Day 3

1. Day 3 Basel II and Bank Risk Management Garrett Glass

2. The Revised Framework • The original international bank capital standards were implemented in 1988 (Basel I) • Market risk amendments were added in 1996 • The Revised Framework has been developed to provide more consistency to capital adequacy regulation and to reduce competitive inequality

3. The Revised Framework • The Revised Framework provides for greater use of risk assessments from banks’ internal systems • A range of options are provided for determining the capital requirements for credit and operational risk • A limited degree of national discretion is allowed but will be monitored

4. The Revised Framework • As with the 1988 Accords, the Revised Framework sets minimum capital standards; regulators can always set higher levels of minimum capital or set higher standards • Major changes are incorporated for the treatment of expected and unexpected losses, and for securitized exposures

5. The Revised Framework • Regulators will need to monitor banks’ progress during the implementation period before allowing a bank to shift over to the new capital standards • The revised Accords now constitute Pillar I of the new Framework • Pillar II has been added requiring supervisory review; Pillar III introduces market discipline to the process

6. The Revised Framework • Some areas require additional work, beginning with the concept of capital for double default risk (systemic risk) • Instruments subject to unanticipated losses need to be defined more precisely • Capital applicable to trading exposure will be studied jointly with the International Organization of Securities Commissions (IOSCO) The Credit Crisis has made this work much more urgent!

7. Credit and Operational Risk • The Revised Framework expands measurement techniques for calculating credit exposure and regulatory capital • A new measure of operational risk capital is introduced • Individual claims are expanded to provide better detail on credit exposure to sovereigns, public sector entities, other banks, securities firms, corporations, residential property holders, and commercial real estate

8. Credit and Operational Risk • The standardized approach to calculating capital is still allowed, and is based on risk weights applied to notional amounts of credit exposure • Risk weights are 0% or somewhat higher for AAA sovereign risk, and become progressively steeper for commercial bank and corporate exposures Libyan banks may be required to use the standardized approach rather than an internal model approach for risk management

9. Credit and Operational Risk • Investment banks and securities firms are granted the same capital requirements as commercial banks as long as the firm is subject to proper regulation and supervision • Real estate is given a concessionary weight of 35% under certain conditions (this is less likely to be granted after the Credit Crisis) • Risk weights progress up to 150% of exposure for doubtful loans, corporate loans rated below BB-, and venture capital exposures

10. Credit and Operational Risk • Off balance sheet credit exposures will continue to have an asset-equivalency weight as well as a risk weight under the Standardized Approach • Acceptable credit mitigation techniques, such as collateral, have been expanded, but banks must meet defined legal standards in order to take advantage of these techniques Home mortgages as collateral will in the future be considered to provide much less risk reduction than assumed in 2004

11. Credit and Operational Risk • The Standardized approach to capital measurement has been considered inadequate or even wrong by many large banks • Since 1988 these banks have made progress on their own internal capital measurement systems • The BIS will now allow such banks to measure regulatory capital with these internal systems, but only a few very large banks will qualify

12. Credit and Operational Risk • Banks using this Internal Ratings-Based (IRB) approach must compute four risk components: probability of default; loss given default; exposure at default; and effective maturity • In addition, to use the IRB approach banks must have a system to determine unexpected losses and expected losses • All IRB assumptions are likely to be tightened considering the Credit Crisis

13. Credit and Operational Risk • The IRB puts assets into five basic categories: corporate, sovereign, bank, retail, and equity • IRB risk parameters and risk weight functions are set at a minimum level by the BIS • If banks wish to use the IRB foundation method, they must calculate loss given default; the BIS will provide the other factors

14. Credit and Operational Risk • Banks which calculate on their own all four risk components will be granted allowance under certain conditions to use these, under the Advanced method • Basel II presents more detail on calculating capital for securitized assets • A Standardized table is provided for most such securities, but IRB banks may use internal measures with regulatory approval Expect major changes in the way central banks calculate the risk of securitized assets

15. Credit and Operational Risk • In either case, the BIS sets the appropriate deductions from capital for credit exposures which have been securitized • Greater flexibility is allowed for interest only strips, Special Purpose Entities, and other risk techniques not covered by the 1998 Accords This flexibility is likely to be eliminated altogether !

