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Basel II implementation at Absa: A case study Presented by: André Blaauw

Basel II implementation at Absa: A case study Presented by: André Blaauw GM: Enterprise-wide Risk Management Absa, South Africa andrebl@absa.co.za. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004. Agenda.

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Basel II implementation at Absa: A case study Presented by: André Blaauw

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  1. Basel II implementation at Absa: A case study Presented by: André Blaauw GM: Enterprise-wide Risk Management Absa, South Africa andrebl@absa.co.za Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004

  2. Agenda 1. About the SA financial system 2. About Absa 3. Risk management history at Absa 4. To B2 or not to B2? 5. B2 implementation strategy 6. Current B2 implementation status 7. Delivering the B2 solution 8. B2 / IFRS alignment 9. Early results 10. Local supervisor’s influence 11. Industry collaboration 12. Remaining issues and challenges 13. Conclusion SA: South Africa B2: Basel II Capital Accord IFRS: International Financial Reporting Standards

  3. 1. About the SA Financial System JSE: Johannesburg Stock Exchange SAFEX: South African Futures Exchange OTC: Over-The-Counter FSB: Financial Services Board • Sophisticated by emerging market standards: • Well developed capital and money markets. • Listed equities market (JSE) – total market capitalisation of approx 200 Billion USD. • Large and liquid listed fixed income market (Bond Market Exchange). • Formal equity and commodity futures and options markets (SAFEX). • Large domestic interest rate- and FX OTC derivatives markets. • Banking industry: • Dominated by 5 large banks – combined holds more than 90% of assets. • Financial conglomerates – retail, commercial, investment banking, insurance, asset management, etc. • Regulatory environment: • Banks are regulated by the central bank. • Insurance, securities trading, asset management, etc. – regulated by the FSB.

  4. 2. About Absa • Absa Group Ltd.: • Domiciled in South Africa (SA) • Listed on Johannesburg Stock Exchange (JSE) • Controlling company of major banking and financial services group in SA • Formed about nine years ago by merging four major South African financial services groups (Amalgamated Banks of South Africa Ltd.) • Absa Bank Ltd.: • One of the 4 largest domestic banks in SA • Market leader in retail banking: mortgages and electronic banking • Geographical footprint: • Represented in 11 countries:South Africa, Europe, Asia, Americas, Other sub-Saharan African countries Who is Absa?

  5. 2. About Absa Absa Group Activities • Absa Bank • Retail banking • Commercial banking • Corporate & Merchant banking • International operations • Africa banking operations • Absa Financial Services • Life insurance • Short-term insurance • Insurance broking • Trust & Investment services • Employee benefits Contribution by Activity (% of Headline Earnings) *31-Mar-2003 • Other Activities • Asset management • Property development • Pension payments

  6. 2. About Absa • 1994 first democratic elections:Ending SA's isolation from international community; Rapidly growing trade between SA and other African countries • Tier 2 Banks liquidity crisis • Micro-lending shake-up • Mergers & acquisitions, and new market players • Currency volatility Salient features Recent events in SA • Black Economic Empowerment • Financial Services Charter • Banking the unbanked/unbankable • King II report on Corporate Governance • AC133 Accounting Standard (1 Jan 2003)(IAS 39 / FAS133 equivalent) • Basel II Capital Adequacy Requirements

  7. 3. Risk management history at Absa 1996 ALCO process fully established. 1997 Trading book VaR implementation. 1998 Active hedging programme for IRR commenced. 1999 ERM approach initiated. 2000 Earnings-at-Risk (EaR) framework implemented. 2001 Re-engineering of credit decisioning platform completed. 2002 Basel 2 programme initiated. 2003 Basel 2 implementation gains momentum. ALCO: Asset & Liability Committee VaR: Value-at-Risk IRR: Interest Rate Risk ERM: Enterprise-wide Risk Management EaR: Earnings-at-Risk

  8. 4. To B2 or not to B2? – Internal considerations 4.1 INTERNAL CONSIDERATIONS 4.1.1 Resource implications: • Significant investment in IT systems would be required. • Data availability challenges. • Complex model requirements. • Ownership, co-ordination of efforts (Finance, IT, Risk). 4.1.2 B2 implementation cost and risk: • Estimated at 2.8% of annual Operating Expenditure, expensed over 5 years. • Capital saving benefits uncertain. • High risk of rework, due to regulatory process uncertainty. 4.1.3 Change management: • Changes to IT systems and business processes, policies and procedures. • Challenge to manage required change effectively.

