Déjeuner causerie Développements canadiens en gestion des risques

Déjeuner causerie Développements canadiens en gestion des risques

Alicia Zemanek

Vice-présidente Relations avec les investisseurs Chef des Risques Gestion intégrée des risquesBanque Laurentienne du Canada

The New Basel II Accord and Its Impact on the Banking Industry

Laurentian Bank of Canada CIRANO-PRMIA

2

Agenda• Evolution of Basel I into Basel II• Old vs New Basel Accord• The New Basel II Accord• Results of the QIS3 Exercise• Who is subject to the New Basel II Accord• Basel II Impact on the Banking Industry• Will we Have a New Accord by Spring 2004 ?


3

Evolution of Basel I into Basel II1988 Endorsement of Basel I Accord by G-10 central banks

“The current accord is based on the concept of a capital ratio where the numerator represents the amount of capital a bank has available and the denominator is a measure of the risks faced by the bank and is referred to as risk-weighted assets”

Problem with the accord: The Accord is insensitive to credit risk ratings. A General Electric loan (AAA rated), inder Basel I, generates more capital requirements than a sovereign debt to Mexico (BBB- rated)

Risk Weights Asset Categories

0% Cash, Sovereign loans, I nsured Residential Mortgages

20% Bank loans, Municipal loans

50% Uninsured Residential loans

100% All other loans and non-performing loans

Tier 1 Total

Basel I 4% 8%

OSFI 7% 10%

Minimum Capital Requirements

Available Capital 1 249 400

Risk Weighted Assets 9 276 528

Total Capital Ratio 13.5%

Calculation of Total Capital Ratio (as of oct 31st 2002 in $K)


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Old Vs New Basel Accord

1 Pillar (20 pages)(covers the quantification of minimum regulatory capital)

1 Methodology (approach) for calculating minimum capital

Not very sensitive to risk

Only credit commitmentswith maturity 1 yearare included in the quantification (explains 364 day revolving lines)

Capital relates only to credit & market risk

3 Pillars (216 pages)Pillar 1: Min. capital requirementsPillar 2: Supervisory review Pillar 3: Public disclosure

3 Methodologies (approaches) for calculating minimum capital

Uses external or internal risk ratings to compute minimum capital requirements for credit risk

All credit commitments are included in the calculation ex. VISA, commitments (for LBC increases capital between 6% & 17%)

Capital relates to Credit, Market & Operational Risk (for LBC OP risk capital represents an additional 10%)

BASEL IBASEL I BASEL IIBASEL II


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The New Basel II Accord

Methodology Measurement

StandardizedOR RAROC

OR

+

= + + =

OR

Standardized

OR

+Standardized

OR

PILLAR I (Minimum Capital Requirements)

PILLAR II (Supervisory Review of Capital Adequacy)

PILLAR III (Public

Disclosure)

DIS

CL

OSU

RE

T

O

STA

KE

HO

LD

ER

S

Strategic Planning

Product Pricing

Capital Mgmt

RE

GU

LA

TO

RY

C

API

TA

L

AD

D-O

NRegulatory Capital for Credit Risk

Cap

ital R

atio

(min

. 8%

)

TO

TA

L R

EG

UL

AT

OR

Y C

API

TA

L

Tot

al B

ook

Cap

ital

less

Ded

uctio

ns

Tot

al R

egul

ator

y C

apita

l X 1

2.5

=

Min. Capital Ratio

Internal Model Approach

Advanced Internal Ratings

(AIRB)

Basic Indicator Approach (BIA)

Regulatory Capital for

Market Risk

Regulatory Capital for Operational

Risk

Foundation Internal Ratings

(FIRB)

Board

Internal Audit

Credit Risk

Struc-tural Risk

Opera-tional Risk

Market Risk

Performance Measurement

Advanced Measurement

Approach (AMA)

Use Test Stress Test

Corporate Governance

Risk Mgmt & Reporting Mgmt

Committee


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The New Basel II Accord Pillar I - Credit Risk - Standardized Approach

AAA A+ BBB+ BB+ B+ Below Un Past

to AA- to A- to BBB- to BB- to B- B- Rated Due

Sovereign 0% 0% 20% 50% 100% 100% 150% 100% 150%

Banks 20% 20% 50% 50% 100% 100% 150% 100% 150%

Corporates 100% 20% 50% 100% 100% 150% 150% 100% 150%

VISA 100% 75% 150%

X X Small Business 100% 75% 150%

Commercial 100% 100% 150%

X

Credit Conversion

Factor

Com

mitm

ents

Credit Conversion

Factor

X100% of exposure

20% of exposure (< or = 1 year), or else 50%

Exp

osur

es d

raw

n

On Balance Sheet Netting

Credit Derivatives

Basel IIBasel

I

50%

100%

100%

less Haircuts

75% 150%

MIN

IMU

M

RE

GU

LA

TO

RY

C

API

TA

L

100% 150%

RIS

K

WE

IGH

TE

D

EX

POSU

RE

S

Credit Risk Mitigation

Financial Collateral

LESS=

Commercial Mortgages

Residential Mortgages

Personal Lines of Credit

RISK WEIGHTS SLOTTING

Credit Risk Assessment

35% 100%Guarantees x 8% =


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Pillar I - Credit Risk - Standardized ApproachAn example...

OLD BASEL ACCORD = $ 40 K of Capital (CCF = 0% )

ExposureCredit

Conversion Factor

Risk Weights

Risk Weighted Exposure

Credit Risk

Mitigation

Min. Regulatory

Capital

$ 0.5 M X 100% X 100% = $ 0.5 M LESS 0 X 8 % = $ 40 K

$ 0.5 M X 20% X 100% = $ 0.1 M LESS 0 X 8 % = $ 8 K

Total $ 48 K

1M$ Commercial

secured Credit Line (secured by receivables with O/S

amount at $0.5 M)


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The New Basel II Accord Pillar I - Credit Risk - Foundation Internal Rating

For illustration onlyFor illustration only

1 0.02%2 0.05%3 0.08% Receivables 35%

4 0.15%5 0.20%6 0.30%7 0.40%8 0.60%9 0.90%

10 1.50%11 2.50%12 4.00%13 6.00%14 9.00% Gold 0%

15 15.00%16 20.00%17 30.00%18 100.00% C

omm

itmen

ts sl

otte

d by

PD

Credit Conversion

FactorE

xpos

ures

slot

ted

by P

D

100% of exposure

Credit Conversion

Factor

X

X

75% of exposure

X

Unsecured Subordinated

% of Loss Given a Default

(LGD)

Residential Real Estate

75%

Unsecured Senior

Commercial Real Estate

45%

35%

40%

0%

XOther Physical

less

CR

ED

IT R

ISK

MIT

IGA

TIO

N

(Cre

dit d

eriv

ativ

es, g

uara

ntee

s, on

-bal

ance

shee

t net

ting)

X 8%=

MIN

IMU

M R

EG

UL

AT

OR

Y C

API

TA

L

Risk Rating

Average historical

probability or default

X

AD

JUST

ME

NT

FO

R C

OR

RE

LA

TIO

N &

MA

TU

RIT

Y

=

RIS

K W

EIG

HT

ED

EX

POSU

RE

S

35%



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Pillar I - Credit Risk - Foundation Internal Rating An example ...

vs $ 48 K for the Standardized approach

ExposuresProbability of Default

(PD)

Credit Conversion

Factor (CCF)

% of Loss Given a Default (LGD)

Risk Weights



Min. Regulatory

Capital

X 0.42% X 100% X 35% X 36% = $ 0.18M 0 X 8 % $14 K

$ 0.5 M X 0.42% X 75% X 35% X 27% = $ 0.14M 0 X 8 % $11 K

Total $ 25 K

Adj

ustm

ent f

or c

orre

latio

n an

d m

atur

ity

$ 0.5 M

1M$ (Internal LBC Risk Rating 7) Commercial secured Credit Line (secured by receivables with $0.5 M O/S)


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The New Basel II Accord Pillar I - Credit Risk - Advanced Internal Ratings For illustration onlyFor illustration only

1 0.02%2 0.05%3 0.08%4 0.15% 50%

5 0.20%6 0.30% Receivables 35%

7 0.40%8 0.60%9 0.90%10 1.50%11 2.50% Corporate = 35%

12 4.00% Sovereign = 35%

13 6.00% Banks = 35%

14 9.00% Commercial = 35%

15 15.00% Res. Mortg.= 50%

16 20.00% Credit lines+VISA= 61%

17 30.00% Small Business = 35%

18 100.00%0%

50%

% of Loss Given a Default

(LGD)

