2. Risk Based Supervision under Basel II Jeffrey Carmichael Cartagena February 16-18, 2004

3. Colombia February 2004 Page 2 Presentation: Jeff Carmichael Outline What is the risk based approach? How does it apply to banks? How does it apply to regulation? How does it apply to supervision? Challenges arising from Basel II

4. Colombia February 2004 Page 3 Presentation: Jeff Carmichael What is the Risk-Based Approach? No universally-accepted definition Meaning depends on the situation Most widely accepted proposition would be that a risk-based approach requires that you: Identify risks and apply resources where the risks are greatest

5. Colombia February 2004 Page 4 Presentation: Jeff Carmichael 1. How Does this Apply to Banking? Major sources of banking risk: Credit Risk Market Risk Liquidity Risk Operational Risk Question: Which is the greatest risk?

6. Colombia February 2004 Page 5 Presentation: Jeff Carmichael Experience Late 80s & Early 90s Widely agreed that credit risk is dominant - experience in the 80s/90s was good reminder Developed markets - worst loan losses for 50 years Common characteristics: oexcessive exposures to individual borrowers oexcessive exposures to sectors oexcessive reliance on collateral opoor credit evaluation All arose primarily from credit risk

7. Colombia February 2004 Page 6 Presentation: Jeff Carmichael RMA & FMCG Survey Better Credit Mgt. = Higher & More Stable Returns

8. Colombia February 2004 Page 7 Presentation: Jeff Carmichael Also Found... Payback to better risk management goes beyond protecting share price Returns to investing in risk management are very high compared losses under best practice with cost of improvements - suggested return of 1,000% over 10 years helped better serve customer needs enabled better business decisions

9. Colombia February 2004 Page 8 Presentation: Jeff Carmichael Main Advances Since Then Improved data management Improved credit grading from one-dimensional to two dimensional (PD and LGD) Shift to portfolio risk assessment Credit risk modelling Risk-based pricing, provisioning and reward structures Integrated risk management Risk-based capital allocation

10. Colombia February 2004 Page 9 Presentation: Jeff Carmichael Motivation for Advances Bankers remember the pain Shareholders react to differential losses Competition is increasing The tools are available There is more to lose (rewards are tied to performance)

11. Colombia February 2004 Page 10 Presentation: Jeff Carmichael 2. “ Risk-Based ” Regulation The central Pillar of banking regulation is capital adequacy Starting with the first Capital Accord in 1988 banking regulators began imposing risk-weighted capital adequacy requirement The philosophy is straightforward - greater risk requires greater capital

12. Colombia February 2004 Page 11 Presentation: Jeff Carmichael Interaction Between Regulation and Banking Practice As noted - banks now allocate capital internally to activities and areas according to the risks taken Not widespread before the first Basel Accord in 1988 Accord encouraged banks to think in terms of risk-based capital allocation Since then, banks have generally gone well beyond the 1988 Accord - hence one of the primary motivations for Basel II … Case for change is in the divergence between regulatory capital and banks’ assessments of economic capital required for risk - illustration ….

13. Colombia February 2004 Page 12 Presentation: Jeff Carmichael Economic Vs Regulatory Capital Basel I 8% Economic

14. Colombia February 2004 Page 13 Presentation: Jeff Carmichael The Challenge for Basel II Need for greater risk sensitivity than Basel 1 and its “one size fits all” Approach Need for a framework that is credible, sound and reflective of industry practices Need to be more incentive compatible with desire of regulators to promote and enhance good credit risk management Problem - there is no standardized approach agreed by industry for the measurement and management of credit risk (unlike market risk)

15. Colombia February 2004 Page 14 Presentation: Jeff Carmichael The Outcome A “menu” approach: – Standardized (modified from Basel I); – IRB Foundation – IRB Advanced Standardized is still “blunt” like Basel I IRB approaches are an attempt to “approximate” what the industry is doing It stops short of allowing banks to use their own models entirely for assessing capital adequacy It allows banks to use some of the critical inputs to their models (PD, LGD, EAD) but constrains the way they are combined to assess capital adequacy

16. Colombia February 2004 Page 15 Presentation: Jeff Carmichael 3. “ Risk-Based ” Supervision Again the idea of a risk-based approach = apply resources where the risks are greatest Thus a supervisor following a risk-based approach will attempt to: Identify those banks in which risks are greatest Identify within each bank those areas in which risks are greatest Apply scarce supervisory resources so as to minimizing the overall “regulatory” risk

17. Colombia February 2004 Page 16 Presentation: Jeff Carmichael Risk Rating Banks Most regulators use some form of rating system (e.g. CAMELS) for banks Following the experience of banks many have moved to a two-dimensional grading scale; e.g. PF - probability of failure CGF - (systemic) consequences given failure

