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BASEL II - WHERE TO NOW?

BASEL II - WHERE TO NOW?. Andrew Jennings January 2009 . Disclaimer. Opinions expressed in this presentation are those of the speaker and do not necessarily reflect the views of Citigroup Inc or its affiliates. BASEL II – Where we are now?. 10 years in its creation

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BASEL II - WHERE TO NOW?

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  1. BASEL II - WHERE TO NOW? Andrew Jennings January 2009

  2. Disclaimer • Opinions expressed in this presentation are those of the speaker and do not necessarily reflect the views of Citigroup Inc or its affiliates

  3. BASEL II – Where we are now? • 10 years in its creation • Banks have spent about £10bn - £20bn on its implementation • Many banks have started to report under Basel II • Significant improvement over Basel I • BUT …. Still needs improvement • Greater importance of Pillar 2 • Basel Committee due to release a paper shortly

  4. Basel II - Enhancements • Trading book risk – inclusion of “Event Risk” • Greater emphasis on Stress Testing • Review of Off-Balance Sheet exposures • Treatment of securitisations • Counterparty risk – reducing credit default swap risk • Liquidity • External Audit Quality • Fair value accounting • Improved disclosure • Others??

  5. Tier 1 Capital and Stress Testing • Increased attention to Tier 1 ratios • Need to have sufficient Tier 1 capital after a severe stress event. • Increased attention to severe stress results • Raises pro-cyclicality of Basel II • Consideration of provisioning policies • More emphasis on building up capital in ‘good times’ • Implications for banking returns

  6. IMPACT OF PROCYCLICALITY UNDER BASEL II

  7. STRESS TESTING • Increased importance • Reverse stress test proposed • Regulators setting stress testing assumptions • Regulators set Basel II parameters if data is lacking • Cover all risks • Informs forward planning, capital requirements and risk appetite. • Contingency capital plans.

  8. USE OF STRESS TESTING RESULTS • Severe but plausible stress test across whole bank. • Identify concentrations: • Single large exposures • Large losses as a result of large moves of a specific factor (eg house prices) • Consider secondary effects and changes in historic correlations. • Identify portfolios with ‘Fat Tails’ e.g. • Secondary mortgages and some sub-prime mortgages • Leveraged or Bridge Loans • Originate to distribute portfolios awaiting sale • Basis risk of ‘well hedged’ positions.

  9. DATA QUALITY • Good quality risk data vital to optimise Basel II capital requirement. • Poor quality leads to conservative capital estimates and potentially excessive capital usage. • Credit and finance data need to be, as near as possible, the same. • Settlements outstanding, • Deferred fees • Impaired counterparties • Correct mark to market

  10. DATA QULAITY (continued) • Include non finance data • Legal netting where available • Full collateral data • Risk ratings assigned • Counterparty identified • Comprehensive netting • Legal vehicle used • Identify defaults and recoveries promptly and comprehensively

  11. Accurate Data for models • Exposure at Default: • Volume of data limited so changes can have a disproportionate effect. • Particularly noticeable for credit cards and un-drawn wholesale commitments. • High quality risk management of use of un-drawn commitments will have a significant benefit in Basel II capital requirements. • Loss Given Default • Evidence of downturn LGD and its variation across cycle. • Management of defaults and recoveries. • Sectoral and geographic analysis.

  12. USE MODELS WHERE POSSIBLE • Operational Risk model – very different distribution of operational risk. • Expected Positive Exposure (‘EPE’) for OTC derivatives. • Model ALPHA (below defined regulatory level x1.4) • VaR or EPE for Secured Finance Transactions (SFTs). • VaR for all aspects of Market Risk, but will include event risk.

  13. POTENTIAL TO OPTIMISE CAPITAL UNDER BASEL II • More difficult than Basel I • Explore those that make sense for your bank – e.g. in Retail: • Potential to sell defaulted credits which are difficult to collect • Reduce undrawn commitments • Explore those that make sense for your bank – e.g. in Wholesale: • Cancel swaps • Reduced intra group exposure • CDS hedging of higher risk exposures • Banking book/trading book split • Undrawn commitments – especially if under 1 year. • Collateralised or covered by parent guarantee.

  14. RETURN ON BASEL II CAPITAL: • Given previous comments there is considerable pressure on banks’ balance sheets • Most significant ratio to many banks is the Tier 1 regulatory ratio. • Need to optimise return on Tier 1 capital • Reduce assets utilisation • Risk has a vital role in helping identify opportunities.

  15. CONCLUSION

  16. Oh Man, I got the BASEL II Blues !

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