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Déjeuner causerie Développements canadiens en gestion des risques. The New Basel II Accord and Its Impact on the Banking Industry. Alicia Zemanek Vice-présidente Relations avec les investisseurs Chef des Risques Gestion intégrée des risques Banque Laurentienne du Canada. Agenda. - PowerPoint PPT Presentation
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Déjeuner causerie Développements canadiens en gestion des risques
Alicia Zemanek
Vice-présidente Relations avec les investisseurs Chef des Risques Gestion intégrée des risquesBanque Laurentienne du Canada
The New Basel II Accord and Its Impact on the Banking Industry
Laurentian Bank of Canada CIRANO-PRMIA
2
Agenda• Evolution of Basel I into Basel II• Old vs New Basel Accord• The New Basel II Accord• Results of the QIS3 Exercise• Who is subject to the New Basel II Accord• Basel II Impact on the Banking Industry• Will we Have a New Accord by Spring 2004 ?
Laurentian Bank of Canada CIRANO-PRMIA
3
Evolution of Basel I into Basel II1988 Endorsement of Basel I Accord by G-10 central banks
“The current accord is based on the concept of a capital ratio where the numerator represents the amount of capital a bank has available and the denominator is a measure of the risks faced by the bank and is referred to as risk-weighted assets”
Problem with the accord: The Accord is insensitive to credit risk ratings. A General Electric loan (AAA rated), inder Basel I, generates more capital requirements than a sovereign debt to Mexico (BBB- rated)
Risk Weights Asset Categories
0% Cash, Sovereign loans, I nsured Residential Mortgages
20% Bank loans, Municipal loans
50% Uninsured Residential loans
100% All other loans and non-performing loans
Tier 1 Total
Basel I 4% 8%
OSFI 7% 10%
Minimum Capital Requirements
Available Capital 1 249 400
Risk Weighted Assets 9 276 528
Total Capital Ratio 13.5%
Calculation of Total Capital Ratio (as of oct 31st 2002 in $K)
Laurentian Bank of Canada CIRANO-PRMIA
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Old Vs New Basel Accord
1 Pillar (20 pages)(covers the quantification of minimum regulatory capital)
1 Methodology (approach) for calculating minimum capital
Not very sensitive to risk
Only credit commitmentswith maturity 1 yearare included in the quantification (explains 364 day revolving lines)
Capital relates only to credit & market risk
3 Pillars (216 pages)Pillar 1: Min. capital requirementsPillar 2: Supervisory review Pillar 3: Public disclosure
3 Methodologies (approaches) for calculating minimum capital
Uses external or internal risk ratings to compute minimum capital requirements for credit risk
All credit commitments are included in the calculation ex. VISA, commitments (for LBC increases capital between 6% & 17%)
Capital relates to Credit, Market & Operational Risk (for LBC OP risk capital represents an additional 10%)
BASEL IBASEL I BASEL IIBASEL II
Laurentian Bank of Canada CIRANO-PRMIA
5
The New Basel II Accord
Methodology Measurement
StandardizedOR RAROC
OR
+
= + + =
OR
Standardized
OR
+Standardized
OR
PILLAR I (Minimum Capital Requirements)
PILLAR II (Supervisory Review of Capital Adequacy)
PILLAR III (Public
Disclosure)
DIS
CL
OSU
RE
T
O
STA
KE
HO
LD
ER
S
Strategic Planning
Product Pricing
Capital Mgmt
RE
GU
LA
TO
RY
C
API
TA
L
AD
D-O
NRegulatory Capital for Credit Risk
Cap
ital R
atio
(min
. 8%
)
TO
TA
L R
EG
UL
AT
OR
Y C
API
TA
L
Tot
al B
ook
Cap
ital
less
Ded
uctio
ns
Tot
al R
egul
ator
y C
apita
l X 1
2.5
=
Min. Capital Ratio
Internal Model Approach
Advanced Internal Ratings
(AIRB)
Basic Indicator Approach (BIA)
Regulatory Capital for
Market Risk
Regulatory Capital for Operational
Risk
Foundation Internal Ratings
(FIRB)
Board
Internal Audit
Credit Risk
Struc-tural Risk
Opera-tional Risk
Market Risk
Performance Measurement
Advanced Measurement
Approach (AMA)
Use Test Stress Test
Corporate Governance
Risk Mgmt & Reporting Mgmt
Committee
Laurentian Bank of Canada CIRANO-PRMIA
6
The New Basel II Accord Pillar I - Credit Risk - Standardized Approach
AAA A+ BBB+ BB+ B+ Below Un Past
to AA- to A- to BBB- to BB- to B- B- Rated Due
Sovereign 0% 0% 20% 50% 100% 100% 150% 100% 150%
Banks 20% 20% 50% 50% 100% 100% 150% 100% 150%
Corporates 100% 20% 50% 100% 100% 150% 150% 100% 150%
VISA 100% 75% 150%
X X Small Business 100% 75% 150%
Commercial 100% 100% 150%
X
Credit Conversion
Factor
Com
mitm
ents
Credit Conversion
Factor
X100% of exposure
20% of exposure (< or = 1 year), or else 50%
Exp
osur
es d
raw
n
On Balance Sheet Netting
Credit Derivatives
Basel IIBasel
I
50%
100%
100%
less Haircuts
75% 150%
MIN
IMU
M
RE
GU
LA
TO
RY
C
API
TA
L
100% 150%
RIS
K
WE
IGH
TE
D
EX
POSU
RE
S
Credit Risk Mitigation
Financial Collateral
LESS=
Commercial Mortgages
Residential Mortgages
Personal Lines of Credit
RISK WEIGHTS SLOTTING
Credit Risk Assessment
35% 100%Guarantees x 8% =
Laurentian Bank of Canada CIRANO-PRMIA
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Pillar I - Credit Risk - Standardized ApproachAn example...
