Risk Management Workshop Colombia: From Theory to Implementation

1
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
Case Study South Africa on the road to Basel
II Pieter Strydom Partner, Ernst Young, South
Africa
2
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
Overview of presentation
3
Overview of presentation 

• Introduction The banking sector in South Africa
• Attitude towards Basel II in South Africa
• Ernst Young survey on Basel II readiness in
  South Africa
• Developments in bank supervision at SARB
• Developments at Bank A
• Developments at Bank B

4
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
1. Introduction The banking sector in South
Africa
5
1.1 The banking sector in South Africa

• 48 banks in SA
• 15 in process of de-registering or closing down
• 7 with limited operations
• 19 remaining of which the big 5 represent 90 of
  market
• Average Basel 1 Capital adequacy 12.6

6
1.2 Total Assets of Banks
7
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
2. Attitude towards Basel II in South Africa
8
2.1 Growing consensus

• Basel I is outdated
• Weakened link between risk and capital
• Internationally active banks will be forced into
  Basel II by rating agencies
• Basel II will reward excellence
• Basel II fits in with risk management initiatives

9
2.2 Standards and codes

• Standards and codes set by international
  bodies, and widely adopted, will provide
• useful basis for improved market functionality
• benchmarks against which banks can be measured
• national practices to reduce un-level playing
  fields and regulatory arbitrage
• markets forces and peer pressure will make
  adoption mandatory
• soft law, which can be more effective than
  hard law enshrined in legislations
• Basel II with its close link between risk and
  capital requirement is fully endorsed by banks in
  South Africa

10
2.3.1 Basel II is complex

• Banking itself is becoming more complex
• Risk management requirements are highly
  sophisticated (assigning equal risk weights to
  all loans is unrealistic)
• Simplicity and greater risk sensitivity are not
  mutually compatible objectives
• Banks with simpler business models have options
  under Basel II to reduce complexity

11
2.3.2 Basel II will reinforce pro-cyclical effect

• Linking the regulatory charge to the quality of
  assets will bring them in line with the business
  cycle
• This can lead to an increase in volatility of
  asset prices and loan interest with the potential
  danger of creating a boom to bust cycle in
  credit markets
• Banks may be encouraged to stop lending at a time
  when the real economy is most vulnerable

12
2.3.2 Basel II will reinforce pro-cyclical effect

• Pro-cyclical behaviour is already endemic and
  perhaps acceptable in order to establish a more
  risk sensitive capital regime
• Countermeasure is to build excess capital in good
  times to have a margin of protection in a
  downturn
• Capital requirements under Pillar 1 should be
  augmented by the capital requirements under
  Pillar 2 and Pillar 3 in order to reinforce the
  incentive to maintain a cushion of capital above
  the minimum

13
2.3.3 Involvement of rating agencies

• Limited penetration 5
• Unique problems with listed exposures
• Low trading volumes volatile markets
• Duel listings flow of funds
• Lumpy exposures concentration risk
• Danger of herd thinking

14
2.3.4 Rating agency data sharing

• Problem creating statistical pool to rate Medium
  Corporate Advances
• Big banks extracting information on 10 000
  account for 3 years on default and non default
  accounts will provide a 90 statistical pool
• To be given to one or more agencies to calculate
  the quantitative (theoretical) PD
• Banks to use this PD as the quantitative basis to
  confirm their own qualitative PD
• Next phase to pool information on LGD - but

15
2.3.5 Required capital of 10 compared to 8

• As a result of South Africas country rating of
  BBB, no local exposure can be rated above BBB
  before taking into consideration collateral
• Banks believe continued use of capital adequacy
  of 10 dont not make sense as their internal
  models already take into account the systemic
  volatility in the SA market resulting in double
  counting of systemic risk of SA

16
2.3.6 Capital requirements for SMEs

• SMEs are essential to build the economy in
  developing countries
• Additional capital requirements for advances to
  SMEs can be used to convince government agencies
  to provide additional collateral or support in
  order for a bank to make these advances

17
2.3.7 Cross border investments in Africa

• Cross border implementation of Basel II for SA
  banks with investments in various African
  countries
• Not all of these African countries have the
  regulatory environment or capacity to enable
  local banks to reap any regulatory benefit in
  line with the host country

18
2.3.8 Cost of implementing IRB and AMA

• Be positive a large portion of the cost would
  have been incurred in order to enhance risk
  management procedures and should not be blamed
  on Basel II
• Bank regulators will need to take steps as their
  own additional costs (internal and external) will
  escalate in order to do model evaluation, etc.

