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Basel II AIRB Implementation “Lessons in Progress”:
AlokAlok SinhaSinhaPrincipalPrincipalDeloitte & Touche LLPDeloitte & Touche LLP
Commercial Credit Risk Data, Measurement and Technology Challenges
Agenda
Basel II – Overview and Current Status
AIRB Credit Risk – Key Requirements / Implications
Closing Remarks
Major Pain Points and Challenges
Industry Impact
Basel Overview & Current Status
Background on the Basel Accord
• The Basel Committee on Banking Supervision operates under the Bank for International Settlements located in Basel, Switzerland– It was established by the central bank Governors of the G10
countries at the end of 1974 and meets four times a year
• In 1988 the Basel Committee issued the first Basel Accord– It quickly became clear that this ‘one size fits all’ approach was
inappropriate given the wide variety of banking institutions
• Market Risk Amendment introduced in 1996
• Significant regulatory capital arbitrage opportunities exist in Basel I
Basel II Timeline for US Implementation
2007 2008
Capital floor of:
80%
Parallel Preparation for implementation/Proposed Rulemaking
2004 20091999 – 2003 2005 2006 2010 2011
Basel I
BIS-Final rules issued
with
• Supervisory Guidance Expected
• Basel 1A NPR Expected
Today
95%90%
Basel II U.S. NPR
draft released
Basel I-A ANPR
Released
U.S. ANPR issued
Final NPR released for
comment
Basel II Introduces a Three Pillar Approach
Minimum Capital
Requirements
Minimum Capital
Requirements
Supervisory Review Process
Supervisory Review Process Market
DisciplineMarket
Discipline
• Menu of measurement approaches
• Increased reliance on internal processes and data
• Subject to extensive qualification requirements
• Supervisors to ensure sound internal processes and practices
• Thorough assessment of a Bank’s risk profile and capital position
• Define actions if risk and capital assessment deemed unsatisfactory
• Extensive reporting requirements
• Promote market discipline through transparency
Pillar 3
Pillar 2
Pillar 1
Economic Capital
Risk orientation: comprehensive
Distinguishes risk by credit quality (risk ratings, EDFs and credit scores)
Explicitly accounts for diversification
Businesses are assigned capital in proportion to economic risks they pose
Regulatory Capital (Basel I)
All risks are considered: credit, market, operational, ALM, country, etc.
No risk differentiation based on credit quality
Does not account for diversification
Considers credit and market risks
Economic Capital vs. Regulatory Capital
Minimum capital requirements (Tier I/Tier II) are based on broad system risk levels
Regulatory Capital (Basel II)
Credit risk quality differences captured
Considers credit, market and operational risks
Capital definitions and minimum capital levels largely unchanged
Distinguishes risks for a counterparty, relationship or transaction
Very limited risk sensitivity; broad brush structure Significantly increased risk sensitivity
Asset orientation Exposure orientation
Accounts for average diversification with broad exposure categories
Customized to institution’s risk tolerance
By definition, comparable across banks; limited value in the comparison
Applies same capitalization standard to all banks; hence comparable
Basel II is expected to lead to greater alignment between economic capital and regulatory capital
AIRB Credit Risk – Key Requirements
Qualification Requirements - Overview
Overall - to Qualify for IRB Approaches in
General
Specific, Separate – for LGD, EAD and Mitigants
Under Advanced IRB
MINIMUM REQUIREMENTS
RATING SYSTEM
• Separate Borrower Vs. Transaction Ratings
• Minimum of 8 grades
• Less than 30% of exposure in one grade
• Separate rating for legal entities
• Annual rating review
• Regulatory default definition
• Stress testing
• ……………
LGD
• LGD Rating Dimension
• Validation / Stress testing
• Use in Pricing Models
• Relationship w/ collateral • ……………
EAD• Specified by Facility Type• Forward looking• Consistent with experience• ………….
