Overview of Basel II and Recent Developments

1. Overview of Basel II and Recent Developments 5th SEACEN Seminar on Preparation for Implementation of Basel II 13 March 2008 Bali, Indonesia Chung Chee Leong Central Bank of Malaysia

2. Outline • Objective of Basel II and its key features • Implications of Basel II • Banks • Supervisors • Recent Developments

3. Regulatory Capital Requirements and Basel I • Capital adequacy requirements are a key regulatory tool • Ensure banks set aside a sufficient level of capital which is commensurate with the level of risk undertaken • To ensure banks operate on a ‘going concern’ basis • Component of prudential framework that provides for preventing / controlling the building up of excessive risks within financial system • Linked to key role of central banks in ensuring financial stability • The Capital Accord or Basel I was released in 1988 by the Basel Committee on Banking Supervision (BCBS) • Aimed at • Strengthening stability and soundness of international banking system • Creating greater consistency in the assessment of internationally active banks • Minimum capital requirement = 8% • Adopted in over 100 countries worldwide • Refinement in 1996 to incorporate market risk

4. Since the implementation of Basel I, the global financial landscape has evolved • Banks have become more innovative • Change in risk appetite and risk profiles • Risk management practices of institutions have improved considerably • Increased use of internal risk models • Risk mitigants in market more prevalent (e.g. derivatives, securitisation) • Several major shortcomings of Basel I have become apparent • Too simplistic; one size fits all approach • Broad-brush risk weighting structure (e.g sovereigns based on OECD and Non-OECD classification,100% risk weight for all corporates) • Confined to credit and market risk • Provides opportunities for regulatory arbitrage • Seen as compliance requirement only and does not encourage good risk management practices

5. Revised International Capital Standard or Basel II was finalised by the BCBS in 2006 • Adoption required in BCBS member countries by 1 January 2007 with most advanced approaches only made available for adoption on 1 January 2008 • Non-BCBS countries not compelled to adopt Basel II Key Objectives of Basel II • To ensure banks set aside sufficient capital for risk it assumes • Not intended to be neutral amongst different banks / exposures / countries • To provide incentive to banks for greater risk management (RM) and corporate governance in recognition of significant enhancements in RM practices since Basel I • Even for simpler approaches, more risk sensitive RM capabilities required • More is expected from banks adopting more advanced approaches • Nevertheless, the reduction in overall level of capital within the industry was not a desired outcome • Financial systems are expected to operate at similar levels

6. Basel II Framework based on 3 Pillars Capital Adequacy • Pillar 1 specifies how banks should determine the capital requirements for the major risks that they face. Basel I only covers Pillar 1 which is the capital measurement process • Pillar 2 recognises that although banks are ultimately responsible for managing their risks, supervisors can play a more active role in assessing banks’ risk management practices • Pillar 3 emphasises the role played by disclosure in ‘regulating’ bank’s behaviour and promoting market discipline. Disclosure & Market Discipline Supervisory Review Process CapitalRequirements 1 2 3

7. Basel II addresses the shortcomings of Basel I • More comprehensive coverage • Introduction of explicit capital charge for operational risk • Able to capture other risks • Basel II provides banks with a menu of options for capital measurement approaches • Risk sensitive approach with wider range of risk weights to reflect the true underlying risks more accurately • Availability of internal ratings based approaches • Greater recognition of credit risk mitigants (Collateral, Guarantees) • Provides more pro-active role for supervisors under Pillar 2 and encourages greater market discipline under Pillar 3

8. How does Basel II compare to Basel I? – A Snapshot Definition unchanged Min requirement unchanged but can be set higher under Pillar 2 Capital Base > 8% Credit RWA + Market RWA + Operational RWA New explicit capital charge Relatively unchanged Significant refinements

9. Pillar 1: Credit risk approaches Greater risk sensitivity & level of sophistication Standardised Approach Foundation IRB Approach Advanced IRB Approach Easier to implement

10. Pillar 1: Credit risk approaches Internal Ratings Based Approach for Credit Risk Why the IRB Approach “ Internal ratings may incorporate supplementary customer information which is usually out of reach of an ECAI ” “ Estimates of credit risk which reflect individual portfolio composition ” “ … driven by success of models in the determination of capital for market risk ” “ A more informed setting of limits and reserves, more accurate risk- and performance-based pricing, and more consistent basis for economic capital allocation ” “ … closer alignment with the perceived riskiness of underlying assets and portfolio concentrations ” Credit Risk Modelling: Current Practices and Applications, BCBS, 1999 Range of Practice in Bank’s Internal Ratings System, BCBS, 2000

