OSFI Basel II An overview of the IRB Credit Risk Approval Process and Using Credit Data Reporting as an Approval

Tool

Presentation to the CSRSA Conference June 13, 2006 by Peter Cheung, Manager Basel Implementation Division, OSFI

Contents
Overview of IRB Approval Process Key Supervisory Considerations Credit Data Reporting Overview Questions

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Contents
 Overview of IRB Approval Process Key Supervisory Considerations Credit Data Reporting Overview Questions

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Basel II Implementation Milestones

Basel Committee released the Revised Framework in May 2004 Quantitative Impact Analysis(QIS) completed IRB Gap analysis onsite reviews commenced in Jan 2004 on a quarterly basis OSFI Consultative Paper on the New Basel Framework issued in June 2004 OSFI Discussion papers on the following AIRB Guidelines were issued in July 2004:
Approval of AIRB approaches Collateral Management Principles for AIRB Banks Data Maintenance at AIRB Banks The Use of Ratings and Estimates of Default and Loss at AIRB Banks Validating Risk Rating Systems at AIRB Banks Risk Quantification of IRB Systems at IRB Banks Corporate Governance and Oversight at IRB Banks

AIRB Banks submitted draft Rollout plans in Dec 2004. Formal Application date - Oct 31, 2005 Parallel run Nov 1, 2006 OSFI conditional approval of applications July 31, 2007 Accord Implementation - Nov 1, 2007
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Approval Review Phases

Phase 1- Monitoring of implementation efforts (Nov/04 to Jan/06) Phase 2 - Formal application (Feb/06 to July/06) Phase 3 OSFI approval reviews (Aug/06 to July/07) Phase 4 Pillar 1 approval ( Aug/07 to Dec/07 or Feb/08) Phase 5 Ongoing monitoring (from Nov/07)

We are currently at Phase 3

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Key Approval Review Principles

IRB Approval Review principles are consistent with the key principles of the OSFI Supervisory Framework: Approval is risk based Reliance based Approval is a work-in-progress and will evolve No surprises Reviews are tailored to the institution The Basel II minimum requirements are the IRB entry requirement standard and OSFI Approval of IRB Approaches Implementation Note Capital impact assessment Effective cooperation with foreign-country supervisors

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Credit Risk Approval Review Process (April/06 to Dec/07)

Approval reviews will consolidate the results from:
Reviews of application packages and Self-assessment process Supervisory Activities

Supervisory Activities:
Gap Meetings and status updates ongoing activity, focused on implementation progress against rollout plans, updates to extensions/waivers, changes to PMO & budgets RRS Specific Reviews (Examinations) - verification of self-assessments ( in coordination with IA work). Microlevel, specific sampling using criteria/standards focused on Minimum Requirements & Implementation Notes Review & monitoring of data submissions for accuracy, timeliness & completeness

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Approval Review Structure

Approval Review Structure

Self-Assessment Process Corporate Governance And Oversight; Internal Audit PMO

RRS Design and Operations Data Management

Validation, Risk Quantification Capital Adequacy Assessment Use Test

Waivers and Extensions

Integrated Review Decision

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Contents
Overview of IRB Approval Process  Key Supervisory Considerations Credit Data Reporting Overview Questions

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Use Test Considerations: Overview

Three key use test areas to consider in the assessment of use test performance:
Macro-use related to governance and oversight Performance track record and demonstration Micro-use related to internal loss estimates

Domestic Use Test expectations are set out in OSFIs IRB Implementation Note Use Test is an entry condition for IRB approaches, viz.
IRB processes should be integrated with overall risk management Banks should use the most appropriate measure for the purpose at hand, however, banks must show an implementation consistent with IRB Banks can use point-in-time measures for capital planning and through-the-cycle measures for IRB, but both measures should be consistent with a underlying common model

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Use Test Considerations: Individual Elements

Use test is about understanding and demonstrating the internal pressures that affect the development of IRB estimates
Systems and estimates should be developed for use outside of regulatory reporting

There are a number of individual elements related to use test that could potentially be considered:
Pricing
The use and application of risk-based pricing Conditional vs. unconditional PDs

