Capital role and requirements in banks

1
Capital role and requirements in banks

• Pat Ryan

4 April 2006
2
Capital

• Why does a bank hold capital?
• Simplified bank balance sheet

Liabilities
Assets
Loans 100
Deposits 90
Capital 10
3
Context and Need - Role of Capital

• Why is capital important?
• Needed to cover the risks undertaken
• Some Operational capital needed for
  infrastructure and working capital
• Maintain confidence in the bank
• How much capital is required?
• Economic capital
• Regulatory capital
• 1988 Basel accord Basel I
• Basel II
• Target rating

4
Economic v Regulatory Capital

• Economic capital
• Amount required to cover true need of the
  business
• Taking account of risk profile of business and
  resilience required
• Regulatory capital
• Amount required to demonstrate solvency to the
  Regulator

5
Differing capital gearing emphasis
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Eligible Capital

• Tier 1
• Paid up ordinary shares, retained earnings,
  certain disclosed reserves
• Perpetual preference shares and other very
  subordinated debt
• Minority interest in subsidiaries
• Tier 2
• Tangible fixed asset revaluation reserves,
  collective provisions
• Various forms of less subordinated debt approved
  by the Regulator
• At least 50 of eligible capital must be made up
  of Tier 1

7
The Relationship Between Shareholders, Capital
and Risks
Board strategy decisions risk appetite
Shareholders
Other sources of capital
Level of capital required
Increase in shareholder value
Risks in business
Performance on a risk-adjusted capital base
Market pressure
Pricing
8
Capital management

• Subordinated Debt Issuance
• Credit Derivatives
• Securitisation

9
Structure of Securitisation Arrangement
Secured Assets
Other Assets
Bank X
SPV
Cashflow on secured assets
Initial Capital
Interest capital payments on ABS
Debt holders
Initial Capital
10
Expected Loss

• Bad debts fluctuate throughout the economic cycle
  but display an average tendency over time
• Expected loss rate is the expected annual bad
  debt rate over a full economic cycle
• Expected losses are predictable and should be
  recovered in loan pricing

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Loss variability
Expected or normal losses are predictable and
need to be recovered.
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Capital

• Capital is required to protect banks against
  unexpected losses.
• Capital provides a cushion to ensure that banks
  can weather the storms and avoid becoming
  insolvent.
• How much capital should be held against
  unexpected loss?

13
Unexpected Loss Capital
The banks target debt rating determines how much
unexpected loss is covered by capital
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Target Debt Rating Capital
Capitalisation level to achieve AAA rating
15
Target Debt Rating Capital
Capitalisation level to achieve BBB rating
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Target Debt Rating Capital
Capitalisation level to achieve AA rating
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Performance Management Taking Capital Into
Account

18
Implementing RAROC / Economic Profit
Risk Pricing
Risk Customer Profitability
Front Line Applications
Risk Quantification
Economic Capital Expected Loss
RAROC PLs Capital Allocation Risk-adjusted
Compensation
Management Applications
EAD
LGD
PD
RAROC Risk Adjusted Return on Capital
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Economic Profit by Business Unit
Figures are illustrative
20
Basel II Enhancing Risk Management

21
Discussion Outline

• Introduction and Background
• The Three Pillars of Basel II
• Programme Structure
• Implementation of Basel II
• Basel II Application
• Regulator Relationship
• Impacts
• Challenges

22
Basel II

• Introduction Background

23
The Basel II Accord

• The Basel II Accord is a set of regulations
  aiming at a sound risk management practice in
  banks.

24
Basel I

• Basel II Accord will replace the original Basel
  Accord (Basel I), which is the current standard
  for capital adequacy in over 100 countries.

• Basel I was published by the BIS in 1988. It
  introduced rules for capital adequacy based on
  the level of risk of assets
• It includes credit risk and market risk
  components in the calculation of asset risk
• Relatively simple rules were used to calculate
  level of credit risk by assigning risk weights to
  asset types
• The minimum capital ratio was set at 8 of a
  banks total Risk-Weighted Assets (RWA)

25
Basel Timeline - Key Dates
Accord finalised
Implementation
Jan 2007
Jan 2006
Jan 2005
Jan 2008
Jan 2009
Jan 2010
Jan 2004
26
Basel II

• The Three Pillars

27
Structure of Basel II
The Three Pillars to Basel II
DISCLOSURE
MINIMUM CAPITAL
SUPERVISORY REVIEW
I
II
III
28
Structure of Basel II
Stipulating capital charges to motivate banks to
improve their risk management and measurement
capabilities
Pillar I Minimum Capital
Requirements
Creating a supervision framework to encourage
best risk practices and to mop up other risks
(e.g. strategic, reputational)
Pillar II Supervision
Requiring banks to disclose, in detail, capital
structure, risk exposures and capital adequacy
Pillar III Market Discipline
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Pillar 1 Overview

• Pillar 1 stipulates the minimum capital
  requirement to mitigate risks arising from the
  banks assets and operations.

