
scenario testing capabilities
(434–437)
• Vended or in-house bespoke
parameterised CPM
Detailed cohorting by risk
characteristics
Thorough treatment of correlations
between counterparties, industries
and geographies
Ability to ‘condition’ losses based on
macro-economic scenarios
Incorporation of securitizations
Explicit treatment of interest rate risk
Option to use value based modelling
NC PC FC
Credit
Mitigation
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
Portfolio
Analysis
Group Positioning
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Credit Risk: Data, IT & Reporting
Data Availability/
Capture
NOTE: Basel II
effectively making
current best practice
industry standard
Group PositioningIndustry Standard Best PracticeBasic
• No firm-wide counterparty ID
• Aggregate exposures manually
compiled at business unit level
• Limited availability of / access
to historical data
• Ad-hoc data capture
• Firm-wide counterparty ID
• Relevant data are available on a
customer / product level
• Historical data available for part
of customer base
• Basic risk information
systematically captured;
connection between
customer/transaction data and
collateral/recovery data is only
partially possible
• Firm-wide risk data warehouse with
consistent counterparty ID
• Automatic aggregation (quasi-online) of
exposure for all customers, products,
divisions etc
• Historical data available across entire
portfolio (429, 430)
• Full customer / risk information
systematically captured and stored for
central analysis (429, 430):
Customer data
Transaction data
Collateral and recovery information
which are connectable to transactions
/ customers
Financial data (e.g. from annual
reports, tax authorities)
Segment specific data
NC PC FC
• Limited reporting of exposure
below portfolio level
• Firm wide write-offs and
delinquencies reporting monthly
• Segment-level EL reporting
• Monthly reporting of business
unit risk and exposure
• Monthly reporting of product
level write-offs and arrears
• Cohort-level EL reporting
• Quarterly risk reports containing
concentration analyses
• (Monthly) reporting of product level
exposure, risk and concentrations (439,
440, 743)
• (Monthly) reporting of product level write-
offs and arrears
• EL/ economic capital reporting to senior
management (743)
• Systematic stress test reporting
Reporting
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
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Credit Risk: Processes & Policies
Portfolio
Management/
Limit Setting
Group PositioningIndustry Standard Best PracticeBasic
• Simple exposure limits in place,
based on subjective judgement
• No formal sector limits
• Passive portfolio management
• More complex exposure limits
based on simple quantitative
analysis for:
Counterparties
Countries
Sectors
• Passive portfolio management
• Exposure limits based on sophisticated
analysis of full portfolio effects (770-777)
• Intra BU limits backed up by BU portfolio
model
• Active portfolio management capabilityNC PC FC
Corporate
Governance
NC PC FC
NOTE: No specific
Basel II requirements
regarding this area
• Risk and price incorporated
subjectively into approval
decision
No formal risk based pricing
• Pricing linked to counterparty
rating (linked to PD), often
based on ‘pricing grid’ - paper
based
• Basic economic capital-based
pricing tools
• Strictly enforced price floors
• Risk-based pricing using EL, economic
capital and fully loaded costs
• Full relationship-based pricing
• Detailed process guidelines, explicit
‘override’ structure
Pricing
• Responsibility for the design or
selection, implementation and
performance of the internal
rating systems lies with an
independent credit risk control
unit (441,442)
• Internal audit performs annual
reviews on the system and
independent checks on
processes and numbers (443)
• The credit policy, rating system
and its uses are approved by
the Board or subcommittee
(438)
• Senior Management needs to
demonstrate understanding and
needs to work with credit control
function to discuss and improve
the rating process (439)
• Same as Industry Standard
115
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Credit Risk: Processes & Policies (Cont’d)
Credit Approval
Process
Group PositioningIndustry Standard Best PracticeBasic
• Fully subjective underwriting
process
• No clear delegation process
• No real collateral valuation as
part of credit approval process
• Incomplete relationship view
• Committee-intensive process
with some delegation
• Process differentiated by facility
size
• Analysis of value of collateral in
approval process
• Business unit level aggregated
view taken
• Extensive documentation of
process and procedures
• Internal ratings and other credit
parameters must play an
essential role in the credit
approval process and bank
must have a credible track
record of their use (444, 445)
• Completion or approval of rating
assignment and review
conducted by a unit that does
not directly stand to benefit from
the extension of credit (424)
• Industry Standard as outlined to the left
and:
• High delegation of decision authority;
strict definition of overrides etc.
• Process differentiated by risk
• Detailed analysis of collateral by type in
the credit process
• Full relationship view of economic capital
/ economic profit used for larger
exposures
Counterparty
Credit
Monitoring /
Provisioning
NC PC FC
NOTE: Basel II largely
in line with current
industry standard
• No automatic customer credit
monitoring after initial approval
process
• Some monitoring for larger
customers
• Qualitative assessment for
general provisioning
• Passive treatment of delinquent
credits
• At least annual review of
customer credit quality and
portfolio delinquency rates (425,
427)
• Specific provisioning based on
qualitative assessment
• Monthly analysis of delayed
payments for certain products
• Recovery process optimised to
ensure maximum recovery
rates.
• Early warning systems of deteriorating
credit quality
• Active management of watchlist using
specialised personnel
• Dynamic forward-looking provisioning
based on EL driven by output from rating
distributions / portfolio models
• Specific provisioning triggered by rating
(linked to PD) downgrades
• Recovery process treated as profit centre
NC PC FC
116
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apital C
alib
ration P
art
ners
Inc.
Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
117
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alib
ration P
art
ners
Inc.
Credit Risk: Methodology & Measurement
Customer/
Counterparty
Evaluation
Group PositioningIndustry Standard Best PracticeBasic
• Judgement-based or simple
quantitative grading tools
• Ordinal grades have meaning
within segments, but not across
(i.e. no calibration to master
scale)
• 5-6 performing grades per
segment
• No empirical or statistical
validation or back-testing
• Mainly quantitative scorecards,
often using vended rating
models
• Ordinal rating mapped
individually to PD or external
ratings
7-8 performing grades (404)
• Judgmental validation by expert
panel in addition to statistical
validation
• Ad hoc migration analysis and
back-testing
• Sometimes calibrated to Group-
wide master scale
Banks
• Tailored internal rating model with both
quantitative and qualitative inputs (411)
• Application even for externally rated
counterparties
• Calibration based on external information
(external ratings and bond spreads) as
well as internal expert opinion
Non banking financial institutions (NBFIs)
• Tailored internal rating model with both
quantitative and qualitative inputs (411)
• Separate models for (life/non-life)
insurance companies and funds,
broker/dealers
• Application even for externally rated
counterparties
• Calibration based on external information
(external ratings and bondspreads) as
well as internal expert opinion
General
• Separation of borrower (PD) and facility
(LGD, EAD) (396)
• Model results are mapped to cardinal
scale (PDs) (397)
• Central tendency calibration (461-463)
• Extensive statistical validation during
development phase (420)
• Routine migration analysis, back-testing
and revalidation of model power (417,
441)
• Master scale, with at least 15 performing
grades
• Customisation of rating model to reflect
local market conditions and accounting
conventions (389)
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
118
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Credit Risk: Methodology & Measurement (Cont’d)
Exposure
Measurement
NOTE: Basel II
effectively making
current best practice
industry standard
Industry Standard Best PracticeBasic
• Ad hoc manual measurement of
aggregate exposure
• Limited treatment of overdraft
facilities / uncommitted lines
• Current value of derivatives
exposures only
• Notional measurement with
basic/ regulatory credit
conversion factors
Some validation with
internal experience
• Explicit treatment of EAD for overdrafts
and uncommitted lines (474 - 479)
• Expected exposure and maximum likely
exposure profiles for derivatives
incorporating netting and collateral effects
(309, 317)
• Values validated with historic data (478)
NC PC FC
• No consistent grouping of
collateral into types
• Generic values used for LGD
with no validation to bank
experience
• Crude LGD estimate, typically
based on collateral value at
origination (not at default) or
only using collateral type, but
not collateral amount
• Some validation to bank
experience
• Guarantees and covenants incorporated
into analysis (332, 480)
• LGD calculation based on economic loss
(468)
Write-off amount, time to recover and
administrative costs all used in
calculation
Based on internal data (431, 470)
• Spreadsheet-based portfolio
aggregation
Questionable quality /
aggregation of input data
Data cohorted at BU level
Little / no recognition of
correlation and
concentration effects
• Minimal portfolio analysis,
typically confined to exposures
and ‘quality’ monitoring
• Incomplete Group view
• Central Portfolio Model (CPM)
(spreadsheet or vended)
Bottom-up measurement on
customer / transaction level
Recognition of correlation
and concentration effects
• Complete Group view
(incorporating interaction effects
between portfolios)
• Rudimentary sensitivity /
scenario testing capabilities
(434–437)
• Vended or in-house bespoke
parameterised CPM
Detailed cohorting by risk
characteristics
Thorough treatment of correlations
between counterparties, industries
and geographies
Ability to ‘condition’ losses based on
macro-economic scenarios
Incorporation of securitizations
Explicit treatment of interest rate risk
Option to use value based modelling
NC PC FC
Credit
Mitigation
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
Portfolio
Analysis
Group Positioning
119
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ners
Inc.
