Basel II and Internal Models

1. Basel II and Internal Models Mary Frances Monroe Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System Presentation to Casualty Actuarial Society Baltimore, Maryland November 16, 2005

2. Overview of Presentation • Background and Overview of Basel I -- the current rules • Advantages and Disadvantages of Basel I – why revise? • Goals of Basel II • Structure of Basel II – the three-pillared approach • Pillar One – Minimum Capital Requirements • Importance of qualifying criteria for internal models • Importance of corporate governance • Importance of stress testing and validation • Pillar Two – Supervisory Review • Pillar Three – Public Disclosure for Enhanced Market Discipline • Looking forward

3. Brief Background of Bank Regulatory Regime • Federal Reserve Board: umbrella supervisor of bank and financial holding companies and primary federal banking regulator of state member banks • Office of the Comptroller of the Currency: primary federal banking regulator of national banks • Federal Deposit Insurance Corporation: deposit insurer and primary federal banking regulator of state-chartered banks that are not Federal Reserve members • Office of Thrift Supervision: primary federal regulator of federal savings associations and savings and loan holding companies

4. Basel I – The Current Risk-Based Regulatory Capital Rules • Basel I represented a significant step forward in the quantification of the risk exposures faced by banking organizations • Risk weights for assets and off-balance sheet (OBS) items reflect an intuitive supervisory view on the relative loss potential of different exposures • Banking organizations are expected to operate with capital levels well above the minimums, especially if expanding or experiencing unusual or high levels of risk

5. Basel I – The Current Risk-Based Regulatory Capital Rules • Basel I established the risk-based capital (RBC) ratio • Both Tier 1 and Total RBC ratios were introduced in the U.S. • The U.S. also established a leverage ratio (Tier 1 capital to total assets) that was similar to the primary capital ratio in use up to that time • The prompt corrective action framework complements capital requirements

6. Advantages of Basel I • Relatively simple structure • Substantially increased the capital ratios of international banks and enhanced competitive equity • Required capital to be held against OBS items • Widespread adoption world-wide • Provided a benchmark for analytical comparative assessment

7. Disadvantages of Basel I • Not aligned with the actual risks faced by banking organizations • Broad-brush risk weighting structure • Organization for Economic Cooperation and Development (OECD): OECD/non-OECD distinction • Opportunities for regulatory capital arbitrage • Covered primarily credit risk

8. Goals of Basel II • Consistency with fundamental safety and soundness banking principles • Reasonable trade-off between enhanced risk sensitivity and implementation burden • Capital charges should be relatively stable over the economic cycle (i.e., non-cyclical) • Roughly maintain the current amount of capital in the banking system while encouraging improvements in risk measurement and management practices

9. Goals of Basel II • Greater risk sensitivity – reliance on a bank’s internal assessments of capital adequacy • Reflect and support sound risk management practices • Adapt to evolving markets and products • Promote and enhance a level playing field across international boundaries

10. Structure of Basel II • Pillar I Minimum Capital Requirements • Credit Risk, Market Risk, and Operational Risk components • Importance of Qualifying Criteria for Use of Internal Models • Importance of Corporate Governance Structure • Importance of Stress Testing and Robust Model Validation

11. Structure of Basel II (continued) • Pillar II Supervisory Review: • Focus on risks not fully captured in Pillar 1, factors not taken into account under Pillar 1, and external factors (e.g., interest rate risk and concentration risk) • Four key principles (in brief): • Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels • Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. • Supervisors should expect banks to operate above the minimum regulatory capital ratios. • Supervisors should seek to intervene at an early stage.

12. Structure of Basel II (continued) • Pillar III Market Discipline/Disclosure: • Guiding Principles: allow market participants to assess key pieces of information on the capital adequacy of a banking organization, especially in light of reliance on internal methodologies that give banks more discretion in assessing capital requirements • Materiality: definition consistent with accounting principles • Frequency: publish material information as soon as practicable

13. Importance of Qualifying Criteria for Use of Internal Models • Modeling methodologies and validation have improved significantly over the last several years. • However, models must be approached with caution: • Models represent a vastly simplified representation of the real world • Models may not capture all risks (for example, value-at-risk models may not capture adequately exposure to sudden defaults or concentrations) • Models may be dependent upon valuations of exposures • Model assumptions/parameters may understate degree of risk • Models may be based on backward-looking data

14. Importance of Corporate Governance Structure • The board of directors and senior management is responsible for understanding the bank’s risk and how that risk relates to capital levels • Capital must be commensurate with the bank’s risk profile and control environment and the stage of the business cycle in which the bank is operating • However, increased capital should not be the only option for addressing risk – improved risk management, exposure limits, internal controls, provisions and reserves also are important risk mitigants

15. Importance of Stress Testing and Robust Model Validation • Stress testing should reflect risks not adequately captured in the model • Results of stress testing should be reflected in internal capital assessments • Taking stress conditions and scenarios into account involves both quantitative analysis and qualitative judgment with an enterprise-wide view

16. Importance of Stress Testing and Robust Model Validation -- continued • Validation should occur when the model is initially developed and when changes are made to the model, when portfolio composition changes significantly or when significant structural changes occur in the market • In addition to backtesting, validation of VaR models can incorporate the use of longer time periods to improve the statistical power of the model and multiple percentiles, which can improve the ability to detect a poor risk model

17. Expansion of the Use of Internal Models – Looking Forward • A significant innovation of Basel II is greater use of assessments of risk provided by banks’ internal systems • Ability of the bank to determine parameters for probability of default, loss given default, exposure at default, and remaining maturity, which are inputs to supervisory formulas • Recognizes evolving nature of credit risk models • Over time, Pillar 2 will offer the banking industry the opportunity to move closer to internal credit risk models as supervisory concerns are addressed

18. Final thoughts… • Models are important risk management tools but they should be used with a full appreciation of their limitations and in the context of a robust risk management framework • Capital is not a substitute for effective risk management • The total amount of capital held by an individual bank is influenced by a variety of factors, of which the minimum regulatory capital requirement is only one • Banks’ business activities and the evaluation of the capital needs of the bank by its board of directors, the banking supervisors, the rating agencies, and the marketplace also impact the total amount of capital held.