Basel 2: Current Status

1
Basel 2 Current Status

• Phil Rogers, HSBC Bank Credit and Risk
• 25 July 2006

2
What is Basel 2?

• A more risk sensitive, method of assessing the
  capital adequacy of financial institutions..
• which encourages banks to develop more
  sophisticated credit and operational risk
  management techniques
• whilst preserving the overall level of capital in
  the banking system

3
3 Pillars

• Pillar One Minimum Capital Requirements.
  (Bottom up)
• Pillar Two Supervisory Review Process. (Top
  down)
• Pillar Three Market Discipline (Public
  Disclosure)

4
3 Types of Risk will Require Capital

• