A New Capital Adequacy Framework Basel II Presentation by OSFI JulyAugust 2004

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A New Capital Adequacy Framework (Basel
II)Presentation by OSFIJuly-August 2004
Office of the Superintendent of Financial
Institutions
Bureau du surintendant des institutions
financières
July-August 2004
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Presentation Outline

• Overview of Basel II
• Standardized Approach
• Credit Risk Mitigation
• Securitization
• Operational Risk
• Pillar 2
• Pillar 3

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Overview of Basel II
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Pillar 1 Options
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Credit Risk - Internal Ratings Based Approach
(IRB)
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Credit Risk - IRB Key Elements

• Four variables
• Probability of default (PD) of borrower
• Loss given default (LGD)
• Maturity (M)
• Exposure at default (EAD)
• Risk weights are a function of these four
  variables and type of exposure (e.g., corporate,
  SME, retail)

Foundation
Advanced
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Credit Risk Standardized Approach
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Credit Risk - Standardized Approach

• Compared to current CAR (Capital Adequacy
  Requirements)
• Recognition of external ratings
• Broader recognition of collateral and guarantees
• Reduced capital for retail and mortgage
  portfolios
• Increased capital for commitments
• Increased capital for past-due loans
• Capital charge for operational risk

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Current CAR

• Under current CAR, there are four risk-weights
  based on the type of asset
• 0 - Cash and Government Securities
• 20 - OECD Banks and Securities Firms
• 50 - Uninsured Residential Mortgages
• 100 - Everything else

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Basel II - External Ratings

• Banks may use assessments by qualifying rating
  agencies to determine risk weights for the
  following exposures
• Claims on sovereigns and central banks
• Claims on non-central government public sector
  entities (PSEs)
• Claims on multilateral development banks (MDBs)
• Claims on banks and securities firms
• Claims on corporates

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Eligible ECAIs

• National supervisors are responsible for
  determining whether an External Credit Assessment
  Institution (ECAI) meets the qualifying criteria
• Supervisors must also assign eligible assessments
  to the applicable risk weight categories
• OSFI proposes to develop a self-assessment
  template and work with agencies to develop a
  mapping process

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Claims on Sovereigns and Central Banks

• Current CAR - all sovereigns weighted at 0
• No longer distinction between OECD and non-OECD
• Based on a sovereigns external rating
• Preferential treatment can apply to exposures
• to a banks own sovereign (or central bank)
• denominated and funded in national currency
• Sovereign risk-weight creates a floor for other
  exposures in that jurisdiction

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Claims on Sovereigns and Central Banks

• Another option is to use ECA (Export Credit
  Agencies) risk scores
• Can use either
• the risk scores published by individual ECAs or
• the consensus risk scores of ECAs participating
  in the Arrangement on Officially Supported
  Export Credits through the OECD
• OSFI will allow this treatment for sovereign
  exposures that are not externally rated

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Claims on Public Sector Entities (PSEs)

• Current CAR - PSEs weighted at 0, 20, or 100
• Under Basel II, all PSEs will receive a
  risk-weight one category higher than its
  sovereign of incorporation with two exceptions
• Claims on Canadian provincial or territorial
  govts treated as claims sovereigns
• PSEs in competition with private sector treated
  as corporate exposures
• Definition of PSEs remains unchanged

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Claims on Multilateral Development Banks (MDBs)

• Current CAR - receive 20 risk weight
• Under Basel II, split into two groups
• (1) Highly rated MDBs that meet eligibility
  criteria receive 0 risk weight
• (2) For all others, risk weight is based on the
  external credit assessment of the MDBs

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Claims on Banks and Securities Firms

• Directly linked to risk-weighting of sovereign
  one category less favourable than the sovereign
  risk weight
• Securities firms may be treated as banks if these
  firms are subject to supervisory and regulatory
  arrangements comparable to those under Basel II
  otherwise treated as claims on corporates

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Claims on Corporates

• Current CAR - risk-weighted at 100
• Under Basel II, DTIs can choose between two
  options
• Use external ratings to determine the risk weight
• Risk weight all corporate exposures at 100

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Claims on Retail

• Current CAR - 100 risk weight
• Under Basel II risk weight reduced to 75
• Criteria for inclusion in retail portfolio
• Exposure to an individual person or small
  business
• Exposure takes the form of certain products
• Retail portfolio should be sufficiently
  diversified
• Aggregated exposure to one counterparty cannot
  exceed 1 million (approx. CAD 1.6 million)

