Page 1

The IRB Project in Overview

Laurie Mayers

Group Head of Basel 2 &Credit Risk Systems Co-ordination

The Royal Bank of Scotland Group

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Agenda

Guiding Principles

Challenges Facing Banks

General Approach

Wholesale IRB

Retail IRB

Implementation of Infrastructure

Managing Expectations

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Guiding Principles• Consistency

Models are developed centrally or within Divisions with central oversight to ensure consistency of approach and standards

The aim is to create ‘Centres of Excellence’ across the Group

Models are made available to other parts of the Group through systems infrastructure

• Appropriateness

Centrally developed models must be modified for roll out to portfolios to reflect jurisdiction requirements, legal differences or other specificities

• Strategic Objectives

Focus on costs and benefit: model development/enhancement driven by materiality of portfolios and data availability

• Common Infrastructure

As much as possible, models are implemented on common systems, with access provided via the internet and aligned where possible to risk workflow processes

• Guided by Prudent Risk Management Practice

Model development and use should enhance internal risk management practice

Avoid implementing a solution in line with the Basel 2 minimum standards that represents a “step backwards” for internal risk management

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Challenges Facing Banks - Group Level IssuesInternationally active banks face the following challenges:

• Home: Host Issues

Implementation and validation requirements may differ between geographies, even within the EU

Scope of application differs between geographies (e.g. USA vs EU)

• Use Test requirements

Managing significant cultural change in a very short period of time

Incorporation of IRB “thinking” into budgeting and forecasting processes and acquisition and disposal strategies

• Education & Communication:

Engaging and educating Board and Executive Management

Achieving and maintaining sufficient focus given 2007 timeframes

Communication and training for risk management, audit, finance and strategy staff

• Resources

Budgets and business prioritisation

Acquiring sufficient skills and resources to get the work done in required timeframes

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Challenges Facing Bans - Scale of the Problem

GROUP FUNCTIONS

RETAIL & INSURANCE DIVISIONS

- Retail Direct

- Retail Bank

- Direct Line

WHOLESALE DIVISIONS

- Corporate & Investment Bank

- Corporate & Commercial Bank

- Financial Markets

- Lombard Leasing

- Greenwich Capital

MIXED WHOLESALE/RETAILDIVISIONS

- Citizens

- Ulster Bank

- Wealth Management

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Wholesale IRB – Challenges

• Implementation of IRB within the wholesale divisions of RBSG is not a single model problem, it is a many model problem

• In the wholesale divisions of RBSG, there are at least 25 models that need to be developed or brought into compliance with Basel standards

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Wholesale IRB – Approach• Banks use different types of corporate grading depending on their chosen risk management approach:

Some banks derive PDs and determine LGDs

Some assign ratings and map these ratings to PDs

All models/approaches include a significant input based on expert judgment, both from credit risk officers and relationship managers

• Validation:

Banks validate PDs against actual experience and/or external data, covering a broad range of practice reflecting availability of internal data

• RBSG Focus:

Our focus has been on accurate ratings of counterparties in order to maintain credit quality within the portfolio and to ensure appropriateness of pricing

For the most part we use scorecard based approaches mapped to external sources of PDs

Significant work will need to be done to increase the robustness of models to meet Basel 2 standards

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Wholesale IRB – Implementation Issues

The Accord deviates from current risk management practice:

• Definition of Default for Leasing (90 day definition of default) and requirement for automatic cross default

• Requirement for LGD to cover losses in an economic downturn

• Good Quality Portfolios: we are still trying to decide what approach to take for good quality, low loss experience business portfolios, such as Project Finance and Leasing

• The collection of sufficient historical data is complicated by the merger of two institutions and migration onto common platforms

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Wholesale IRB – Evolution and Pragmatism?

• Evolution: In meeting the full requirements of IRB, banks need to be allowed the opportunity to:

Evolve their practices as they improve the quality of their internal data and model sophistication

Educate and train staff and management, the front office and the investor community

• Pragmatism:

RBSG supports the concept of a single IRB, combining the Foundation and Advanced IRB approaches

Allow banks to make pragmatic decisions whether to develop data histories for certain portfolios on a cost/benefit basis

Would allow banks to evolve through a single IRB, initially using regulatory inputs for LGD and EAD for some portfolios and internal assessment for others. Such an approach would logically lead to the removal of the ‘cliff effects’ and other/perverse incentives that exist to some extent between FIRB and AIRB

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Retail IRB – Application

• Within the UK, Retail practices are already more closely aligned to the proposed Basel 2 standards

• Systems are already more automated, working on centralised platforms with less expert judgment

• Typically, different types of models are used for mortgages, cards and personal/SME businesses

• Banks typically use multi-factor models, either application or behavioral scoring, to provide a point-in-time and/or on-going prediction of default and loss given default

• Generally, models are more dynamic based on point-in-time estimates of default having a forward looking default horizon of 12 months

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Retail IRB – Challenges

A different range of technical issues arise within Retail portfolios:

• Definition of Default: many banks already use Definitions of Default that are more complex (and appropriate) than just a monitoring of days past due

• Need for permanent use of Point-In-Time vs Through the Cycle estimates of default

• SME/Retail Boundary €1m: Addressing the boundary issue for IRB may mean that banks will be asked to calculate capital differently from the way they manage risk

However, the following issues are common with Wholesale:

• Demand for budget and skilled resources (but to a lesser extent)

• The cultural change Basel 2 implementation will represent

• Collection of sufficient historical data complicated by merger of two institutions

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Implementation of Infrastructure

• Model Development

• Automation and development of models

• Implementation of bottom up aggregation, storage and reporting infrastructure

• Reconciliation of risk and finance data

• Enhanced MI capabilities

What does it comprise?

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Managing the Market

• Comparability

“The national differences on WRA calculations will be so subjective for the large banks as to create genuine uncertainty over relative capital strength and, in turn, cash flows and market values. A further layer of “information asymmetry” will, in other words, enter the equation.” (William de Winton, Morgan Stanley)

• Complexity

Concepts of grading and portfolio modeling not widely understood within banks or by the market

• Disclosures Under Pillar 3

Need to be comprehensible to the market, so information disclosed is not misunderstood or compared inappropriately

• Rating Agency Views

How will their views on capital adequacy change in light of more volatile WRAs and Tier 1 ratios?