Basel 2: Current Status Phil Rogers, HSBC Bank Credit and Risk 25 July 2006

What is Basel 2? A more risk sensitive, method of assessing the capital adequacy of financial institutions…….. which encourages banks to develop more sophisticated credit and operational risk management techniques…… whilst preserving the overall level of capital in the banking system

3 Pillars Pillar One: Minimum Capital Requirements. (Bottom up) Pillar Two: Supervisory Review Process. (Top down) Pillar Three: Market Discipline (Public Disclosure)

3 Types of Risk will Require Capital Credit Risk. Far more sophisticated approach than current Basel 1 Accord Operational Risk. New capital charge Market Risk. Modified version of current rules. Defined by the Trading Book Review, 2005

Legal Framework The BIS Framework Document, published July 2005, known as “Basel 2”, is an agreement of Central Bankers only. It has no legal status In the EU the legal authority derives from the Capital Requirements Directive (CRD), September not identical with Basel 2 In the UK the Rules are implemented by the FSA Prudential Source Book (BIPRU) - not identical with CRD

3 Approaches to Credit Risk Standardised Approach (SA), a modified version of Basel 1. Generally regarded as suitable only for smaller banks Foundation Internal Ratings Based Approach (FIRBA) Advanced Internal Ratings Based Approach (AIRBA)

3 Approaches to Operational Risk Basic Indicator (capital based on 15% of income). Suitable only for smaller banks Standardised (capital based on 12% to 18% of income depending on risk of individual business lines) Advanced Measurement (capital assessed using the Bank’s operational risk models)

Timings for Credit Approaches Standardised Approach and Foundation IRB Approach: From 1 January Must be in place by 1 January 2008 Advanced IRB Approach: From 1 January 2008 IRB Approaches have experience requirements for the use of ratings and a 1 year parallel run US has delayed until 2009 at the earliest, but delay in the EU considered unlikely

Basel 2 Credit Parameters Probability of Default (PD) –How likely is it that the customer will default in a 12 month period? Exposure at Default (EAD) –What will exposure to the customer be at default? Loss Given Default (LGD) –How much of the exposure at default will be lost?

IRB: Foundation re Advanced For Foundation IRB banks estimate only PD for non-retail exposures. EAD and LGD are set by the regulators. For retail exposures banks estimate all 3 parameters For Advanced IRB banks estimate PD, LGD and EAD Advanced is, therefore, more costly, more complex and subject to higher quality standards but It is intended that there should be capital incentives for banks to adopt more comprehensive and accurate measures of risk

Credit Risk associated with an exposure is a function of the characteristics of both borrower and facility Credit Risk of Transaction Borrower characteristics Facility characteristics Who are you lending to? Probability of Default (PD - %) How much exposure do you have to this facility? Exposure at Default (EAD - £) What would you expect to lose on this facility if the customer defaults? Loss Given Default (LGD - %)

Expected Loss Long run average of losses in a portfolio Analysis should be based on at least one full economic cycle (but most UK banks do not have the data) Is not part of capital calculation, but is a cost to the business. Is expected by Basel 2 to be covered by provisions. Any difference between EL and provisions must be explained and a capital adjustment may be necessary

Components of Expected Loss 12 month Probability of Default (PD) % Loss Given Default (LGD) % Exposure at Default (EAD) £ PD x LGD x EAD = Expected Loss

Examples of Expected Loss Expected Loss (£) / (%) Probability of Default (%) = Loss Given Default (%) x Exposure at Default (£) x PD % LGD % EAD - £2.8m xx £ % = LGD - 11% LGD - 24% £ % £ % x x = = x x

Unexpected Loss Part of Regulatory and Economic Capital Calculation Is a function of PD, LGD, EAD plus Loss Volatility Level is determined by complex algorithms For Regulatory Capital algorithms are set by the regulator

Expected & Unexpected Loss Expected Loss is the average loss Portfolio 2 Portfolio 1 Unexpected Loss measures the variability around the Expected Loss (one standard deviation) Source: Moody’s KMV

Examples of Basel 2 RWA and Capital Calculations Credit Risk Basel II Formula MaturityPD (%)EAD (£)LGD (%) 2.5 Years£2.8m 7bp 39.5%£784£599,977£47,998 MaturityEADPDLGDELRWACapital* 1.2% 24% 11% 39.5% 24% 11% £470 £216 £13,440 £8,064 £3,696 £359,986 £164,994 £2,451,210 £1,470,726 £674,083 £28,799 £13,199 £196,097 £117,658 £53,927 Total Capital = RWA*8%

Outstanding Issues Downturn LGD/EAD. The Rules require estimates to be based on downturn experience. UK data not available for many portfolios. Uncertainty re what will be acceptable Governance. Draft FSA Rules require material aspects of credit rating systems to be signed off by a main Board member. Practicality under discussion Stress Testing. Draft FSA Rules require banks to stress ratings for a 1 in 25 year event. Practicality for large banking groups under discussion with the FSA

Outstanding Issues (2) Use Test. Banks are required to use Basel 2 risk measures in their day to day business but the level of conservatism required by the Regulators creates challenges in some areas Home/Host. Balance of responsibility between “home” and “host” regulators not always clear, especially outside EU. Implications of the US delay not fully defined Pillar 2. Practicalities of the Internal Capital Adequacy Assessment Process (ICAAP) unclear

Summary Banks and other financial institutions must move to Basel 2 by 1 January Some will already be parallel running Higher quality business will attract more capital than at present and vice versa Many financial institutions are upgrading risk management processes to meet the new demands Some uncertainties but, in the EU at least, it will happen