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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
Laurentian Bank of Canada
CIRANO-PRMIA
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 ?
2
Laurentian Bank of Canada
CIRANO-PRMIA
Evolution of Basel I into Basel II
1988
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”
Risk Weights
0%
Asset Categories
Cash, Sovereign loans, Insured Residential Mortgages
Calculation of Total Capital Ratio
(as of oct 31st 2002 in $K)
Available Capital
1 249 400
Risk Weighted Assets
9 276 528
Total Capital Ratio
20%
Bank loans, Municipal loans
50%
Uninsured Residential loans
100%
All other loans and non-performing loans
13.5%
Minimum Capital
Requirements
Tier 1
Total
Basel I
4%
8%
OSFI
7%
10%
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)
3
Laurentian Bank of Canada
CIRANO-PRMIA
Old Vs New Basel Accord
BASEL I
BASEL II
 1 Pillar (20 pages)
(covers the quantification of
minimum regulatory capital)
 3 Pillars (216 pages)
Pillar 1: Min. capital requirements
Pillar 2: Supervisory review
Pillar 3: Public disclosure
 1 Methodology (approach) for
calculating minimum capital
 3 Methodologies (approaches) for
calculating minimum capital
 Not very sensitive to risk
 Uses external or internal risk ratings
to compute minimum capital
requirements for credit risk
 All credit commitments are included
 Only credit commitments
in the calculation ex. VISA,
with maturity  1 year
commitments (for LBC increases
are included in the quantification
capital between 6% & 17%)
(explains 364 day revolving lines)
 Capital relates only to credit &
market risk
 Capital relates to Credit, Market &
Operational Risk (for LBC OP risk
capital represents an additional 10%)
4
CIRANO-PRMIA
Laurentian Bank of Canada
The New Basel II Accord
OR
Regulatory
Capital for
Credit Risk
Advanced
Internal Ratings
(AIRB)
+
=
Basic Indicator
Approach (BIA)
OR
Standardized
OR
Regulatory
Capital for
Operational
Risk
Advanced
Measurement
Approach
(AMA)
+
Standardized
OR
Internal Model
Approach
Regulatory
Capital for
Market Risk
PILLAR III
(Public
Disclosure)
Corporate
Governance
RAROC
Credit Risk
Risk Mgmt &
Reporting
Mgmt
Committee
Struc-tural
Risk
Capital Mgmt
+
+
=
Board
Product Pricing
Operational Risk
Strategic Planning
Market
Risk
Internal Audit
DISCLOSURE TO STAKEHOLDERS
Foundation
Internal Ratings
(FIRB)
TOTAL REGULATORY CAPITAL
OR
Capital Ratio (min. 8%)
Standardized
Stress
Test
Use Test
=
Measurement
Total Book Capital less Deductions
Total Regulatory Capital X 12.5
Methodology
Min.
Capital
Ratio
PILLAR II
(Supervisory Review of Capital Adequacy)
REGULATORY CAPITAL ADD-ON
PILLAR I
(Minimum Capital Requirements)
Performance
Measurement
5
CIRANO-PRMIA
Laurentian Bank of Canada
The New Basel II Accord
Pillar I - Credit Risk - Standardized Approach
Credit Risk
Assessment
X
100% of
X
exposure
Credit
Conversion
Factor
X
20% of X
exposure
(< or = 1
year), or
else 50%
Basel
I
AAA
to AA-
A+
BBB+
BB+
B+
Below
Un
Past
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%
Residential
Mortgages
50%
35%
100%
Personal Lines
of Credit
100%
VISA
100%
75%
150%
Small Business
100%
75%
150%
Commercial
100%
100% 150%
Commercial
Mortgages
100%
100% 150%
75%
Credit Risk
Mitigation
150%
=
RISK WEIGHTED EXPOSURES
Exposures drawn
Commitments
Basel II
Financial
Collateral
LESS
Guarantees
Credit
Derivatives
On Balance
Sheet Netting
x 8% =
MINIMUM REGULATORY CAPITAL
RISK WEIGHTS SLOTTING
Credit
Conversion
Factor
less Haircuts
6
CIRANO-PRMIA
Laurentian Bank of Canada
Pillar I - Credit Risk - Standardized Approach
An example...