18. Colombia February 2004 Page 17 Presentation: Jeff Carmichael Example - PAIRS APRA Reviewed developments in US, UK and Canada Developed PAIRS system (Probability and Impact Rating System) As in banking - risk grading system should not eliminate subjectivity but the discipline imposed by a structured approach should increase objectivity Back up with peer review and quality control

19. Colombia February 2004 Page 18 Presentation: Jeff Carmichael Conceptual Framework for PF Inherent Risk Management & Control Capital Support Risk of Failure PF _ _

20. Colombia February 2004 Page 19 Presentation: Jeff Carmichael The Structured Approach The Impact rating is based largely on size - with some management over-ride if needed PF x Impact (CGF) = index of supervisory attention The Index of Supervisory Attention is exponential from 1 to 56,000 The Index is grouped into: Normal Oversight Mandated Improvement Restructure

21. Colombia February 2004 Page 20 Presentation: Jeff Carmichael Supervisory Attention Grid

22. Colombia February 2004 Page 21 Presentation: Jeff Carmichael Beyond Risk Grading Risk-based supervision requires better risk grading to identify the institutions posing the greatest risks It also requires targeted inspections and investigations It requires judgement and graduated supervisory responses This is where Basel II has focused its attention through Pillar 2

23. Colombia February 2004 Page 22 Presentation: Jeff Carmichael Pillar 2 - Supervisory Review Philosophy: 1.Pillar 1 Capital Framework is only an approximation - it is not entirely comprehensive 2.Capital is critical in mitigating risk but it is not the only relevant factor - a bank should have sound processes and procedures for measuring, monitoring and managing risk

24. Colombia February 2004 Page 23 Presentation: Jeff Carmichael Supervisory Review Process Use tools available to assess how accurately Pillar 1 matches minimum capital with risks taken by the bank Use tools available to understand how strong a bank’s processes & procedures are and how well they are implemented Use supervisory judgement to impose additional supervisory requirements (including capital) where residual risk is excessive

25. Colombia February 2004 Page 24 Presentation: Jeff Carmichael Assessing the Adequacy of a Bank ’ s Capital Principle 1: Banks should have a process for assessing capital relative to risks and a strategy for maintaining it Supervisors: Review the risk assessment processes for relevance and comprehensiveness - does the bank recognise other risks such as interest rate risk? Identify inconsistencies Check that management is engaged Assess application and controls - are processes followed? Require stress tests

26. Colombia February 2004 Page 25 Presentation: Jeff Carmichael Specific Guidance Interest Rate Risk in the banking book Operational Risk Definition of default Risk mitigation Concentration Risk Securitization

27. Colombia February 2004 Page 26 Presentation: Jeff Carmichael Demands Related to IRB Banks that choose IRB need to meet a series of demanding qualifying and validation criteria These have been set out in detail by the Basel Committee - along with guidance about what and how to check The on-going monitoring of the appropriateness and application of these model-based risk management processes is a fundamental part of Pillar 2 supervisory review - especially stress testing

28. Colombia February 2004 Page 27 Presentation: Jeff Carmichael Responding to Assessed Risks Principle 2: Supervisors should take enforcement action if not satisfied with a bank’s approach to risk management Principle 3: Supervisors should expect banks to hold above the minimum and should be able to require them to do so Principle 4: Supervisors should intervene early to prevent capital falling through the minimum

29. Colombia February 2004 Page 28 Presentation: Jeff Carmichael Is Pillar 2 Really Anything New? To the extent that Pillar 2 emphasises: Assessment of risks Supervisory judgement & discretion Active enforcement It is just an extension of the already growing risk- based approach to supervision It does provide detailed guidance - but many countries already exercised this type of approach Problem was - not all countries could! Pillar 2 formalises the central role of flexibility Without that flexibility Basel II is a waste of time

30. Colombia February 2004 Page 29 Presentation: Jeff CarmichaelSummary The “risk-based” approach is about identifying risks and devoting resources to where they will be most effective in reducing risks This approach is as critical in banking as it is in regulation and supervision In regulation it requires that capital requirements are greater where risks are greater In supervision it requires supervisors to: Assess where the risks are greatest Intervene and enforce standards flexibly where the risks are greatest Pillar 2 of Basel II provides a framework for the assessment and intervention process Pillar 2 is a fundamental component of Basel II

31. Colombia February 2004 Page 30 Presentation: Jeff Carmichael Thank You

32. Risk-Based Supervision: Challenges under Basel II ARMICHAEL ONSULTING Pty Ltd