1. Basel II and Standard & Poor’s Approach to Financial Institution’s Capital Adequacy
Craig Bennett
House keeping – due to finish, questions, genuine reason to thank
Creative open:
Introduction: here to share RACF methodology, timing and use
May 20, 2008

2. Capital ratios “have been the focus of much attention, both internal and external, over recent months,” Chairman Royal Bank of Scotland Group, Tom McKillop.
Britain’s second biggest lender announcing the sale of £12 billion shares to boost capital depleted by subprime write-downs and joint acquisition of ABN Amro for €72 billion.

3. Agenda Why do we need a different capital measure?
S&P Risk-Adjusted Capital Framework concepts
Interactions with Basel II capital requirements
How are we going to use Pillar III
Concluding remarks

4. 1. Why do we need a different capital measure?

5. Two primary goals Enhance our quantitative and qualitative analysis
Address inconsistencies in:
Local regulations, including definition of regulatory capital;
Risk measures;
Regulatory options (incl. stress tests); and
Economic capital models
Incorporate our different risk assessment
Trading book, equity portfolios, securitisation, etc.
Opinion on credit markets
Correlations / diversification
Development a globally consistent risk adjusted measure to facilitate the assessment and comparison of capital adequacy as well as profitability.
The Project has two main goals    
First : Develop a globally consistent risk adjusted measure that will facilitate the assessment and comparison of banks’ capital adequacy as well as profitability.
Our ambition is to develop a globally consistent Basel II derived risk adjusted capital measures that will be possible to fine tune in order to reflect more precisely the specificities of banks individual risk profile.
Second enhance our quantitative expertise by setting up expert teams responsible to develop methodologies to analyse the information embedded in banks quantitative models (Basel II, Stress tests, Economic capital models), train analysts;

6. Standard & Poor’s Applauds Basel II
More comprehensive and risk sensitive than
Basel I
Leverage ratio
Incentive to develop better risk management systems
Increased disclosure to the market should allow better market discipline
Global framework
But some issues remain …
The Project has two main goals    
First : Develop a globally consistent risk adjusted measure that will facilitate the assessment and comparison of banks’ capital adequacy as well as profitability.
Our ambition is to develop a globally consistent Basel II derived risk adjusted capital measures that will be possible to fine tune in order to reflect more precisely the specificities of banks individual risk profile.
Second enhance our quantitative expertise by setting up expert teams responsible to develop methodologies to analyse the information embedded in banks quantitative models (Basel II, Stress tests, Economic capital models), train analysts;

7. Comparing different approaches will be difficult
Differing methodologies employed impact results

8. Direct comparisons between IRB results could be misleading
Database infrastructure and models are still unseasoned.

9. Transition period could last up to a decade
Floors, grandfathering options (up to 2017)
Technical challenges to move to advanced methodologies
Trend comparisons difficult due to continued changes in methodologies
Most bank’s will apply several methodologies at the same time

10. Trends in Basel II ratios will be complex to compare
Transitional regulatory requirements and floors affect peer comparison

11. 2. S&P Risk-Adjusted Capital Framework Concepts

12. A two stage process to calculate risk weighted assets
Starting Point Benchmark Charges Approach (BCA)
Based on publicly or already available information
Globally consistent “industry capital charges” per risk class and regions through the implementation of “floors”
Specific Charges Adjustments (SCA)
Leveraging bank-specific data where available and satisfactory
Review of the information provided by the institutions and potentially adjust benchmark capital charges to reflect specificities of individual bank’s specificities risk profile compared to the industry average

13. Specific Case Adjustment Example
Illustrative purpose
Corporate portfolio average risk weight (after diversification) was reduced to 63.2% from 82.9% to reflect systematic hedging policy
Market risk risk-weighted assets (after diversification) was increased from $2.8 bn to $6.9 bn due to large specific risk not captured by the Value-at-Risk
Corporate portfolio average risk weight was reduced to 79% from 88% reflecting non public geographic diversification details
Large portfolio of investment risk weight was reduced to 322% from 706% to reflect large proportion of low risk funds in the portfolio, such as Money Market type and rated Fixed Income funds

14. 3. Interactions With Basel II Capital Requirements

15. Introduction of benchmark charges per Basel II Asset Class
Floors to the regulatory capital charges to factor in:
Standard & Poor’s different risk assessment; or
Uncertainty/lack of robustness of the institution’s internal data: or
Non risk-sensitive standardized charges.
Risk sensitivity maintained across several risk categories under BCA
We differentiate with 10 floor levels for each risk class
Operational risk, a revenue based floor used
Similar to Basel II standardized approach’
Add-ons for above average model risk, legal risk or fraud risk; and
In some cases, such as custody, we use other metrics
Trading risk
Leverage VaR as least worst
Scaling the regulatory measure by a factor of three to align 1 year time horizon

16. S&P capital benchmark charges a function of BICRA score
Bank industry country risk (BICRA) affects risk weight

17. The benchmark concept allows better comparability
Future ratios driven by changes in methodologies

18. Capturing other risks
In addition to our adjustments to Basel II “Pillar I”, we will reflect the following factors into the adjusted RWA
Concentration & Diversification (name; industry sector; geographic; asset class; risk types); and
Interest rate risk in the banking book
A number of risks will not impact capital measures at this stage
Liquidity and Funding risk; and
Reputation risk.

19. Accounting for diversification / concentration
Diversification / concentration is one of the most sensitive factors of loss distributions
Results from the International Association of Credit Portfolio Managers (IACPM) ISDA study 2006
It is not differentiated in Basel II Pillar I, which assumes that portfolios are diversified and exposures granular

20. 4. How are we going to use Pillar III

21. How are we going to use Pillar III
Pillar III disclosure will also allow us to enhance our analysis of a bank’s risk profile
Expect a far richer disclosure of risk attributes
Our intention is to store systematically this information in a S&P internal risk database, and use it for our analysis of bank’s risk profile.
Pillar III risk disclosure will allow us to roll out our global Risk Adjusted Capital Framework (RACF)
The more granular the information, the more we will be able to factor in diversification benefits.