3 Acceptable PD Calibration Approaches:- Bank’s internal historical default
experience- Mapping to external data (rating agency)- Statistical default models (KMV EDFs /
RiskCalc)
Banks are required to develop a one year PD measure for each borrower grade
Risk Mitigation Options • Collateral
– Financial Collateral (cash, securities, equity, etc.)– Non-Financial Collateral (property, equipment, etc.)
• Guarantees and Credit Derivatives– Standby L/Cs, financial guarantees, etc.– Credit default swap (CDS), Nth to default CDS, etc.
• Netting– Master netting agreements (OTC derivatives, repos, etc.)– On-balance sheet deposit netting
• Securitization*– Traditional, synthetic
Portfolio Management – Regulatory Capital Relief via Credit Derivative Hedging
• Types of eligible credit derivatives for capital relief– Single name CDS
– Nth to default CDS
– Total Return Swaps (TRS)
• Credit Derivative eligibility requirements summary– Legal enforceability in the relevant jurisdiction
– Explicit, irrevocable and unconditional contracts
– Full or pro-rata coverage of contractual payments
– Inclusion of relevant credit events (failure to pay, bankruptcy, etc.)
– Net income/credit losses accounting requirements for TRS
– Protection provider eligibility (e.g. highly rated financial firms for double default treatment)
– Application of haircuts: currency, maturity, restructuring
– Monitoring of wrong way, concentration and liquidity risks
Portfolio Management – Regulatory Capital Relief via Credit Derivative Hedging
• CDS Hedging Process and Data Implications– Assignment of CDS eligibility flags
– Linkage to reference obligors and assets
– Determination of net positions at reference obligor level
– Identification and matching of internal and external hedges
– Determination of qualifying capital hedges (PD substitution, double default, etc.)
– Maximization of capital relief through ‘optimal’ allocation of hedges
– Systematic identification and assessment of wrong-way, liquidity risks, etc.
– Lack of systematic access to legal agreement information (e.g. legal enforceability flags, etc.)
Portfolio Management – Regulatory Capital Relief via Credit Derivative Hedging
• CDS Hedging Example – Capital Calculations under Basel II (double default approach)
Exposure Credit DerivativePD 0.08% 0.02%ELGD 45% 40%Instrument Type Term Loan CDSAmount (USD) 1,500,000 1,500,000Term (yrs) 4 3Currency USD EUR
No restructuringImmediate Pay-out
N/AContract Terms
Assumptions
Haircuts Application
CDS Application
CDS Notional 1,500,000Mat. Mism. Haircut 27%Restr. Haircut 40%CCY Mism. Haircut 2%Haircut Adj. Notional 646,800
Amount RWAExposure 1,500,000 596,368
Covered Portion 646,800 46,001Uncovered 853,200 339,214
Total 385,215
RWA Savings 211,153RWA % Savings 35%
Synthetic Securitization / CLO considerations
• Basel II securitization framework:– Identification of exposures that are not considered as
‘securitizations’ by the businesses but qualify per Basel II
– Determination of the appropriate treatment requires consideration and understanding of several factors:
Product Type• Internal Assessment Approach (IAA) is only available for ABCP conduits• RBA can be used for investment securities of ABS, MBS, CMO; however most
structured products are not rated therefore cannot use RBA.
Eligibility• IAA requires the Bank’s internal rating methodologies to meet a number of
criteria; some products (e.g. Tender Option Bonds, Structured Investment Vehicles, etc.) can qualify as an ABCP program and can be eligible for IAA.
Data Availability • If underlying loan level data is not available (or its quality is questionable), the Supervisory Formula cannot be used
Materiality• The Bank can choose dollar-for-dollar deduction of unrated exposures that are
immaterial in size rather than sourcing and maintaining the required data for SF approach.