Unsecured Subor- dinated 60%

Residential Real Estate

Commercial Real Estate

Unsecured Senior


Other Physical

Credit Conversion Factor (CCF)

100%

Estimate of CCF

X

AD

JUST

ME

NT

FO

R C

OR

RE

LA

TIO

N &

MA

TU

RIT

Y

=

RIS

K W

EIG

HT

ED

EX

POSU

RE

S

25%

25%

less

CR

ED

IT R

ISK

MIT

IGA

TIO

N

(C

redi

t der

ivat

ives

, gua

rant

ees,

on-b

alan

ce sh

eet n

ettin

g)

X 8%=

MIN

IMU

M R

EG

UL

AT

OR

Y C

API

TA

L

X

X

X

X

Exp

osur

es sl

otte

d by

PD

Com

mitm

ents

slot

ted

by P

D

Risk Rating

Average historical

probability or default


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Pillar I - Credit Risk - Advanced Internal Ratings An example ...

vs $ 48 K under the Standardized approach and $ 25 K for the Foundation Approach

ExposuresProbability of Default

(PD)

Credit Conversion

Factor (CCF)

% of Loss Given a Default (LGD)

Risk Weights



Min. Regulatory

Capital

X 0.42% X 100% X 35% X 36% = $ 0.18M 0 X 8 % $14 K

$ 0.5 M X 0.42% X 35% X 35% X 13% = $ 65 K 0 X 8 % $5.2 K

Total $ 19.2 K

Adj

ustm

ent f

or c

orre

latio

n an

d m

atur

ity

$ 0.5 M

1M$ (Internal LBC Risk Rating 7) Commercial secured Credit Line (secured by receivables with $0.5 M O/S)


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The New Basel II Accord Pillar I - Operational Risk - Basic Indicator

AVERAGEOF BANKS’

ANNUAL ADJUSTED

GROSS INCOME

OVERLAST

3 YEARS

PRESCRIBED ALPHA

FACTOR () OF 15%

x = MINIMUM REGULATORY

CAPITAL


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The New Basel II Accord Pillar I - Operational Risk - Standardized Approach

Averageof Bank’s

annual gross

income overlast

3 years

PRESCRIBED BETAFactor by Business Line

Corporate finance 18%Trading & Sales 18%Retail Banking 12%Commercial Banking 15%Payment & Settlement 18%Agency Services 15%Asset Management 12%Retail Brokerage 12%

x =MINIMUM

REGULATORY CAPITAL


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The New Basel II Accord Pillar I - Operational Risk - AMA

Inte

rnal

Fr

aud

Empl

oym

ent

Pr

acti

ces

&

Wor

kpla

ce

safe

tyCl

ient

s,

Prod

ucts

ad

Bu

sine

ss

Prac

tices

Exec

utio

n,

Del

iver

y &

Pr

oces

s M

gmt

Corporate Finance

Trading & Sales

Payment & Settlement

Agency Services

Asset Management

Retail Brokerage

Commercial Banking

Retail Banking

Busi

ness

D

isru

ptio

n an

d Sy

stem

Fa

ilure

s

Exte

rnal

Fr

aud

Reduction in Operational

Losses

Outputs

Management Tools

Risk and Control Self-Assessment Workshops

Internal Operational Loss Data

Scenarios

Statistical Distributions

Self-Assessments

Scenario Analysis

Standardized Approach for 6 business lines

7 Categories of Operational Losses

8 Bu

sine

ss L

ines

External Operational Loss Data

I nputs

Statistical Models

Methodologies

Regulatory Capital

AMA Approach for 2

businesses

Dam

age

to

Phys

ical

As

sets


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Who is Subject to the New Basel II Accord ?In the US

• Banks that are subject to the AIRB on a mandatory basis are those with total banking assets of $250 billion or more or total on-balance-sheet foreign exposure of $10 billion or more

• Banks not subject to the AIRB on a mandatory basis can choose voluntarily to apply this approach.

• Other banks would continue to apply the existing Basel I capital rules. Neither the standardized nor foundation approach will be permitted in the US.

• Furthermore, all banks would continue to be subject to the existing capital ratio requirements. That is, a 10% total capital ratio, a 6% tier 1 capital ratio, and a 5% leverage ratio.