19
2.3.9 Operational risk

• Infant stage AMA might result in implementing one
  of the standardised approaches
• Gross income as the driver for operational risk
  capital is open for debate
• The double whammy effect of high margin
  advances (to cater for high delinquency) will
  cause a higher credit capital charge and a higher
  capital charge on the high interest margin
• Data sharing on operational risk is problematic

20
2.3.10 Ability of Regulator to cope

• In order for the Big 5 banks to implement the IRB
  approaches from inception in 2007
• process from Guidelines to Regulations to be
  completed
• political approval process to be completed
• Big 5 banks see little benefit in a standardised
  approach as there is no fit to their risk
  management structures
• Big 5 banks believe standardised approaches can
  be seen as Basel 1.2 and not as Basel II

21
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
3. Ernst Young survey on Basel II readiness in
South Africa
22
3.1 Introduction to survey

• Timing Second quarter 2003
• Population
• 48 banks in SA
• 15 in process of de-registering or closing down
• 7 with limited operations
• 19 remaining, of which 12 participated
• Methodology first used in Luxembourg

23
3.2 Summary of results

• Banks are partly prepared
• Re-evaluation of the way business is conducted
• Banks will be ready for implementation
• Technology seen as the major problem/expense

24
3.3 Key challenges

• Data collection
• Improvement of credit environment
• Implementation costs
• Regulatory uncertainty
• Skills availability
• Disclosure requirements

25
3.4 Opportunities

• Integrated risk management approach
• Align regulatory and economic capital more
  closely
• Better understanding of their business
• Improve investor relations
• Improve market discipline

26
3.5 Results per question
27
3.6 Tier structure model

28
3.7 Methodology used

29
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
Developments in bank supervision at
SARB (Website resbank.co.za)
30
4.1 SARB structured workgroups
31
4.2 SARB Implementation Plan

• 4.2.1Strategic plan
• To address issues regarding work streams, project
  plans, implementation measures, regulation
  approval process, staffing, funding, etc.
• 4.2.2 Position paper
• Due February 2004 to indicate the approach SARB
  will take in implementing Basel II in SA
• Comments to be coordinated through workgroups

32
4.2 SARB Implementation Plan

• 4.2.3 Compilation of Regulations
• Use the regulatory work group to give guidance on
  the content of the regulations
• Legal department of SARB will write regulations
• First draft regulations for standardised
  approaches submitted for approval by end of 2004
• In the interim work with banks on the IRB and AMA
  approaches to develop regulations at a later
  stage
• 4.2.4 Readiness assessment
• First one in November 2003 on Basel II
• To be repeated after June 2004
• Basel II readiness subject of all trilateral
  meetings

33
4.2 SARB Implementation Plan

• 4.2.5 Test data
• Gave 5 banks the names of 10 corporate clients
  (includes high quality and volatile) and the
  description of a retail portfolio
• Requested the PD for each corporate loan, the PD
  for the retail portfolio, the capital requirement
  for both portfolios and a description of models
• Results were consistent PDs for high quality
  corporate exposures
• However, PDs for volatile corporate exposures
  and the retail portfolios were not sufficiently
  consistent
• Next phase to investigate reasons for
  inconsistent results

34
4.2 SARB Implementation Plan

• 4.2.6 Model validation
• Believe will be able to go a long way in doing
  model validation by
• getting information from the various banks
• benchmarking the results
• requesting banks to use different assumptions in
  their model
• Model evaluation will start early
• based on sensitivity testing
• using different assumptions
• on different models
• of different banks
• Coordinate the model validation with other
  Regulators

35
4.2 SARB Implementation Plan

• 4.2.7 Economic impact
• An economic impact study will be initiated under
  the Economic Impact Workgroup to evaluate the
  effect on the economy to use Basel II looking
  at
• The effect of the lower capital requirement on
  residential mortgages
• The effect of the SA 10 capital requirement
  versus the international minimum of 8
• Capital requirement for lending to SMEs
• The extent of Double whammy on high margin
  lending

36
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
5. Developments at Bank A
37
5.1 Attitude towards Basel II

• Bank already has an economic capital model in
  line with Basel II principles
• Started internal credit rating models from 1999
• As bank operating internationally it needed an
  investment rating which makes implementation of
  Basel II compulsory
• Performance bonuses are based on return on
  economic capital above a hurdle rate

38
5.2 Goals for Basel II

• Advance IRB for retail credit
• Foundation IRB for corporate credit
• Advance measurement approach for operational risk
  if at all possible

39
5.3 Responsibility for Basel II

• Basel II falls under capital management
• Operating division is responsible for own
  economic capital management
• Economic capital is calculated on Basel II
  principles
• Bonus is based on economic capital divisions
  therefore already optimising their economic
  capital by using Basel II principles for credit
  risk
• Divisions fully aware that they manage risk and
  that capital management only measures risk
• Basel II not a project but the day-to-day
  responsibility of business units as it adds value
  to the risk management process