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Claims secured by residential mortgages
(uninsured)

• Current CAR - 50 risk weight
• Under Basel II risk weight reduced to 35
• Criteria for residential mortgage treatment
• Property occupied by borrower or rented
• Limited to 1-4 unit building
• Loan-to-value ratio cannot exceed 75
• Uninsured collateral mortgages that would
  otherwise qualify as residential mortgages except
  that their loan-to-value ratio exceeds 75 percent
  will receive 75 risk weight

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Claims secured by residential mortgages (contd)

• OSFI proposes to modify its definition of
  qualifying residential mortgages,
• To include condominium residences and
• To require that the mortgage loan be to a
  person(s) or guaranteed by a person(s)
• Excluded are investments in hotel properties and
  time-share properties
• Claims secured by commercial real estate will
  receive 100 risk weight

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Past due loans

• Currently, no distinction between performing and
  non-performing loans
• Under Basel II, unsecured part of a non-mortgage
  loan that is past due by more than 90 days
  receives following risk weight
• 150 when specific provisions are less than 20
• 100 when specific provisions are 20 or more
• Residential mortgages (uninsured) that are past
  due by more than 90 days receive 100 risk weight

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Off-balance sheet positions commitments

• RWA CCF x RW
• Apply credit conversion factors (CCF)
• Short-term commitments (i.e. up to one year
  original maturity) receive 20 CCF (increased
  from 0)
• Commitments with maturity of greater than one
  year remains unchanged at 50 CCF
• Only commitments that are unconditionally
  cancellable receive 0 risk weight
• Apply risk weights based on the counterparty

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Standardized Approach - Credit Risk Mitigation
(CRM)
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Definition of CRM Techniques

• Techniques used to reduce credit risk,
  encompassing
• Collateral (cash or securities)
• Third party guarantees
• Credit derivatives
• On-balance sheet netting

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Changes to CRM framework under Basel II

• Expanded range of eligible collateral and
  guarantors
• Explicit guidance for credit derivatives
• Recognition of netting effects in on-balance
  sheet positions
• Special treatment for repo transactions
• Two approaches for determining the effectiveness
  of collateral
• Simple Approach
• Comprehensive Approach

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Collateral - Minimum operational requirements

• Legal certainty a bank must ensure that it has
  the right to liquidate or take possession of
  collateral in a timely manner
• Low correlation with exposure credit quality of
  the counterparty should not be positively
  correlated to the value of collateral
• Robust risk management process to ensure that
  legal conditions are met, that collateral is
  liquidated promptly and that the custodian (if
  any) properly segregates collateral from its own
  assets

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Collateral in Current CAR

• A short set of eligible collateral
• Cash on deposit at the lending bank
• OECD sovereign securities
• OECD non central government public sector entity
  (PSE) securities
• Some multilateral development bank securities

0
20
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Eligible Financial Collateral

• Under the simple approach
• Cash
• Gold
• Debt securities with, at least, a BB- rating (for
  sovereign and PSEs), a BBB- rating (for other
  issuers) or A3P3 (for short-term securities)
• Unrated debt securities if they are (i) issued by
  banks, (ii) listed and (iii) senior
• Equities included in a main index
• Under the comprehensive approach
• All instruments listed above
• Equities not included in a main index but listed
  on a recognized exchange

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Collateral - Simple Approach

• Similar to Current Accord substitution approach
• Collateral must be revalued at least every six
  months
• No maturity mismatch
• Floor at 20, except for cash and government
  securities
• Approach designed for banks that engage only to a
  limited extent in collateralized transactions

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Collateral - Comprehensive Approach

• Adjust the exposure amount and value of
  collateral using haircuts to account for
  fluctuations in the future market value of each
• 3 different methods are available to determine
  the appropriate haircuts
• DTIs using the Standardized Approach may use one
  method application of supervisory haircuts

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Supervisory Haircuts
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Formula of Comprehensive Approach

• General formula of the comprehensive approach
• E the adjusted exposure
• E the gross amount of exposure
• C the amount of collateral
• Hc the haircut for the collateral

E max0, E C x (1 Hc )
 
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Comprehensive Approach - Example

• Step 1 Calculate adjusted amount of exposure
  (E)
• Step 2 Multiply the adjusted amount of exposure
  by the risk weight of the counterparty
• Example
• Loan of 100 to a 100 risk-weighted
  counterparty, collateralised by bonds up to 80
• Risk weight of the borrower is 100 and the
  haircut is 10
• Adjusted exposure 100 80 x (1 0.10) 28
• Risk weighted loan 28 x 100 28