Credit Risk: Data, IT & Reporting
Data Availability/
Capture
NOTE: Basel II
effectively making
current best practice
industry standard
Group PositioningIndustry Standard Best PracticeBasic
• No firm-wide counterparty ID
• Aggregate exposures manually
compiled at business unit level
• Limited availability of / access
to historical data
• Ad-hoc data capture
• Firm-wide counterparty ID
• Relevant data are available on a
customer / product level
• Historical data available for part
of customer base
• Basic risk information
systematically captured;
connection between
customer/transaction data and
collateral/recovery data is only
partially possible
• Firm-wide risk data warehouse with
consistent counterparty ID
• Automatic aggregation (quasi-online) of
exposure for all customers, products,
divisions etc
• Historical data available across entire
portfolio (429, 430)
• Full customer / risk information
systematically captured and stored for
central analysis (429, 430):
Customer data
Transaction data
Collateral and recovery information
which are connectable to transactions
/ customers
Financial data (e.g. from annual
reports, tax authorities)
Segment specific data
NC PC FC
• Limited reporting of exposure
below portfolio level
• Firm wide write-offs and
delinquencies reporting monthly
• Segment-level EL reporting
• Monthly reporting of business
unit risk and exposure
• Monthly reporting of product
level write-offs and arrears
• Cohort-level EL reporting
• Quarterly risk reports containing
concentration analyses
• (Monthly) reporting of product level
exposure, risk and concentrations (439,
440, 743)
• (Monthly) reporting of product level write-
offs and arrears
• EL/ economic capital reporting to senior
management (743)
• Systematic stress test reporting
Reporting
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
120
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ners
Inc.
Credit Risk: Processes & Policies
Portfolio
Management/
Limit Setting
Group PositioningIndustry Standard Best PracticeBasic
• Simple exposure limits in place,
based on subjective judgement
• No formal sector limits
• Passive portfolio management
• More complex exposure limits
based on simple quantitative
analysis for:
Counterparties
Countries
Sectors
• Passive portfolio management
• Exposure limits based on sophisticated
analysis of full portfolio effects (770-777)
• Intra BU limits backed up by BU portfolio
model, as appropriate
• Active portfolio management capability
(within BU and group)
• Financial Institutions typically distinct
entity within Corporate BU or individual
Business Unit
NC PC FC
Corporate
Governance
NC PC FC
NOTE: No specific
Basel II requirements
regarding this area
• Risk and price incorporated
subjectively into approval
decision
• No formal risk based pricing
• Pricing linked to counterparty
rating (linked to PD), often
based on ‘pricing grid’;
sometimes still paper based
• Basic economic capital-based
pricing tools
• Risk-based pricing using EL, economic
capital and fully loaded costs
• Full relationship-based pricing (where
appropriate, e.g. Insurance companies)
Pricing
• Responsibility for the design or
selection, implementation and
performance of the internal
rating systems lies with an
independent credit risk control
unit (441,442)
• Internal audit performs annual
reviews on the system and
independent checks on
processes and numbers (443)
• The credit policy, rating system
and its uses are approved by
the Board or subcommittee
(438)
• Senior Management needs to
demonstrate understanding and
needs to work with credit control
function to discuss and improve
the rating process (439)
• Same as Industry Standard
121
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apital C
alib
ration P
art
ners
Inc.
Credit Risk: Processes & Policies (Cont’d)
Credit Approval
Process
Group PositioningIndustry Standard Best PracticeBasic
• Fully subjective underwriting
process
• No clear delegation process
• No real collateral valuation as
part of credit approval process
• Incomplete relationship view
• Committee-intensive process
with some delegation
• Process differentiated by facility
size
• Analysis of value of collateral in
approval process
• Business unit level aggregated
view taken
• Extensive documentation of
process and procedures
• Internal ratings and other credit
parameters must play an
essential role in the credit
approval process and bank
must have a credible track
record of their use (444, 445)
• Completion or approval of rating
assignment and review
conducted by a unit that does
not directly stand to benefit from
the extension of credit (424)
• High delegation of decision authority
• Process differentiated by risk
• Detailed analysis of collateral by type in
the credit process
• Full relationship view of economic capital
/ economic profit used for larger
exposures
Counterparty
Credit
Monitoring /
Provisioning
NC PC FC
NOTE: Basel II largely
in line with current
industry standard
• No automatic customer credit
monitoring after initial approval
process
• Some monitoring for larger
customers
• Qualitative assessment for
general provisioning
• Passive treatment of delinquent
credits
• At least annual review of
customer credit quality and
portfolio delinquency rates (425,
427)
• Specific provisioning based on
qualitative assessment
• Monthly analysis of delayed
payments for certain products
• Recovery process optimised to
ensure maximum recovery
rates.
• Early warning systems of deteriorating
credit quality
• Active management of watchlist using
specialised personnel
• Dynamic forward-looking provisioning
based on EL driven by output from rating
distributions / portfolio models
• Specific provisioning triggered by rating
(linked to PD) downgrades
• Recovery process treated as profit centre
NC PC FC
122
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apital C
alib
ration P
art
ners
Inc.
Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
123
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apital C
alib
ration P
art
ners
Inc.
Credit Risk: Methodology & Measurement
Customer/
Counterparty
Evaluation
Group PositioningIndustry Standard Best PracticeBasic
• Judgement-based or simple
quantitative grading tools
• Ordinal grades have meaning
within segments, but not across
(i.e. no calibration to master
scale)
• 5-6 performing grades per
segment
• No empirical or statistical
validation or back-testing
• Mainly quantitative scorecards,
often using vended rating
models
• Ordinal rating mapped
individually to PD or external
ratings
7-8 performing grades (404)
• Judgmental validation by expert
panel in addition to statistical
validation
• Ad hoc migration analysis and
back-testing
• Sometimes calibrated to Group-
wide master scale
Banks and Sovereigns
• Tailored internal rating model with both
quantitative and qualitative inputs (411)
• Application even for externally rated
counterparties
Large Corporates
• Tailored internal rating model with both
Tailored internal rating model with both
quantitative and qualitative inputs (411)
• Development based on actual default
history, expert input or external ratings as
benchmark
• Possibly complement with vended
solutions, e.g. EDF model when
appropriate
Mid market / SME
• Tailored internal rating models with both
quantitative, qualitative as well as
behavioural inputs (411)
• Development based on actual default
history
General
• Separation of borrower (PD) and facility
(LGD, EAD) (396)
• Model results are mapped to cardinal
scale (PDs) (397)
• Central tendency calibration (461-463)
• Extensive statistical validation during
development phase (420)
• Routine migration analysis, back-testing
and revalidation of model power (417,
441)
• Master scale, with at least 15 performing
grades
• Customisation of rating model to reflect
local market conditions and accounting
conventions (389)
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
124
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apital C
alib
ration P
art
ners
Inc.
