Agenda

1. Current Credit Risk Issues in Basel IIFSI-SEACEN Regional Seminar on Current Issues and Developments in Credit Risk Management(Bali, Indonesia 10-12 March 2008) Ruediger Gebhard

2. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 2

3. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 3

4. Which kinds of risks are charged for? Which methods? The big picture … Standardised approach Trading intention ? Banking book Credit risk Equity no yes Standardised measurement Method (SMM) Bond Market risk(general+ sprecific) Trading book IRB approach Internal models approach (IMA) Approval Approval Supervisory capital requirements for market risk Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 4

5. TB and BaB Only TB FX-Risk Commodity risk Equity position risk Interest rate risk General market risk Specific risk General market risk Specific risk SMM CRMR CRMR CRMR CRMR CRMR CRMR Approval IMA Capital requirement for market risk (CRMR) Approval Partial use IMA CRMR Supervisory capital requirement for market risk Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 5

6. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 6

7. Basel „Market Risk Amendment“: Setting the VaR (99%; 10 days)-standards 1996 ‚Prototypical trading book‘: • highly liquid instruments • many equities • rather low default risks Since then Structural changes to the ‚prototypical trading book‘: • increase of less liquid instruments (e.g. complex derivatives) • large increase of innovative debt instruments • (credit derivatives, structured products) Motives for IDRC Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 7

8. Adequacy of the VaR(99%; 10 days)-standards is questionable! Forecasting horizon 10 days may be too short → Risk number may be too low Characteristics of the VaR as a risk measure: e.g. BBB-Zerobondwith maturity = 1year(assuming no changeof interest rates) ¬ Default (p=99,7%) 100 VaR(99%) = 0 ! 100 ∙(1–LGD) Default (p=0,3%) Motives for IDRC min. holding period 10 days Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 8

9. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 9

10. 2004 ‚Revised Framework‘ („Basel II“) but:Document already contains the information (Paragraph 16),that in some limited areas further development is necessary. 2005 „Trading Book Review“ c.r. ↓ • counterparty credit risk (recognition of double default effects) • delimitation trading book vs. banking book and IDRC c.r. ↓ c.r. ↑ IDRC – overview IDRC – short historical presentation: ? 2008 „IDRC-Guidelines“ Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 10

11. TB and BaB Which institutions must determine IDR? FX-Risk Commodity risk Only TB Interestrate risk Equity position risk General market risk Specific risk General market risk Specific risk CRMR CRMR CRMR CRMR CRMR CRMR Zulassung Internal market risk model Inclusion of equitiesin IDRC is in dispute IDRC – overview Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 11

12. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 12

13. Guidelines for the determination of the IDRC (co. Para. 307 TBR): „… the bank must have an approach in place to capture … the default risk of its trading book positions that is incremental to the risk captured by the VaR-based calculation …“ No double capital requirement, of far as default risk has already been taken account in the internal market risk model [in practise, this is the exception.] „No specific approach for capturing the incremental default risk is prescribed; it may be part of the bank’s internal model or a surcharge from a separate calculation.” Mapping of IDR according to the model:- internal market risk model which integrates IRD [barely imaginable in practise]- separate model [:= IDR-model] IDRC – specifics Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 13

14. Guidelines for the determination of the IDRC (ctd.): 1 ! „… the bank must demonstrate that it meets a soundness standard comparable to that of the internal-ratings based approach for credit risk …, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging, and optionality.“ 1 IDRC – specifics → Interpretation? IDR-Model = VaR (99,9%; 1 year) for losses from defaults in the TB?? Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 14

15. Guidelines for the determination of the IDRC (ctd.): ! „… the bank must demonstrate that it meets a soundness standard comparable to that of the internal-ratings based approach for credit risk …, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging, and optionality.“ 2 • „liquidity“: Model-output must be sensitive relative to the liquidity of the financial instruments. 2 • „concentrations“: Model-Output must reflect (c.p.-) higher risk of concentrated positions by individual obligor. • „hedging“: Model-Output should reflect (c.p.-) risk reducing effect of hedging (e.g. short-position in bonds). • „optionality“: Model-Output must reflect non-linear financial instruments adequately (e.g. options). IDRC – specifics Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 15

16. Guidelines for the determination of the IDRC (ctd.): ! „… the bank must demonstrate that it meets a soundness standard comparable to that of the internal-ratings based approach for credit risk …, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging, and optionality.“ 3 „constant level of risk“: The concept allows for the structural difference between the trading book (→ „Trading“, frequent turnover of positions) and banking book (→ rather „buy and hold“, there may be no [liquid secondary] market for the assets); assertion that an institution aims at a specific level of risk and maintains it by rebalancing the portfolio; antonym: „constant position“ 3 IDRC – specifics Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 16

17. time Forecasting horizon ∆PV > 0 Rating AA Bond i Bond k Bond j Bond i Bond i ∆PV = 0 Rating A Rating A Rating A Rating A Rating A Rating A ∆PV < 0 Rating BB AA and so forth A BB IDRC – specifics Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 17