  9. 4. To B2 or not to B2? – Internal considerations 4.1.4 Other compliance requirements: • AC133 (IFRS), AML, etc. 4.1.5 Business benefits: • Enhanced reputation. • Improved control environment, information integrity, etc. • Tools to improve operational and process efficiencies. 4.1.6 Enhancing risk management framework: • Opportunity to further embed risk-reward management culture in decision making. AC133: Accounting standard AC133, “Financial Instruments: Recognition and Measurement”, a recent addition to South African GAAP and local equivalent of IAS39 / FAS133. IFRS: International Financial Reporting Standards AML: Anti-Money Laundering

  10. 4. To B2 or not to B2? – External considerations • 4.2 EXTERNAL CONSIDERATIONS: EMERGING MARKETS ACCEPTANCE • 4.2.1 Cross border capital flows: • Improved transparency of SA banks’ risk profiles and best practices benchmark compliance could improve ratings. • Improved capital inflows could result. • 4.2.2 Unintended consequences: • Higher capital requirements volatility in emerging markets. • More challenging for banks to maintain profitability due to combined impact of AC133 and B2. • 4.2.3 Benefits to banking and financial system: • Improved risk management practices could lead to reduced systemic risk and improved market perception. • More efficient utilisation of capital employed in the banking system. • Growth in risk transfer instruments promoted. • Industry consistent disclosure. • Improved corporate governance through board and senior management oversight requirements. • Complements supervisor’s risk based approach.

  11. B2 No B2 4. To B2 or not to B2? – Conclusion 4.3 CONCLUSION • Reputational risk of non-compliance too high. • Large retail base should lead to reduced capital requirements. • Positive spin-offs. • Benefits outweigh costs. • B2 should be viewed as an opportunity to enhance competitive position.

  12. 5. B2 Implementation Strategy • Absa’s goal: To be fully B2 compliant by January 2007 • B2 approach aspirations: • Retail credit exposures: IRB Advanced • Corporate credit exposures: IRB foundation • Operational Risk: Advanced measurement approach Some subsidiaries will be excluded from Group adopted approach based on materiality and will follow standardised approach. IRB: Internal Ratings Based

  13. 6. Current B2 Implementation Status Final Accord Jun Full Implementation Jan CP2 May CP3 Apr Legislative Process OIS3 Dec CP1 Jan Parallel Run Regulatory Timeline 01 04 05 06 07 02 03 Planning/mobilisation Gap/Impact Analysis Pre requisite systems Methodologies and data Measurement Models Programme Timeline B2/IFRS alignment Systems integration Process and organisation Operationalisation Programme Management Awareness/Communication Change Enablement Quality & Compliance Assurance 2001 2002 2003 2004 2005 2006 2007

  14. 7. Delivering the B2 solution Planning, programme mobilising and governance • Oversight by Board • Group program SteerCo • Work stream structures with clearly defined outputs • Programme sponsorship • Budgeting, priority setting, etc. • IT strategy alignment • Subject expertise

  15. 7. Delivering the B2 solution Programme management: Governance Structure Group Risk Committee (Board Risk Committee) B2 Programme SteerCo (Chairman: FD) ACMB B2 SteerCo CRMO B2 SteerCo ERM B2 SteerCo Group Finance B2 SteerCo B2 Credit Risk Work Streams B2 Capital & Disclosure Work Streams B2 Credit Risk Project Management B2 Market Risk Work Streams B2 Operational Risk Work Streams

  16. 7. Delivering the B2 solution Communication and Awareness • Ongoing • Board member training programmes • Interpreted B2 • External training • Core group with requisite expertise • Training material • B2 knowledge base • Ongoing impact analysis and communication of results

  17. 7. Delivering the B2 solution Models: Credit Risk • PD: • Corporates: KMV • SMEs: Moody’s RiskCalc (SA default database) • Retail: Own development based on internal default experience related to application and behavorial scoring (TRIAD) • Specialised lending: Slotting criteria • Banks and sovereigns: Derived from internal to external rating mappings • LGD Retail: • Own development based on internal recovery experience • EAD Retail: • Own development based on internal draw down experience • Capital measurement: • Pillar 1: SAP Bank Analyser • Pillar 2: Own development in SAS PD: Probability of Default SMEs: Small and Medium sized Enterprises LGD: Loss Given Default EAD: Exposure At Default

  18. 7. Delivering the B2 solution Models: Operational Risk • Quantitative operational loss modeling: Algorithmics • Qualitative measurement – self-assessment surveys: Horizon (JP Morgan) • Models: Market Risk • Trading book: Algorithmics • Equity investments: Algorithmics • IRR in banking book: Kamakura (being evaluated)

