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Risk Based Supervision under Basel II Jeffrey Carmichael

Cartagena February 16-18, 2004

Outline
What

is the risk based approach? How does it apply to banks? How does it apply to regulation? How does it apply to supervision? Challenges arising from Basel II

Colombia February 2004

Presentation: Jeff Carmichael

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What is the Risk-Based Approach?


No universally-accepted definition Meaning depends on the situation Most widely accepted proposition would be that a risk-based approach requires that you:

Identify risks and apply resources where the risks are greatest
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1. How Does this Apply to Banking? Major sources of banking risk:


Credit Risk Market Risk Liquidity Risk Operational Risk Question: Which is the greatest risk?
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Experience Late 80s & Early 90s


Widely agreed that credit risk is dominant experience in the 80s/90s was good reminder Developed markets - worst loan losses for 50 years Common characteristics:
o o o o excessive exposures to individual borrowers excessive exposures to sectors excessive reliance on collateral poor credit evaluation

All arose primarily from credit risk


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RMA & FMCG Survey


Stock Price Performance 89-97 Ave annual return Risk (SD) Sharpe Ratio Lower Loan Losses 25% 22% .08 Higher Loan Losses 16% 44% .02

Better Credit Mgt. = Higher & More Stable Returns


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Also Found ...


Payback to better risk management goes beyond protecting share price
helped better serve customer needs enabled better business decisions

Returns to investing in risk management are very high


compared losses under best practice with cost of improvements - suggested return of 1,000% over 10 years
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Colombia February 2004

Main Advances Since Then


Improved data management Improved credit grading from one-dimensional to two dimensional (PD and LGD) Shift to portfolio risk assessment

Credit risk modelling


Risk-based pricing, provisioning and reward structures Integrated risk management Risk-based capital allocation
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Motivation for Advances


Bankers remember the pain Shareholders react to differential losses

Competition is increasing
The tools are available

There is more to lose (rewards are tied to performance)


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2. Risk-Based Regulation
The central Pillar of banking regulation is capital adequacy
Starting with the first Capital Accord in 1988 banking regulators began imposing risk-weighted capital adequacy requirement The philosophy is straightforward greater risk requires greater capital
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Interaction Between Regulation and Banking Practice

As noted - banks now allocate capital internally to activities and areas according to the risks taken Not widespread before the first Basel Accord in 1988 Accord encouraged banks to think in terms of risk-based capital allocation Since then, banks have generally gone well beyond the 1988 Accord - hence one of the primary motivations for Basel II Case for change is in the divergence between regulatory capital and banks assessments of economic capital required for risk - illustration .
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Economic Vs Regulatory Capital


% 35 30 25 20 15 10 5 0 AAA AA A BAA BB B CCC-C Current Proposed Economic Capital (High Side) Economic Capital (Low Side) % 35

Economic

30 25 20 15 10 5 0

Basel I 8%

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Presentation: Jeff Carmichael

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The Challenge for Basel II

Need for greater risk sensitivity than Basel 1 and its one size fits all Approach Need for a framework that is credible, sound and reflective of industry practices Need to be more incentive compatible with desire of regulators to promote and enhance good credit risk management Problem - there is no standardized approach agreed by industry for the measurement and management of credit risk (unlike market risk)
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The Outcome

A menu approach:
Standardized (modified from Basel I); IRB Foundation IRB Advanced

Standardized is still blunt like Basel I IRB approaches are an attempt to approximate what the industry is doing It stops short of allowing banks to use their own models entirely for assessing capital adequacy It allows banks to use some of the critical inputs to their models (PD, LGD, EAD) but constrains the way they are combined to assess capital adequacy

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3. Risk-Based Supervision
Again the idea of a risk-based approach = apply resources where the risks are greatest
Thus a supervisor following a risk-based approach will attempt to:
Identify those banks in which risks are greatest Identify within each bank those areas in which risks are greatest Apply scarce supervisory resources so as to minimizing the overall regulatory risk
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Risk Rating Banks


Most regulators use some form of rating system (e.g. CAMELS) for banks Following the experience of banks many have moved to a two-dimensional grading scale; e.g.
PF - probability of failure CGF - (systemic) consequences given failure