Comparison (reconciliation?) of Economic and Regulatory Capital

This is a key requirement for greater flexibility in strict use Different estimates should be demonstrated as consistent Banks are responsible for making the case

Performance Measurement
Contract definition and incentive-compatibility
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Use Test Considerations: Individual Elements (continued)

Individual elements related to use test
Role of IRB information in capital decision-making
Information from IRB systems should play a key role

Granularity of use in decision-making

No prescribed approach The bank will need to make the case that use is effective

Common data vs. common measures

Common data is a start Consistent vision of risk Risk measures should be consistent but different

So-called capital optimization

Use expectation of individuals and groups should be commensurate with their respective role and responsibility Other perspectives of use test
Board and senior management oversight of IRB systems History of using processes, models, parameters
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IRB Risk Quantification & Validation: Background

Banks must meet the broad risk-quantification standards for own-estimates of PD, LGD and EAD
PD estimates must be a long-run average of 1-yr default rates LGD estimates must reflect economic downturn conditions EAD estimates must be a long-run default weighted average EAD

Banks must have a robust system in place to validate the accuracy and consistency of rating systems, processes, and the estimation of all relevant risk components
Internal validation processes should be designed to provide an EFFECTIVE CHALLENGE to the outputs of internal rating systems

Risk quantification and validation remains a key implementation focus for banks and supervisors
The Accord Implementation Groups Validation Sub-Group (AIGV) is a forum for supervisors to promote IRB validation (and implied risk quantification) discussion and information exchange
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IRB Risk Quantification & Validation: Downturn considerations

The Pillar 1 capital formula is driven by an assumption that defaults (and possibly severity of default) is driven by a (single) systematic factor Whether or not a bank accepts the Pillar 1 capital formula, it must develop a view on the influence of systematic factors to show that long run averages really represent the long-run to demonstrate conservatism, where historical data does not incorporate stress years to demonstrate adherence of the capital planning process to the requirements set out in paragraphs 434-437 (stress testing used in the assessment of capital adequacy) to identify stress years in order to produce a downturn LGD to explain differences between realised outcomes and estimates (validation requirements) Downturn LGD estimates some questions to consider: Where is this applicable? What are the drivers of downturn (where applicable)? What are the plausible ranges of drivers that are applicable to downturn and why?
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Implementation Considerations: Overarching Points

The completion of Basel II implementation is largely within the grasp of banks. However, much work remains before (and after!) the start date of Basel II
Basel II wont disappear as Y2K did Greater comfort and use over time Ongoing requirements after the start date of Basel II

What might success look like overall?

Pillar 1 processes (e.g., IRB) are seamlessly integrated with overall risk management A capital planning process that succeeds in
predicting Pillar 1 requirements (and dynamics) understanding the interplay of Pillar 1 and Pillar 2 measures explaining Pillar 1 outcomes to market participants (Pillar 3)

A flexible system that allows risk management to evolve and permits banks to answer new questions with old data
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Implementation Considerations: Some Issues

Technology is a necessary, but not a sufficient condition
Significant time and resources have been focused on technology and data maintenance solutions While important, the fundamental requirements of risk measurement and risk management often remain

Risk Quantification and Validation (IRB)

Risk measurement methodologies will need to be innovative in order to appropriately develop IRB estimates
Long-run estimates (history, condition ranges, etc) Downturn LGDs (drivers, condition ranges, etc)

Validation processes should create a mosaic of evidence by combining information from various sources (both quantitative and qualitative)
The effective challenge principle permits a range of possible approaches to structuring this work

Data limitations mean an increasing and necessary role for expert judgment (credit experts and quants are complements not substitutes!)
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Implementation Considerations: Some Issues (continued)

Demonstrating a clear understanding of credit RWA dynamics
Acceptance of IRB approaches will mean that a bank has adequately assessed the dynamic drivers of credit RWA
How is regulatory capital expected to vary through the economic cycle? How does this dynamic process compare and contrast with that of a banks internal, capital assessments? (Pillar 1/Pillar 2 interplay) How does stress testing help answer the above?

