The Evolution to Basel II XBRL and the Basel II Capital Accord

1. The Evolution to Basel IIXBRL and the Basel II Capital Accord Donald Inscoe Deputy Director Division of Insurance and Research U.S. Federal Deposit Insurance Corporation XBRL International, Tokyo, Japan November 8, 2005

2. First Basel Accord • The first Basel Accord (Basel I) was completed in 1988 • Set minimum capital standards for banks • Standards focused on credit risk, the main risk incurred by banks • Became effective end-year 1992

3. Reason for the Accord • To create a level playing field for internationally active banks • Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans

4. 1988 Accord Capital Requirements • Capital was set at 8% and was adjusted by a loan’s credit risk weight • Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100% • Commercial loans, for example, were assigned to the 100% risk weight category

5. Risk-Based Capital • The Accord was hailed for incorporating risk into the calculation of capital requirements

6. Capital Calculation • To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8% • Thus a $100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of $8

7. Criticisms of the Accord • The Accord, however, was criticized for taking too simplistic an approach to setting credit risk weights and for ignoring other types of risk

8. Risk Weights • Risk weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset • Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary

9. Operational and Other Risks • The requirements did not explicitly account for operating and other forms of risk that may also be important • Except for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques

10. Banks Develop Own “Capital Allocation” Models • Advances in technology and finance allowed banks to develop their own capital allocation (internal) models in the 1990s • This resulted in more accurate calculations of bank capital than possible under Basel I • These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank

11. Internal Models and Basel I • Internal models allow banks to more finely differentiate risks of individual loans than is possible under Basel I • Risk can be differentiated within loan categories and between loan categories • Allows the application of a “capital charge” to each loan, rather than each category of loan

12. Variation in Credit Quality • Banks discovered a wide variation in credit quality within risk-weight categories • Basel I lumps all commercial loans into the 8% capital category • Internal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated risk

13. Capital Arbitrage • If a loan is calculated to have an internal capital charge that is low compared to the 8% standard, the bank has a strong incentive to undertake regulatory capital arbitrage • Securitization is the main means used by U.S. banks to engage in regulatory capital arbitrage

14. Example of Capital Arbitrage • Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirements • AA-A: 3%-4% capital needed • B+-B: 8% capital needed • B- and below: 12%-16% capital needed • Under Basel I, the bank has to hold 8% risk-based capital against all of these loans • To ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge • Lower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicates

15. New Approach to Risk-Based Capital • By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel II) • Effort focused on using banks’ internal rating models and internal risk models • June 1999: Committee issued a proposal for a new capital adequacy framework to replace the 1998 Accord

16. Basel II • Basel II consists of three pillars: • Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I) • Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II) • Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)

17. Pillar I • In the United States, all banks that will be required to conform to the new capital standard will use the Advanced Internal Ratings Based approach (AIRB)

18. AIRB Approach Requirements • Collect sufficient data on loans to develop a method for rating loans within various portfolios • Develop a Probability of Default (PD) for each rated loan • Develop a Loss Given Default (LGD) for each loan

19. Example: Safe v. Risky Loans • Safe loans: • Over a 1-year period, only 0.25% of these loans default • If a loan defaults, the bank only loses 1% on the outstanding amount • Risky loans: • Over a 1-year period, 1% of loans default every year • If a loan defaults, the bank loses 10% of the outstanding amount

20. Example: Safe v. Risky Loans (continued) • For a $100 million portfolio of the safe loans, the bank would expect to see $250,000 in defaults in a year and a loss on the defaults of $2500 • ($100 million X .25% = $250,000) • ($250,000 X 1% loss rate = $2500)

21. Example: Safe v. Risky Loans (continued) • For a $100 million in a risky portfolio the bank would expect to see $1 million in defaults in a year and a loss on the defaults of $100,000 • ($100 million X 1% = $1 million) • ($1 million X 10% = $100,000)

22. Goal of Pillar I • Although simplistic, this example demonstrates what Pillar I is trying to achieve • If the bank’s own internal calculations show that they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high • Likewise, lower risk loans should carry lower risk-based capital charges

23. Complexity of Pillar I • Banks have many different asset classes each of which may require different treatment • Each asset class needs to be defined and the approach to each exposure determined • Minimum standards must be established for rating system design, including testing and documentation requirements • The proposals must be tested in the real world

24. Assessing Basel II • To determine if the proposed rules are likely to yield reasonable risk-based capital requirements within and between countries for banks with similar portfolios, four quantitative impact studies (QIS) have been undertaken