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Guarantees and Credit Derivatives

• Contracts must be direct, explicit, irrevocable,
  and unconditional
• Capital treatment remains unchanged
  substitution approach
• Minimum operational requirements
• Eligible guarantors
• Sovereigns, PSEs, banks and securities firms
  attracting a more favourable risk-weighting than
  the obligor
• Other entities rated A- or higher

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Guarantees Operational Requirements

• Eligible guarantees
• Guarantees provide a direct and unconditional
  claim on the guarantor
• The bank acquires the right to pursue the
  guarantor for monies outstanding, rather than the
  obligor
• Explicitly documented obligation
• Covers all types of payments the obligor is
  supposed to make

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Credit Derivatives Operational Requirements

• Eligible protection
• total return swaps and credit default swaps sold
  by eligible guarantors mentioned above
• Operational requirements
• Credit events should include failure to pay,
  bankruptcy and restructuring. If restructuring is
  not included, capital benefit will be discounted
• In case of cash settlement, there should be a
  robust valuation process
• If obligation delivery, the transfer process must
  be certain
• Parties determining credit events should be
  clearly identified
• Asset mismatch between underlying obligation and
  reference obligation is permissible if both rank,
  at least, pari passu and if cross-default clauses
  are in place

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On-balance sheet netting

• Banks may net loans to and deposits from the same
  counterparty if there is a netting agreement with
  this counterparty
• Operational requirements
• Legal certainty of the netting agreement
• Assets and liabilities must be determinable
• Bank monitors roll-off risks
• Bank monitors and controls relevant exposures on
  a net basis

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Standardized Approach - Securitization
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Securitization

• Different treatment for originating bank vs.
  investing bank
• Risk weight for a tranche is based solely on the
  external rating
• If a tranche is not rated, it must be deducted
  from capital
• Exceptions
• Look-through for most-senior tranche
• 2nd loss positions in ABCP
• Eligible liquidity facilities

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Securitization Risk Weights
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Securitization - Off-balance sheet exposures

• For off-balance sheet exposures, apply a credit
  conversion factor and then risk weight the
  resultant credit equivalent amount
• All off-balance sheet exposures will receive 100
  credit conversion factor (CCF) except
• Eligible liquidity facilities
• Eligible servicer cash advance facilities

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Securitization - Off-balance sheet exposures

• Eligible liquidity facilities that meet criteria
  may apply
• 20 CCF for original maturities of less than 1
  year
• 50 CCF for original maturities of more than 1
  year
• 0 CCF to eligible liquidity facilities only
  available in the event of a general market
  disruption
• Eligible servicer cash advance facilities
• Servicer cash advances that are unconditionally
  cancellable without prior notice may be eligible
  for 0 CCF

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Operational RiskApproaches
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Basic Indicator Approach

• Simplest of the three approaches
• No specific qualifying criteria DTIs encouraged
  to comply with Sound Practices paper
• Capital charge Gross Income x 15
• Gross Income is
• net interest income net non-interest income
• three-year average positive gross income

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Standardized Approach

• Banks must map their business activities into
  eight Basel business lines (Annex 6)
• Average three-year gross income used to calculate
  capital charge

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Advanced Measurement Approach

• Banks can use their internal capital assessment
  techniques to calculate capital charges
• Both qualitative and quantitative standards
• Approach must incorporate certain key elements
• Internal data
• External data
• Scenario analysis
• Business environment and control factors

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AMA - Subsidiaries

• Non-significant subsidiary may use an allocated
  AMA to determine its capital charge
• Management of subsidiary responsible for own
  assessment of operational risk and controls
• Allocation methodology subject to approval
• Significant subsidiary may be required to
  calculate a stand-alone AMA capital
• Cannot incorporate group-wide diversification
  benefits
• May incorporate diversification benefits arising
  at sub-consolidated level
• AMA capital calculation needs to reflect the
  risks and control environment unique to the
  subsidiary

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Pillar 2 Supervisory Review Process
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Pillar 2

• Pillar 2 is based on four key principles
• Banks' own assessment of capital adequacy
• Supervisory review process
• Capital above regulatory minimum
• Supervisory intervention
• Target capital ratios of 7 and 10

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Pillar 3 Market Discipline
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Pillar 3

• Enhanced disclosure imposes discipline on
  management
• Imposes minimum disclosure requirements on banks
• qualitative and quantitative
• credit risk, market risk, operational risk,
  interest rate risk