  19. 7. Delivering the B2 solution Data Collection Strategy • Retail credit loss data: • Data collection efforts commenced some time ago. • Four years of historical data available already. • SME credit loss data: • Data pooling arrangement with peer group initiated. • Corporate, sovereign, banks credit loss data: • Insufficient data availability in local market. • Statistical model approach to be followed. • Calibrated to international default experience. • Operational risk: • Historical data available for frauds and some loss events. • Data collection efforts for remaining loss types have commenced. • Data pooling arrangement with peer group under discussion. • Centralised financial transaction database: • Development in progress.

  20. 7. Delivering the B2 Solution Integrated Credit Risk System STRATEGY optimiser CAPITAL ALLOCATION engine PORTFOLIO engine PROVISIONING engine R O R A C DI Formatter EAD Recovery Rating Simulators Economic Scenario Generator BIS CAPITAL engine PRICING engines EL-UL Engine Interface Layer LGD engine EAD engine Loan valuation engine (AC133) Fixed Property Moveable Property Finance Securities Concurrent Creditors LGD Estimators External Retail Business Client Corporate Client Financial Institution Sovereign Unlisted PD Estimators Banking Book Trading Book PFE Calculators Credit conversion Factors Haircut Engine Ratings Calibrator Fixed Property Moveable Property Finance Securities Concurrent Creditors Recovery Statistics Collateral Management Retail Client Business Client Corporate Client Limits/Exposure Application Scoring Judgmental Behavioral scoring  FES Rating Systems Customer/Product Systems Slide 20

  21. 7. Delivering the B2 solution Integrated Operational Risk System OPRISK CAPITAL allocation OPRISK PERFORMANCE management Operational Risk Analysis and Modeling INTEGRATED OPRISK PROFILE dashboard Operational Risk Profile Integration 1 Interface Layer 1 2 3 RISK INDICATORS QUANTITATIVE OPRISK data QUALITATIVE OPRISK data 1 2 3 Industry Database Economic Crime Profile Loss/Events Database Assurance Compliance Qualitative Operational Risk Profile Alignment Indicator Monitoring Indicator Identification Business Units ERM Sourcing Business Units ERM Sourcing Loss/Event Capturing Loss/event Validation Sourcing Business Units ERM Enterprise Operational Risk Framework Version 3.1 Slide 21

  22. 7. Delivering the B2 solution Risk Management Framework Enhancement– Credit Risk Significant enhancement required to existing processes for B2 Legend: Minor enhancement required to existing processes for B2

  23. 7. Delivering the B2 solution Risk Management Framework Enhancement– Operational Risk Compliance assessment Board and Senior Management Oversight Audit reports Oversight Assurance Compliance Disclosure Risk appetite Approved capital Profile Alignment Modeling Capital Measurement Capital Allocation Performance Management Mitigation Strategies Enterprise Operational Risk Management Indicator Database Loss Event Database Qualitative Database Information Sourcing • Sources • Business Units • Sources • Industry Database • Public Sources • External Research • Sources • Business Units • Fraud Related Events • Sources • Control Self-Assessments • Compliance profiles Performance Management BU Strategies BU Operational Risk Management Reducing operational losses Effective and efficient internal control Business process reengineering Significant process changes in progress Legend: Minor process changes in progress Slide 23

  24. 7. Delivering the B2 solution Risk Management Framework Enhancement– Market Risk Compliance assessment Board andSenior Management: Oversight Oversight Assurance Compliance Disclosure Audit reports Risk appetite Risk Management Unit: Measure, Monitor, Control, Report Capital + Risk Measurement Capital Allocation Set and enforce limits Set Policies Portfolio Management Risk Mitigation Position taking functions Significant enhancement required to existing processes for B2 Legend: Minor enhancement required to existing processes for B2 • Existing Risk Management Framework unchanged. • Interest Rate Risk in the Banking Book does not attract a minimum Pillar 1 capital charge, but supervisory review process requires disclosure of economic value sensitivities relative to capital. • Computation of capital for position risk in the trading book: Compliance with Capital Adequacy Requirement (1998) represents compliance to Basel II. Absa had its internal model approved for the computation of position risk capital in the trading book in 1998. • Capital requirements for equity risk: Equities in the banking book under the internal models approach (VaR).