40
5.4 Initiative - Operational risk

• Dont agree with basic indicator approach or use
  of gross income to calculate the capital charge
• Developed qualitative and self assessment
  information
• Created lost data base for purposes of optimising
  insurance cost
• Data base to combine all these under development
• Will keep operational capital charge centrally
  and allocate by transfer pricing system
• Operational risk only monitored centrally but
  managed by individual business units

41
5.5 Regulator positive view

• The Regulator has various methods to evaluating
  models
• Benchmarking
• Comparisons of assumptions
• Same data through different models
• No need to verify detailed workings of models

42
5.6.1 General

• Banks in non-investment rated countries should
  consider the benefit to implement Basel II other
  than on a standardised approach (benefit in risk
  management measures not in Capital savings)
• Banks should be allowed a maximum of 15 of group
  assets not to be subject to the IRB approach,
  subject to confirmation by the Regulator to
  prevent cherry picking of assets

43
5.6.2 General

• A staged rollout period to allow for credit
  portfolios to be measured under IRB from 2007 to
  2010 (in line with the UK proposal)
• In the interim Basel I would be used on the
  portfolios not yet rolled out
• The requirements in terms of IAS 39 on provisions
  are not in line with Basel II although they have
  some common data requirements

44
5.7 Warning

• Concerned that a false confidence in
  statistically quantification of risk can cause
  potential market distortions
• The bank will continue to use its internal
  ratings and only use external ratings as a point
  of reference and investigate any differences more
  than three notches
• Basel II only measures risk risk must continued
  to be managed at operational level

45
5.8 Negotiation with Government

• The bank also believes that Basel II will assist
  in negotiations with Government regarding the
  extension of credit to certain sectors of the
  economy as the black box effect of pricing of
  credit risk can be reduced
• The bank used the principles of Basel II to
  calculate credit risk price as the basis of
  negotiations with Government for the purchase of
  a portfolio of advances from a bank in distress

46
5.9 Disclosure under Pillar III

• This bank is very active in the Disclosure
  Workgroup
• Already completed discussion documents to
• compare disclosure requirements under Basel II
  with the accounting disclosures required under
  the various banking-related GAAP statements
• compile a suggested disclosure model for banks in
  order to comply with both Basel II and with GAAP

47
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
6. Developments at Bank B
48
6.1 Attitude towards Basel II

• Fully supports Basel II and sees it as a natural
  development of risk management
• Integrated Basel II in the business plans of
  business units in order to use
• advance IRB for retail credit
• foundation IRB for other credit risk
• standardised approach for operational risk
• migrate to advance operational risk approach in
  future

49
6.2.1 Project - Risk rating models

• Model development and validation
• Scorecard development and validation
• Approval by Regulator

50
6.2.2 Project - Data collection and integration

• Default data
• Exposure data (for EAD)
• Collateral data (for LGD)
• Default data (for PD)

51
6.2.3 Project - Operational risk

• Framework
• Tool selection and implementation
• Risk assessment
• Key risk indicator
• Incident management
• Capital calculation (AMA methodology)

52
6.2.4 Project - Regulatory relationship
management

• 25 regulators
• Various countries
• Varied satisfaction levels

53
6.3.1 Challenge - Program management

• Sustaining momentum given negative international
  utterances on Basel II
• Co-ordinating complex initiatives
• Getting budget approval for initiatives
• Getting sufficient specialised skills (risk, IT
  and programme management)
• Other priorities specifically anti-money
  laundering

54
6.3.2 Issue - Non-South African operations

• Strategy for implementation
• Approval process duplication with other
  regulators
• Alignment of systems
• Is group-wide system feasible?

55
6.4.1 Concerns Regulator

• Will Regulator allow
• capital to go below 10
• deviation between big banks
• Some of the big 5 banks to use models and others
  not
• (only 1 bank has a market risk model approved)
• Time available to
• Approve credit models
• Development of regulations
• Regulations for standardised approach developed
  first
• Later development of regulation for advanced
  approaches
• Both to be completed long before 2007
• Number of resources at Regulator

56
6.4.2 Concerns General

• SA was an early adopter of IAS39 (Recognition
  and Measurement of Financial Instruments)
  substantial problems were experienced with this
• The combined volatility effect of IAS 39 and
  Basel II on capital should be considered
• Are we underestimating the effect of implementing
  Basel II considering the spend by international
  banks?
• Are we arrogant to think that we will be able to
  do the same with a substantially smaller spend?

57
Risk Management Workshop Colombia From Theory to
Implementation Cartagena, Colombia 16-19 February
2004
END OF PRESENTATION