Credit Risk: Methodology & Measurement (Cont’d)
Exposure
Measurement
NOTE: Basel II
effectively making
current best practice
industry standard
Industry Standard Best PracticeBasic
• Ad hoc manual measurement of
aggregate exposure
• Limited treatment of overdraft
facilities / uncommitted lines
• Current value of derivatives
exposures only
• Notional measurement with
basic/ regulatory credit
conversion factors
Some validation with
internal experience
• Explicit treatment of EAD for overdrafts
and uncommitted lines (474 - 479)
• Expected exposure and maximum likely
exposure profiles for derivatives
incorporating netting and collateral effects
(309, 317)
• Values validated with historic data (478)
NC PC FC
• No consistent grouping of
collateral into types
• Generic values used for LGD
with no validation to bank
experience
• Crude LGD estimate, typically
based on collateral value at
origination (not at default) or
only using collateral type, but
not collateral amount
• Some validation to bank
experience
• Guarantees and covenants incorporated
into analysis (332, 480)
• LGD calculation based on economic loss
(468)
Write-off amount, time to recover and
administrative costs all used in
calculation
Based on internal data (431, 470)
• Spreadsheet-based portfolio
aggregation
Questionable quality /
aggregation of input data
Data cohorted at BU level
Little / no recognition of
correlation and
concentration effects
• Minimal portfolio analysis,
typically confined to exposures
and ‘quality’ monitoring
• Incomplete Group view
• Central Portfolio Model (CPM)
(spreadsheet or vended)
Bottom-up measurement on
customer / transaction level
Recognition of correlation
and concentration effects
• Complete Group view
(incorporating interaction effects
between portfolios)
• Rudimentary sensitivity /
scenario testing capabilities
(434–437)
• Vended or in-house bespoke
parameterised CPM
Detailed cohorting by risk
characteristics
Thorough treatment of correlations
between counterparties, industries
and geographies
Ability to ‘condition’ losses based on
macro-economic scenarios
Incorporation of securitizations
Explicit treatment of interest rate risk
Option to use value based modelling
NC PC FC
Credit
Mitigation
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
Portfolio
Analysis
Group Positioning
125
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apital C
alib
ration P
art
ners
Inc.
Credit Risk: Data, IT & Reporting
Data Availability/
Capture
NOTE: Basel II
effectively making
current best practice
industry standard
Group PositioningIndustry Standard Best PracticeBasic
• No firm-wide counterparty ID
• Aggregate exposures manually
compiled at business unit level
• Limited availability of / access
to historical data
• Ad-hoc data capture
• Firm-wide counterparty ID
• Relevant data are available on a
customer / product level
• Historical data available for part
of customer base
• Basic risk information
systematically captured;
connection between
customer/transaction data and
collateral/recovery data is only
partially possible
• Firm-wide risk data warehouse with
consistent counterparty ID
• Automatic aggregation (quasi-online) of
exposure across countries for all
customers, products, divisions etc
• Historical data available across entire
portfolio (429, 430)
• Full customer / risk information
systematically captured and stored for
central analysis (429, 430):
• Customer data
• Transaction data
• Collateral and recovery information which
are connectable to transactions /
customers
• Financial data (e.g. from annual reports,
tax authorities)
• Segment specific data (e.g. for real
estate)
NC PC FC
• Limited reporting of exposure
below portfolio level
• Firm wide write-offs and
delinquencies reporting monthly
• Segment-level EL reporting
• Monthly reporting of business
unit risk and exposure
• Monthly reporting of product
level write-offs and arrears
• Cohort-level EL reporting
• Quarterly risk reports containing
concentration analyses
• (Monthly) reporting of product level
exposure, risk and concentrations (439,
440, 743)
• (Monthly) reporting of product level write-
offs and arrears
• EL/ economic capital reporting to senior
management (743)
• Systematic stress test reporting
Reporting
NOTE: Basel II
effectively making
current best practice
industry standard
NC PC FC
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Credit Risk: Processes & Policies
Portfolio
Management/
Limit Setting
Group PositioningIndustry Standard Best PracticeBasic
• Simple exposure limits in place,
based on subjective judgement
• No formal sector limits
• Passive portfolio management
• More complex exposure limits
based on simple quantitative
analysis for:
Counterparties
Countries
Sectors
• Passive portfolio management
• Exposure limits based on sophisticated
analysis of full portfolio effects (770-777)
• Intra BU limits backed up by BU portfolio
model
• Active portfolio management capability,
international exposures used for strategic
diversificationNC PC FC
Corporate
Governance
NC PC FC
NOTE: No specific
Basel II requirements
regarding this area
• Risk and price incorporated
subjectively into approval
decision
No formal risk based pricing
• Pricing linked to counterparty
rating (linked to PD), often
based on ‘pricing grid’;
sometimes still paper based
• Basic economic capital-based
pricing tools
• Risk-based pricing using EL, economic
capital and fully loaded costs
• Full relationship-based pricing; defined
‘override’ structure
Pricing
• Responsibility for the design or
selection, implementation and
performance of the internal
rating systems lies with an
independent credit risk control
unit (441,442)
• Internal audit performs annual
reviews on the system and
independent checks on
processes and numbers (443)
• The credit policy, rating system
and its uses are approved by
the Board or subcommittee
(438)
• Senior Management needs to
demonstrate understanding and
needs to work with credit control
function to discuss and improve
the rating process (439)
• Same as Industry Standard
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Credit Risk: Processes & Policies (Cont’d)
Credit Approval
Process
Group PositioningIndustry Standard Best PracticeBasic
• Fully subjective underwriting
process
• No clear delegation process
• No real collateral valuation as
part of credit approval process
• Incomplete relationship view
• Committee-intensive process
with some delegation
• Process differentiated by facility
size
• Analysis of value of collateral in
approval process
• Business unit level aggregated
view taken
• Extensive documentation of
process and procedures
• Internal ratings and other credit
parameters must play an
essential role in the credit
approval process and bank
must have a credible track
record of their use (444, 445)
• Completion or approval of rating
assignment and review
conducted by a unit that does
not directly stand to benefit from
the extension of credit (424)
• High delegation of decision authority
• Process differentiated by risk
• Detailed analysis of collateral by type in
the credit process
• Full relationship view of economic capital
/ economic profit used for larger
exposures
• Organisational setup differs, either
distinct ‘Business Unit’ with dotted
reporting lines to Corporate etc. or
specific expertise within relevant
business units
Counterparty
Credit
Monitoring /
Provisioning
NC PC FC
NOTE: Basel II largely
in line with current
industry standard
• No automatic customer credit
monitoring after initial approval
process
• Some monitoring for larger
customers
• Qualitative assessment for
general provisioning
• Passive treatment of delinquent
credits
• At least annual review of
customer credit quality and
portfolio delinquency rates (425,
427)
• Specific provisioning based on
qualitative assessment
• Monthly analysis of delayed
payments for certain products
• Recovery process optimised to
ensure maximum recovery
rates.
• Early warning systems of deteriorating
credit quality
• Active management of watchlist using
specialised personnel
• Dynamic forward-looking provisioning
based on EL driven by output from rating
distributions / portfolio models
• Specific provisioning triggered by rating
(linked to PD) downgrades
• Recovery process treated as profit centre
NC PC FC
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Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
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Country and Transfer Risk: Methodology & Measurement
Treatment of
Country Risk
Group PositioningIndustry Standard Best PracticeBasic
• Use of agency ratings and ECA
scores (55)
• Rudimentary/no treatment of
country transfer risk in
economic capital framework
• Internal country rating mapped
to PD and complemented by
agency ratings and ECA scores
(462)
• Annual review process (425)
• Country risk economic capital
calculated as overlay to credit
risk
• Country and transfer risk are
captured through the same
model
• Some double counting of risk of
consecutive customer and
country default
• Internal country rating mapped to PD and
complemented by agency ratings, ECA
scores and bond spreads (462)
• Annual review process (425)
• Country and transfer risk are captured
through different models or different
calibrations of the same model
• Country risk economic capital calculated
as overlay to credit risk
• Calibrated to ensure no double counting
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
• Ad hoc manual measurement of
aggregate exposure
• Straightforward methodology for
country exposure
• Current utilization used as EaD
• Straightforward methodology for country
exposure
• Current utilization used as EaD
Exposure
Measurement
NC PC FC
• No consistent grouping of
collateral into types
• Generic values used for LGD
with no validation to bank
experience
• LGD for country risk is
determined by Basel II values
• LGTE (=loss given transfer
event) not directly modelled
• Guarantees and covenants incorporated
into analysis (332, 480)
• LGTE is explicitly modelled using historic
data
• Sovereign LGD different from LGTE
Credit
Mitigation
NC PC FC
• Transfer risk is not included in
the credit portfolio model
• Transfer risk is partially included
in the credit risk calculations
Treatment as an additional
exposure
Treatment through separate
model
• Transfer risk is explicitly modelled using a
bottom up approachPortfolio
Analysis
NC PC FC
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Country and Transfer Risk : Data, IT & Reporting
Data Availability/
Capture
Industry Standard Best PracticeBasic
• Country risk component is not
stored in the system
• Relevant risk data are stored on
a customer / transaction level
• Country risk component is not
separately stored in the system
• All country and transfer risk components
are stored on a customer / transaction
level
NC PC FC
• No reporting for transfer risk • Country risk is reported through
simple report (e.g. foreign
exposures split by country,
rating, etc.)