Major Pain Points & Challenges
Complexity of Basel II Implementation is Compounded by a Multiple Touchpoints and Dependencies
Risk Rating Systems
Risk Analytics
Problem Asset Mgt
Collateral Mgt
Economic Capital
CDS Hedging Process
Country Risk Mgt
Retail Scoring
Retail Segmentation
OTC Derivatives
Structured Products
Business Process Design
Information Flows & Controls
Credit MIS Design
Reference Data Mgt
Technology Program Mgt
Data Quality & Integrity
Reporting Systems: Financial, Risk Mgt.
and Regulatory
Data & Information Modeling
Architecture – Logical,
Physical and Application
Credit to Finance Reconciliations
Legal Entity Rules Interpretation
Governance, Oversight & Controls
Guarantees
Repo Style Transactions
Systems
Structured Finance Systems
Collateral Mgt
Systems
Legal Netting Rules
Regulatory Accounting
Supervisory Processes
Deposit Systems
Methodologies Processes Technology Operations Reporting
Multi-jurisdictional solution design
Data Maintenance
and Mgt.
Data Privacy & Secrecy Laws
Fin. Acctg
Regulatory Review
Private Equity Investments
Internal Reviews and Audit
RWA Calculation Engine Design & Implementation
Operational Loss Data, Measurement
and Modeling
Internal Audit, Validation and
Compliance Testing Programs
Change Management, Communication and
Training
Regulatory Compliance Processes
LOB Credit Policy Regulatory Reporting
Operational Risk Mgt
Technology & Operations
Corporate Treasury
Derivatives Technology
Credit Risk Mgt Finance Loan
AdministrationPortfolio
ManagementFinance
OperationsCorporate
Accounting Internal Audit
REQUIREMENTS
BANK FUNCTIONS
DATA DATA
DATA
Basel II Enterprise Program Profile
• Basel II program characteristics at core US and large global banks– Huge in scale, scope and complexity
– Multiple threads and workstreams
– Matrixed accountability structure
• Programs span diverse constituencies that do not often speak the same “language”– Challenging task to communicate the “implications” and “impacts” of
requirements
• While Basel II will end up as a regulatory directive, investments in improved risk and business management are at the core of severalrequirements
• Implementation activity is accelerating within significant technology, change management involvement– IA is keeping a close watch
Some Key Observations and Lessons to Date
• Largest banks (and experts) under estimated the complexity (and costs)
• Excessive focus on some narrow areas
• 80/20 solutions for Basel II will not work
• Current Risk to Finance reconciliationprocesses untenable under Basel II
• Limited applicability of vendor solutions
• Project Management – Single Biggest Challenge
• Linear approach
• Traditional PMO point of view or
• Excessive reliance on Risk Analysts to drive PMO
• Limited success in leveraging Economic Capital systems for operational implementation
• Largest banks (and experts) under estimated the complexity (and costs)
• Excessive focus on some narrow areas
• 80/20 solutions for Basel II will not work
• Current Risk to Finance reconciliationprocesses untenable under Basel II
• Limited applicability of vendor solutions
• Project Management – Single Biggest Challenge
• Linear approach
• Traditional PMO point of view or
• Excessive reliance on Risk Analysts to drive PMO
• Limited success in leveraging Economic Capital systems for operational implementation
• Project Management Lessons
1. Top Down with an end to end view
2. Structured Approach– Clear definition of ownership and
accountability
– Balance “Risk” vs. “Finance” roles
– Detailed project planning
3. Coordination and Communication– Front office, middle office and back office
– Involvement of appropriate constituents
• Integrity of the Information Architecture
• Credit MIS Design and Data Model
• Qualification “data” vs. computation “data” attributes