18. Why does „constant position“ vs. „constant level of risk“ makea difference for a given forecasting horizon? a stylised 1-year-transition matrix: Resulting 2-year-transitionmatrix [assuming serialindependence](multiplication of matrix)! Result for a „portfolio“ of a r_1-Bond: PD(2 years; „constant position“) = 1/8 PD(2 years; „constant level of risk“) = 0 IDRC – specifics Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 18

19. There is no specific period for the determination of VaR then: time capital horizon ≡ Forecasting horizon Terminology of the „IDRC-Guidelines“ - less liquid financial instruments FI_1 „liquidity horizon“: „… time required to sell the position or to hedge all material credit risk factors …“ liquidity horizon liquidity horizon Terminology of the „IDRC-Guidelines“ terminology of the „IDRC-Guidelines“ von FI_2 of FI_1 „IDRC-Guidelines“, Tz. 21 - more liquid financial instruments FI_2 IDRC – specifics Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 19

20. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 20

21. The IRB approach use test • Paragraph 444 of the “Revised Framework” (Basel II): “Internal ratings and default and loss estimates must play anessential role in the credit approval, risk management, internal capital allocation and corporate governance functions of banks using the IRB approach. Rating systems and estimates designed and implemented exclusively for the purpose of qualifying for the IRB approach and used only to provide IRB approach inputs are not acceptable. It is recognised that banks will not necessarily be using exactly the same estimates for both IRB approach and all internal purposes. For example, pricing models are likely to use PDs and LGDs relevant to the life of the asset. Where there are such differences, a bank must document them and demonstrate their reasonableness to their supervisor.“ Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 21

22. The IRB approach use test • The “IRB approach components” (I) • Classification of risk: borrower ratings, facility ratings, retail segmentation • Quantification of risk: estimates of PD, EAD and LGD • IRB approach components must play an essential role” in how banks measure and manage risk in their businesses to be used for determining minimum regulatory capital requirements. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 22

23. The IRB approach use test The “IRB approach components” (II) • The “quantitative IRB approach components” PD; EAD and LDG that the bank use internally may be (or may have to be) adjusted or transformed before the are used to determine minimum regulatory capital requirements. • The bank must comment such differences and demonstrate their reasonableness. • IRB approach components used only to provide IRB approach inputs are not acceptable. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 23

24. The IRB approach use test An example (I): A bank has hitherto focused on consumer lending. It wishes now to lend more to small enterprises, and to treat such lending under the IRB approach. (So far the bank had determined the minimum regulatory capital requirements under the standardised approach for credit risk – permanent partial use due to immateriality.) Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 24

25. The IRB approach use test An example (II): The bank has collected • default frequencies by obligor rating grade, • realised LGDs and • data on the frequency and size of further draws on the undrawn part of a limit prior to default. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 25

26. The IRB approach use test An example (III): The bank rates the obligors on an ordinal scale (obligor rating categories 1,2,3,4 …). To each rating category it assigns PD estimates that are • aggressive as far as the target credit spread is concerned (to provide staff with incentives to gain market share as remuneration is based on the difference between to get credit spread and the credit spread obtained in them) • the bank’s best estimate as far as reporting and capital allocation are concerned (to provide unbiased information to management) … Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 26

27. The IRB approach use test An example (III): PD estimates are … • adjusted upwards relative to the best estimate for regulatory capital purposes (because the bank has relatively little data for this relatively new business line, and is therefore required to employ a particular amount of conservatism). • No objection (same ordinal ratings used throughout, but PD estimates differ by purpose of calculation in a plausible way). Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 27

28. The IRB approach use test An example (IV): Assume, one department of the bank has found out that entrepreneurs with young children tend to draw less on unused lines as they approach default compared to entrepreneurs with no children to feed. This observation is used to forecast future provisioning needs. Assume further, that the department that prepares the supervisory report uses a single estimate for the credit conversion factor (CCF) for undrawn line not withstanding. • Internal use requirement may not be met (an ordinal rating for CCF–related transaction characteristics is used for internal management purposes but not for minimum capital requirements). Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 28

29. The IRB approach use test An example (V): LGD: Let us have your stories! Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 29

30. The IRB approach use test • Principles (I) • Banks are responsible for demonstrating their compliance with the use test. • Internal use of IRB approach components should be sufficiently material to result in continuous pressure on the quality of IRB approach components. • Demonstrating consistency and explaining differences between IRB approach components and internal measures can establish sufficient comfort that the first two principles are met. … Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 30

31. The IRB approach use test • Principles (II) … • The importance of an internal process to the bank’s decision making influences the extent to which that process contributes to an assessment of use test compliance. Banks should take a holistic approach when assessing overall compliance of their institution with the use test requirements. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 31

32. Agenda • Default Risk in the Trading Book – Beyond 10-day VaR • Supervisory capital requirement for market risk • Motives for Incremental Default Risk Charge (IDRC) • IDRC – overview • IDRC – specifics • The IRB Approach Use Test • The Use of Vendor Products in the IRB Framework Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 32