Colombia February 2004

Presentation: Jeff Carmichael

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Example - PAIRS
APRA Reviewed developments in US, UK and Canada Developed PAIRS system (Probability and Impact Rating System) As in banking - risk grading system should not eliminate subjectivity but the discipline imposed by a structured approach should increase objectivity Back up with peer review and quality control
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Conceptual Framework for PF


Inherent Risk

_ Management & Control _ Capital Support


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Risk of Failure PF

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The Structured Approach


The Impact rating is based largely on size - with some management over-ride if needed PF x Impact (CGF) = index of supervisory attention The Index of Supervisory Attention is exponential from 1 to 56,000 The Index is grouped into:
Normal Oversight Mandated Improvement Restructure
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Supervisory Attention Grid


'PAIRS' PROBABILITY RATING LOW I M P A P C A T I R R S A T I N G low EXTREME
NORMAL OVERSIGHT

MEDIUM high
MANDATED IMPROVEMENT

HIGH

EXTREME

RESTRUCTURE

RESTRUCTURE

MANDATED

HIGH

NORMAL

OVERSIGHT

IMPROVEMENT

RESTRUCTURE

MANDATED

MEDIUM

NORMAL

NORMAL

OVERSIGHT

IMPROVEMENT

RESTRUCTURE

MANDATED

LOW

NORMAL

NORMAL

IMPROVEMENT

RESTRUCTURE

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Beyond Risk Grading


Risk-based supervision requires better risk grading to identify the institutions posing the greatest risks It also requires targeted inspections and investigations It requires judgement and graduated supervisory responses

This is where Basel II has focused its attention through Pillar 2


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Pillar 2 - Supervisory Review


Philosophy:
1. Pillar 1 Capital Framework is only an approximation - it is not entirely comprehensive 2. Capital is critical in mitigating risk but it is not the only relevant factor - a bank should have sound processes and procedures for measuring, monitoring and managing risk
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Supervisory Review Process


Use tools available to assess how accurately Pillar 1 matches minimum capital with risks taken by the bank Use tools available to understand how strong a banks processes & procedures are and how well they are implemented Use supervisory judgement to impose additional supervisory requirements (including capital) where residual risk is excessive
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Assessing the Adequacy of a Banks Capital


Principle 1: Banks should have a process for assessing capital relative to risks and a strategy for maintaining it Supervisors:

Review the risk assessment processes for relevance and comprehensiveness - does the bank recognise other risks such as interest rate risk? Identify inconsistencies Check that management is engaged Assess application and controls - are processes followed? Require stress tests
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Colombia February 2004

Specific Guidance
Interest Rate Risk in the banking book Operational Risk Definition of default Risk mitigation Concentration Risk

Securitization

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Presentation: Jeff Carmichael

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Demands Related to IRB


Banks that choose IRB need to meet a series of demanding qualifying and validation criteria These have been set out in detail by the Basel Committee - along with guidance about what and how to check The on-going monitoring of the appropriateness and application of these model-based risk management processes is a fundamental part of Pillar 2 supervisory review - especially stress testing
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Responding to Assessed Risks


Principle 2: Supervisors should take enforcement action if not satisfied with a banks approach to risk management Principle 3: Supervisors should expect banks to hold above the minimum and should be able to require them to do so Principle 4: Supervisors should intervene early to prevent capital falling through the minimum
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Is Pillar 2 Really Anything New?


To the extent that Pillar 2 emphasises:
Assessment of risks Supervisory judgement & discretion Active enforcement

It is just an extension of the already growing riskbased approach to supervision It does provide detailed guidance - but many countries already exercised this type of approach

Problem was - not all countries could!


Pillar 2 formalises the central role of flexibility Without that flexibility Basel II is a waste of time
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Summary
The risk-based approach is about identifying risks and devoting resources to where they will be most effective in reducing risks This approach is as critical in banking as it is in regulation and supervision In regulation it requires that capital requirements are greater where risks are greater In supervision it requires supervisors to:
Assess where the risks are greatest Intervene and enforce standards flexibly where the risks are greatest

Pillar 2 of Basel II provides a framework for the assessment and intervention process Pillar 2 is a fundamental component of Basel II
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Thank You

Colombia February 2004

Presentation: Jeff Carmichael

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Risk-Based Supervision: Challenges under Basel II

ARMICHAEL
ONSULTING Pty Ltd

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