OLD BASEL ACCORD = $ 40 K of Capital (CCF = 0% )
ExposureCredit
Conversion Factor
Risk Weights
Risk Weighted Exposure
Credit Risk
Mitigation
Min. Regulatory
Capital
$ 0.5 M X 100% X 100% = $ 0.5 M LESS 0 X 8 % = $ 40 K
$ 0.5 M X 20% X 100% = $ 0.1 M LESS 0 X 8 % = $ 8 K
Total $ 48 K
1M$ Commercial
secured Credit Line (secured by receivables with O/S
amount at $0.5 M)
Laurentian Bank of Canada CIRANO-PRMIA
8
The New Basel II Accord Pillar I - Credit Risk - Foundation Internal Rating
For illustration onlyFor illustration only
1 0.02%2 0.05%3 0.08% Receivables 35%
4 0.15%5 0.20%6 0.30%7 0.40%8 0.60%9 0.90%
10 1.50%11 2.50%12 4.00%13 6.00%14 9.00% Gold 0%
15 15.00%16 20.00%17 30.00%18 100.00% C
omm
itmen
ts sl
otte
d by
PD
Credit Conversion
FactorE
xpos
ures
slot
ted
by P
D
100% of exposure
Credit Conversion
Factor
X
X
75% of exposure
X
Unsecured Subordinated
% of Loss Given a Default
(LGD)
Residential Real Estate
75%
Unsecured Senior
Commercial Real Estate
45%
35%
40%
0%
XOther Physical
less
CR
ED
IT R
ISK
MIT
IGA
TIO
N
(Cre
dit d
eriv
ativ
es, g
uara
ntee
s, on
-bal
ance
shee
t net
ting)
X 8%=
MIN
IMU
M R
EG
UL
AT
OR
Y C
API
TA
L
Risk Rating
Average historical
probability or default
X
AD
JUST
ME
NT
FO
R C
OR
RE
LA
TIO
N &
MA
TU
RIT
Y
=
RIS
K W
EIG
HT
ED
EX
POSU
RE
S
35%
Financial Collateral
Laurentian Bank of Canada CIRANO-PRMIA
9
Pillar I - Credit Risk - Foundation Internal Rating An example ...
vs $ 48 K for the Standardized approach
ExposuresProbability of Default
(PD)
Credit Conversion
Factor (CCF)
% of Loss Given a Default (LGD)
Risk Weights
Risk Weighted Exposure
Credit Risk Mitigation
Min. Regulatory
Capital
X 0.42% X 100% X 35% X 36% = $ 0.18M 0 X 8 % $14 K
$ 0.5 M X 0.42% X 75% X 35% X 27% = $ 0.14M 0 X 8 % $11 K
Total $ 25 K
Adj
ustm
ent f
or c
orre
latio
n an
d m
atur
ity
$ 0.5 M
1M$ (Internal LBC Risk Rating 7) Commercial secured Credit Line (secured by receivables with $0.5 M O/S)
Laurentian Bank of Canada CIRANO-PRMIA
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The New Basel II Accord Pillar I - Credit Risk - Advanced Internal Ratings For illustration onlyFor illustration only
1 0.02%2 0.05%3 0.08%4 0.15% 50%
5 0.20%6 0.30% Receivables 35%
7 0.40%8 0.60%9 0.90%10 1.50%11 2.50% Corporate = 35%
12 4.00% Sovereign = 35%
13 6.00% Banks = 35%
14 9.00% Commercial = 35%
15 15.00% Res. Mortg.= 50%
16 20.00% Credit lines+VISA= 61%
17 30.00% Small Business = 35%
18 100.00%0%
50%
% of Loss Given a Default
(LGD)
Unsecured Subor- dinated 60%
Residential Real Estate
Commercial Real Estate
Unsecured Senior
Financial Collateral
Other Physical
Credit Conversion Factor (CCF)
100%
Estimate of CCF
X
AD
JUST
ME
NT
FO
R C
OR
RE
LA
TIO
N &
MA
TU
RIT
Y
=
RIS
K W
EIG
HT
ED
EX
POSU
RE
S
25%
25%
less
CR
ED
IT R
ISK
MIT
IGA
TIO
N
(C
redi
t der
ivat
ives
, gua
rant
ees,
on-b
alan
ce sh
eet n
ettin
g)
X 8%=
MIN
IMU
M R
EG
UL
AT
OR
Y C
API
TA
L
X
X
X
X
Exp
osur
es sl
otte
d by
PD
Com
mitm
ents
slot
ted
by P
D
Risk Rating
Average historical
probability or default
Laurentian Bank of Canada CIRANO-PRMIA
11
Pillar I - Credit Risk - Advanced Internal Ratings An example ...
