SFSCs Credit risk working group update

1
SFSCs Credit risk working group update

• Development of internal model methodology for
  regulatory capital (Credit Risk Only)
• September 25, 2008

2
Contents

• Introduction to working group members
• Scope and criteria for credit risk capital
• Summary of regulatory solvency models compared
• CRWGs draft proposal
• Implementation considerations

3
Introduction to credit risk working group (CRWG)

• Section 1

4
List of members of Credit Risk Working Group
(CRWG)

• Bryan Rowe, Director, Economic Capital,
  SunLife Financial
• Cam MacDougall, VP, Credit Risk Management,
  Manulife Financial
• David Ayers, Director Bond Investments (Risk
  Management) , Great West Life
• Erik Von Schilling, Senior Manager , TD Life
• Jean- Guy Lapointe, Capital Division, OSFI
• Karim Nanji, Director, Strategic Planning, Munich
  Re
• Mark Austin, Vice President, RBC
• Simone Brathwaite, Principal, Oliver Wyman

5
Scope and criteria for credit risk capital

• Section 2

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Scope Possible working definitions of credit risk

• Broad definition (aligned with Solvency II
  includes market liquidity risk)
• Credit risk is the risk of loss or of adverse
  change in the financial situation resulting from
  fluctuations in the price or value of securities
  and counterparty debt due to
• Adverse fluctuation in credit quality of issuers,
  counterparties and debtors (specific risk)
• Adverse fluctuation in market liquidity (systemic
  risk or generic spread-widening)
• Stricter definition (aligned with Basel II IRB
  excludes market liquidity risk)
• Credit risk is the risk of loss or of adverse
  change in the financial situation resulting from
  fluctuations in the credit standing of issuers,
  counterparties, and any debtors
• CRWG favoured the treatment of market liquidity
  risk under a separate risk model
• Note Market liquidity risk is also referred
  to as generic spread risk

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Objectives of internal solvency model for credit
risk

• Consistent with over-arching principles for all
  risks, such as
• Confidence level
• 1 year time horizon
• Captures all material risk drivers appropriately
  without unnecessary complexity
• Relevant and useful for managing risk
  incentives risk management
• Appropriate reflection of risk mitigation
  techniques
• Appropriate capture of diversification and
  correlations
• Widely-recognized and vetted industry approach
  an approach which is compatible internationally

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Summary of regulatory solvency models reviewed

• Section 3

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CRWG reviewed 2 regulatory frameworks 1. Basel
II formula-based approach

• Basel II approach pillar 1 Advanced Internal
  Ratings Based formula-based approaches
• Credit risk capital is determined using a
  closed-form analytical formula
• Advanced IRB - certain input parameters are
  determined internally at a transaction-level Key
  advantages
• Widely recognized by global financial industry
  and Canadian regulator
• Captures pure credit risk - loss of value due to
  defaults and migrations at
• Excludes systemic risk (market liquidity
  risk/generic spread widening)
• Consistent with the one-year time horizon
• Key disadvantages
• Single factor correlations (the economy or
  portfolio taken as the single factor)
• Also assumes infinite granularity and maturity
  multiplier cap of 5 years
• Unclear if it will integrate well with proposed
  model approaches on other risks

Basel Capital (Worst case loss Expected Loss)
x Maturity Multiplier
Capital held for default losses over 1 year time
horizon
Capital held for value loss from credit
migrations over 1 year time horizon
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and 2. proposed Solvency II model for credit risk

• 2. Proposed Solvency II approach for European
  insurers
• Credit risk capital also determined using a
  closed form analytical approach
• Where credit risk is expressed primarily by the
  volatility of credit spreads, and
• Movements in credit spreads assumed to capture
  pure credit risk and market liquidity risk
• Includes an additional explicit recognition of
  specific risk arising from high concentrations
• Key advantages
• A theoretically fully integrated model which
  captures both credit and market liquidity risk
• Disadvantages
• Cannot be used to manage risk at transaction
  level (grouped by public rating)
• Theoretically fully integrated, but unclear as to
  whether available data can appropriately
  parameterize model (e.g. not clear that data
  captures default risk- over 1 yr time horizon)
• Not used industry wide as sole approach SST
  uses this approach in combination with a default
  loss Basel II type model

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CRWGs preference is for a Basel II modified
approach

• In addition to existing regulatory models CRWG
  discussed the option of using stochastic
  portfolio models
• However, despite possible advantages, during
  discussions it was determined that neither the
  insurance industry nor the regulator would be
  ready for this option over the next 5-8 years
• As a result CRWG is in favour of using the Basel
  II advanced IRB analytical formula approach with
  possible enhancements to address
• Restricted maturity under Basell II
• Assumption of infinite granularity
• Integration with other proposed risk models
• Next steps
• MAC to prioritize modifications and investigate
  resources to specify model modifications

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CRWGs draft proposal

• Section 4

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Overview of IRB formula based approach

• The formula is based on 5 key parameters
• PD Probability of default
• LGD Loss given default
• EAD Exposure at default
• Correlation (Asset Correlation)
• Effective Maturity (similar to duration)
• The capital formulas determine Basel II capital
  net of EL
• Basel capital is intended to cover the unexpected
  loss portion of the loss distribution, whereas
  balance sheet asset values are intended to cover
  the expected loss portion
• Under the AIRB, financial institutions provide
  the PD, LGD, EAD and Effective Maturity
  parameters
• The correlation parameter is based on
  standardized formulas
• Relative to the Standardized approach, the IRB
  approaches are designed to yield a capital
  benefit via lower PDs

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The Basel II capital formula computes a capital
requirement for each holding individually . . .
Worst case loss1
Expected loss
Transaction level credit capital


Worst case default loss
Expected default loss
Maturity multiplier
Transaction level credit capital


x
Capital held against loss due to default
Multiplier accounts for value loss due to credit
migration
Maturity multiplier
Loss given default2 (LGD)
Exposure at default2 (EAD)
Transaction level credit capital

x
x
x

• Worst case losses are those that occur for the
  99.95 worst case of the economy.
• Basel II assumes static LGD and EADthe same
  values are used for the worst case and
  expected scenarios

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. . . and sums the transaction level numbers to
generate a portfolio level capital requirement
Portfolio level credit capital
Transaction level credit capital
S

• Portfolio capital represents the aggregate worst
  case loss minus the aggregate expected loss by
  summing transaction-level capital
• The Basel methodology assumes infinite
  granularity in the portfolio, not capturing the
  effects of single-name concentration

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Implementation considerations

• Section 4

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What to expect for internal approval

• OSFI will expect a rigorous validation framework
  to confirm the accuracy and consistency of the
  Companys internal rating system
• Approval will also depend on the robustness of
  quantification, corporate governance oversight,
  quality of documentation, and the use test
• For further details - See CAR A-1 (Chapter 5) and
  Implementation notes for IRB institutions on
  OSFIs website
• http//www.osfi-bsif.gc.ca/osfi/index_e.aspx?artic
  leid1218
• http//www.osfi-bsif.gc.ca/app/DocRepository/1/eng
  /guidelines/capital/guidelines/CAR_A1_e.pdf
• For companies planning to seek approval on
  implementation date (2014)
• Provide statement of intent before Oct 14, 2008
• Gap analysis, implementation planning (with OSFI)
  before 2011
• Formal application by 2012
• Parallel reporting 2012-2014
• Full internal model approval by 2014 (and ongoing
  compliance)