16. The Trading Book • Trading assets are given a new definition under the Framework: financial instruments and commodities held in a trading book must be intended to be traded or to hedge other instruments in the book • These assets must be free of restrictive covenants on their tradability • Mark to market of the book must take place frequently and actively (at least daily), and the portfolio must be actively managed

17. The Trading Book • A financial instrument is any contract that gives rise to both a financial asset and liability of an entity or equity • Primary financial instruments have cash characteristics; derivatives are secondary financial instruments • Trading intent means the positions are held intentionally for short-term resale or for the purpose of benefiting from expected short-term price movements

18. The Trading Book • A trading book must have a clearly documented trading strategy set by senior management; this strategy must include a holding horizon • Policies and procedures for the trading book require that it be managed on a trading desk, have position limits, be subject to daily mark to market or mark to model, and be assessed regularly for liquidity availability

19. The Trading Book • Prudent valuation policies must give management confidence that the values are reliable, the sources of market information are identified and appropriate, closing prices are chosen when available, and that the valuation be done independent of the front office • The more prudent side of the bid/offer must be chosen for mark to market purposes

20. The Trading Book • Where mark to market is not possible, mark to model is permitted if prudent • Mark to model is any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input • Extra conservatism is required for marking to model

21. The Trading Book • Senior management should know at all times which books or components are being marked to model, and the materiality should be identified • The market inputs must be sourced as much as possible from market sources • Generally accepted valuation methodologies must be used if known

22. The Trading Book • If the institution develops the model on its own, the assumptions should be appropriate and assessed by a party independent from the developers • The front office should not participate in the development or testing process of a model • Change control procedures for models should be clear and independent

23. The Trading Book • The model should be reviewed periodically for performance, including analysis of P/L against the risk factors • Valuation adjustments should be made to cover the uncertainty of model valuation • Dealers may perform daily mark to market, but price verification must be done independently

24. The Trading Book • The independent verification need not be done daily, but at least monthly or coinciding with valuations done for purposes of the bank’s books and records • Reserves may be necessary when a third-party is providing valuation • Reserves are required for unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, future administrative costs, and model risk

25. The Trading Book • Less liquid positions may also require reserves; reserves may also be necessary for stale positions or concentrated positions • Banks must consider the volatility of market prices in close-out situations • All valuation adjustments must be reflected in regulatory capital

26. The Trading Book • Internal models have been found to be a major source of financial loss in the Credit Crisis • Securitized assets and derivatives have been poorly modeled, with inadequate reserves for loss of liquidity in the market • The problem for regulators is that some products demand such high reserves against loss that they are no longer profitable • On the other hand, these products should never have been traded in the first place

27. Operational Risk • One of the recognized weaknesses of Basel I was the lack of capital charges for operational risk • Operational risk is defined as the risk of loss from inadequate or failed internal processes, people, or systems, or from external events • Legal risk is included but operational risk excludes strategic and reputation risk

28. Operational Risk • The Framework now provides for a capital charge for operational risk; banks may use one of three methods, but may not revert to a simpler method without supervisory approval • The Basic Indicator approach assesses a 15% capital charge on the past 3 years of gross annual income (net interest plus non-interest income)

29. Operational Risk • The Standardized approach is similar except that eight businesses are identified: corporate finance, trading and sales, retail banking, commercial banking, payments and settlements, agency businesses, asset management, and retail brokerage • Regulators provide a table of capital charges to be applied to the past 3 years average gross annual income for these businesses • The charges range from 12% to 18%

30. Operational Risk • The Advanced Measurement Approach is allowed for those banks with their own internal operational risk measurement systems • Typically, such banks have extensive internal data available on their operational losses • These banks will be allowed diversification benefits across businesses where such benefits can be justified

31. Pillars II and III • Pillar II emphasizes supervisory review processes and is intended to encourage banks to continue to improve their risk management processes • Pillar II recognizes that Pillar I capital requirements are only minimum standards

32. Pillars II and III • Pillar II is intended to capture risks not considered in Pillar I, and risk factors not taken into account in Pillar I • These would include business cycle effects and other recurring loss phenomena • Banks can mitigate these additional capital charges through strengthened risk management, improved internal limits and controls, and higher provisions and reserves

33. Pillars II and III • Pillar III recognizes the weaknesses of the regulatory capital approach: banks may pay more attention to regulatory requirements than to market discipline • Accordingly, under Pillar III banks are judged on the quality and type of information they disclose publicly, subjecting themselves to market discipline

34. Pillars II and III • Banks can enhance their exposure to market discipline with greater disclosure about their risk management practices, the capital assigned to their businesses, capital assigned to risk categories (credit, market, operational, strategic, etc.), and capital resulting from IRB or Advanced Method approaches

35. Pillars II and III • Supervisors will assess publicly disclosed information against accounting requirements (including materiality and frequency considerations), proprietary standards, and legal requirements • Banks are expected to disclose sufficient information on their Tier 1, 2 and 3 capital levels, and capital ratios