vs $ 48 K under the Standardized approach and $ 25 K for the Foundation Approach
ExposuresProbability of Default
(PD)
Credit Conversion
Factor (CCF)
% of Loss Given a Default (LGD)
Risk Weights
Risk Weighted Exposure
Credit Risk Mitigation
Min. Regulatory
Capital
X 0.42% X 100% X 35% X 36% = $ 0.18M 0 X 8 % $14 K
$ 0.5 M X 0.42% X 35% X 35% X 13% = $ 65 K 0 X 8 % $5.2 K
Total $ 19.2 K
Adj
ustm
ent f
or c
orre
latio
n an
d m
atur
ity
$ 0.5 M
1M$ (Internal LBC Risk Rating 7) Commercial secured Credit Line (secured by receivables with $0.5 M O/S)
Laurentian Bank of Canada CIRANO-PRMIA
12
The New Basel II Accord Pillar I - Operational Risk - Basic Indicator
AVERAGEOF BANKS’
ANNUAL ADJUSTED
GROSS INCOME
OVERLAST
3 YEARS
PRESCRIBED ALPHA
FACTOR () OF 15%
x = MINIMUM REGULATORY
CAPITAL
Laurentian Bank of Canada CIRANO-PRMIA
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The New Basel II Accord Pillar I - Operational Risk - Standardized Approach
Averageof Bank’s
annual gross
income overlast
3 years
PRESCRIBED BETAFactor by Business Line
Corporate finance 18%Trading & Sales 18%Retail Banking 12%Commercial Banking 15%Payment & Settlement 18%Agency Services 15%Asset Management 12%Retail Brokerage 12%
x =MINIMUM
REGULATORY CAPITAL
Laurentian Bank of Canada CIRANO-PRMIA
14
The New Basel II Accord Pillar I - Operational Risk - AMA
Inte
rnal
Fr
aud
Empl
oym
ent
Pr
acti
ces
&
Wor
kpla
ce
safe
tyCl
ient
s,
Prod
ucts
ad
Bu
sine
ss
Prac
tices
Exec
utio
n,
Del
iver
y &
Pr
oces
s M
gmt
Corporate Finance
Trading & Sales
Payment & Settlement
Agency Services
Asset Management
Retail Brokerage
Commercial Banking
Retail Banking
Busi
ness
D
isru
ptio
n an
d Sy
stem
Fa
ilure
s
Exte
rnal
Fr
aud
Reduction in Operational
Losses
Outputs
Management Tools
Risk and Control Self-Assessment Workshops
Internal Operational Loss Data
Scenarios
Statistical Distributions
Self-Assessments
Scenario Analysis
Standardized Approach for 6 business lines
7 Categories of Operational Losses
8 Bu
sine
ss L
ines
External Operational Loss Data
I nputs
Statistical Models
Methodologies
Regulatory Capital
AMA Approach for 2
businesses
Dam
age
to
Phys
ical
As
sets
Laurentian Bank of Canada CIRANO-PRMIA
15
Who is Subject to the New Basel II Accord ?In the US
• Banks that are subject to the AIRB on a mandatory basis are those with total banking assets of $250 billion or more or total on-balance-sheet foreign exposure of $10 billion or more
• Banks not subject to the AIRB on a mandatory basis can choose voluntarily to apply this approach.
• Other banks would continue to apply the existing Basel I capital rules. Neither the standardized nor foundation approach will be permitted in the US.
• Furthermore, all banks would continue to be subject to the existing capital ratio requirements. That is, a 10% total capital ratio, a 6% tier 1 capital ratio, and a 5% leverage ratio.
