Regulatory Convergence under Post Basel II: some comments Giovanni Majnoni Contractual Saving Conference Washington, DC, May 1, 2002

2 The Second Consultative Document The January 2001 Consultative Document is over 600 pages long (against the 26 pages of the 1988 Capital Accord; the 62 pages of the March 2000 Consultative Document). Why is it more complex? From one to three approaches (Standardized, Foundation IRB, Advanced IRB). From one to three pillars (Capital, Supervisory Review, Market Discipline); Better definition of additional sources of risk (operational risk; interest risk in banking books)

3 The present (tentative) timetable October 2002 – A new Quantitative Impact Study (QIS3) will be launched to supplement the information gathered in the two previous exercises; Early 2003 – review of results from the QIS3; Spring 2003 – release of a third Consultative Document; Late 2003 (?) – Finalization of the new Capital Accord (?) - Implementation of the new Accord

4 A still evolving regulatory design More extensive coverage of expected losses; Operational risk reduction from a 20% to a 12% charge and possibly even further under the advanced measurement option; Greater recognition of collateral and receivables ; Modified risk weight curve for corporate, sovereign, inter-bank, residential mortgage and other retail exposures; Forthcoming paper on securitization.

5 A still evolving regulatory design An example of the changes deriving from the ongoing calibration exercise: Capital charges for a corporate exposure with default probability equal to 20% was equal to over 50%, in the second Consultative Paper and has been brought down to 30% in the November 2001 risk weights revision.

6 1.To provide a new definition of regulatory capital more in line with the risk exposure of banking books. By reducing the misalignment between economic and regulatory capital a risk based capital regulation should reduce the perverse incentives to keep in the banking books only the riskier assets. 2.To provide a regulatory framework for banks with different levels of sophistication and banking systems at different levels of developments. The two challenges of the revised Capital Accord…

7 The first Pillar is represented by the specific minimum capital requirement regulation. The second pillar recognizes the importance of supervisory review as a tool for encouraging banks to improve their risk management. The third pillar is represented by market discipline. It is therefore related to disclosure initiatives intended to increase the level of transparency of the bank’s risk and capital position Three building blocks (pillars)

8 Pillar 1: the Standardized approach New risk weighting for corporate: The 150% risk bucket applies to: BB- rated assets (previously B-); Unsecured portion of assets past due >90 days; High risk equity (venture capital; other). 1988June 1999January %AAA to AA- A+ to B Below B- Unrated 20% 100% 150% 100% AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated 20% 50% 100% 150% 100%

9 Pillar 1: the Internal Rating Based (IRB) approach. The IRB builds on internal credit risk rating practices. It represents “the” innovative elements of the new proposal. Two major options: –The simpler “foundation” IRB; –The more complex “advanced” IRB. Banks must meet an extensive set of eligibility standards (qualitative requirements) to use the IRB approach

10 The structure of IRB approach (1). It relies on rating systems differentiated by borrowers and by facilities. Breakdown of bank portfolio into six categories: –Corporate; Sovereign; Bank;Retail ;Project finance; Equity. Required parameters for assessing the risk exposure (the amount of potential credit losses): –Probability of Default (PD) for any of the six categories. –Losses in the event of default defined as Losses Given Default (LGD). –A measure of actual credit risk exposure called Exposure At Default (EAD). –Maturity (M) of the credit instrument. Expected losses (EL) are equal to PDxLGDxEAD.

11 The structure of IRB approach (2). A common notion of default based on the occurrence of any of the following events: 1.determination that the obligor is unlikely to pay its debt obligation; 2.Realization of a credit loss event (charge-off, specific provision); 3.More than 90 days past due on any credit obligation; 4.The obligor has filed for bankruptcy.

12 Pillar 2 & 3 The Supervisory Review Process, defined in Pillar 2, is based on the following four principles defined in the spirit of the Core Principles of Banking Supervision. They require bank supervisors to: –check that the organizational structure of a bank matches the complexity of the chosen approach; –review periodically banks’ internal capital adequacy assessments and strategies; –request banks to operate above the minimum solvency ratio; –intervene at an early stage to prevent capital depletion. The Market Discipline, defined in Pillar 3, is based on an extensive set of disclosure requirements of banks portfolio composition by risk categories, of portfolio composition.

13 –What capital charges on contracts designed to unbundle and transfer risk? An example is the provided by the suggested treatment of insured operational risk. One of the proposed approaches suggested not to recognize it fully in order to reduce contagion across different segments of the financial system. –More generally, what capital requirements on insured positions. –How to insure regulatory convergence now that Basel II will shift away from the previous level playing field approach? –Where misalignements of capital requirements are larger providing incentives to asset shifting from bank to insurance (or viceversa) within the same holding group? Issues in regulatory convergence