• Operating Model - regulatory process and governance
• Revisit short cuts from prior merger “integration” projects
• Project Management Lessons
1. Top Down with an end to end view
2. Structured Approach– Clear definition of ownership and
accountability
– Balance “Risk” vs. “Finance” roles
– Detailed project planning
3. Coordination and Communication– Front office, middle office and back office
– Involvement of appropriate constituents
• Integrity of the Information Architecture
• Credit MIS Design and Data Model
• Qualification “data” vs. computation “data” attributes
• Operating Model - regulatory process and governance
• Revisit short cuts from prior merger “integration” projects
Surprise
Exploring role of Economic Capital systems/processes in Basel II Implementation
• Role and Contribution of Economic Capital Systems – Drives consistency in risk definitions and risk measurement approaches
• Create a level playing field to assess businesses and activities affected by different risk forms
– Incorporates Bank’s risk tolerance objectives in capital measure
– Brings focus and attention to “first order” data elements required for quantification
– PD, LGD, EAD data histories and calibration• Have proven very valuable starting point for Basel II
• Serves as the foundation for RAROC, value based performancemanagement and strategic decision support– Primary role is management reporting
• The 80/20 rule works for economic capital– Provides directionally correct and reasonably consistent results to support
key decision making
Limited success in leveraging economic capital systems for Basel II “operational” implementation
• From a process and controls perspective, most bank economic capital systems would be considered “immature” or ad hoc
– Systems were not designed and developed with a view to support external or regulatory reporting
– Focus has been on methodology, analytics and assumptions, not so much on controls, review, reconciliation and documentation
– “data” was considered good enough for risk modeling
• Minimum Basel II qualification criteria were never focus of economic capital systems
– Risk ratings systems, corporate governance and oversight, credit process and policies, etc.
• Basel II regulatory view of risk continues to differ from economic capital view in several areas
– Securitizations, repo-style transactions, credit hedging, OTC derivatives
– In many aspects, regulatory model would be a simplification of EC model
• Pillar II (supervisory review) and Pillar III (reporting/disclosure)
protection_provider
PK,I1 protection_provider_id
protection_provider_nameguarantor_typestandalone_grade_protection_providerrating_protection_providerdefault_grade_protection_provider
crm
I2 crm_id
FK2,I4,I6 outstanding_idFK1,I3,I1 crm_haircuts_idFK3,I5,I8 protection_provider_id
loss_given_defaultprobability_defaultrwa_crm_portioncrm_currencycollateral_typecrm_term_out_dateallocated_exposurecash_flaggold_flagsenior_debt_flagliquidity_approved
I7 index_iducits_flagmutual_funds_flagdaily_price_flagCRM_typecredit_derivative_typecollateral_amountcredit_protection_valuesupervisory_input_OCexchange_id
FK4 tranche_idFK2 obligor_id
collateral_fair_value
deposit
PK,I5 deposit_id
FK2,I2,I3 exposure_iddepositnet_ag_flag_ddeposit_maturity_date
FK1,I1,I4 crm_haircuts_iddeposit_currency
FK2 obligor_id
portfolio
PK portfolio_type
int_portfolioRWA_expected_lossRWA_unexpected_lossasset_classint_asset_classallowance_spec_chaprov_portfolioprov_def_surpl
securitization_tranche
PK,I4 tranche_id
FK1,I1,I3 securitizations_ide_tranchebank_interest_in_trancheexposure_seniorityindividual_tranche_ratingtranche_of_interest
obligor
PK,I1 obligor_id
obligor_nameprobability_default_obligorasset_classint_asset_classSDBC_exemption_flagstandalone_gradedefault_gradeobligor_gradeborrower_group_sizeborrower_group_total_assetsborrower_group_turnover
