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Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004

Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004. Case Study: South Africa on the road to Basel II Pieter Strydom Partner, Ernst & Young, South Africa. Risk Management Workshop Colombia: From Theory to Implementation

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Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004

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  1. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 Case Study: South Africa on the road to Basel II Pieter Strydom Partner, Ernst & Young, South Africa

  2. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 Overview of presentation

  3. Overview of presentation • Introduction: The banking sector in South Africa • Attitude towards Basel II in South Africa • Ernst & Young survey on Basel II readiness in South Africa • Developments in bank supervision at SARB • Developments at Bank A • Developments at Bank B

  4. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 1. Introduction: The banking sector in South Africa

  5. 1.1 The banking sector in South Africa • 48 banks in SA • 15 in process of de-registering or closing down • 7 with limited operations • 19 remaining of which the big 5 represent 90% of market • Average Basel 1 Capital adequacy 12.6%

  6. 1.2 Total Assets of Banks

  7. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 2. Attitude towards Basel II in South Africa

  8. 2.1 Growing consensus • Basel I is outdated • Weakened link between risk and capital • Internationally active banks will be forced into Basel II by rating agencies • Basel II will reward excellence • Basel II fits in with risk management initiatives

  9. 2.2 Standards and codes • Standards and codes set by international bodies, and widely adopted, will provide: • useful basis for improved market functionality • ‘benchmarks’ against which banks can be measured • national practices to reduce ‘un-level playing fields’ and regulatory arbitrage • markets forces and peer pressure will make adoption mandatory • ‘soft law’, which can be more effective than ‘hard law’ enshrined in legislations • Basel II with its close link between risk and capital requirement is fully endorsed by banks in South Africa

  10. 2.3.1 Basel II is complex • Banking itself is becoming more complex • Risk management requirements are highly sophisticated (assigning equal risk weights to all loans is unrealistic) • Simplicity and greater risk sensitivity are not mutually compatible objectives • Banks with simpler business models have options under Basel II to reduce complexity

  11. 2.3.2 Basel II will reinforce pro-cyclical effect • Linking the regulatory charge to the quality of assets will bring them in line with the business cycle • This can lead to an increase in volatility of asset prices and loan interest with the potential danger of creating a ‘boom to bust’ cycle in credit markets • Banks may be encouraged to stop lending at a time when the real economy is most vulnerable

  12. 2.3.2 Basel II will reinforce pro-cyclical effect • Pro-cyclical behaviour is already endemic and perhaps acceptable in order to establish a more risk sensitive capital regime • Countermeasure is to build excess capital in good times to have a margin of protection in a downturn • Capital requirements under Pillar 1 should be augmented by the capital requirements under Pillar 2 and Pillar 3 in order to reinforce the incentive to maintain a cushion of capital above the minimum

  13. 2.3.3 Involvement of rating agencies • Limited penetration – 5% • Unique problems with listed exposures • Low trading volumes – volatile markets • Duel listings – flow of funds • Lumpy exposures – concentration risk • Danger of herd thinking

  14. 2.3.4 Rating agency data sharing • Problem creating statistical pool to rate Medium Corporate Advances • Big banks extracting information on 10 000 account for 3 years on default and non default accounts – will provide a 90% statistical pool • To be given to one or more agencies to calculate the quantitative (theoretical) PD • Banks to use this PD as the quantitative basis to confirm their own qualitative PD • Next phase to pool information on LGD - but

  15. 2.3.5 Required capital of 10% compared to 8% • As a result of South Africa’s country rating of BBB, no local exposure can be rated above BBB before taking into consideration collateral • Banks believe continued use of capital adequacy of 10% don’t not make sense as their internal models already take into account the systemic volatility in the SA market – resulting in double counting of systemic risk of SA

  16. 2.3.6 Capital requirements for SMEs • SMEs are essential to build the economy in developing countries • Additional capital requirements for advances to SMEs can be used to convince government agencies to provide additional collateral or support in order for a bank to make these advances

  17. 2.3.7 Cross border investments in Africa • Cross border implementation of Basel II for SA banks with investments in various African countries • Not all of these African countries have the regulatory environment or capacity to enable local banks to reap any regulatory benefit in line with the host country

  18. 2.3.8 Cost of implementing IRB and AMA • Be positive – a large portion of the cost would have been incurred in order to enhance risk management procedures and should not be blamed on Basel II • Bank regulators will need to take steps as their own additional costs (internal and external) will escalate in order to do model evaluation, etc.

