Déjeuner causerie Développements canadiens en gestion des risques Alicia Zemanek Vice-présidente Relations avec les investisseurs Chef des Risques Gestion intégrée des risques Banque 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 ?

Laurentian Bank of Canada CIRANO-PRMIA 3 Evolution of Basel I into Basel II 1988 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)

Laurentian Bank of Canada CIRANO-PRMIA 4 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 commitments with maturity  1 year are included in the quantification (explains 364 day revolving lines)  Capital relates only to credit & market risk  3 Pillars (216 pages) Pillar 1:Min. capital requirements Pillar 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 I BASEL II

Laurentian Bank of Canada CIRANO-PRMIA 5 The New Basel II Accord

Laurentian Bank of Canada CIRANO-PRMIA 6 The New Basel II Accord Pillar I - Credit Risk - Standardized Approach

Laurentian Bank of Canada CIRANO-PRMIA 7 Pillar I - Credit Risk - Standardized Approach An example... OLD BASEL ACCORD = $ 40 K of Capital (CCF = 0% )

Laurentian Bank of Canada CIRANO-PRMIA 8 The New Basel II Accord Pillar I - Credit Risk - Foundation Internal Rating For illustration only

Laurentian Bank of Canada CIRANO-PRMIA 9 Pillar I - Credit Risk - Foundation Internal Rating An example... vs $ 48 K for the Standardized approach

Laurentian Bank of Canada CIRANO-PRMIA 10 The New Basel II Accord Pillar I - Credit Risk - Advanced Internal Ratings For illustration only

Laurentian Bank of Canada CIRANO-PRMIA 11 Pillar I - Credit Risk - Advanced Internal Ratings An example... vs $ 48 K under the Standardized approach and $ 25 K for the Foundation Approach

Laurentian Bank of Canada CIRANO-PRMIA 12 The New Basel II Accord Pillar I - Operational Risk - Basic Indicator AVERAGE OF BANKS’ ANNUAL ADJUSTED GROSS INCOME OVER LAST 3 YEARS PRESCRIBED ALPHA FACTOR () OF 15% x= MINIMUM REGULATORY CAPITAL

Laurentian Bank of Canada CIRANO-PRMIA 13 The New Basel II Accord Pillar I - Operational Risk - Standardized Approach Average of Bank’s annual gross income over last 3 years PRESCRIBED BETA Factor by Business Line Corporate finance18% Trading & Sales18% Retail Banking12% Commercial Banking 15% Payment & Settlement18% Agency Services15% Asset Management12% Retail Brokerage12% x = MINIMUM REGULATORY CAPITAL

Laurentian Bank of Canada CIRANO-PRMIA 14 The New Basel II Accord Pillar I - Operational Risk - AMA

Laurentian Bank of Canada CIRANO-PRMIA 15 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.

Laurentian Bank of Canada CIRANO-PRMIA 16 Who is subject to the New Basel II Accord ? In Canada OSFI expects implementation of AIRB by October 2006 for all 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.

Laurentian Bank of Canada CIRANO-PRMIA 17 Results of the QIS3 Exercise For the Industry 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

Laurentian Bank of Canada CIRANO-PRMIA 18 The banks with the greatest reduction in capital requirements are those banks with a large proportion of retail activity” Basel May 5th, 2003 Results of the QIS3 Exercise For the Laurentian Bank

Laurentian Bank of Canada CIRANO-PRMIA 19 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

Laurentian Bank of Canada CIRANO-PRMIA 20 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

Laurentian Bank of Canada CIRANO-PRMIA 21 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 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.