11. IRB Approach: Key Features

12. IRB Approach: Minimum Requirements • Banking institutions adopting IRB approach are expect to demonstrate to supervisors that they have met the minimum requirements at the outset and on an on-going basis • Key minimum requirements include: • Data requirements for estimation of risk parameters • Sufficient no. of data for estimation of PD (5 years), LGD (7 years or 5 years for retail) and EAD (7 years or 5 years for retail) • Transition period • Use test • Internal ratings must play essential role in areas such as credit approval, risk management, limit setting, internal capital allocation • Validation of internal estimates • Internal validation process must enable banks to adequately assess the performance of internal ratings and risk estimation systems • Backtesting of internal estimates

13. Pillar 1: Market risk approaches • Refined treatments on double default effects and improvement to the current trading book regime was introduced in The Application of Basel ll to Trading Activities and the Treatment of Double Default Effects in the 2005 BCBS paper. • The risks subjected to this requirement are: • those pertaining to interest rate/profit rate related financial instruments and equities in the trading book; • foreign exchange risk and commodities risk throughout the bank. • Based on internal estimates of the bank • Subject to minimum requirements and supervisory approval Internal Models Approach Increasing sophistication • Use standard measurement templates • Application of standardised risk weights to reflect potential loss Standardised Approach

14. Pillar 1: Operational risk • Defined as ‘the risk of loss resulting from inadequate or failed internal processes, people & systems or from external events’ • Based on internal estimates of the bank • Subject to minimum requirements and supervisory approval Advanced Measurement Approach • Banks’ activities divided into 8 business lines • Beta factor set by BCBS multiplied by gross income of business line Standardised Approach /ASA Increasing sophistication Basic Indicator Approach • Based on a fixed percentage of gross income (15%)

15. Another key feature of Basel II is the areas of national discretion • Provides supervisors with options on possible treatment in specific area Examples: • Standardised Approach • Risk weight for banks can either be dependent on external rating of sovereign (Option 1) or of the bank itself (Option 2) • 0% risk weight can be applied to exposures to sovereigns denominated and funded in local currency • Use of unsolicited ratings • IRB Approach • Coverage of internal models (Segments which can be permanently exempted) • Availability of a transition period for IRB adoption, where supervisors can provide greater flexibility for banks intending to adopt the IRB approach

16. Pillar 2: Supervisory Review Process • Aims of Pillar 2: • Ensure banks have adequate capital to support all risks • Encourages banks to implement better risk management techniques & more effective governance • Focuses on internal capital rather than regulatory capital • Provides platform for greater discussion between banks and supervisors • Based on four guiding principles: • Banks must have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels - ICAAP • Supervisors should review and evaluate banks’ internal risk assessments and strategies and should take appropriate action if the results of this process are not satisfactory. • Supervisors should expect banks to operate above the minimum regulatory capital ratios • Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the bank’s risk characteristics.

17. ICAAP is a critical component of Pillar 2 • Banks’ ICAAP should be tailored towards banks’ activities and risks involved in these activities • No ‘one size fits all’ in ICAAP but there are some key features which should be included in every bank’s ICAAP process • Oversight from Board & senior management • Policies & procedures to ensure all material risks are appropriately identified, measured, monitored and controlled • Linkages to be seen between capital & risk, banks’ strategic focus & business plan • Internal controls put in place to ensure integrity of process • Possible considerations in determining appropriate internal capital levels • Regulatory requirements • Peer comparisons • Expectations of counterparties & rating agencies • Cycle effects, stress testing • Shareholder value

18. Pillar 3: Market Discipline • Complements Pillar 1 & Pillar 2 • Greater disclosure requirements for banks using Basel II • Recognises the role played by market participants in ‘regulating’ bank behaviour • promotes market discipline through the use of disclosure requirements. • Enhances disclosure regarding capital, risk measurement and management, risk levels and risk processes and broken down into: • Fundamental disclosures – all banks are required to provide vital information • Supplementary disclosures – only applicable to certain institutions depending on their risk profile • Disclosures as a requirement for the adoption of specific internal methodologies/use of internal data; e.g. in order to use IRB approach for credit risk