Minimum Regulatory Capital
8

Credit risk Market risk Operational risk

• Total capital Tier 1 Tier 2
• Tier 1 Shareholders equity disclosed reserves
• Tier 2 Supplementary capital (e.g. undisclosed
  reserves, provisions)

Total Capital
unchanged
Credit Risk

• The risk of loss arising from default by a
  creditor or counterparty

new sophisticated measures
Market Risk

• The risk of losses in trading positions when
  prices move adversely

unchanged
Operational Risk

• The risk of loss resulting from inadequate or
  failed internal processes, people and systems or
  from external events

new measures and explicit charge
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Pillar I Credit Risk
Pillar 1 Credit Risk stipulates three levels of
increasing sophistication. The more sophisticated
approaches allow a bank to use its internal
models to calculate its regulatory capital. Banks
who move up the ladder are rewarded by a reduced
capital charge
REDUCED CAPITAL REQUIREMENT
Banks use internal estimations of PD, loss given
default (LGD) and exposure at default (EAD) to
calculate risk weights for exposure classes
INCREASED SOPHISTICATION
Advanced Internal Ratings Based Approach
Foundation Internal Ratings Based Approach
Banks use internal estimations of probability of
default (PD) to calculate risk weights for
exposure classes. Other risk components are
standardized.
Standardized Approach
Risk weights are based on assessment by external
credit assessment institutions
31
Operational Risk
Simple
Intermediate
Advanced
Advanced Measurement Approach
ADVANCED
Standardised approach
Standardised Approach
Basic Indicator Approach
Internal measurement approach
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The Three Pillars to Basel II
DISCLOSURE
MINIMUM CAPITAL
SUPERVISORY REVIEW
I
II
III
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Pillar II - Supervisory Review Process

• Four Principles

Review of Internal Assessment Response
Internal Assessment of Capital Adequacy
Requirement to hold capital above minimum
Early intervention with remedial action
Principle II
Principle IV
Principle 1
Principle III
Institutions
Regulator
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Pillar II - ICAAP

• ICAAP
• Internal Capital Adequacy Assessment Process
• Basel II requires that banks implement an
  enterprise-wide risk management framework that
  links regulatory (Pillar 1) and economic capital
  (Pillar II).
• Pillar I is about minimum regulatory capital
  requirements for credit, market and operational
  risk.
• Pillar II requires banks to assign (economic)
  capital to all their material risks to determine
  their overall capital adequacy
• An ICAAP framework is required to meet this
  requirement

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Elements of ICAAP Framework

• Accountabilities
• Use
• Risk Appetite
• Culture

Governance

• Risk Processes
• Identify
• Assess
• Manage

Economic capital
Capital
Risk

• Risks
• CR
• MR
• OR

• Composition Targets
• Planning Allocation
• Regulatory Economic Capital

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Pillar I II

Pillar I Review
Pillar II Review
Review of regulatory capital calculation and
compliance with min requirements
Review of internal capital calculation and
compliance with min requirements - ICAAP
Institutions will be required to explain the
differences between their regulatory and
economic capital
Supervisors will determine required level of
capital that institutions should hold
Outcome of Review Individual Capital Guidance
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The Three Pillars to Basel II
DISCLOSURE
MINIMUM CAPITAL
SUPERVISORY REVIEW
I
II
III
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Pillar 3 - Market Discipline
Disclosure requirements that allow market
participants assess key pieces of information on
risk and capital adequacy

• Qualitative quantitative disclosure on capital
  and capital adequacy
• Disclosure of risks and techniques used to
  identify, measure, monitor, and control key
  banking risks
• Disclosure if using different approaches to
  assessment of regulatory capital
• Disclosure based on the concept of materiality,
  at a minimum on a semi-annual basis
• Management has discretion in the appropriate
  medium for disclosure (e.g website, regulatory
  filings) for those that are not mandatory under
  accounting or other requirements
• Failure to comply with mandatory disclosure could
  result in remedial action, e.g cannot apply IRB

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Pillar 3 - Market Discipline
What impact will these requirements have?

