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Essential Risk-Based Capital Concepts and the (Not So New) Basel II Accord. FCA FAST rack Capital Workshop June 15, 2006 Bruce J. Sherrick Section C2. ● iFAR ● integrated F inancial A nalytics and R esearch, LLP. Some Quotes…. - PowerPoint PPT Presentation
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Essential Risk-Based Capital Concepts and the (Not So New) Basel II Accord
FCA FASTrack Capital Workshop
June 15, 2006
Bruce J. Sherrick Section C2
● iFAR ● integrated Financial Analytics and Research, LLP
Some Quotes….. “The proposed new Basel II Accord is now described and
amended on over 750 pages of text, and the word ‘agriculture’ does not appear once.” (Peter Barry’s observation at the Capitalizing for Risk in Agriculture Symposium, subsequently revised upward)
“The impact and consequences of Basel II will be immense for financial institutions. New processes and procedures need to be implemented, and there is a tremendous need for new data management…. data issues are enormously complex requiring (long histories) and external validation” (Susan Andre)
Some More Quotes….. “Basel I aged quickly and not gracefully”
John Hawke, Comptroller of the Currency, 2002
“… these proposals on Basel II and the amended Basel I represent substantial revisions to the regulatory risk-based capital rules applied to U.S. banking institutions, from the very largest to the smallest” Governor Susan Schmidt Bies, 2006
“Far better an approximate answer to the right question than an exact answer to the wrong one – the latter of which may be made arbitrarily precise via a redefinition of the question” (various attributions including Sherlock Holmes)
Does Basel II ask the right questions?
Introduction to Economic Capital Basel-II’s Role in encouraging the “right
amount” of economic (rather than regulatory minimum) capital
Basel II and the FCS Some Strategic Implications
Views of “Capital” differ: Owners see as synonymous to wealth:
Growth in value Current Return (income) Riskiness of growth and return stream
Financial Officers (CFO, Treasurer…): Funding source and capacity for growth Constraint
Regulators: Safety and soundness: Historic View that Too Much is
Never Enough Basel II – Economic Capital Aligned for Efficiency
…Economic Capital
Risk Emphasis: Hold Economic Capital to Cover Future losses
Expected: loss allowance Unexpected: equity
Arising from Credit risk: borrower’s default Market risk: effects of interest rate changes on
asset and liability values Operational risk: failed human, performance,
processes and technology
…Economic Capital
Loss Attributes
Frequency: Probability of default (PD) Severity: Loss given default (LGD) Amount: Exposure at default (EAD)
…Economic Capital
N.B.: Separation of PD from LGD is a KEY distinction from typical risk-rating practices in current practice.
What is Economic Capital ?
Amount needed to “insure” against undesirable outcome with given tolerance
Guided by actuarial principles and market pricing of ROE risk
Backstop for risk and growth Includes equity capital and loss reserves
…Economic Capital
Various views including:
Who is this “Basel” anyhow.. Basel Committee on Bank Supervision Committee of central banks and regulators
from major industrialized countries Headquartered in Basel, Switzerland Hosted by the Bank for International
Settlements (www.bis.org)
What Does Basel Do? Provides broad policy guidelines for each
country’s regulators to adopt or modify
Forum for Industry interaction Extensive staff and research program Fosters international monetary and
financial cooperation and serves as a bank for central banks.
1988 Basel Accord (Basel I)
Targeted at large, international banks Adopted by over 100 countries; applied to
all U.S. banks and other financial institutions, including the FCS
Slots loans and securities into four risk classes (e.g. all commercial and agricultural loans treated the same)
The de facto standard. Period.
Basel I (1988 cited as 1st adoption) Advantages
Simplicity Uniformity Capital refinement New measures and
models
Disadvantages Simplicity Crude risk classes Not responsive to
innovation Ignores diversification Largely ignores passage
of time and risk mitigation
Background – Basel I to present Basel Accord of 1988 aimed to homogenize (capital and other) practices of
internationally active banks, beginning with those in the G-10 countries. Formally in place now in >100 countries, de facto standard for nearly all. Represents a Minimum Hurdle view of capital
e.g., 8% with standard weights, non-responsive to changes in non-categoric risks
“The purpose of requiring banks to hold capital is to prevent 1-sided bets.” – K. Rogoff, Journal of Economic Perspectives, 1999 special issue on international bank regulation.
Viewed as deductible applied against implied public backstop for financial institutions.
Asymmetry…. Cost of excess capital not borne by public regulator
Cost of too little capital is borne by taxpayer
Leads to….. Rational intent to set capital requirements with high likelihood
for adequacy = low tolerance for insolvency risk
Background – continued
Basel II – the main idea Basel II consultative (early warning) document in 1999 with indications
that new proposal would represent a move toward “economic” capital and more market pricing of risk.
