Presented by: Dr. Peter Larose

Key Components of Credit Risk under Basel II Credit Risk Elements Transaction Risk Borrower’s RiskExposure Risk The probability of default (PD) being assessed using both quantitative & qualitative information about the borrower and the market. 2. Loss given default assessed on actual details such as: recovery time, collateral, market value of debt, and also within the perceived risk of the borrower. 3. Exposure at default of the loan (EAD). This component takes into consideration value of the outstanding debt at the time of default (t), and also any committed by unused line of credit. Note: Other factors such as: the amount outstanding, borrower’s position within the Industry, degree of concentration risk involved, scope of diversification, and maturity

Option 1 – Advanced Internal Ratings-Based (Advanced IRB) This approach is derived from banks’ own assessment of all risk factors Option 2 – Simplified Standardized Approach ((Simplified SA) This option is very close to the current Basel I, and the standardized (SA) based on external assessments of risks. Option 3 – Foundation Internal Ratings-Based (Foundation IRB) This option depends mostly on the banks’ own assessment of probability of default. * Either Option can be used to calculate the capital charge

Proposed Basic Structure of BASEL II 3 Basic Pillars Minimum Capital Requirement Supervisory Review Process Market Discipline Risk Weighted Assets (RWAs) Definition of Capital Market Risk Operational Risk Credit Risk Internal Ratings- Based Approach Core Capital Supplementary Capital Basic Indicator Approach Standardized Approach Advanced Measurement Approach Standardized Approach Models Approach Standardized Approach

Why Basel II? Basel I was not implemented to the maximum by all the banks. Banks had different portfolio risk profiles in terms of client base (e.g. blue chip companies vs small & medium enterprises) Banks had different activities (e.g. inter-bank lending vs commercial) Banks actual exposure varied over time with intensity of competition, which resulted into changes in the risk weighting approach. New framework is more flexible for banks, which had reached different levels of complexity and sophistication in their operations. It is more comprehensive in application as it recognizes and includes operational risk in the capital adequacy calculations. It also includes two new pillars within the framework (e.g. market & supervisory discipline).

Business Line AAA to AA- A+ to A-BBB+ to BBB- BB+ to B- Below B-Unrated Banks *Option 1 20%50%100% 150%100% **Option 2 20%50%100% 150%50% ***Option 3 20% 50%150%20% Retail Mortgage 35% Other 75% Corporate 20%50%100% 150% Sovereigns 0%20%50%100%150%100% Measurement of Capital Charge Under Basel II - SA *Sovereign : Risk weighting based on risk weights of sovereign state where the bank is originally incorporated to operate. ** Risk weights based on the assessment of Individual Bank *** Claims on banks of original maturity of 3 months receive a weight which is less favourable.

Identified Weaknesses of Basel I (i)Basel I does not provide good incentives for credit risk mitigation techniques. (e.g. hedging of forex risk, and interest rate risk) (ii) Credit Risk in G10 countries were taken for granted that they were less risky from a sovereign risk perspective. (iii) Does a solid platform to assess capital adequacy in relation to a bank’s true risk profile. (e.g. no recognition of operational & other risks).

Objective of Basel II In line with previous framework, Basel II is to continue to promote safety and soundness among internationally active banks. The new framework is to encourage banks to further improve their internal risk management systems. Bring the regulatory capital in line with the identifiable risks of the commercial banks.

Internal Ratings-Based Approach Risk Components (1) Probability of Default (PD), Loss Given Default, Maturity, Exposure at Default Risk Weight Function (2) Various weights Minimum Capital Requirements (3)

Component Recognition Probability of Default (PD) Bank FoundationAdvanced Loss Given Default (LGD)45%Bank Exposure at Default (EAD)100%Bank Maturity2 1/2 YearsBank IRB use Separate Approaches for EACH Portfolio of Assets Note: 3 Categories of Exposure in Banks’ Assets. Retail Residential Mortgages Qualifying Revolving Exposures Other Retail Corporate  SMEs  Specialized Lending  Sovereign  Commercial Real Estate Equities

Treatment of Operational Risk in Pillar 1 Definition of Operational Risk in the context of Basel II “ It is defined as being the risk of operating financial loss resulting from inadequate or failed: systems, loss of key personnel, internal processes, and external events”. Possible Events, which can trigger an operational risk: Damage to physical assets of the bank Business interruptions and I.T/Accounting System failure Internal collusion of employees committing fraudulent transactions External collusion of employee-customer committing fraudulent transactions Sudden shift in clients’ business behaviour – switching to other parties Change in business practices by the bank Change in employment practice and work place safety. Business execution and delivery

Risks To Be Covered Under the 3 Pillars Pillar 1 Pillar 2Pillar 3 Operational Risk X X X Liquidity Risk X X Interest Rate Risk X X Strategic (Reputation Risk) X X