• No reporting for transfer risk as
a separate risk category
• Separate reporting (using ECAP
framework) for transfer risk within the
monthly risk reports
NC PC FC
Reporting
Group Positioning
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Credit Risk: Processes & Policies
Limit Setting
Group PositioningIndustry Standard Best PracticeBasic
• Simple exposure limits in place,
based on subjective judgement
• More complex exposure limits
based on simple quantitative
analysis
• Passive portfolio management
• Exposure limits based on sophisticated
analysis of full portfolio effects (770-777)
• Incorporation of cross-country sector
concentrations
• Active portfolio management capabilityNC PC FC
Country - level
Credit
Monitoring
/Provisioning
NOTE: Basel II largely
in line with current
industry standard
NC PC FC
• Country Risk not incorporated
in credit approval or pricing
• Internal ratings and other credit
parameters must play an
essential role in the credit
approval process and bank
must have a credible track
record of their use (444, 445)
• Completion or approval of rating
assignment and review
conducted by a unit that does
not directly stand to benefit from
the extension of credit (424)
• (Regulatory requirements; additionally:
• Country (Transfer) Risk incorporated in
approval and pricing process, either as
part of the capital charge or as a cost
item
Approval
Process and
Org.
Governance
NC PC FC
• No automatic monitoring after
initial approval process
• Some monitoring for larger risk
areas
• Qualitative assessment for
general provisioning
• At least annual review of
customer credit quality and
portfolio delinquency rates (425,
427)
• Specific provisioning based on
country ratings and other
qualitative and quantitative risk
assessments
• Early warning systems of deteriorating
credit quality
• Active management of watchlist using
specialised personnel
• Specific provisioning triggered by rating
(linked to PD) downgrades (either on
country or obligor basis)
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Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
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Credit Risk: Methodology & Measurement
Recognition
Group PositioningIndustry Standard Best PracticeBasic
• Only partial recognition of
counterparty credit risk in the
trading book
• Partial recognition of
counterparty credit risk for OTC
derivatives transactions, repo-
style and other transactions
booked in the trading book
through the Basel II framework
(702)
• Recognition of counterparty credit risk for
OTC derivatives transactions, repo-style
and other transactions booked in the
trading book through the Basel II
framework (702)NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
• Inclusion of counterparty credit
risk using a simplified
framework:
EaD is defined as in the
Basel II document, i.e.
replacement cost plus add-
on
Static LGD
• Inclusion of counterparty credit
risk in the credit portfolio model
• Simplified consideration of
netting agreements
• Granular measurement of counterparty
credit risk within the portfolio context
using relevant risk drivers (e.g.
incorporation of an interest rate model)
• Netting agreements are explicitly
incorporated in the model
Portfolio
Analysis
NC PC FC
• Usage of Basel II framework
with haircuts set by the
regulator (e.g.186 for OTC
derivatives)
• Usage of Basel II framework
with haircuts set by the
regulator (e.g.186 for OTC
derivatives)
• Calculation of haircuts for repo-
style transactions using an
internal VaR-model (178)
• Usage of Basel II framework with haircuts
set by the regulator (e.g.186 for OTC
derivatives)
• Calculation of haircuts for repo-style
transactions using an internal VaR-model
taking correlations and netting
agreements into account (178)
Exposure
Measurement /
Credit Mitigation
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
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Credit Risk: Data, IT & Reporting
Data Availability/
Capture
Industry Standard Best PracticeBasic
• Basic risk components are
captured on standalone system
• Firm-wide counterparty ID
• Product level information stored
in the market risk data base
• Historical data available for part
of customer base
• Basic risk information
systematically captured
• Firm-wide risk data warehouse with
consistent counterparty ID
• Automatic aggregation (quasi-online) of
exposure for all customers, products,
divisions etc
• Historical data available across entire
portfolio (429, 430)
• Full customer / risk information
systematically captured and stored for
central analysis (429, 430)
NC PC FC
• No reporting of counterparty
credit risk in the trading book
• Monthly reporting of business
unit risk and exposure
• Monthly reporting of product
level write-offs and arrears
• Cohort-level EL reporting
• Quarterly risk reports containing
concentration analyses
• Monthly) reporting of product level
exposure, risk and concentrations (439,
440, 743)
• (Monthly) reporting of product level write-
offs and arrears
• EL/ economic capital reporting to senior
management (743)
• Systematic stress test reporting
NC PC FC
Reporting
Group Positioning
NOTE: Basel II
effectively making
current best practice
industry standard
NOTE: Basel II
effectively making
current best practice
industry standard
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Contents
1 Why Capital Calibration Partners (CCP)?
Market Risk
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Corporate
Division
Credit Risk
Corporate
1. Corporate Wing
2. Commercial Wing
Financial
Institutions
International
Activities
Country
Risk
Credit Risk
in Trading
Retail
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
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Credit Risk: Methodology & Measurement
Customer/
Counterparty
Evaluation
Group PositioningIndustry Standard Best PracticeBasic
• Basic risk pooling (using risk
related factor(s)) by Expected
Loss AND/OR
• Uncalibrated (i.e. not linked to
probabilities of default)
scorecard, potentially multi-
purpose
• No empirical or statistical
validation or back-testing
• Application and behavioural tool
on facility level
• Ad hoc migration analysis and
back-testing
• Sometimes calibrated to Group-
wide master scale
• Each exposure must be
assigned to a pool (401, 402)
• Internal rating tool tailored to Retail (395)
Using both application and
behavioural data
Separation of borrower (PD) and
facility (LGD, EAD) (401 & 402)
Development based on actual
defaults
• Model results are mapped to cardinal
scale - central tendency calibration
• Extensive statistical validation during
development phase (420)
• Routine migration analysis, back-testing
of PD calibration, and revalidation of
model power (417, 441)
• Calibration of all tools to master scale
• Well-defined bankwide validation process
• Each exposure must be assigned to a
pool (401, 402)
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
• Ad hoc manual measurement of
aggregate exposure
• Limited treatment of overdraft
facilities / uncommitted lines
• Notional measurement with
basic/ regulatory credit
conversion and k-factors
Some validation with
internal experience
• Explicit treatment of EAD for overdrafts
and uncommitted lines (336, 337)
• Values validated with historic data (479)
Exposure
Measurement
NC PC FC
NOTE: Basel II
effectively making
current best practice
industry standard
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Credit Risk: Methodology & Measurement (Cont’d)
Credit
Mitigation
Industry Standard Best PracticeBasic
• No consistent grouping of
collateral into types
• Basic risk pooling (using risk
related factor(s)) by Expected
Loss AND/OR
• Generic values used for LGD
with no validation to bank
experience
• Crude LGD estimate, typically
based on collateral value at
origination (not at default)
• Some validation experience
• Guarantees incorporated into analysis
(332, 480)
• LGD calculation based on economic loss
(468)
Write-off amount, time to recover and
administrative costs all used in
calculation
Based on internal data (473)
NC PC FC
• Credit risk in retail is not
included in the credit portfolio
model
• Central portfolio model (CPM)
(spreadsheet or vended)
High-level cohorting of input
data along main risk
characteristics
Simple recognition of
correlation and
concentration effects
Retail part is included in a
high level fashion (e.g.