January 2001 “package” reflecting comments on proposals and indicating additional details on risk classes, rating and so forth. First attempt at timeline for implementation – since delayed formally at least 5 times.
Outlines 3-pillar approach minimum capital calculations explicit and more homogenized role of supervisory review reliance on increased market discipline through increased disclosure
requirements.
Basel II - continued Early 2002 began development and distribution of QIS
materials – intent to assess the implications for aggregate and specific capital under new guidelines. Current version is QIS5 template.
Some important information about use of QIS results: calibration during phase-in
same total capital in system (more later about this point…) incentive to use more risk-sensitive internal ratings systems working example: loan asset with .7% probability of default and 50%
LGD and 3 year maturity would require 8% capital.
Basel II - continued Interest rate risk moved toward “operational risk” and treated
in pillar 2. Sophistication in funding can transform interest rate risk to counter
party credit risk (W. Staats).
Increased granularity – more finely disaggregated risk categories in principle leads to better risk-pricing opportunities – has been bane to FCS Banks – conflict with existing bond rating categories and Rating Agency tables.
Requires formal evaluation of PD, EAD, LGD, and some measures of “relatedness” (correlation).
Basel II – Major issues for Ag involve credit and operational risk
adapted from PWC and BIS
OperationalEvaluation Mitigation Risk
SimpleStandardized externally supplied
SimpleBasic (30% Gross income)
IntermediateFoundation Internal Ratings Based (IRB)
ComprehensiveStandardized (beta/gamma)
Advanced Advanced IRB
Institution Calculated, Regulator approved
Internal Measurement based
---- Credit Risk ----
Credit Risk Options – the pecking order Standardized approach
Similar in concept to BASEL I with a few additional risk ranges and weights.
Foundation IRB Broad categorizations required (no choice); institution assigns ratings
linked to PD calculations. Other inputs set by supervisor/regulator
Advanced IRB In addition to PD calculations, institution uses model-based estimates
of LGD and EAD, subject to regulatory approval.
FCS Institutions are planning to be FIRB and AIRB – some are getting pretty good infrastructure…..
The Basel II Proposed Accord
Basel’s Role: To Standardize Economic Capital and encourage Efficient Deployment of Capital.
Allow Market Price of Risk to be determined
Respond to changes in risk through time
Simplify and Homogenize Safety and Soundness practices
Basel-II’s Role..
Basel II Basel II is both following and leading
Following “best practices” of the top tier of banks world wide
Major developments in management, measurement, and modeling
Leading/stimulating wider adoption and tailoring to institutional size and
complexity
First draft - 1999 35 pages Too simple
Second draft - 2001 500 + pages Too complicated; trades off complexity and refinement
First “Final” version - 2003 Scaled back with calibration for phase in Implementation: end of 2006 or later
2nd through 5th Final Versions include QIS studies and templates for “parallel” calculations and “calibration” factors.
Basel II Process
Basel II – Current Timeline
2003 2004 2005 20072009 – 95% floor
G-10 approvals
QIS 3 Calibration
Begin Parallelrunning
Begin phasein (e.o.y)
Phase inand beginenforcementvoluntarily
Beyond
Prep for Basel III….
2006
2007
2008
2009
20112010 – 90% floor2005 - prelim
2006 - final 2011 – 85% floor
Three Pillars1. Minimum capital requirements (our focus)2. Supervisory review
More intense as an institution uses itsinternal systems to measure risk
Goal attainment and management quality
3. Market discipline Increased disclosure and market discipline
General Characteristics
Accord contains a spectrum of approaches Institutions can choose the appropriate
approach, subject to documentation and approval
Incentives (lower capital) are provided for better risk management
Minimum Capital Requirements for Credit Risk – 3 approaches
1. Standardized Approach Similar to existing capital regulations More risk weighting categories for commercial
loans (0%, 50%, 100%, 125%, 150%) Mapped to external credit ratings or not rated Applicable to “community banks” or those
approved by regulator
2. Internal-Ratings Based Foundation Approach:
Commercial loans Institution estimates the probability of default
(PD) for at least eight risk classes and five years of data
Retail loans: Estimate PD by customer segment Regulator provides severity of default (LGD) Regulator approves institutions methodology Applicable to “regional banks” or those
approved by regulator
3. Advanced IRB Approach
Commercial loans: Institution estimates PD, LGD, and EAD
Retail loans: Same as Foundation approach Adjustments for loan maturity,
concentration, and risk enhancements More rigorous documentation Applicable to “Large, Internationally active
banks”, or those approved by regulator
Operational Risks Failed human practices, processes, and
technology: Enron, WorldCom, Tyco Fraud Employment practice and work place safety Clients, products and business practices Damage to physical assets Execution, delivery and process management
Alternative approaches Percent allocation: 20% - 12% Build a database for adverse events (type, frequency,
severity)
Market Risk Risk in trading book Addressed in several amendments to
Basel I, using VaR approaches Interest rate risk not yet included in
minimum capital requirement, yet explicit in FAMC, OFHEO regulations
Much Left to supervisory review
Dual Ratings1. Rating the Customer
• Risk classes• Probability of default by class
2. Rating the loan facility• Loan attributes
• Collateral quality• Seniority of claim• 3rd party guarantees
• Loss-given default by attribute
The Dual Rating Idea
ExpectedLoss
CustomerRelated
Probabilityof
Default= x
Loan Related
LossGiven
Default
Exposureat
Defaultx
LGDPD EAD= xEL
Economic Capital includes UEL or the Unexpected Loss as well.