33. Use of vendor products (VP) • Why do banks use vendor products? • Enhancement of economic synergies • Standardisation of risk measures to help with risk transfer • Consistent use of assessments of risk within banking groups (e.g. parent company as „vendor“) • No effort using IRB approach for such portfolios, which do not belong to a bank´s core operations • Address data scarcity issues. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 33

34. Use of vendor products (VP) Vendors’ concern: Protect proprietary information on key aspects of the products and retainsuperior expertise. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 34

35. Use of vendor products (VP) • A hierarchy of VP: complete adoption of the IRB approach components for the transactions in a portfolio(borrowers and facility ratings, assignments, retail and segments, PD, LGD, EAD) from the vendor  the rating method (perhaps including estimation of PD, LGD, CCF) is from vendor but it is applied by the bank  … Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 35

36. Use of vendor products (VP) A hierarchy of VP: …  the sample for developing a rating method is adopted from the vendor, but the development is made by the bank  the raw data for developing a rating method is adopted from the vendor, but the bank starts from these (including perhaps drawing a sample) for calibrating and confirming its models. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 36

37. Use of vendor products (VP) • Paragraph 421 of the Revised Framework: No exceptions from minimum requirements when VP are used within banks’ IRB approach processes. • Balance between transparency of IRB approach risk estimates to banks and protection of the intellectual property of the vendors must be found. The newsletter applies to both vendor models and vendordata. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 37

38. Use of vendor products (VP) Principles regarding the use of VP • Banks must be able to document and explain the role of VP and the extend to which they are used within their IRB approach processes. • Demonstration and documentation of how the bank´s risk estimates are derived and validated • Explanation of the underlying rationale for choosing third-party products over internally developed models and data (e.g., lack of default data or internal resources) • Explanation of what alternative solutions the bank has considered, and, if possible, how results using the vendor products compare to those of alternative products or solutions Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 38

39. Use of vendor products (VP) • Banks must be able to demonstrate a thorough understanding of VP used in their IRB approach processes. • In-depth knowledge of the methodological underpinnings and basic construction of vendor models, including an understanding of the models’ capabilities, limitations, and appropriateness for use in developing IRB approach risk estimates for the bank’s own portfolio of credit exposures. • Demonstration of a full understanding of the effect and significance of the proprietary elements in the vendor models. • Documentation of the rationale behind any judgment-based overrides or any other adjustments made to vendor data sets or vendor model outputs. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 39

40. Use of vendor products (VP) • Banks must be able to demonstrate a thorough understanding of VP used in their IRB approach processes. • Retention of in-house expertise on the vendor products for as long as these products are used within the bank’s IRB approach processes. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 40

41. Use of vendor products (VP) • VP must be appropriate to the bank´s exposures and risk rating methodologies and suitable for use within the IRB approach framework. • No mirror of the vendor model inputs and data to those of the bank´s portfolio in detail. • In the case of the use of a vendor rating model, the bank should be able to demonstrate how well the historical reference data used to develop this model map into the bank’s existing portfolio in terms of significant risk characteristics. • In the case of vendor models used to assign exposures to risk grades or segments, if there is material information (e.g., expert judgment) not incorporated into the vendor Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 41

42. Use of vendor products (VP) • VP must be appropriate to the bank´s exposures and risk rating methodologies and suitable for use within the IRB approach framework. • In the case of vendor models used to assign exposures to risk grades or segments, if there is material information (e.g., expert judgment) not incorporated into the vendor model, the output of the vendor model should be supplemented to incorporate such information. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 42

43. Use of vendor products (VP) • Banks must have clearly articulated strategies for regularly reviewing the performance of vendor model results and the integrity of external data used in their IRB approach risk quantification processes. • Implementation of clear strategies designed to periodically (at least once a year) assess the performance of any vendor models used in the bank’s IRB approach processes to ensure the models continue to function as intended. • Development and implementation of strategies designed to verify the accuracy and consistency of any external data used within the bank’s IRB approach risk quantification processes. Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 43

44. Abbreviations BaB Banking book c.r. Capital requirement CRMR Capital requirement for market risk c.p. ceteris paribus ctd. to be continued EAD Exposure at default Def. Default FI Financial instrument FX Foreign exchange TB Trading book TBR Trading book review IDR Incremental Default Risk IDRC Incremental Default Risk Charge IRBA Internal Ratings-Based Approach LGD Loss Given Default (in %) MR Market risk Para. Paragraph PD Probability of Default PV Present Value R Rating category VaR Value-at-Risk ¬ no Default risk in the Trading Book - Beyond 10-day VaR | 12. March 2008 | Page 44

45. Current Credit Risk Issues in Basel IIFSI-SEACEN Regional Seminar on Current Issues and Developments in Credit Risk Management(Bali, Indonesia 10-12 March 2008) Ruediger Gebhard