outstanding
PK,FK6 obligor_idPK,I2 outstanding_id
FK1,I3,I1 outstanding_haircuts_idFK4 netting_idFK5 facility_id
nominal_exposurenotional_principal_amountadd_on_derivative_typeexposure_reporeplacement_costexposure_abs_net_positionexposure_abs_net_fxoutstanding_currencyreporting_datevaluation_typeshort_term_exposure_typeresidual_value_risk_flagresidual_lease_valueLPperiod-tDfactor-tfair_value_leaseeffective_maturityt_derivativeloss_given_defaultLGD_Business_typeEADc_percent_poolrwa_outstanding
FK3,I6 securitizations_idFK2,I7 tranche_id
partial_write_offspecific_provisiondefaulted_assets_flagspecialised_lending_eligibility_flagVaR backtest_exceptionVaR flagsecuritization_purchase_discount
securitizations
PK,I1 securitizations_id
spe_idexpected_maturitycurrency_codeearly_amortization_flagearly_am_controlled_flagearly_am_uncommitted_flagearly_am_retail_flagexcess_spread_trapping_pointearly_amortization_trigger3_month_average_excess_spreadclean_up_call_indicatorclean_up_call_exercise_pointbank_chosen_formulamfmi_securitization
oustanding haircuts
PK,I1 outstanding_haircuts_id
internal_haircut_flaginternal_exposure_haircutinternal_currency_haircutissue_rating_of_debt_security_outstandingrating_agency_outstandinginstrument_type_outstandingissuer_type_outstanding
crm_haircuts
PK,I1 crm_haircuts_id
days_between_remarginingrating_agency_collateralissue_rating_of_debt_security_collateralinstrument_type_collateralissuer_type_collateraltransaction_typebank_holding_periodinternal_collateral_haircutbank_holding_period_haircut
cashflow
PK,I1 cashflow_id
FK1,I3,I2 outstanding_idfees_cashflowinterest_cashflowprincipal_cashflowcashflow_period
FK1 obligor_id
provisions
tier_2_Limitallowance_gen
Basel II Credit Risk Logical Data Model
Last Update: 02 October 2003
Obligor
Asset Securitization
Credit Risk Mitigation
Outstandings Data
Provisions
netting
PK netting_id
netting_enforceablenetting_contractnet_exposure
facility
PK facility_id
facility_maturity_datefacility_start_datefacility_term_out_date
derivatives
PK derivative_id
FK2 securitizations_idspe_idderivative_counterparty_idderivative_counterparty_ratingnotional_amounte_swap_m2madd_on_factorderivative_maturity
liquidity_facility
PK liquidity_facility_id
program_wide_flagFK2 securitizations_idFK1 tranche_id
spe_idliquidity_provider_idliquidity_facility_ratingeligible_liquidity_facilityeligible_liquidity_facility_md_flagliquidity_facility_seniorityliquidity_facility_line_amounte_ccf_liquidity_facilityliquidity_facility_maturity
credit_enhancement
PK credit_enhancment_id
FK1 securitizations_idtranche_idspe_idcredit_enhancement_provider_idcredit_enhancement_provider_ratingcredit_enhancement_senioritye_ccf_credit_enhancementcredit_enhancement_maturity
This diagram illustrates attribute groupings and high-level relationships. These will be fullydefined in the Analyse Phase.
Transition From Logical Model to Physical Model…..
• Linkage of Facilities to Borrowers
• Multi Borrower Facilities
• Multiple Ratings for Same Borrower
• Borrower Legal Hierarchies
• Credit Product to Account Mappings
• Consistent Product Hierarchies
• Legal Hierarchies vs. LOB Hierarchies
• Collateral, Guarantees and Hedges
• Identification of Structured Finance Facilities • ABCP Conduits
• Credit Support
• Standby Letter of Credit
• Tax driven securitization structures etc
• Risk Mapping of the Balance Sheet
…is Uncovering Significant Credit Data Issues
Some sample implementation pain points
Internal Historical Data, especially LGD and EAD
CDS Hedging Process for Qualification and Application of Rules
Structured Finance / Securitization Products
Securitization Data Infrastructure
Banking Book vs. Trading Book (overlaps)
Collateral data capture and reporting
Repo-Style Transaction Data Capture / Netting Rules etc.