19. For Islamic Banks, Capital Adequacy Standard by the Islamic Financial Services Board (IFSB) also shares common objectives with Basel II • Issued in December 2005 to address specifics in Islamic banking assets and transactions BCBS Capital Adequacy Standard (Dec 2005) Pillar 1 (SA for Credit & Market Risks, and BIA for Operational Risk) Pillar 1 (Market risk in trading book) Pillar 2 (1 Principle on ICAAP & 3 Principles on Supervisory Review) Supervisory Review Process (End-2007) Transparency and Market Discipline (End-2007) Pillar 3 (Disclosure & Transparency) • Two more standards are being developed by IFSB – related to securitisation and profit-sharing investment accounts (PSIA) as a risk absorbent, to complete the capital adequacy standards for Islamic banks

20. Key Differences Between Basel II and CAS Category Basel II CAS Only standardised approach for credit and market risks, and basic indicator approach for operational risk Risk measurement Standardised and internal models approaches allowed Financial instruments Eligible collateral for Credit Risk Mitigation purposes Introduction of physical assets as eligible collateral • Operational risk measurement • Approach available BIA only TSA is implemented based on national discretion, in view of complexity and appropriateness of business line mapping BIA, TSA & ASA • Market risk measurement • Introduction of new risk category Introduce inventory risk or assets price risk arising from holding of physical assets for onward sale or lease For credit and market risks inherent in assets funded by the PSIA. Thus, allowing the credit and market RWA to be deducted from the total RWA Recognition of PSIA as a risk mitigant

21. Outline • Objective of Basel II and its key features • Implications of Basel II • Banks • Supervisors • Recent Developments

22. How will Basel II affect the banking industry? • Risk management • Expectations on the Board • Human capital • Industry structure (mergers?) & competitiveness • Capital impact

23. Enhanced risk management practices advocated by Basel II & infrastructural investments will lead to stronger banks • Adoption of good risk management practices • Robust policies and procedures • Comprehensive oversight function at Board & senior management level • Use of enhanced risk assessment methodologies particular for IRB banks • Sufficient internal controls to mitigate any risk exposures • Enhanced role of internal audit to undertake review function • Improved risk management infrastructure • More sophisticated rating systems leading to better assessments of borrowers • Systems in place to cater for enhanced risk management requirements • More efficient borrower assessment procedures • Support more sophisticated risk measurement techniques • Facilitate borrower monitoring & recovery process • Data management infrastructure must be able to support massive data requirements

24. Importance of data in Basel II requires adequate attention Loss data Market data Basel II is driven by data!!!! Rating history Borrower info Collateral info Income data • The importance of data magnifies the need to ensure banks have adequate data infrastructure, regardless of approach undertaken • Sound data management process for data collection & to ensure data quality • Adequate system capabilities to facilitate efficient management of vast data requirements under Basel II • Sufficient human resources to effectively manage data

25. Much will be expected of board & senior management under Basel II • Financial resources for enhanced capabilities • Human resources – training and /or recruitment • Understand the business benefits of Basel II • Derives basis for decision making on appropriate approach to adopt • Must realise that Basel II gains are in long term • Inculcate change in risk management culture • To get buy-in across the institution • Requires sufficient awareness on risk management capabilities of institution

26. Basel II also emphasises the value of human capital • Risk Management • Sufficient technical expertise • Must be adept to change as risk management function would continue to change • Origination • Willingness & ability to learn & familiarise themselves with more automated & sophisticated assessment techniques • Internal Audit • Adequate capabilities to undertake meaningful review of BI policies & procedures compliance • Board & Senior Management • Sufficient expertise to make informed decisions based on output of risk management • Approval of models reside with Board

27. Hence, banks stand to derive long term benefits • More efficient conduct of business • Better decision making in terms of: • Credit origination / Pricing • Portfolio management • New product development • Future strategic direction of institution • Better recovery processes • More efficient capital management process • Expectations under internal capital adequacy assessment process (ICAAP) of Pillar 2 • Greater alignment between economic and regulatory capital • Capital an expensive commodity thus return on shareholders must be commensurate

28. Will Basel II impact the market structure and competition? • IRB banks will be better positioned in customer selection, pricing and management of risk, across all customer segments • Skills and manpower constraints and ability of larger banks to afford specialised people, may lead to smaller banks being in a less competitive position Competitiveness Consolidation • Basel II is not anticipated to drive consolidation • Other forces such as operational efficiency and distribution reach would remain the key drivers of consolidation. Customer segments • Potentially higher pricing or lesser availability of credit may occur in certain customer segments with higher risks e.g. SMEs/middle market/retail, although impact likely to be marginal. • However, capital not the sole/key-driver behind pricing of borrower.