Basic Indicator Approach (BIA) The level of requested capital charge is calculated by multiplying a single Indicator by a fixed percentage (%). The proposed indicator is the Gross Income, where: Capital Charge = X indicator Please note that Basel II calibrates this ration to 12% not 8% of MRC with an set at 15%. The indicator used should be the 3-year average gross revenue. Standardized Approach The standardized approach is more detailed that the basic one. It divides the banking activities into 8 business portfolios. The indicator used Is also the Gross Income (GI), but the capital charge is calculated using A specific Beta factor for each portfolio. The total capital charge to be Provisioned for by each bank is the total of all the portfolios together such as: Capital Charge = sum(GI(t-8) x B(t-8)

8 Portfolio Assets Details Beta Value 1.Trading & Sales 18% 2.Retail Banking 12% 3.Corporate Finance 18% 4.Commercial Banking 15% 5.Payment & Settlement 18% 6.Agency Services 15% 7.Retail Brokerage 12% 8.Asset Management 12%

Pillar 2 – Supervisory Review Process This new pillar is to support the capital requirement quantitative Techniques and cover those dimensions of capital adequacy Requirements not considered under Pillar 1 ( e.g. large exposures, concentration risk etc ) and other risks not taken into account ( e.g. liquidity risk, interest rate risk ) as well as all external factors that may affect the bank. Under Pillar 2, the role of the bank supervisors is absolutely very crucial

Pillar 3 – Market Discipline Market discipline is as important as the other two pillars as it should Result into a greater level of confidence with the customers and Members of the public that the banking system is much safer. Timely disclosure of reliable information as required under Pillar 3 Allows for well founded counterparty risk assessment. Disclosure requirement will involve: a.Capital adequacy b.Risk exposures (e.g. credit, market and others) c.Composition of capital structure.

Reasons to Defer the Implementation of Basel II Basel I has not been fully implemented by all banks Each bank depending on their level of sophistication will choose the most advantageous model to minimize capital charge It is a rather complex model to implement fully It will be difficult for international comparison of bank performance, if there is a lack of standard model applied Not all regulatory agencies will be equipped to handle the model It will be very difficult for banks to quantify “operational risk” and make provisions for natural disaster. There has been no concrete evidence using real data, which justify its implementation – “trial & error”

Reasons to Adopt Basel II The Accord should improve cross-borders supervisory co-operation Unless the model is tried and tested, some banks may be marginalized from the rest of the international community It is an impetus for banks to modernize their risk management infrastructure

Challenges Ahead in the Implementation of Basel II Data availability, accuracy, and reliability Legal framework improvement needed Feasibility of cross-border co-operation and its lasting effect Human resources requirement with adequate knowledge of the model Operational assistance from developed countries needed Change in customer expectations and behaviour Political support to bring change to the banking system

Data Availability, Accuracy, and Reliability In some countries, it may be difficult to collect accurate and reliable data from the financial sector. This is especially the case with the developing countries, which may not have a developed financial system. Regular up date of information would be needed (both quantitative & qualitative) in order to implement Pillar 1 If information is not forthcoming with a stated time frame, it would become more difficult to follow through the full implementation with more delays.

New Legal Framework Needed In some developing countries, bank supervisors do not have sufficient legal and regulatory power to intervene when the management of a commercial bank has not fulfilled the required data submission. This poses a problem, unless, otherwise, the Government is prepared to bring about new changes in the existing legislations. There can be major time-lag from the consultative period to the full enactment of the legal requirement. International banks having representative operations or branches located in those jurisdictions may be severely handicapped, when due consideration is taken to evaluate Basel II implementation at the group level.

Feasibility of Cross-Border Co-operation & Its Lasting Effect While many neighbouring countries are co-operating with one another in the implementation of Basel I, it may not always be the case with Basel II. This is due to its level of sophistication and the demand for resources. The more advanced institutions will have to assist those international banks having difficulty to implement it. There will be a huge cost involved for the bank to take into consideration as part of their operating expenditure.

Human Resources Requirement to Implement the Model The existing employees of the banks including supervisors must be adequately trained to understand the new Accord. Regular training will be an issue for the banks to consider in their forward planning for them to update their knowledge about the dynamics of their portfolios and the impact on capital structure.

Operational Assistance from Developed Countries The local supervisors at the respective regulatory authorities will require a fair amount of assistance ( in terms of technical assistance) from developed countries. Exchange programs will have to be established for regional sessions to allow the supervisors to learn from each other and to strengthen their collaboration.

Changes in Customer Expectations & Behaviour The customers would more curious and demanding in the level of Information, which is presently available in the public domain. This is due that as they request for additional services from their respective bank, the risk premium, which they have to pay for the varied services will change. Consequently, we will apply pressure on the banks to package the interest paid collectively rather than paying for the individual risk. As a result, the customers may consider the banker-customer relationship, which they could have negotiated for the interest rates in a different manner.

Political Support to Bring Change to the Banking System With every new regulation, there will always a fair amount of “critique” coming from the opponents. Bank supervisors must ensure that all stakeholders are adequately informed of the implications and results of the Basel II. Otherwise, the Government may be subject to unnecessary pressure to maintain the “status quo”.

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