FINANCIAL SERVICES ADVISORY SERVICES 13 March 2007 Challenges faced by consultants whilst consulting on Basel II

2 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Agenda 1. Recent surveys – The areas of concern 2. The landscape in India 3. Issues 4. ORM – The conceptual difficulties 5. Challenges – A consultant’s view

3 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Agenda 1. Recent surveys – The areas of concern 2. The landscape in India 3. Issues 4. ORM – The conceptual difficulties 5. Challenges – A consultant’s view

4 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Recent surveys – The areas of concern FICCI’s 2005 survey (India) 27% of banks expected their capital requirements to increase by 1-2% while 20% expected the increase to be larger than 3% IBA’s 2006 survey (India) A long term roadmap for Basel II implementation was missing in India, in respect of operational risk. 65% banks had gone into implementation without a preceding project planning exercise. 40% of the banks considered cost of compliance to be a significant concern in implementing Basel II

5 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Recent surveys – The areas of concern (contd.) KPMG India 2006 survey (27 public and private sector banks) Compliance with regulation was driving Basel II implementation in half the banks surveyed. From a technology perspective some progress had been made in credit and market risk management but not in OR. Only a few (16%) had commenced planning for the more advanced approaches. A large number of Banks had not fully understood the complexities of OR

6 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Agenda 1. Recent surveys – The areas of concern 2. The landscape in India 3. Issues 4. ORM – The conceptual difficulties 5. Challenges – A consultant’s view

7 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. The landscape In India RBI guidance to implement The Standardised Approach for credit and Basic Indicator Approach for operational risk Original deadline of March ‘07 extended by two years (one year in respect of banks with overseas operations) Potential for lowering capital and other business benefits have not been fully appreciated Pillar II requirements not entirely understood Few banks will have an adequate number of data points in the near future to enable model building Banks do not have access to relevant external loss databases

8 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. The landscape In India (contd.) As implementation gathers momentum, it would help to discuss and debate the challenges and experiences at forums that include the Regulator, trade bodies, banks and consultants There are fundamental misconceptions regarding operational risk management in the industry As a result there is uncertainty about the benefits from implementing a Basel II compliant integrated risk methodology Banks are largely approaching this as a compliance exercise

9 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Agenda 1. Recent surveys – The areas of concern 2. The landscape in India 3. Issues 4. ORM - The conceptual difficulties 5. Challenges – A consultant’s view

10 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Issues Basel II was designed to achieve greater balance between risk sensitivity and capital management through the use of incentives Without the “carrot”, implementation becomes an exercise in compliance The lack of a justifiable business case makes it difficult for banks Individual banks need to be clear about the target operating model and objectives of their programme Incentives for using more sophisticated approaches and Pillar II implications are not well understood

11 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Agenda 1. Recent surveys – The areas of concern 2. The landscape in India 3. Issues 4. ORM - The conceptual difficulties 5. Challenges – A consultant’s view

12 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. “Managing OR revolves around optimising the risk – control relationship. This requires accurately measuring the changing risk & control profile” Ali Samad Khan, ex-Bankers’ Trust Bank Operational risk management should not be equated with managing the business process Risk is a metric used to describe the uncertainty surrounding an adverse consequence such as a fraud event The terms “Expected” and “Unexpected” loss have important practical applications ORM – The conceptual difficulties

13 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Control weaknesses are NOT the same as risks It is a measure NOT a type of event Risk is neither inherently good nor bad Effective ORM requires historical data ORM – The conceptual difficulties (contd.)

14 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. The 4 essential ingredients of ORM: The desired risk appetite Objective information to understand where the risks lie. This requires measurement / quantification to judge what is a major / minor risk & what needs management Effectiveness of controls A reporting & monitoring process ORM – The conceptual difficulties (contd.)

15 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Agenda 1. Recent surveys – The areas of concern 2. The landscape in India 3. Issues 4. ORM - The conceptual difficulties 5. Challenges – A consultant’s view

16 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Challenges – A consultant’s view Scope of project Lack of clarity RFP’s read as a “Soup to Nuts” requirement Pillar II requirements Objectives of the programme Undefined target operating model Lack of a long term road map

17 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Challenges – A consultant’s view (contd.) Timing Quick Solutions are sought Obtaining valid data can be a challenge as Data can be inappropriate / insufficient The Price – Value perception Value of the programme often long term and intangible Smaller players able to offer a lower price but value is not the same IT solution not the equivalent of a Basel II compliant programme Process for selection of vendor

18 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Challenges – A consultant’s view (contd.) Management buy-in and commitment Lack of ownership within the bank for the consulting assignment Availability of “cheap” solutions Technology preceding the risk framework could result in the “tail wagging the dog”

19 © 2007 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Presenter’s contact details Amreshwar Seth KPMG