Exposure
1M$
Commercial
secured
Credit Line
(secured by
receivables
with O/S
amount at
$0.5 M)
Credit
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
X8% = $8K
Total
$ 48 K
OLD BASEL ACCORD = $ 40 K of Capital (CCF = 0% )
7
CIRANO-PRMIA
X
100% of
exposure
Unsecured
Subordinated
75%
Unsecured Senior
45%
Receivables
35%
Commercial Real
Estate
35%
X
X
Credit
Conversion
Factor
X
75% of
exposure
Residential Real
Estate
35%
Other Physical
40%
Gold
0%
X
=
RISK WEIGHTED EXPOSURES
0.02%
0.05%
0.08%
0.15%
0.20%
0.30%
0.40%
0.60%
0.90%
1.50%
2.50%
4.00%
6.00%
9.00%
15.00%
20.00%
30.00%
100.00%
% of Loss
Given a Default
(LGD)
Credit
Conversion
Factor
ADJUSTMENT FOR CORRELATION & MATURITY
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Average
historical
probability
or default
Commitments slotted by PD
Risk
Rating
Exposures slotted by PD
Pillar I - Credit Risk - Foundation Internal Rating
For illustration only
less
X 8%=
MINIMUM REGULATORY CAPITAL
The New Basel II Accord
CREDIT RISK MITIGATION
(Credit derivatives, guarantees, on-balance sheet netting)
Laurentian Bank of Canada
Financial Collateral 0%
8
CIRANO-PRMIA
Laurentian Bank of Canada
Pillar I - Credit Risk - Foundation Internal Rating
An example ...
Exposures
Probability
of Default
(PD)
Credit
Conversion
Factor
(CCF)
% of Loss
Given a
Default
(LGD)
$ 0.5 M X 0.42% X 100% X 35%
X
$ 0.5 M X 0.42% X 75% X 35% X
Adjustment for correlation and maturity
1M$ (Internal LBC Risk Rating 7) Commercial secured Credit Line (secured by receivables with $0.5 M O/S)
Risk
Weights
Risk
Weighted
Exposure
Min.
Regulatory
Capital
Credit Risk
Mitigation
36%
= $ 0.18M
0
X8%
$14 K
27%
= $ 0.14M
0
X8%
$11 K
Total
$ 25 K
vs $ 48 K for the Standardized approach
9
CIRANO-PRMIA
Laurentian Bank of Canada
The New Basel II Accord
X
Unsecured Subor60%
dinated
Unsecured
Senior
Receivables
Estimate of CCF
X
Corporate =
35%
Sovereign =
35%
Banks =
35%
Commercial =
35%
Res. Mortg.=
50%
Credit lines+VISA=
61%
Small Business =
35%
50%
35%
Commercial Real
Estate
25%
Residential Real
Estate
25%
Other Physical
50%
Financial
Collateral
0%
X
X
=
less
X 8%=
MINIMUM REGULATORY CAPITAL
100%
X
% of Loss
Given a Default
(LGD)
CREDIT RISK MITIGATION
(Credit derivatives, guarantees, on-balance sheet netting)
Credit Conversion
Factor (CCF)
ADJUSTMENT FOR CORRELATION & MATURITY
0.02%
0.05%
0.08%
0.15%
0.20%
0.30%
0.40%
0.60%
0.90%
1.50%
2.50%
4.00%
6.00%
9.00%
15.00%
20.00%
30.00%
100.00%
Exposures slotted by PD
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Average
historical
probability or
default
Commitments slotted by PD
Risk
Rating
RISK WEIGHTED EXPOSURES
For illustration only
Pillar I - Credit Risk - Advanced Internal Ratings
10
CIRANO-PRMIA
Laurentian Bank of Canada
Pillar I - Credit Risk - Advanced Internal Ratings
An example ...
Exposures
Probability
of Default
(PD)
Credit
Conversion
Factor
(CCF)
% of Loss
Given a
Default
(LGD)
$ 0.5 M X 0.42% X 100% X 35%
X
$ 0.5 M X 0.42% X 35% X 35% X
Adjustment for correlation and maturity
1M$ (Internal LBC Risk Rating 7) Commercial secured Credit Line (secured by receivables with $0.5 M O/S)
Risk
Weights
Risk
Weighted
Exposure
Min.