29. Testing Basel II effects - QIS exercises undertaken by BCBS has provided initial insights • BCBS and Committee of European Banking Supervisors (CEBS) conducted a study entitled Quantitative Impact Study 5 (QIS 5) in 2005 • 382 banks encompassing member countries of BCBS (G10), several EU and EES countries and a handful of other countries • To evaluate if the proposed regulations could be expected to achieve reasonable and desirable results, or if the regulation should be re-calibrated • Conclusion drawn by the Basel Committee • Results from QIS 5 do not indicate a need for any adjustments before the new capital accord regulations come into force • Still an artificial exercise in which “complete” Basel II approaches were not being used • 1.06 scaling factor to be retained

30. QIS 5 results – G10 and CEBS countries

31. QIS 5 results – Non-G10 countries

32. Role of supervisors and regulators in ensuring financial stability will also evolve under Basel II • More comprehensive assessment of risk • Expanded coverage of regulatory capital requirements • Credit, Market, Operational risk etc • Improved internal processes • Risk-based examination procedures • Model recognition / validation process • Greater supervisory interaction • With banks • Understanding banks implementation plans • Model review process • Pillar 2 assessment • With other supervisors • Discussions on cross-border issues • Foreign banks operating in local jurisdictions • Local banks with foreign operations • Enhanced surveillance mechanism • Rigorous off-site surveillance processes (Eg stress testing) • Access to greater amount of information • Will require enhanced infrastructure • Prompt intervention & corrective action mechanism • Differentiated capital requirements for banks with different risk profile • Subject to legal capabilities • Expansion in resources • Supervisors have to move in tandem with banking industry • Expanded supervisory skills required • Engagement of specialised staff • Training of current staff • Surveillance infrastructure needs to cater for expanded scope / greater amount of data

33. Nevertheless, there are issues which require careful consideration particularly in emerging economies • Understanding the pro-cyclicality and economic impact • Emerging economies are more fragile • Greater dependence on banking system as provider of funds • Economic sectors are more correlated and sensitive to effects of economic cycle • Calibration of IRB (based on G-10 environment) results in significant acceleration in capital charge as ratings (PDs) deteriorate • Potential credit crunch for emerging economies during recessionary periods • Use of IRB approach may affect lending behavior and starve financing to certain critical sectors of the market e.g. SMEs • Nevertheless, capital requirements are not the sole driver behind lending decisions made by banks • Business strategy, pricing amongst other things taken into consideration • Actual impact on lending will only be seen once Basel II is implemented

34. Competitive intensity may heighten with implementation of Basel II • Industry structure must be considered in the implementation plan • Internationally active banks enjoy benefits of diversification and hence greater capital relief from advanced approaches • pressure on local supervisors to accept advanced approaches • competitive advantage over domestic institutions • However, foreign banks may have the tools for Basel II, but they may still lack sufficient local data to meet requirements like most domestic banks • Implementation of Basel II should not be seen merely as a regulatory exercise • Emphasise on cost and benefit analysis • Understand impact of banks’ roll-out plans/changes in lending behaviour on availability of credit to all consumer segments (e.g. SME)

35. Resolution of home-host issues is also critical to facilitate smooth implementation • An effective and efficient implementation of Basel II for banks with cross border operations seek to balance between: • Ensuring that concerns of regulators are sufficiently addressed • Minimising regulatory burden on banks • BCBS has provided broad principles to facilitate this process by identifying “who does what?” [High-level Principles for Cross-border Implementation of Basel II (Aug 2003)] • Home supervisors responsible for consolidated supervision and host supervisor on entities operating in their country [Basel II reinforces the Basel Concordat] • Home supervisor responsible for oversight of implementation of Basel II on a consolidated banking group • Subsidiary banks in other countries must satisfy supervisory and legal requirements of host • Need for enhanced and pragmatic cooperation among supervisors • Supervisors should avoid performing redundant and uncoordinated approval/validation work • Supervisors should communicate respective roles as home/host supervisors as clearly as possible

36. Key-lessons drawn from these principles • Banks with global coverage should engage regulators to agree on ways to address multiple regulators’ specific requirements, information requests & approval processes • College of supervisors seen to be an effective avenue to discuss concerns and details related to the cross-border implementation and supervision of banks • Each situation is unique, so flexible pragmatic solutions are required • Supervisory arrangements dependent largely on approach bank intends to adopt • “Significant” cross-border activities will require special attention • Clear communication of implementation plans between head office & local offices critical • Home supervisors required to plan effective communication with host supervisors • It is critical that host supervisors assess what information they really need