Review and explanation of capital reporting requirements is key to managing expectations of different stakeholders
Parallel reporting is the first real opportunity for a meaningful dress-rehearsal of systems and processes that support capital computation Analysis of results is essential to promoting greater comfort with the outputs of Pillar 1 approaches recognizing and relating changes/differences to risk comparing capital drivers over time (and to QIS) continued track record, post-implementation

On going demonstration of compliance

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Supervisory Activities: Self-Assessment and Approval Recommendation

Review of Self-Assessment Packages

Self-Assessment Process Review

Technical/ RRS Specific Exam Reviews

Conclusion on Self-Assessment

Data Submission Quality Assessment

Basel Readiness Assessment

Status/ Gap Meetings

Approval Recommendation
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Contents
 Overview of IRB Approval Process Key Supervisory Considerations Credit Data Reporting Overview Questions

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Background
OSFI presently collects supervisory data from banks for the following:
Financial Statements Credit Risk Market Risk Liquidity Capital Securitization

Basel II requirements for approval and ongoing on-site work and monitoring, resulted in revising the capital and credit risk data requirements. Allowed flexibility in the data requirements during the parallel run period Also provided flexibility in reporting requirements for domestic and international subsidiaries for capital and credit risk data.

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Scope of Credit Risk Data Analytics

Tool to compliment the established Approval process in IRB risk rating performance To assess the Financial Institutions credit risk profile To determine the need for specific reviews To enable peer comparison and relative benchmarking On-going monitoring to support credit risk assessment Use of early warning capabilities

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Work to date - Credit risk data

Developed the list of data requirements within OSFI Presented the data tables for Wholesale and Retail metrics to CBA and obtained agreement for the data call during 2005 Final data requirements for both wholesale and retail were substantially reduced from initial data ask based on industry comments Provided data definitions, taxonomies and technical specifications to the CBA in October 2005. Set up a OSFI support model to answer questions on the above. Developed a modified credit risk data call for Standardized banks Internal work efforts underway to develop analytic reporting capabilities using a business intelligence tool (COGNOS).

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Portfolios that intend to report on the IRB Approach, begin reporting Oct 31st 2006
Portfolio Approach Internal Ratings Based Ready and Approved Expected by Nov 1, 2007
Begin reporting Oct 31, 2006 for 4 quarters (i.e., Q1, Q2, Q3 and Q4 of 2007) of meaningful dress rehearsal

Internal Ratings Based Transitional and To Be Approved Expected by Nov 1, 2010

No impact on Capital Adequacy Report requirements Financial Institutions are expected to submit internal management reporting that is sufficient to characterize the risk associated with these portfolios Reports should generally reflect the types and dimensions of data presented in the data call documents Submission of the electronic data call is expected as soon as the systems are in place, even if this is before the ultimate approval date

Not Necessarily Internal Ratings Based Standardized / Immaterial

Nothing submitted to OSFI beyond the requirements of the Capital Adequacy Report Financial Institutions are expected to submit management reporting that is sufficient to characterize the risk associated with these portfolios

Credit Data Reporting

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Details of the credit risk data call

Credit risk data is to be submitted via either of two means:
Electronic flat file structure to be submitted via Automated Data Transmission facility A standardized Excel template has been created for some Economic Capital, Back testing and Transition Matrices. These to be provided via CD or other electronic medium.

Initial focus is on the Deposit Taking Institutions adopting the Advanced Internal Ratings Based Approach although similar deliverables have been created for those that have adopted the Standardized Approach. CBA has received business and data definitions from OSFI. These documents are also available on the OSFI website.

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Basel II Credit Data Support: Submission of Inquiries

Please submit all inquiries regarding credit data to this address using the proposed structure (see appendix): CreditDataSupport@osfi-bsif.gc.ca

OSFI Website: www.osfi-bsif.gc.ca

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Appendix: Basel II Credit Data Support - Proposed Structure for Inquiries

To expedite inquiries, please ensure that the following items are covered in each question submitted: Inquiry References: For any Business or Technical inquiry, please provide: Full Document Title Document Page Number and Section number (if applicable) Document Schedule Number/Reference (if applicable) Inquiry: A concise summary of the question. Background: Sufficient background information that supports the inquiry. Proposal: A suggested or proposed response or solution that the institution has considered in relation to the inquiry submitted.

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QUESTIONS?