through beta-distribution,
inverse normal, or using
historic loss levels on
business unit level)
Rudimentary stress testing
• Vended or in-house bespoke
parameterised CPM
• Retail credit risk is included in a pooled
fashion taking the average risk
parameters (i.e. PD, LGD, correlation
within pool, industry, number of
counterparties in the pool) as well as
volatility of the pool into account
• Stress testing based on consistent,
group-wide macroeconomic shock
framework
NC PC FC
Portfolio
Analysis
Group Positioning
NOTE: Basel II
effectively making
current best practice
industry standard
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Credit Risk: Data, IT & Reporting
Data Availability/
Capture
Industry Standard Best PracticeBasic
• No firm-wide counterparty ID
• Aggregate exposures manually
compiled at business unit level
• Limited availability of / access
to historical data
• Ad-hoc data capture
• Firm-wide counterparty ID
• Basic framework for
identification of
connected/correlated credit
risks
• Historical data available for part
of customer base
• Basic risk information
systematically captured
• Firm-wide risk data warehouse with
consistent counterparty ID
• Automatic aggregation (quasi-online) of
exposure for all customers, products,
divisions etc
• Historical data available across entire
portfolio (429, 433)
• Full customer / risk information
systematically captured and stored for
central analysis (429, 433)
• Banks must retain data on the pools to
which the exposure was assigned over
the year prior to default and the realised
outcomes on LGD and EAD (433)
NC PC FC
• Limited reporting of exposure
below portfolio level
• Firm wide write-offs and
delinquencies reporting monthly
• Segment-level EL reporting
• Monthly reporting of business
unit risk and exposure
• Monthly reporting of product
level write-offs and arrears
• Pool-level EL reporting
• Monthly) reporting of product level
exposure, risk and concentrations (441,
733, 734, 735)
• (Monthly) reporting of product level write-
offs and arrears (433)
• EL/ economic capital reporting (743)
• Systematic stress test reporting (434-
437)
NC PC FC
Reporting
Group Positioning
NOTE: Basel II
effectively making
current best practice
industry standard
NOTE: Basel II
effectively making
current best practice
industry standard
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Credit Risk: Processes & Policies
Pricing
Industry Standard Best PracticeBasic
• Pricing purely against the market • Basic Segmentation • Pricing underpinned by economic capital-based
analysis
• Partial risk-based pricing for mortgages
• Detailed segmentation (e.g. by product, customer
etc.)
• Fully subjective underwriting process
using unparameterised bureau scores
• No clear delegation process
• Incomplete relationship view
• Internal ratings play an essential role in
the credit approval process and credible
track record of usage (444, 445)
• Process differentiated by facility size
• Line of Business unit level aggregated
view taken
• Completion or approval of rating
assignment and review conducted by a
unit that does not directly stand to benefit
from the extension of credit (424)
• Industry standard as outlined to the left; additionally::
• Approval process is highly automated (driven by
internal rating model)
• Overrides involve high delegation of decision
authority
• Process differentiated by risk
• Full relationship view of economic capital / economic
profit used for larger exposures
NC PC FC
Credit Approval
Process
Group Positioning
NOTE: No specific Basel II
requirements regarding
this area
• No automatic customer credit monitoring
after initial approval process
• Some monitoring for larger customers
• Qualitative assessment for general
provisioning
• Passive treatment of delinquent credits
• At least annual review of customer credit
quality and portfolio delinquency rates
(425, 427)
• Specific provisioning based on qualitative
assessment
• Monthly analysis of delayed payments for
certain products (e.g. credit cards)
• Recovery process optimised to ensure
maximum recovery rates.
• Industry Standard as outlined on the left; additionally:
• Early warning systems of deteriorating credit quality
• Active management of watchlist using specialised
personnel
• Dynamic forward-looking provisioning based on EL
driven by output from rating distributions / portfolio
models
• Specific provisioning triggered by rating (linked to PD)
downgrades
• Recovery process treated as profit centre
NC PC FC
Counterparty Credit
Monitoring/
Provisioning
NOTE: Basel II largely in
line with current industry
standard
NC PC FC
Corporate
Governance
• Responsibility for the design or selection,
implementation and performance of the
internal rating systems lies with an
independent credit risk control unit (441-
442)
• Internal audit performs annual reviews on
the system and independent checks on
processes and numbers (443)
• The credit policy, rating system and its
uses are approved by the Board or
subcommittee (438)
• Senior Management needs to
demonstrate understanding and
involvement (439)
• Responsibility for the design or selection,
implementation and performance of the internal rating
systems lies with an independent credit risk control
unit(441-442)
• Internal audit performs annual reviews on the system
and independent checks on processes and numbers
(443)
• The credit policy, rating system and its uses are
approved by the Board or subcommittee (438)
• Senior Management needs to demonstrate
understanding and involvement (439)
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Contents
1 Why Capital Calibration Partners (CCP)?
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Credit Risk
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
Market Risk
Trading Banking Book
(incl. Investments)
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Market Risk: Methodology & Measurement
VaR
Methodology
Group PositioningIndustry Standard Best PracticeBasic
• Spreadsheet parametric VaR • Combination of Parametric,
Monte Carlo and Historical VaR
• VaR information reported
includes:
Group-wide VaR
Decomposition of VaR
Close-out adjusted VaR
• Regular back-testing (AMR
B.2.b)
• Combination of Parametric, Monte Carlo
and Historical VaR
• VaR information reported includes:
Group-wide VaR
Decomposition of VaR
Close-out adjusted VaR
• Complex pricing processes for options
and exotic derivatives explicitly modelled
(AMR B.4.h)
• Regular back-testing (AMR B.2.b)
NC PC FC
• Regulatory Capital
• Linear sensitivity testing
• Economic capital based on
closed formulae
Deriving P&L distribution
Confidence level
Annualization factor
Management intervention
• No break-down to BU
• Complete sensitivity analysis
and ad hoc scenario analysis at
business unit level
• Monte Carlo simulation
Confidence level
Time horizon
Management intervention
• Breakdown to BU & desk level
• Daily firm-wide & desk-level stress testing
(Quasi-real time stress grids for option
books)
• Stress scenarios tied to probability of
occurrence and account for correlations
between factors
• One year scenarios for estimating
economic capital
Economic Capital
Calculation
(& Stress Testing)
NC PC FC
• No diversification taken into
account
• Limited decomposition of risk
along dimensions like desk &
asset class
• Diversification within BU’s
• Decomposition of risk along
dimensions like desk, asset
class, geography & position
• Diversification fully taken into account
• Hot Spot, Best Hedge
• Best Replicating Portfolio Construction
Aggregation &
Portfolio Analysis
NOTE: No specific
Basel II requirements
regarding this area
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Market Risk: Data, IT & Reporting
Quality of Data
(for Economic
Capital
Calculation)
Group PositioningIndustry Standard Best PracticeBasic
• Market data from traders and
brokers
• Manual collection & analysis of
data
• Market data from independent
sources
• Automated data collection &
manual analysis feeds
• Data sets updated at least every
three months (AMR B.4.e)
• Risk factors cover interest rates,
exchange rates, equity prices
and commodity prices with
appropriate granularity (AMR
B.3)
• Market data automatically collected from
independent sources
• Central warehouse for firm-wide market
and position data & automatic analysis
feeds
• Data sets updated daily
• Risk factors cover interest rates,
exchange rates, equity prices and
commodity prices with appropriate
granularity (AMR B.3)
NC PC FC
• Weekly/daily risk reports at
business unit level
• Risk reports prepared by
Treasury
• Ad-hoc discussions
• Weekly/daily risk reports at
business unit level
• Risk reports prepared by
independent unit
• Regular business unit risk
management meetings
• Market risk is aggregated & managed
across all BUs
• Daily risk reports at business and desk
level with appropriate summaries to
senior management
• Regular business unit risk management
meetings
• Real time systems enable scenario
analysis across entire book at any time
Reporting
NOTE: No specific
Basel II requirements
regarding this area
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Market Risk: Processes & Policies
Risk
Management
Organisation
Group PositioningIndustry Standard Best PracticeBasic
• No formal separation between
risk taking and risk
management functions
• Independent management of
market risk in business units
• Centralisation of market risk
measurement
• Independence of risk
management compensation
from trading results
• Annual review of overall market
risk management process by
independent audit (AMR B.2.h &
B.6)
• Close integration of model into
risk management process (AMR
B.2.d)
• Risk reports prepared by financially
independent unit (AMR B.2.a)
• Give brief daily narrative reports in risk
profiles to traders and Senior
Management (active involvement) (AMR
B.2.a & B.2.c)
• Clear separation of risk taking & risk
assessment (AMR B.2.a)
• Annual review of overall market risk
management process by independent
(internal & external) audit (AMR B.2.h &
B.6)
NC PC FC
• Senior Management sets all
limits
• Soft limits
• Limits in terms of exposure due
to pre-defined sensitivity
analysis
• Notional & Duration limits
• Risk Management sets all limits
• Granular & aggregate VaR
limits
• Hard limits with link to
compensation
• Limit violations automatically
generate reports
• Limits based on risk
management models; limits well
understood by management
and traders (AMR B.2.e)
• Documentation of procedures,
controls and methodology (AMR
B.2.g)
• Regulatory requirements outlined to the
left; additionally:
• Risk Management sets BU limits. BU
distributes limits among desks
• Establishment and storing of global and
regional limits
• Target VaRStress test results used for
strategic decisions (limit allocation)
• Granular & aggregate VaR limits
• Limits set on tolerance for losses
• Limit violations automatically generate
hedges
• Routine and rigorous programme of
stress testing; results to be reflected in
policies and limits (AMR B.2.f)