Regulatory
Capital
Credit Risk
Mitigation
36% = $ 0.18M
0
X8%
$14 K
13% = $ 65 K
0
X8%
$5.2 K
Total
$ 19.2 K
vs $ 48 K under the Standardized approach and $ 25 K
for the Foundation Approach
11
CIRANO-PRMIA
Laurentian Bank of Canada
The New Basel II Accord
Pillar I - Operational Risk - Basic Indicator
AVERAGE
OF BANKS’
ANNUAL
ADJUSTED
GROSS
INCOME
OVER
LAST
3 YEARS
x
PRESCRIBED
ALPHA
FACTOR ()
OF 15%
=
MINIMUM
REGULATORY
CAPITAL
12
CIRANO-PRMIA
Laurentian Bank of Canada
The New Basel II Accord
Pillar I - Operational Risk - Standardized Approach
PRESCRIBED BETA
Factor by Business Line
Average
of Bank’s
annual
gross
income
over
last
3 years
x
Corporate finance
Trading & Sales
18%
18%
Retail Banking
12%
Commercial Banking
15%
Payment & Settlement
18%
Agency Services
15%
Asset Management
12%
Retail Brokerage
12%
=
MINIMUM
REGULATORY
CAPITAL
13
CIRANO-PRMIA
Laurentian Bank of Canada
The New Basel II Accord
Pillar I - Operational Risk - AMA
Business
Disruption
and
System
Failures
Execution,
Delivery &
Process
Mgmt
Damage to
Physical
Assets
Employme
nt
Practices &
Workplace
safety
Clients,
Products
ad
Business
Practices
External
Fraud
Internal
Fraud
7 Categories of Operational Losses
8 Business Lines
Corporate Finance
Trading & Sales
Standardized
Approach for 6
business lines
Payment & Settlement
Agency Services
Asset Management
Retail Brokerage
AMA Approach
for 2
businesses
Commercial Banking
Retail Banking
Inputs
Methodologies
Outputs
Statistical Models
Statistical Distributions
Regulatory
Capital
Self-Assessments
Management
Tools
External Operational Loss Data
Risk and Control Self-Assessment
Workshops
Internal Operational Loss Data
Scenarios
Scenario Analysis
Reduction in
Operational
Losses
14
Laurentian Bank of Canada
CIRANO-PRMIA
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.
15
Laurentian Bank of Canada
CIRANO-PRMIA
Who is subject to the New Basel II Accord ?
In Canada
• OSFI expects implementation of AIRB by October 2006 for
all 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.
16
Laurentian Bank of Canada
CIRANO-PRMIA
Results of the QIS3 Exercise
For the Industry
Contributions to change in capital
% Change in Regulatory Capital from
Current Accord (new CP3 basis)
IRB Advanced
Portfolio
Group 1 Group 2
G10
Approach
Group 1
Group 2
average
minimum
11%
-15%
3%
-23%
maximum
84%
81%
Standardized
IRB Foundation
average
minimum
3%
-32%
-19%
-58%
maximum
55%
41%
IRB Advanced
average
minimum
-2%
-36%
maximum
46%
Corporate
-4%
n.a.
Sovereign
Bank
1%
0%
n.a.
n.a.
Retail
SME
-9%
-3%
n.a.
n.a.
Securitization
0%
n.a.
Provisions
Other portfolios
-2%
2%
n.a.
n.a.
Overall credit Risk
-13%
n.a.
Operational Risk
11%
n.a.
Overall change
-2%
n.a.
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
17
Laurentian Bank of Canada
CIRANO-PRMIA
Results of the QIS3 Exercise
For the Laurentian Bank
Current BIS approach
250
New Standardized Approach
New IRB Foundation Approach
New IRB Advanced Approach
200
150
100
50
0
Corporate
Commercial
Small Business Sovereign/Bank Res. Mortgages Personal Loans Line of credit &
VISA
The banks with the greatest reduction in capital requirements are
those banks with a large proportion of retail activity”
Basel May 5th, 2003
18
Laurentian Bank of Canada
CIRANO-PRMIA
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
19
Laurentian Bank of Canada
CIRANO-PRMIA
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
20
Laurentian Bank of Canada
CIRANO-PRMIA
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.
21