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Who is subject to the New Basel II Accord ?In Canada

• OSFI expects implementation of AIRB by October 2006 forall material portfolios in Canada and the US by domestic banks that have total capital in excess of $5 billion Canadian,or that have greater than 10% of total assets or greater than 10% of total liabilities that are international.

• For the other banks, OSFI’s guideline is less clear as there seemed to be legitimate questions about how or if the Accord should apply to other small domestic deposit-taking institutions in Canada. In other words, OSFI is debating whether smaller institutions should stay with Basel I (ex. Banks such as the recently incorporated Canadian Tire bank or Sears bank).

• OSFI confirmed to Laurentian Bank that it may choose to apply voluntarily for approval from OSFI to use the AIRB approach, so long as it meets the same infrastructure requirements that other banks must satisfy.


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Results of the QIS3 Exercise For the Industry

Approach Group 1 Group 2

Standardized average 11% 3% minimum -15% -23% maximum 84% 81%

IRB Foundation average 3% -19% minimum -32% -58% maximum 55% 41%

IRB Advanced average -2% minimum -36% maximum 46%

G10

% Change in Regulatory Capital from Current Accord (new CP3 basis)

There’s considerable variation in the change in capital requirements from Basel I to Basel II. This reflects the relative risk insensitivity of the current accord

Portfolio Group 1 Group 2

Corporate -4% n.a.Sovereign 1% n.a.Bank 0% n.a.Retail -9% n.a.SME -3% n.a.Securitization 0% n.a.Provisions -2% n.a.Other portfolios 2% n.a.Overall credit Risk -13% n.a.

Operational Risk 11% n.a.

Overall change -2% n.a.

Contributions to change in capitalIRB Advanced


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The banks with the greatest reduction in capital requirements are those banks with a large proportion of retail activity” Basel May 5th, 2003

0

50

100

150

200

250

Corporate Commercial Small Business Sovereign/Bank Res. Mortgages Personal Loans Line of credit &VISA

Current BIS approachNew Standardized ApproachNew IRB Foundation ApproachNew IRB Advanced Approach

Results of the QIS3 Exercise For the Laurentian Bank


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Impact on the Industry• Banks will shift to more aggressive risk-based pricing such as in the

already tightly squeezed mortgage market as these portfolios will require even less capital. Banks who do not choose to go towards the advanced approach will not be able to compete against the 6 big banks.

• A bank that is highly concentrated in one or two of the businesses that will require more regulatory capital might face a crisis. An example: prime-based lending

• Players in the card industry that have offered large limits as a marketing tool in their approach to customers might well have to shrink unused lines

• Lending to high-quality credits will gain a strong beneficial effect and might hamper the credit offering for low quality credits.

• There could be strategic implications for portfolios of construction lending, as they are classified as “high volatility” under Basel II with capital charges starting at 8% and rising as high as 28% for weaker credits


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Impact on the Industry (cont.)

• Big capital markets players will face higher capital charges for securitization activities and be harder hit by operational risk charges, which are based on revenues

• The potential for big banks to free up excess capital by buying a smaller bank non IRB Bank might foster mergers

• Bank money management specialists will be at a disadvantage compared with non bank fund managers due to the operational risk capital they will now have to maintain

• If a bank can structure a loan to reduce LGD by half, the capital requirement falls by half. Banks may respond by giving more emphasis to LGD. This is called “lending on collateral”. It has been a profitable lending activity for asset-based finance companies (e.g. Home Capital, GE Capital). Japan is an example of a lending system that over-emphasized collateral


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WILL WE HAVE AN ACCORD BY 2004?• There are sharp differences between 2 leading US Banking Supervisors.

The FED is determined to reach agreement on Basel II by mid 2004 and still see the new rules come into force at the end of 2006.

• On the other end, the OCC has strong reservations as it feels the rules are excessively complex and detailed making them difficult for banks to implement and supervisors to enforce. Furthermore, they would like to see a QIS4.

• Following comments received by the banking industry, competitive effects of the New Accord are determined to be significant. Some of the big banks that are supposed to be the prime beneficiaries of Basel II have strong reserves and contend that the potential risks of the New Accord are too great.

• In Canada, banks have requested a further delay of 1 year for implementation without support from US banks have indicated that they will be ready on time.

Déjeuner causerie Développements canadiens en gestion des risques

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