Limit Setting
Responsibility
and Limit Policy
NC PC FC
• Minimum documentation in
place before trading is allowed
• Complete documentation and
authorisation from legal
department in place
• Internal software and settling
procedures set before trading is
allowed
• Complete documentation and
authorisation from legal department in
place
• Internal software and settling procedures
set before trading is allowed
• Price, valuation and risk models validated
New Product
Sanctioning
Process
NOTE: No specific
Basel II requirements
regarding this area
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Contents
1 Why Capital Calibration Partners (CCP)?
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Credit Risk
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
Market Risk
Trading Banking Book
(incl. Investments)
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ALM Risk: Methodology & Measurement
Transfer Pricing &
Separation of Hedgeable/
Unhedgeable Risk
Group PositioningIndustry Standard Best PracticeBasic
• Not all products fully transfer priced • Full transfer pricing • Full transfer pricing
• Storage of transfer price on deal level
NOTE: No specific Basel II
requirements regarding
this area
• Embedded options are not modelled • Simple measurement of embedded
options
• Embedded options are modelled using Monte Carlo
• Capture interaction(s) between:
Product balances
Administered rates
Modelling of
Customer Behaviour
NOTE: No specific Basel II
requirements regarding
this area
• Parallel shift in yield curve
Sensitivity analysis
Standardised rate shock
(PMSIRR 60)
• ‘Worst case’ assumptions for real estate
& equity
• Diversification benefits are not
accounted for
• Forecasts of future interest rates
incorporate a sufficiently large change
(PMSIRR 49)
• All material sources of IRR are covered
(repricing, yield curve, basis and option)
(PMSIRR 43)
• Stress testing includes ‘worst-case’
scenarios (PMSIRR 60)
• Scenario analysis with associated
probabilities
- Shift/twist
• IRR is modelled separately for each
currency with a significant exposure
(PMSIRR 53)
• For equity and real estate,
1-year volatilities are derived and ‘Worst
case’ is linked to confidence interval
• Variance/covariance approach for taking
diversification into account
Additional to industry standard:
• Historical stress testing including major events
• Monte Carlo generated interest rate scenarios
• For equity and real estate, 1-year volatilities are
derived and ‘Worst case’ is linked to confidence
interval; incl. stress testing
Modelling of Asset
Classes
& Aggregation of
Risk Classes
NC PC FC
NOTE: Currently ALM risk
is treated only under Pillar
II
• Basis point sensitivity testing (764: shock
of 200bp)
• Portfolio revaluation based on simplifying
assumption of revaluation and stress
tests
• IRR measurement systems assess
effects of rate changes on both earnings
and economic value (economic capital)
(PMSIRR 44)
• Capital held is commensurate with IRR
(PMSIRR 75)
• Full portfolio revaluation based on Monte Carlo and
historical simulation
• IRR measurement systems assess effects of rate
changes on both earnings and economic value
(economic capital) (PMSIRR 44)
• Capital held is commensurate with IRR (PMSIRR 75)
Economic Capital
Calculation
NC PC FC
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ALM Risk: Data, IT & Reporting
Quality of Data
Group PositioningIndustry Standard Best PracticeBasic
• Manual collection from
standalone spreadsheets held
at business units
• Infrequent (monthly) or no
aggregation of some business
units
• Benchmarking for equity/ real
estate
• Automated data feeds from all
business unit front end systems
to ALM unit providing data for
stress testing and limit
monitoring
• Commercially available external
data used to parameterise risk
models
• Volatility figures for real estate
and equity extracted from
external sources;no further
analysis
• Daily cashflow position for mapping onto
zero-coupon yield curve
• Bespoke market information collected
and used to parameterise risk models
• Volatility figures for real estate and equity
are based on extensive analysis of
various time windows; trend analysis, etc.
• Monthly reporting of limit
utilisation and sensitivity
analysis
• Funds solvency is not
monitored by group risk
management
• Monthly reporting of exposure,
limit utilisation, duration and
VaR from business units to ALM
unit
• Funds solvency is monitored,
but not regularly by group risk
management
• Board of Directors approve IRR
management policies;
Board/subcommittee and senior
management regularly review
IRR (PMSIRR 27, 28, 31)
• Regular review by independent
audit (PMSIRR 68)
• Weekly reporting
• Economic capital reporting
• Stress test reports based on
macro economic scenarios
• Funds solvency is regularly monitored by
group risk management
• Board of Directors approve IRR
management policies;
Board/subcommittee and senior
management regularly review IRR
(PMSIRR 27, 28, 31)
• Regular review by independent audit
(PMSIRR 68)
Reporting/
Oversight
NC PC FC
Note: Automated data
feeds are not
necessarily a
requirement for
calculation of economic
capital but useful for
better management
NOTE: Currently ALM
risk is treated only
under Pillar II
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Market Risk: Methodology & Measurement
Limit Setting
Group PositioningIndustry Standard Best PracticeBasic
• ‘Soft’ or no position target set
• Limits based on local metrics
• Limit methodology consistent
with simple exposure metrics
• No limits set for investment of
with-profit funds (investments
with implicit options)
• Single group-wide limit (with
allocation as appropriate) which
considers potential impact to
earnings and value of economic
capital (PMSIRR 57)
• Limits for IRR must be
established and enforced, and
should ensure that exceptions
receive prompt management
attention (PMSIRR 54, 56)
• Guidelines set for investment of
with-profit funds
• Industry Standard as outlined to the left;
additionally:
• Explicit position target set
• Loss limits combined with exposure limits
to enable dynamic management
intervention
• Limits set for investment of with-profit
funds
• Responsible for internal transfer
pricing policy
• Input to rate setting/changes in
administered rates
• Localised management
• Detailed daily risk reporting
• Support product structuring and
pricing
• Work with asset and liability
units for new product
development
• Centralised management with
ability to aggregate risks,
insurance and bank separate
• Provide pricing signals and assistance to
business units to redesign products in
order to achieve desired funding profile
• Centralised management with ability to
aggregate risks, insurance and bank are
aggregated for benefiting from natural
hedges across these businesses
• Actively manage group risk/reward profile
based on economic capital
A/L Mismatch
Management
NOTE: No specific
Basel II requirements
regarding this area
NC PC FC
• Performance targets not linked
to size of risk positions
• Regular measurement of
gapping profit
• ‘Cost of hedge’ analysis
• Cost of hedge’ analysis
• Performance Measurement consistent
with ALM policy (e.g. active risk
taking/profit centre vs. passive
management of risk within defined
parameter space)
Performance
Measurement
NOTE: No specific
Basel II requirements
regarding this area
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Contents
1 Why Capital Calibration Partners (CCP)?
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Credit Risk
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
Market Risk
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Operational Risk: Methodology & Measurement
Operational Risk
Awareness
Group PositioningIndustry Standard Best PracticeBasic
• Currently no explicit recognition
• Implicit concern confined to
those directly involved - Audit,
Insurance, Group level execs
• Driven by future regulatory
compliance
• Wider conceptual
acknowledgement across BUs
and central functions of the
need to explicitly assess
operational risk
• BUs cooperate in self-
assessments, although may not
fully buy-in
• Extent of awareness largely a
function of top level impetus /
initiative
• Group-wide acknowledgement of need to
explicitly assess and manage Op Risk
(SPMSOR 11, 660 - 663)
• Clear definition of activity process maps
in BUs enabling identification of process
interfaces / point sources for ex-ante
mitigation (SPMSOR 18, 660 - 663)
• Systematic tracking of observable
symptoms e.g. volume/error rates by
activity (SPMSOR 25, 670 - 673)
• Currently not quantified
• Regulatory capital proposed
• Varying standards of
methodology & approach to
quantifying Operational Risk
capital - combining regulatory
benchmarks & internal
approaches
• Some analysis of external loss
events
• No relevant adjustments to
multiple data sources
• Simplistic (e.g. cost base)
allocation methodology (causing
inconsistency across BUs)
• Unsystematic aggregation
• Clear formulaic link between targeted
rating and required capitalisation (669 f)
• Methodology in place for systematic
adjustments to external data relevant to
bank profile & translation of modelled loss
distribution to required economic capital
(665, 669 f, SPMSOR 23)
• Sophisticated quantitative allocation
methodology to identified BUs (e.g.