37. Outline • Objective of Basel II and its key features • Implications of Basel II • Banks • Supervisors • Recent Developments

38. The Subprime crisis – What happened? • Subprime crisis started out from an US household bubble and caused worldwide turbulences on financial markets • Institution-specific liquidity problems transformed into a systemic liquidity crisis • Significant write-offs in banks due to losses caused by holdings of subprime related ABS / CDOs (Full extent of losses have yet to be ascertained) • Bailout or bankruptcy of several banks • Main causes of the subprime crisis: • Low interest rate environment heightened mortgage competition resulting in lower credit standards and wrong loan pricing in some banks / mortgage lenders • Investments in highly innovative financial products such as ABS and CDOs which were linked to subprime exposures has exacerbated problem • Risk attached to instruments were less transparent • Bank-backed structured investment vehicles (SIVs) created mainly to invest in these instruments had difficulty in obtaining funding • Due to uncertainty in the SIV’s portfolio (Perception issue) • Banks backing these SIVs had to extend liquidity although they did not actually have committed line

39. Key Lessons from the Recent Crisis • Supervisors should not lose sight on the importance of assessing liquidity risk • Banks which were well-capitalised were not protected from the recent crisis and were also faced by liquidity problems • Stress testing scenarios in banks were inadequate • Difficulty in assessing Interbank markets was not anticipated • Greater attention needs to be accorded to off-balance sheet exposures • Greater cross border cooperation is essential and helped mitigate the impact of the recent crisis • Globalisation has allowed crisis to more easily cross over from one jurisdiction to another

40. How has the recent crisis had an effect on Basel II? Some key questions • Use of external ratings for the capital adequacy assessment • Credibility of external credit assessment institutions (ECAIs) have somewhat been affected under Basel II • Failure to notify market on change in risks on a timely basis • Robustness of assessment methodologies and assumptions used? • Is a AAA-rated corporate exposure similar to a AAA-rated ABS? • How have the banks’ own internal models performed during recent periods of stress? • Has liquidity risk been accorded sufficient attention by banks & regulators? • The 0% credit conversion factor for liquidity facilities in securitsation transactions which can only be used during periods of market disruptions • Is the 0% CCF appropriate given that during the recent crisis may banks were obliged to honour these facilities?

41. Whilst Basel II is not perfect, it is still a big step forward from Basel I…. • ECAIS have been taking steps to enhance capabilities • Increased monitoring • Review of methodologies & assumptions • Confidence building and increasing investors’ understanding via increased disclosure in methodology and ratings validation • Continuous review of internal models would make models more robust over time taking into account recent history of stress • More analysis can be done with greater amount of data now available • Basel II goes beyond risk measurement • Advocates the enhancement of management practices as well • Pillar 2 will provide an avenue to address issues arising from the crisis, which have not been already addressed under Pillar 1

42. Risk transfer under securitisation now subject to greater scrutiny • For securitisation, ability of banks to enjoy capital savings subject to stringent operational requirements • The transferor also cannot maintain effective or indirect control over the transferred assets • More stringent clean-up call requirements (e.g. only exercisable at threshold level of 10% or less of underlying portfolio) • Similarly, recognition of credit derivatives as a risk mitigant and to reduce capital requirements also subject to more rigorous standards • However, the stringent requirements may hamper developments of securitisation in emerging markets • Penetration is still very low for these transactions in emerging market

43. The BCBS has also already initiated work on liquidity risk since 2006 • Working Group on Liquidity formed in December 2006 to review liquidity supervision practices • Evaluation on type of approaches and tools used to evaluate liquidity risk • Published key findings of study in February 2008 • BCBS aims to strengthen banks liquidity risk management practices • Will update core principles and best practice guidance through the 2000 Sound Practices for Managing Liquidity in Banking Organisations on areas such as: • Identifying full range of liquidity risks including contingent liquidity risks associated with off-balance sheet vehicles • Stress testing • Role of supervisors, collaboration • Management of intra-day liquidity risk • The role of disclosures

44. Central Bank of Malaysia website: http://www.bnm.gov.my THANK YOU Chung Chee Leong Banking Supervision Department chung@bnm.gov.my