  19. 2.3.9 Operational risk • Infant stage AMA might result in implementing one of the standardised approaches • Gross income as the driver for operational risk capital is open for debate • The ‘double whammy’ effect of high margin advances (to cater for high delinquency) will cause a higher credit capital charge and a higher capital charge on the high interest margin • Data sharing on operational risk is problematic

  20. 2.3.10 Ability of Regulator to cope • In order for the Big 5 banks to implement the IRB approaches from inception in 2007 • process from ‘Guidelines to Regulations’ to be completed • political approval process to be completed • Big 5 banks see little benefit in a standardised approach as there is no fit to their risk management structures • Big 5 banks believe standardised approaches can be seen as ‘Basel 1.2’ and not as Basel II

  21. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 3. Ernst & Young survey on Basel II readiness in South Africa

  22. 3.1 Introduction to survey • Timing: Second quarter 2003 • Population • 48 banks in SA • 15 in process of de-registering or closing down • 7 with limited operations • 19 remaining, of which 12 participated • Methodology first used in Luxembourg

  23. 3.2 Summary of results • Banks are partly prepared • Re-evaluation of the way business is conducted • Banks will be ready for implementation • Technology seen as the major problem/expense

  24. 3.3 Key challenges • Data collection • Improvement of credit environment • Implementation costs • Regulatory uncertainty • Skills availability • Disclosure requirements

  25. 3.4 Opportunities • Integrated risk management approach • Align regulatory and economic capital more closely • Better understanding of their business • Improve investor relations • Improve market discipline

  26. 3.5 Results per question

  27. 3.6 Tier structure model

  28. 3.7 Methodology used

  29. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 Developments in bank supervision at SARB (Website resbank.co.za)

  30. 4.1 SARB structured workgroups

  31. 4.2 SARB Implementation Plan • 4.2.1Strategic plan • To address issues regarding work streams, project plans, implementation measures, regulation approval process, staffing, funding, etc. • 4.2.2 Position paper • Due February 2004 to indicate the approach SARB will take in implementing Basel II in SA • Comments to be coordinated through workgroups

  32. 4.2 SARB Implementation Plan • 4.2.3 Compilation of Regulations • Use the regulatory work group to give guidance on the content of the regulations • Legal department of SARB will write regulations • First draft regulations for standardised approaches submitted for approval by end of 2004 • In the interim work with banks on the IRB and AMA approaches to develop regulations at a later stage • 4.2.4 Readiness assessment • Firstone in November 2003 on Basel II • To be repeated after June 2004 • Basel II readiness subject of all trilateral meetings

  33. 4.2 SARB Implementation Plan • 4.2.5 Test data • Gave 5 banks the names of 10 corporate clients (includes high quality and volatile) and the description of a retail portfolio • Requested the PD for each corporate loan, the PD for the retail portfolio, the capital requirement for both portfolios and a description of models • Results were consistent PD’s for high quality corporate exposures • However, PD’s for volatile corporate exposures and the retail portfolios were not sufficiently consistent • Next phase to investigate reasons for inconsistent results

  34. 4.2 SARB Implementation Plan • 4.2.6 Model validation • Believe will be able to go a long way in doing model validation by • getting information from the various banks • benchmarking the results • requesting banks to use different assumptions in their model • Model evaluation will start early • based on sensitivity testing • using different assumptions • on different models • of different banks • Coordinate the model validation with other Regulators