25. Results of Quantitative Impact Studies • Results of the QIS studies have been troubling • Wide swings in risk-based capital requirements • Some individual banks show unreasonably large declines in required capital • As a result, parts of the Accord have been revised

26. Operational Risk • Pillar I also adds a new capital component for operational risk • Operational risk covers the risk of loss due to system breakdowns, employee fraud or misconduct, errors in models or natural or man-made catastrophes, among others

27. Pillars II and III • Progress has also been made on Pillars II and III • Pillar II focuses on supervisory oversight • Pillar III looks at market discipline and public disclosure

28. Pillar II • Supervisory Oversight • Requires supervisors to review a bank’s capital adequacy assessment process, which may indicate a higher capital requirement than Pillar I minimums

29. Pillar III • Market discipline and public disclosure • The United States is currently in the forefront of disclosure of financial data • SEC disclosure requirements for publicly traded banks • Bank regulators require quarterly filing of call reports for all banks • U.S. authorities are currently considering what banks should publicly disclose about their Basel II calculations

30. U.S. Implementation of Basel II • Based on results for QIS4, which show the potential for substantial declines in capital, the U.S. banking regulators have proposed a revised implementation timeline • The revised timeline includes a minimum three-year transition period

31. Revised U.S. Timeline for Basel II Implementation

32. U.S. Implementation of Basel II (Continued) • After 2011, an institution’s primary federal supervisor will assess the institution’s readiness to operate under Basel II • Institutions will be assessed on a case-by-case basis • Further revisions to the floors are anticipated • Both Prompt Corrective Action and leverage capital requirements will remain

33. Basel I-A: The Search for Equal Capital Treatment • In the U.S., concerns that Basel II could give those banks operating under it a competitive advantage over other banks has resulted in a proposal called Basel 1-A • Basel 1-A is designed to modernize the way all U.S. banks and thrifts calculate their minimum capital requirements

34. Implications • The practices in Basel II represent several important departures from the traditional calculation of bank capital • The very largest banks will operate under a system that is different than that used by other banks • The implications of this for long-term competition between these banks is uncertain, but merits further attention

35. Implications • Basel II’s proposals rely on banks’ own internal risk estimates to set capital requirements • This represents a conceptual leap in determining adequate regulatory capital • For regulators, evaluating the integrity of bank models will be a significant step beyond the traditional supervisory process

36. Implications • The proposed Accord will elevate the importance of human judgment in the process of capital regulation • Despite its quantitative basis, much will depend on the judgment of banks in formulating their estimates and of supervisors in validating the assumptions used by banks in their models

37. Work Continues • During the past 3 years the FDIC has expressed its concern that the proposed Accord will result in banks having too little risk-based capital • Work continues on recalibrating the proposals and a workable solution is expected

38. ImplicationsAdditional Data Needed to Counterbalance to Changes in Environment • Changes in environment necessitate changes in risk analysis for banks and supervisors/insurers • Additional information will be needed to: • Inform policy development. • Supplement other sources of risk information used in supervisory resource planning and overall risk assessments • Serve as an input into deposit insurance pricing and overall insurance funds adequacy analyses

39. Why XBRL ? • Internal ratings based and standard approach measures require complex data model • Common data requirements flow from Accord and Quantitative Impact Studies (QIS I – IV) • Domestic and international comparisons needed to ensure consistent application • Taxonomy needed to compare banks’ internal ratings of similar and diverse risks

40. Reporting Granularity Summary Data Common Data Elements Flow from Accord:Standardized Internal Risk Estimates Data Types

41. Why XBRL ? • Internal ratings based measures and standard approach require complex data model • Supervisors need detailed information to qualify banks for advanced approaches (IRB, AMA, and Market Risk) • Data can be shared across different supervisory regimes - Independent of systems, platforms, geography and language translation

42. % of Wholesale Exposures 40 Bank’s PD Distribution Mapped to S&P Rating Scale 35 Peer Banks’ PD Distribution Mapped to S&P Rating Scale 30 25 20 15 10 5 0 AA or better A to AA BBB to A BB to BBB B to BB >B Consistent data needed to help identify risk estimates that may be inconsistent with peer estimates. Follow-up: Can differences between Bank’s PD and benchmark be adequately explained by differences in risk?

43. Why XBRL ? • XBRL provides a framework for complex data model • Open standard facilitates reuse and innovation • Analysts can spend more time analyzing data • Reduced reporting burden, especially for organizations operating in multiple jurisdictions

44. Why XBRL ? • A standard is needed in any case.

45. Why XBRL ? FINIS