  25. 7. Delivering the B2 solution Capital adequacy management framework Set Risk Appetite Monitor Risk Profiles Obtain Assurance & Ensure Compliance Board Risk Committees Capital Management Regulatory Reporting Public Disclosure Risk-Adjusted Performance Measurement Group Finance Models & Methodologies Portfolio Risk Measurement Capital Requirement Projections Portfolio Limit Monitoring Group Risk Profile Reporting Structuring Enterprise RM Risk Underwriting Set Risk Policies Risk Assessment Allocate Risk Ratings Risk Pricing Quantitative Risk Measurement Risk Mitigation Exposure Monitoring Collateral Management Provisioning Recovery Risk Management Strategic Planning Market Segmentation and Targeting Deal Origination Service Delivery Operations Management IT / Information Management Customer Relationship Management SBUs

  26. 8. B2 / IFRS alignment • Overlap between IFRS and B2. • Common data requirements. • Common valuation models. • Provisioning / capital interrelationship. • Capital adequacy implications of fair value adjustments. • B2 / IFRS development strategy to ensure consistency in risk and financial performance measurement. • Common validation needs. • Ownership. B2: Basel II Capital Accord IFRS: International Financial Reporting Standards

  27. 9. Early results • Capital impact • Ongoing capital impact measurement. • As of December 2003: • Overall: Estimated 5% capital saving • Retail credit portfolios: Significant (30%+) capital saving • SMEs: Slight increase • Corporate : Increase • Banks: Significant increase • Operational risk capital: 7% increase (preliminary AMA) • Early indication of further capital relief from EL / UL amendment. AMA: Advanced Measurement Approach EL / UL: Expected Loss / Unexpected Loss

  28. 9. Early results • Strategic implications • Protecting the Retail base. • Increased focus on Wealth Management services. • Increased focus on CRM. • Reviewing LTV lending criteria for some Mortgage segments. • Reviewing speculative grade Corporate lending criteria. • Increased focus on customer retention. • Consider risk-based product re-pricing (declining capital needs over loan life). CRM: Customer Relationship Management LTV: Loan-To-Value

  29. 10. Local Supervisor’s Influence Accord Implementation SteerCo • Senior Bank Executives • Bank Supervision Heads Risk Management Disclosure Compliance Economic Impact • Data issues • Model validation • Consolidated response to BIS proposals • Co-ordinated QIS

  30. 11. Industry Collaboration Industry has taken initiatives … Credit loss data pooling Operational loss data pooling • SME default data(in progress) • SME LGD data(next phase) • Still under discussion • Issues: context, confidentiality, etc.

  31. 12. Remaining issues and challenges – Pillar 2 clarity • Judgmental approach to Pillar 2 – strong reliance on supervisor expertise. • Economic capital measurement assumptions for interest rate risk in banking book. • Measurement issues and assumptions for risks not covered under Pillar 1 – eg. Liquidity risk. • Capital stress testing methodology. • Capital buffer requirements. • Credit concentration risk measurement approaches. • Risk diversification treatment in buffer determination.

  32. 12. Remaining issues and challenges – Pro-cyclicality B2 Credit Capital Risk Weight Curve • Static LGD, EAD and term assumptions. • Non-linear sensitivity to credit quality changes.

  33. 12. Remaining issues and challenges – Pro-cyclicality • Absa’s capital requirement would have increased by over 30% under a B2 regime in the aftermath of the 1998 Emerging Markets Crisis. • Problem exacerbated by dynamic internal rating systems. • Capital stress testing/planning simulation model capability. • Buffer management. • Ongoing capital attribution analysis. • Hedge capital fluctuations.

  34. 12. Remaining issues and challenges – Model validation • Supervisory approach to model validation. • Statistical validation (backtesting, out of sample testing, etc.) not feasible in all areas. • Benchmarking. • Mapped ratings. • Methodology reviews. • Pragmatic approach. • Ongoing validation strategy. • Rating agents.

  35. 12. Remaining issues and challenges – Capital level & Ratings Long-term Impact of Basel II on Bank Ratings • Higher CAR won’t necessarily lead toupgrade, and cutting capital because ofa higher CAR could lead to a downgrade. • But better data on risk profile will beconsidered, and better risk management a positive: • Better asset allocation • Better risk-adjusted pricing. “ ” Moody’s Investors Services CAR: Capital Adequacy Requirements

  36. 13. Conclusion • B2 benefits outweigh costs. • Plethora of model tools and data availability is improving. • Strong programme management required for successful implementation. • Industry collaboration critical. • Communication and education – bank management, investors, stakeholders, etc. • Key role of Regulator: To be pro-active on issues - reduce uncertainties.

  37. Victor Hugo

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