• Substantially increases disclosures to the market
  - much more detail required than in the past
• Banks required to have a formal disclosure policy
  in place
• Varying degrees of information required on a
  quarterly, half-year and year-end basis
• Information will be used by analysts and
  investors to compare and analyse a banks
• risk management practices,
• risk exposure,
• capital planning approach and
• ability to withstand adverse market events

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Basel II

• Typical Programme Structure

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Basel Programme Structure
Basel II Project Director
Technology
Planning Programme Mgt
Pillar 2 3
Market risk
Regulatory Capital
Ratings
OperationalRisk
Communications
Regulator Interface
Tools
Infrastructure
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Basel II

• Implementation

43
Basel Timeline - Key Dates
Accord finalised
Implementation
Jan 2007
Jan 2006
Jan 2005
Jan 2008
Jan 2009
Jan 2010
Jan 2004
44
4 Major Deliverables...
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Rating Tools

• Build Basel-compliant rating tools
• Across all material portfolios
• Integrate these tools into to be technology
  infrastructure
• Integrate these tools into use in the business

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Rating Tool Development

• Develop rating model prototypes
• Model Approach Data Collection
  Statistical Analysis
• Build Validate Calibration
  Pilot
• Assess solution impacts
• Implement rating solutions
• Re-rate portfolios
• Use test compliance

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Operational Risk Framework

• Basel II requires banks to have a well-documented
  and readily auditable framework for Operational
  Risk identification, assessment, monitoring,
  reporting and control/mitigation
• Implement enterprise compliant Basel II processes
  and structures
• IT enable the enterprise Operational Risk
  Framework
• Embed Operational Risk Management in enterprise
  culture and behaviour

48
Building a Regulatory Capital Engine
From this
Calculation of Capital under Existing Rules
Exposure
Risk Weight
8
Capital Requirement
x
x

20
0
50
100
Risk Assets
OECD Banks
Residential Mortgages
Govt
Other
49
Building a Regulatory Capital Engine
To this
Capital under IRB Foundation
Exposure
Risk Weight
8
Capital Requirement
x
x

EAD
LGD 45
8
Capital Requirement
PD
M 2.5yrs
Credit Risk Mitigation
x
x
x
x
-

Grading / Scoring Systems
Product Type
Supervisor Estimates
Account Level
Each Asset Class
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Pillar II - ICAAP Framework

• ICAAP could be delivered via five work streams
• WS1 - Economic Capital Calculation
• WS2 - Economic Capital IT Solution (data mart)
• WS3 - Stress Testing and Concentrations
• WS4 - ICAAP integration and submission to
  regulator
• WS5 - Strategic Direction

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Basel II

• Application AIB example

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What is the Basel Application?

• Banks require the formal approval of the
  Financial Regulator to use an IRB Approach
• Single Application on behalf of AIB Group
• The Financial Regulator will use the Application
  to assess its readiness/compliance with the
  requirements of Basel II/Capital Requirements
  Directive
• FSA National Bank of Poland also involved in
  the review
• Structure of the Application
• Two key elements
• Preliminary Information
• Final Application
• Information to be prepared on a licensed entity
  basis
• Sign off required by the Group CEO

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Basel II

• Regulator Relationship

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Regulator Relationship

• Banks dealing with multiple Regulators -
  consistency of approach
• High level of interaction with Regulators
• Working groups
• College of supervisors
• Basel updates
• Bank - Regulator relationships
• Regulator - Regulator relationships home / host
  issue

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Basel II

• Impacts

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Who will Basel Impact?
External Relationships
Shareholders
Information Technology
Customers
Board Members
Lenders
Risk Management
Finance Management
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Key Impacts

• Shareholders
• Potential release of capital may present
  opportunities
• Improved risk management processes should
  positively impact share price
• More information available to market
• Board Members
• Increased governance and responsibilities
• Consider other opportunities if capital is
  released
• High cost of programme
• Risk Management
• Improved risk management techniques
• Increased regulator interactions
• Resource demands

58
Key Impacts

• Finance Management
• Additional reporting requirements - both
  regulatory and statutory
• Management of ICAAP - capital management
  considerations
• Lenders
• New rating systems
• More information on customers required
• IT
• Significant systems aspects
• Data quality and governance improvements required
• External Relationships
• Increased interaction with rating agencies,
  regulators investors
• More information available

59
Basel II

• Challenges

60
Challenges

• Scarce Resources
• Multiple pulls on the same resources from a
  number of areas.
• Heavy use of external resources
• Large requirement for knowledge transfer
• Costs
• Tight timeframe
• Extracting business benefits
• Interpretation challenge
• Bottleneck challenge for Regulator
• Business-as-usual