Mumbai, March “Regulatory Capital and Economic Capital: Mind the Gap” by prof. Cristiano Zazzara Managing Director or Italian Association of Banking and Finance (Homepage:

- 2 - AGENDA  Banks’ Capital Requirements according to Basel 2  First Pillar: some simplifications in credit risk measurement  The Economic Capital: a New Paradigm  The Second Pillar of Basel 2: - Economic Capital considered - How to measure additional capital - How to estimate concentration and correlation

- 3 - Capital Requirements according to Basel 2 Banks’ Risk Management Systems quantify risk, which is then transformed into regulatory capital through tables or regulatory functions provided for in the First Pillar. Basel 2 provides for additional capital as well, in order to include: simplifications implied by the first pillar (i.e., correlation), and sensibility to macroeconomic conditions. This is the Second Pillar.

- 4 - First Pillar: some simplifications in credit risk measurement Credit risk capital is equal to the maximum possible loss -- exceeding the expected loss -- in the 99.9% of the cases To estimate this loss, bank’s data to PD, LGD, EAD of the Bank are inserted into a simplified formula that assumes: -A portfolio made of many small loans (“high granularity”) -No diversification in terms of industry sector and geographical areas (“portfolio invariant capital”) Therefore, Basel 2 Regulatory Capital is different than the “true” economic capital of a Bank

- 5 - The Economic Capital: a New Paradigm - Residential Mortgage-backed securities are becoming more popular with UK banks to raise funds and reduce risk, which improves their economic capital Louisa Mitchell and Paul J. Davies, Financial Times, July 18, The assets backing the deal come from Barclays £8bn book of loans to small and medium-sized enterprises and is designed to give the bank regulatory and economic capital relief on its balance sheet Paul J. Davies, Financial Times, November 7, The Japanese Banking Sector’s main weakness has been lack of economic capital. Organisational structure, product mix, investment strategies, new lending products – all these strategic and/or operational issues follow the capital and they matter only when they have capital. David Ibison, Financial Times, October 11, 2005

- 6 - The Economic Capital, the “real” Capital at Risk  It is the amount of capital that limits the Bank’s PD at the desired level [for example, for a rating A- (S&P’s) the economic capital should limit the 1-year PD to approximately 0.05%]  It is the necessary capital to cover risks of the banking business  It allows an adequate loan pricing and helps evaluate creation or destruction of value for shareholders (EVA)  Conceptually, it is similar to the Basel 2 Regulatory Capital…. …. but requires for the inclusion of all kinds of risks and a more “realistic” portfolio model Bank’s Balance Sheet

- 7 - The Second Pillar of Basel 2: Economic Capital considered  Banks evaluate the adequacy between capital and risks and are able to maintaining over time: - measuring correctly capital and all risks - under the supervision of the Board of Directors and the Top Management - through effective monitoring systems, reporting and internal controls  Authorities examine these valuations and strategies, adopting prudential measures if not satisfied with the banks’ results  Authorities ask for a capital base greater than the minimun one, and may impose an additional capital buffer on banks  Authorities intervene early, before capital lowers below the minimum level, and require for prompt corrective measures (such as, restrictions to dividend payment, immediate increase of capital)

- 8 - The Second Pillar of Basel 2: how to measure additional capital  Analysis of Compliance with requirements provided for in the First Pillar - for example, number of rating classes, time series adequacy (5 years for PD, 7 years for LGD)  More accurate estimate of risks considered in a simplified manner in the First Pillar - for example, concentration risk  Estimate Risks not included in the First Pillar, such as, interest rate risk on the banking book  Evaluate the impact of factors external to the bank envinronment - such as, macroeconomic risks, technological progress

- 9 - The Second Pillar of Basel 2: how to measure additional capital “Banks should have a process for assessing their overall capital adequacy in relation to their risk profile” (New Basel Capital Accord, par. 725)  Second Pillar “invites” banks to measure their Economic Capital - banks’inability is sanctioned with an additional capital requirement  Proactive banks could minimize this additional buffer: - quantifying their diversification risk policy through robust measures of concentration and correlation - measuring and keeping under control the interest rate risk on the banking book - proving to the authorities, the market and the rating agencies that the First Pillar regulatory capital is an upper limit of their economic capital  The New Basel Capital Accord (known as Basel 2) offers an important opportunity to develop advanced risk measurement tools through an “active” dialogue with banking supervisors

The Second Pillar of Basel 2: how to estimate concentration and correlation  First Pillar of Basel 2 provides only for an average correlation measure within the loan portfolio: this assumption is obviously unrealistic…but necessary to get a closed formula…  It is therefore essential to build a credit risk portfolio model where absorption of economic capital should be “portfolio dependent” (and not “portfolio invariant”). Particularly: - various macro factors influence debtors, such as industry sector and geographic correlation, - large and small loans are present in the portfolio: their impact should be measured in terms of credit risk (“name concentration”) - closed formula may not be sufficient to measure all the above factors: Monte Carlo simulation is a good candidate for a precise risk measurement  Sophisticated banks will use their internal models to perform these analyses, others can start using popular models provided by international vendors (such as, “Creditmetrics”) Reconciling Regulatory and Economic Capital

THANKS FOR THE ATTENTION HOPE THESE COMMENTS ARE USEFUL FOR INDIAN BANKS AS WELL