Risk Tolerance ___% capital should be adequate ___% of
the time How Safe – How many vote for:
50% of the time 95% of the time 99% of the time 99.97% of the time 100% of the time (don’t lend) Now answer as a borrower…
Greater safety = more conservative = more expensive
Basel’s Risk Rating Factors At a minimum, methods and data should account
for: Historical and projected cash flow repayment ability Capital structure Quality of earnings Quality of information Operating leverage Financial efficiency Financial flexibility: Liquidity Management quality Position in industry: Peer group standing Country risk
Correlations and Concentrations Very real effects
Correlations: How returns and losses move together; lower the better
Concentrations: Dominating portfolio positions by commodities and loan sizes
Measurement challenges Basel adjusts for concentration and assumes
an average correlation Ag Losses unlikely to satisfy best principles for
low correlation, low concentration, and easy diversification
Basel II in Pricing… Loan pricing
Expected loss: provision and allowance Unexpected loss: risk premium covers the cost
of holding equity capital (see C8.xls) Explicit cost of capital in loan pricing against
actual RBC requirement for that loan exposure
Stress Testing Shocking the model with significant
downgrades of credit quality (increases in PD and LGD) and assessing capital adequacy
Could be linked to changes in borrower conditions, or macro conditions
Stress testing is an inherent part of enterprise-wide risk management
Economic capital models and measures should be designed to include stress testing
To Qualify an IRB system… Portfolio broken into 9 or more groups: Corp, Retail, Bank,
Sovereign, Equity, Project, etc., – not clear where ag fits Must demonstrate ability to estimate PD and backfit (out of
sample validation) – very tough for small community banks, small commercial banks with limited ag loans
Collect, store, and update key borrower/loan characteristics – very tough for ag loans, esp. mortgages
Board and Management Qualifications Distinctions for credit risk that are “meaningful”
(i.e., cannot use scale where all loans get same score)
Possible Translations… Development of IRB Risk Rating systems involves tradeoff
between high fixed development cost and (potentially) lower flow costs. Favors large lenders with good data (FCS, a few large banks).
Increase pressure to consolidate. Data becomes increasingly valuable. Pay to play? Some may opt out, or contract for coordinated
services Successful == more accurate risk pricing as well. RBCST parallels (tries to reflect Basel II ideas)
Possible Translations… Markets are brutally efficient in long run – capital will seek its
highest return. Operational risk – much larger issue than in past. Regulator are more “on the hook” in any case. Basel and FFSC documents have some similar intent to
“promote the standardization in capitalizing, reporting, and accounting…” (BIS).
Less data availability makes those that are available more valuable, and increases potential for more “overfitting”.
Disclosure pillar reduces distance (insulation) between management and boards.
Market discipline – embarrassment of non-compliance will be critical.
Regulated vs. unregulated lenders (i.e., how will Deere react?).
Top Ten Discussion Points Regulators much more involved. Incentive to avoid interest rate risk or convert to
credit risk. Pro-cyclicality (not good news for ag-lenders). Flow advantages to IRB methods. Fixed cost advantages of non-compliance and
standard approaches. Ostrich strategies will fail.
Top Ten Discussion Points – cont’d Different effects on different types of lenders (coops vs. mutual, vs. stock
vs. vendors) New opportunities for packaging/partnering with different firms if easier to lend to vendor than to customer.
Calibration to current “total on average, but not individual lenders” strongly favors IRB approaches, very scary for standard approaches. Current QIS4 and QIS5 Calibration examples seem extreme for ag loans with good collateral.
Catch-22 of establishing new compliant data systems with length of history requirements.
Extremely data dependent/model driven – strong likelihood for overfitting with existing ag data sets. Good potential for increased risk delineation.
“Lead or Follow” a meaningful strategic decision – especially for FCA
FCA Issues … Huge benefits to standardized reporting, updating financials on
current loans, and development of data warehousing. Chance for System to manifest “demand for regulation” (ala
Stigler, ADM,….) to suit comparative advantages Additional pressures for historic data consolidation. New more complicated incentives and payoffs to capital
arbitrage – and new forms (e.g., w/FAMC). BIS studies of effects of Basel I found few cases of credit
rationing, likely to be worse with Basel II.