Laurentian Bank of Canada CIRANO-PRMIA
16
Who is subject to the New Basel II Accord ?In Canada
• OSFI expects implementation of AIRB by October 2006 forall material portfolios in Canada and the US by domestic banks that have total capital in excess of $5 billion Canadian,or that have greater than 10% of total assets or greater than 10% of total liabilities that are international.
• For the other banks, OSFI’s guideline is less clear as there seemed to be legitimate questions about how or if the Accord should apply to other small domestic deposit-taking institutions in Canada. In other words, OSFI is debating whether smaller institutions should stay with Basel I (ex. Banks such as the recently incorporated Canadian Tire bank or Sears bank).
• OSFI confirmed to Laurentian Bank that it may choose to apply voluntarily for approval from OSFI to use the AIRB approach, so long as it meets the same infrastructure requirements that other banks must satisfy.
Laurentian Bank of Canada CIRANO-PRMIA
17
Results of the QIS3 Exercise For the Industry
Approach Group 1 Group 2
Standardized average 11% 3% minimum -15% -23% maximum 84% 81%
IRB Foundation average 3% -19% minimum -32% -58% maximum 55% 41%
IRB Advanced average -2% minimum -36% maximum 46%
G10
% Change in Regulatory Capital from Current Accord (new CP3 basis)
There’s considerable variation in the change in capital requirements from Basel I to Basel II. This reflects the relative risk insensitivity of the current accord
Portfolio Group 1 Group 2
Corporate -4% n.a.Sovereign 1% n.a.Bank 0% n.a.Retail -9% n.a.SME -3% n.a.Securitization 0% n.a.Provisions -2% n.a.Other portfolios 2% n.a.Overall credit Risk -13% n.a.
Operational Risk 11% n.a.
Overall change -2% n.a.
Contributions to change in capitalIRB Advanced
Laurentian Bank of Canada CIRANO-PRMIA
18
The banks with the greatest reduction in capital requirements are those banks with a large proportion of retail activity” Basel May 5th, 2003
0
50
100
150
200
250
Corporate Commercial Small Business Sovereign/Bank Res. Mortgages Personal Loans Line of credit &VISA
Current BIS approachNew Standardized ApproachNew IRB Foundation ApproachNew IRB Advanced Approach
Results of the QIS3 Exercise For the Laurentian Bank
Laurentian Bank of Canada CIRANO-PRMIA
19
Impact on the Industry• Banks will shift to more aggressive risk-based pricing such as in the
already tightly squeezed mortgage market as these portfolios will require even less capital. Banks who do not choose to go towards the advanced approach will not be able to compete against the 6 big banks.
• A bank that is highly concentrated in one or two of the businesses that will require more regulatory capital might face a crisis. An example: prime-based lending
• Players in the card industry that have offered large limits as a marketing tool in their approach to customers might well have to shrink unused lines
• Lending to high-quality credits will gain a strong beneficial effect and might hamper the credit offering for low quality credits.
• There could be strategic implications for portfolios of construction lending, as they are classified as “high volatility” under Basel II with capital charges starting at 8% and rising as high as 28% for weaker credits
Laurentian Bank of Canada CIRANO-PRMIA
20
Impact on the Industry (cont.)
• Big capital markets players will face higher capital charges for securitization activities and be harder hit by operational risk charges, which are based on revenues
• The potential for big banks to free up excess capital by buying a smaller bank non IRB Bank might foster mergers
• Bank money management specialists will be at a disadvantage compared with non bank fund managers due to the operational risk capital they will now have to maintain
• If a bank can structure a loan to reduce LGD by half, the capital requirement falls by half. Banks may respond by giving more emphasis to LGD. This is called “lending on collateral”. It has been a profitable lending activity for asset-based finance companies (e.g. Home Capital, GE Capital). Japan is an example of a lending system that over-emphasized collateral
Laurentian Bank of Canada CIRANO-PRMIA
21
WILL WE HAVE AN ACCORD BY 2004?• There are sharp differences between 2 leading US Banking Supervisors.
The FED is determined to reach agreement on Basel II by mid 2004 and still see the new rules come into force at the end of 2006.
• On the other end, the OCC has strong reservations as it feels the rules are excessively complex and detailed making them difficult for banks to implement and supervisors to enforce. Furthermore, they would like to see a QIS4.
• Following comments received by the banking industry, competitive effects of the New Accord are determined to be significant. Some of the big banks that are supposed to be the prime beneficiaries of Basel II have strong reserves and contend that the potential risks of the New Accord are too great.
• In Canada, banks have requested a further delay of 1 year for implementation without support from US banks have indicated that they will be ready on time.