through scorecards) with consistent
grading scale and interactive process
(SPMSOR 25)
Analysis/
Methodology
Framework
NC PC FC
NOTE: Basel II
effectively migrating
industry standard
towards current best
practice
NOTE: Basel II (AMA)
effectively migrating
industry standard
towards current best
practice
NC PC FC
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Operational Risk: Processes & Policies
Target
Setting
Group PositioningIndustry Standard Best PracticeBasic
• No targets set for operational
risk losses
• Events accepted as routine
errors or as that which cannot
be mitigated against
• Rough/arbitrary group
expectation of operational
losses
• Where BU allocation attempted,
largely arbitrary, imposed top-
down
• Performance against targets not
really assessed or utilised for
review
• Looked upon as exercise for
determining rough level of
‘provisions’
• Joint decision between Group & BUs on
Operational Loss target (on the basis of
identified risk drivers)
• Feedback loop into periodic target review
(also concerning best practice control
processes)NOTE: No specific
Basel II requirements
regarding this area
• No formal capitalisation/ control
mechanisms
• Confined to minimal regulatory
compliance
• Annual procedural compliance
review
• Error detection through audit
(mostly high frequency/low-
severity errors)
• Audit & compliance
enforcement, focusing on major
areas (high risk or volume)
• (Conceptual) contingency
planning e.g. disaster recovery
plan, crisis management team
• Event-driven (reactionary)
adjustments to control policies
• Ex-post error detection - no
early warning signals
• Ad-hoc and largely reactionary
audit of controls
• Comprehensive quality assurance & risk
mitigation/control programs (SPMSOR
31)
• Consistent capture of operational loss
events (SPMSOR 25)
• Quality / error detection systems for early
warning signals (SPMSOR 27)
• Compliance & performance assessed by
independent central function with
explicitly linked penalty / reward system
(SPMSOR 16,21)
• Audit policies reflecting audit outcomes
and external benchmarking (666 e, 666 f,
SPMSOR 16, 29)
• Continuous model validation (663e)
• Pro-active scan for internal and external
changes (SPMSOR 15)
Controls
NC PC FC
NOTE: Basel II
effectively migrating
industry standard
towards current best
practice
• Standard external policy
undertaken
• More selective policies based
on recognised / identified risk
sources
• Adjustments in reaction to
events (ex-post)
• Recognition of Insurance as a means of
countering operational risk, which needs
to be integrated with risk control /
mitigation and capital allocation (677,
678, SPMSOR 36)
NC PC FC
NOTE: Basel II effectively
migrating industry
standard towards current
best practice
Insurance
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Contents
1 Why Capital Calibration Partners (CCP)?
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Credit Risk
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
Market Risk
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Business Risk: Processes & Policies
Methodology
Group PositioningIndustry Standard Best PracticeBasic
• Business Risk not calculated • Business Unit specific
benchmarks and high-level
diversification assumptions
used
OR
• Business Unit level income
volatility estimates and intra BU
diversification via high level
VAR/COVAR calculations
• Analogue Approach used or
accounting data (not fully
sanitised)
• Inter and intra BU diversification
accounted for at various levels of detail
(product categories) based on
sanitised/adjusted accounting data
• Typically VAR/COVAR approach
• Income and Cost volatility captured
• Historical data covering, continuously, a
complete business cycle (or pieces
thereof, adjusted appropriately)
NOTE: No specific
Basel II requirements
regarding this area
• Not applicable • High level analysis of
breakdown and drivers
• Detailed analysis of risk drivers and
potential concentrations
• Sensitivity tests as part of a group-wide
macro-economic shock scenario
framework
• Pro-cyclicality and impact of changes in
the business cycle
Analysis
NOTE: No specific
Basel II requirements
regarding this area
• Not applicable • Reported as part of overall
Economic Capital figures
• Basic analysis of risk drivers
• Detailed reporting by line of business
• Risk driver and diversification benefit
analysis
• Management at group and BU-level
through portfolio steering and targeted
segment entry/exit where possible and
otherwise appropriate
Reporting
NOTE: No specific
Basel II requirements
regarding this area
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Contents
1 Why Capital Calibration Partners (CCP)?
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Credit Risk
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
Market Risk
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Economic Value: Methodology
Risk Based
(Economic)
Capital and
Aggregation
Group PositioningIndustry Standard Best PracticeBasic
• Top-Down Economic Capital
Model and Framework for major
risk types (Credit, Market,
Operational)
• Aggregation via simple
summation or high-level
benchmarks used to account
for inter and intra risk
diversification
• Group-wide economic risk
framework covering all
economic risks (implied by 731,
732)
• Granular assessment of market
(VAR) and credit risk (CPM)
• Quantification of inter and intra
risk diversification benefits;
VAR/COVAR approach to
aggregation
• Stressed correlations used for
scenario analyses
• Simplifying distribution
assumptions made for some
risk types
• Multi-year capital calculations
on the basis of one-year results
and basic assumptions about
portfolio migration
• Group-wide, comprehensive economic
risk framework (implied by Basel II: 731,
732)
• Multi-period credit capital model
• Fully integrated simulation engine for
estimating aggregate distribution function
or use of suitably parameterised copulas
• Extensive impact analyses and stress
tests on the basis of macro-economic
factors and consistently defined
scenarios/shocks
• One period view based on
reasonably accurate parameter
estimates
• Sensitivity analysis
• Basic multi-period view
incorporating simple
prepayment and other
behavioural assumptions
• Reasonably accurate parameter
forecast (e.g. qualitative, based
on expert judgement)
• New business modelled on the
basis of simplified assumptions,
not linked to economic forecasts
• Multi-period view incorporating
behavioural models for prepayment and
other optionalities linked to bank-wide
stress tests and scenario analyses
• Accurate and robust parameter forecast
ranges (risk parameters and discount
rate) based on macro-economic analyses
• Forecast of new business on the basis of
group strategy and models of the
economic environment
Multi-period / One
period view
NC PC FC
• No fully risk-adjusted P&L • RAROC and EP used
categorically; not tailored to
specific type of evaluation (e.g.
investment project vs. BU
performance comparison)
• Differentiated use of performance metrics
• Multi-period Economic Profit (SVA, AVA)
used as the primary metric for decision
making purposes
• RAROC used for high-level differentiation
and selected comparison purposes
Economic Profit
vs RAROC
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Economic Value: Processes & Policies
Budgeting and
Strategic
Planning
Group PositioningIndustry Standard Best PracticeBasic
• Accounting based measures
used for budgeting
• Market share or revenue
oriented top-off the house
planning
• Little consultation with the
Business Units
• No scenario-based forecasts or
impact assessment
• Strategic decisions based on
simple market analyses or
revenue forecasts
• Little or no regulatory capital
forecasting and management
• Strategic planning and group-
wide budgeting primarily in
accounting terms, or only high
level EP target set at group
level
• Planning as an iterative process
with the Business Units
• Scenario analyses and group-
level impact assessment
• Risk-based planning in
organisational silos, no
comprehensive risk/capital
framework and lack of
consistency in risk assessment
capabilities across the group
• Reactive regulatory and
economic capital management
• Group-level EP or Shareholder Value
Added (SVA) targets (also communicated
to the markets)
• Well-defined risk appetite (730)
• Cascading of EP targets to BU or product
category level (in some cases to segment
and customer grade) in an iterative,
consultative process between Group
Risk, Group Centre and the BUs
• Strategic planning based on in-depth
analyses of value generation across the
portfolio and evaluation of
market/expansion strategies
• Bottom-up Economic Capital used as a
portfolio steering tool
• Sophisticated scenario analysis and BU-
level impact assessment
• Group-wide communication phrased in
terms of economic value creation
• Pro-active capital planning and
management (729)
• Revenue or market share
oriented performance metrics
• Crude differentiation by Line of
Business
• Little or no account taken of
portfolio riskiness
• Large number of metrics and
targets to be met
• Accounting-type profit or RoE
targets
• Implicit consideration of portfolio
quality (via provisions or write-
offs)
• Differentiated targets by
products and/or customer types
• Potentially, high level EP targets
• Full Economic P&L at Business Unit and
sometimes CRM level
• Differentiated Economic Profit or RAROC
targets
• Portfolio quality explicitly accounted for
via EL and Economic Capital
• Multi-period targets; strong Shareholder
Value Added (SVA) / VBM focus
• Small number of pertinent metrics other
than EP targets (e.g. tactical: market
share etc.)