  35. 4.2 SARB Implementation Plan • 4.2.7 Economic impact • An economic impact study will be initiated under the Economic Impact Workgroup to evaluate the effect on the economy to use Basel II – looking at • The effect of the lower capital requirement on residential mortgages • The effect of the SA 10% capital requirement versus the international minimum of 8% • Capital requirement for lending to SMEs • The extent of ‘Double whammy’ on high margin lending

  36. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 5. Developments at Bank A

  37. 5.1 Attitude towards Basel II • Bank already has an economic capital model in line with Basel II principles • Started internal credit rating models from 1999 • As bank operating internationally it needed an investment rating which makes implementation of Basel II compulsory • Performance bonuses are based on return on economic capital above a hurdle rate

  38. 5.2 Goals for Basel II • Advance IRB for retail credit • Foundation IRB for corporate credit • Advance measurement approach for operational risk – if at all possible

  39. 5.3 Responsibility for Basel II • Basel II falls under capital management • Operating division is responsible for own economic capital management • Economic capital is calculated on Basel II principles • Bonus is based on economic capital – divisions therefore already optimising their economic capital by using Basel II principles for credit risk • Divisions fully aware that they manage risk and that capital management only measures risk • Basel II not a project but the day-to-day responsibility of business units as it adds value to the risk management process

  40. 5.4 Initiative - Operational risk • Don’t agree with basic indicator approach or use of gross income to calculate the capital charge • Developed qualitative and self assessment information • Created lost data base for purposes of optimising insurance cost • Data base to combine all these under development • Will keep operational capital charge centrally and allocate by transfer pricing system • Operational risk only monitored centrally but managed by individual business units

  41. 5.5 Regulator – positive view • The Regulator has various methods to evaluating models • Benchmarking • Comparisons of assumptions • Same data through different models • No need to verify detailed workings of models

  42. 5.6.1 General • Banks in non-investment rated countries should consider the benefit to implement Basel II other than on a standardised approach (benefit in risk management measures not in Capital savings) • Banks should be allowed a maximum of 15% of group assets not to be subject to the IRB approach, subject to confirmation by the Regulator to prevent cherry picking of assets

  43. 5.6.2 General • A staged rollout period to allow for credit portfolios to be measured under IRB from 2007 to 2010 (in line with the UK proposal) • In the interim Basel I would be used on the portfolios not yet rolled out • The requirements in terms of IAS 39 on provisions are not in line with Basel II although they have some common data requirements

  44. 5.7 Warning • Concerned that a false confidence in statistically quantification of risk can cause potential market distortions • The bank will continue to use its internal ratings and only use external ratings as a point of reference and investigate any differences more than three notches • Basel II only measures risk – risk must continued to be managed at operational level

  45. 5.8 Negotiation with Government • The bank also believes that Basel II will assist in negotiations with Government regarding the extension of credit to certain sectors of the economy as the ‘black box’ effect of pricing of credit risk can be reduced • The bank used the principles of Basel II to calculate credit risk price as the basis of negotiations with Government for the purchase of a portfolio of advances from a bank in distress

  46. 5.9 Disclosure under Pillar III • This bank is very active in the Disclosure Workgroup • Already completed discussion documents to: • compare disclosure requirements under Basel II with the accounting disclosures required under the various banking-related GAAP statements • compile a suggested disclosure model for banks in order to comply with both Basel II and with GAAP

  47. Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February 2004 6. Developments at Bank B

  48. 6.1 Attitude towards Basel II • Fully supports Basel II and sees it as a natural development of risk management • Integrated Basel II in the business plans of business units in order to use • advance IRB for retail credit • foundation IRB for other credit risk • standardised approach for operational risk • migrate to advance operational risk approach in future

  49. 6.2.1 Project - Risk rating models • Model development and validation • Scorecard development and validation • Approval by Regulator

  50. 6.2.2 Project - Data collection and integration • Default data • Exposure data (for EAD) • Collateral data (for LGD) • Default data (for PD)

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