22. 5. Concluding remarks

23. Bank responses could potentially impact rating levels
Some banks might seek to ‘spend’ the regulatory benefits of Basel II
Capital buybacks
Higher growth
We will assess such changes in capital policy closely
Basel II merely changes the measurement of risk but not the economic risk itself
We will use our new adjusted RWA to assess banks’ risk adjusted capital adequacy and profitability
It is not a change in criteria (no rating changes expected as a consequence of the implementation of this framework)
Is the quantitative transcription of our current qualitative opinion on banks risk adjusted capitalization
Capital is just one rating factor among others
Business profile analysis, strategy, risk management, earnings, liquidity, market risk, credit risk, etc…are equally important factors.

24. Capital is just one rating factor among others
Other factors are equally important

25. Conclusion: smoothing the transition to Basel II
Benchmarking tool
Internal (against bank’s own data)
External (against other banks and other banking systems)
Transparent framework
Provide much more insight on the drivers of S&P opinion on capital
Opportunity to have more structure dialogue
Consistent over time, across banks and geographies
Neutralise impact of Basel II methodologies
National discretions, grandfathering options, etc.
Bank’s internal estimates
Less volatile than Basel II

26. Appendix 1. Pillar III Best Practice Disclosure

27. Pillar III disclosure – Credit risk
What could be best practice?
Breakdown by relevant risk classes
Mortgage, consumer, revolving, etc.
Public sector loans should be separately identified
Within corporate loans (break down by other sub-asset class if relevant)
For each risk class
Exposure at default: before and after credit risk mitigation (we consider that disclosure on CRM is too limited)
Breakdown per significant geographic area, with disclosure of weighted average Probability of Default, Loss Given Default and Capital allocated.
Industry sector breakdown
Disclosure of amount of impaired loans as well as realized losses/expected loss for each significant risk class would also be a useful risk indicator
Single name concentration indicator

28. Pillar III disclosure – Operational Risk
What could be best practice?
Breakdown of capital charge for each risk factor with explanations of the major drivers behind these charges
Breakdown for each business line
Magnitude of the largest operational risk losses and event type
These disclosures would also contribute to the development of a better operational risk culture and awareness of analysts and investors

29. Pillar III disclosure – Trading Risk
What could be best practice?
Definition of trading book / banking book perimeter
Disclosure of Specific risk component
Capital required, concentration indicator (size of top three contributors to specific risk), breakdown of EAD in the trading book per risk bucket, and incremental default risk measure
Disclosure of key characteristics and drivers of regulatory approved Value-at-Risk measures
Contribution of risk factors, diversification benefits, maximum/minimum/average VaR during the year, results of VaR back testing
Information on Stress tests and or expected shortfall as complementary measures
Amount of assets which are fair valued based on mark to model in the absence of reliable observable market prices.
Comprehensive analysis of valuation methodologies and assumptions should be disclosed

30. Pillar III disclosure – Equity Portfolios
What could be best practice?
Separate disclosure of:
Listed and unlisted exposures;
Identification of book and current value;
Methodology used to determine current value;
Geographic breakdown; and
Concentration issues, when relevant (sector, geographic, single name).

31. Pillar III disclosure – Securitisation and Pillar II risks
Securitization framework
Extensive disclosure would be necessary
Volume of securitization performed broken down per type of asset securitized with the details and amounts of retained portions and other supporting factors
For Pillar II risks - extensive disclosure should be provided
Internal capital assessment process, including identification and quantification of key risk factors not factored in Pillar I
Interest rate risk in the banking book
200bp parallel shock impact on NAV and interest income
When calculated, sensitivity analysis to multiple interest rate scenarios, including slope curve changes
Qualitative and quantitative disclosure on the metric used, including the underlying assumptions and model parameters

32. Appendix 2. Related Publications

33. Related Publications on RatingsDirect 2007
Transition To Basel II Creates a Need For A Consistent , Comparable Measure of Bank Capital, February 21, 2008
Implication For Japanese Banks of Basel II Pillar III Disclosure, December 11th, 2007
Latin American Banks In Dissimilar Stages Of Implementation Of Basel II, October 4th, 2007
Greater Basel II Pillar III Disclosure would Enhance Transparency and Comparability In the Global Banking Sector, July 10, 2007
FAQ: Building Standard & Poor's Risk-Adjusted Capital Framework, June 5, 2007
Financial Institutions Group Provides More Transparency Into Adjustments Made To Bank Data, April 26, 2007
Japan’s Banks Rethink Fund Investments As Basel II Dawns, February 20, 2007
Where do the Key Formulas Come From?, February 15, 2007
Basel II In EU Gives Banks Greater Incentive To Invest In High-Quality Fixed-Income Funds, January 3, 2007

34. Main contacts Asia-Pacific
Craig Bennett, Melbourne,
Ritesh Maheshwari, Singapore,
Naoko Nemoto, Tokyo,
Yuri Yoshida, Tokyo,
Europe
Bernard de Longevialle, Paris,
Elie Heriard Dubreuil, Paris,
Thierry Grunspan, Paris,
Nick Hill, London,
Harm Semder, Frankfurt,
Renato Panichi, Milan,
Unites States
Chuck Rauch, New York,
Tanya Azarchs, New York,
Vicky Wagner, New York,
Simon Kam, New York,
Latin America
Carina Lopez, Buenos Aires,
Angelica Bala, Mexico,

35. Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.