Risk Adjusted
Performance
Measurement
NC PC FC
• Traditional accounting
profitability measure
• Economic Pricing incorporating
Expected Loss (EL) and
Economic Capital charges
• Limited use of other account
information
• Customer Value (CVM) based pricing
incorporating both economic perspectives
as well as all other available customer
information (cross-sell, expected
behaviour etc.)
Pricing
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Economic Value: Data, IT, Reporting and Areas of Application
IT Infrastructure
Group PositioningIndustry Standard Best PracticeBasic
• No centralised data warehouse or
only legacy mainframe-type
systems
• Risk-information silos (BU level)
• IT-dominated information handling
and retrieval; lack of access for
business level analysts
• Data often held by analysts in
spreadsheets and Access
databases (‘Data Queens’)
• Simple Excel models
• Central data warehouse containing
the majority of data relevant to
bottom up risk assessment (risk
parameters, ratings) and results
(e.g. allocated capital figures)
OR
• Well-defined extraction and load
processes to retrieve data and feed
it to the relevant tools/models
• Data readily accessible for analysis
throughout the organisation (e.g.
Excel interface)
• Custom-built or vended solutions for
risk modelling (e.g. credit, market
risk etc.)
• Extensive modelling based on Excel
with database access
• Industry Standard as described to the left;
additionally:
• All relevant data and output held centrally with
fully automated data feeds for relevant models
• Data and analysis results standardised across
the group (including subsidiaries) and readily
accessible
• Standardized reports generated automatically
• Accounting focused reporting,
insufficient representation of
economic results
• Misaligned use of metrics; lack of
clear communication regarding
meaning of to businesses and
senior management by group risk
function
• Lack of standardised layouts used
across the group and/or
subsidiaries
• Redundant reporting and
‘information overload’; lack of focus
and targeted provision of
information to enable decision
making
• Accounting and Economic/VBM
focused reports
• Diversity of formats and excessive
information provision to senior
management
• Some automation in report
production
• Standardised format
• Clearly structured and concise risk
management reports for senior management
with consistently defined levels of detail
• Automated production of standard reporting
sections supplemented by relevant ad-hoc
analyses
• Risk Dashboard & related online tools with
drill-down capabilities for senior management
Reporting
• No real VBM framework • Group and BU Level, limited
application at product category or
customer level
• Pervasive use across group and areas of
application (Performance Measurement,
Pricing, Strategy evaluation etc.)
Area of Application
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Contents
1 Why Capital Calibration Partners (CCP)?
Economic Value Framework
Operational Risk
Business Risk
Pillar II
Credit Risk
Executive Summary2
Basel II – First Pillar: Credit Risk Capital Charges3
Basel II – First Pillar: Operational Risk Capital Charges4
Basel II – Second Pillar: Supervisory Review5
Basel II – Third Pillar: Market Discipline6
Stakeholder selection for self assessment7
Self assessment8
Market Risk
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Pillar II: Overview
This area of the Basel II Accord is primarily concerned with regulatory supervision
It comprises of several sections, covering, most notably, four ‘principles of supervision’:
• Reduce capital supporting non-performing loans
• Reduce negative carry by eliminating financing needs
• Shift capital and resources into more profitable businesses
• Optimize bank’s balance sheet
• Improve bank’s credit ratings
• Reduce operating costs due to smaller work-out departments
While explicit requirements are only detailed in the first principle, other areas of the document imply minimum standards of documentation and senior management involvement and education
Pillar II also covers a number of areas that warrant particular supervisory review, thus designating current industry standard (or best practice) as a future regulatory requirement
Source: Text 159
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Pillar II: Principle 1 – Capital Adequacy and Risk Profile
1. Basel II effectively defines current Best Practice as the future industry standard.
Board &
Management
Oversight
Group PositioningRequirements1
• Need to understand nature and level of all material
risks (728)
• Set risk tolerance and appetite (730)
• Ensure capital adequacy (728)
• Decide overall strategy with regards to capital
sources and expenditures (729)
• Set policies and procedures (730)
NC PC FC
Sound Capital
and
Comprehensive
Risk
Assessment
• Policies and procedures need to ensure
identification, measurement and reporting of all
material risks (731)
• A process must relate capital to the level of risk,
capital adequacy goals to risk and strategy and
business plan (731)
• Internal controls, reviews and audit to ensure
integrity of management process (731)
• All material risks faced by the bank need to be
addressed (732)
• Credit Risk based on detailed rating systems and
with respect to concentrations etc. (734, 735)
• Operational Risk (736, 737)
• Market Risk (738)
• Structural Interest Rate Risk (739, 740)
• Liquidity Risk (741)
• Other risks; not necessarily on a quantitative basis
(742)
NC PC FC
Monitoring,
Reporting and
Internal Control
Review
• Evaluate level and trend of material risks, in
particular (743):
Sensitivity analysis of key assumptions, checks
for reasonableness
Compliance with capital adequacy goals (current
and future, with respect to the bank’s strategy)
• Produce reports for senior management and board
(743)
• Board has responsibility that management institutes
adequate control and compliance policies (744)
• Periodic reviews to ensure integrity, accuracy and
reasonableness (745):
Capital assessment vis-à-vis nature, scope and
complexity of operations
Risk Concentration
Accuracy and completeness of data inputs
Validity of scenarios
Stress testing and analysis assumptions
NC PC FC
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Pillar II: Principles 2 – 4, Guidelines for the regulator
Principle 2:
Review process
• Stipulates regular supervisory reviews
through (746):
On-site examinations or inspections
and off-site reviews
Discussions with management
Periodic reporting
• Review of risk assessment adequacy (748)
• Assessment of capital adequacy (749):
Target levels & monitoring
Composition of Capital
Provision for unexpected events
• Assessment of the control environment
(751, 752)
• Review of compliance with minimum
standards (753 – 755)
Principle 3:
Beyond
minimum
requirements
• Supervisors should expect banks to
operate above the minimum regulatory
capital levels
• The accord recognises that there may be
several reasons why banks may choose to
do so (757):
Strategic / Rating
Buffer for normal business fluctuations
Cost aspect
• Supervisors are required to consider the
appropriateness of the capital level in
respect to the particular market
environment
Principle 4:
Early
Intervention
• The accord dictates close monitoring and
early intervention to prevent capital levels
from falling below minimum
• Supervisors may choose from a number of
corrective actions, such as (759):
Intensified monitoring
Restriction of dividend payments
Immediate raising of additional capital
• The Accord also stresses that additional
capital may not be a permanent solution
but that the bank should be put in a better
position to assess and manage its risks
(760)
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Pillar II: Specific Issues
Pillar II mentions a range of specific areas warranting particular supervisory scrutiny
While not stipulating requirements for banks’ systems and procedures explicitly, they implicitly refer to a range of models and processes generally considered as current industry standard. In particular:
• Structural Interest Rate Risk (762 – 764): Not captured under Pillar I, but recognised as significant, thus warranting close supervision and implying sound systems and management practice
• Review of Stress Tests in Credit Risk (765): Stress tests should be part of a consistent bank wide review and planning framework
• Impact of changes in the definition of default (766): Implies that all relevant data should be captured and readily available for modelling purposes
• Additional risks introduced through Credit Risk Mitigation (767 – 769): Requires sound collateral management and assessment systems as well as documented (and sound) management processes to adjust capital figures appropriately
• Credit Risk Concentration (770 – 777): Concentration is explicitly mentioned as the single most important cause of problems. Sound assessment implies some form of Credit Portfolio Model (CPM) and accompanying stress and scenario testing. N.B. The accord recognises that concentration risk can also occur other than in terms of single-name or segment exposure.
• Operational Risk (778): The Basic Indicator and Standardised approach should be seen as a guidance; appropriateness vis-à-vis the market and other banks should be reviewed
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Disclaimer
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