Transitioning information from front office to risk data repositories
Credit MIS to General Ledger Reconciliations
Legal Entity Reporting in different jurisdictions
Future state operating model for regulatory reporting
Data Quality (in risk MIS and Finance)
End to end testing
Basel II driven transformation can lead to long term benefits
Common Data &
Definitions
Qualification
Methodology & Analytics
Calculation Requirements
• Specific disclosure reports• Additional data requirements
• Data flows and control processes• Calculation engine• Roles and responsibilities
• Required and optional process changes
• Recognition of credit risk mitigants
• Data attributes• Data quality• Data model• Data definitions
• Calibration techniques• Treatment choices and options• Risk modeling
• Governance and controls• Process and policy• Historical data
• Integration with current regulatory reporting
• Local legal entity requirements• Parallel run of Basel I and Basel
II
Transformational
Initiatives
CREDIT
FINANCE
TECHNOLOGY
OPERATIONS
C
U
R
R
E
N
T
S
T
A
T
E
T
A
R
G
E
T
O
P
E
R
A
T
I
N
G
M
O
D
E
L
Efficient Credit Process:
Underwriting
Approvals
Risk Rating
Administration
Credit Review
Active Portfolio Management:
Limit Monitoring
Risk Reporting
Problem Asset Mgt
Hedging Strategy
Tactical Rebalancing
Value Realizatio
Pricing
Business Unit Profitability
Relationship Profitability
Targeting
Strategic Positioning
Reconcilable Views
Consistent Hierarchies
High Quality Data
Process Requirements
Implementation of RWA Requirements
Integration with Regulatory Reporting
Pillar 3 Reporting Requirements
Common Data &
Definitions
Qualification
Methodology & Analytics
Calculation Requirements
• Specific disclosure reports• Additional data requirements
• Data flows and control processes• Calculation engine• Roles and responsibilities
• Required and optional process changes
• Recognition of credit risk mitigants
• Data attributes• Data quality• Data model• Data definitions
• Calibration techniques• Treatment choices and options• Risk modeling
• Governance and controls• Process and policy• Historical data
• Integration with current regulatory reporting
• Local legal entity requirements• Parallel run of Basel I and Basel
II
Transformational
Initiatives
CREDIT
FINANCE
TECHNOLOGY
OPERATIONS
C
U
R
R
E
N
T
S
T
A
T
E
T
A
R
G
E
T
O
P
E
R
A
T
I
N
G
M
O
D
E
L
Efficient Credit Process:
Underwriting
Approvals
Risk Rating
Administration
Credit Review
Active Portfolio Management:
Limit Monitoring
Risk Reporting
Problem Asset Mgt
Hedging Strategy
Tactical Rebalancing
Value Realizatio
Pricing
Business Unit Profitability
Relationship Profitability
Targeting
Strategic Positioning
Reconcilable Views
Consistent Hierarchies
High Quality Data
Process Requirements
Implementation of RWA Requirements
Integration with Regulatory Reporting
Pillar 3 Reporting Requirements
Industry Impact
Basel II vs. Basel I – Winners and Losers
Investment-grade corporate lending
Retail banking, and secured residential real estate lending, esp. residential mortgages
Lending against financial assets and collateralized lending
Short-term lending – i.e. trade finance
Hedged (CDS) or guaranteed credit exposures
Lower Capital Charges
Lending to emerging markets (perhaps excluding “advanced” ones)
Non-investment grade corporate lending, sub-prime retail lending, project finance and lease finance
Significant equity investments; equity investments to hedge funds
Operationally intensive businesses – asset management, clearing, trust and custody
Higher Capital Charges
Prime brokerage (business with hedge funds)
Credit card ABS programs or conduit facilities
Potential trends
• Greater alignment between EC and Regulatory capital– Some unintended consequences are possible
– Possible integration for management reporting
– Fewer opportunities for capital arbitrage
• Data Quality improvement– Reduced noise in credit data
– Consistency
– Greater objectivity in credit assessment
• Improved AQ and Concentration reporting
• Streamlined regulatory reporting process
Competitive Landscape• A-IRB banks vs. Basel 1A banks• Banks vs. unregulated finance companies• US vs. European banks
– Leverage ratio requirement– Adoption timing differences
• Impact on average capital levels for banks– 1. Markets– 2. Markets– 3. Markets– 4. Rating agencies– 5. Regulatory minimum requirements
©2006 Deloitte Development LLC All rights reserved.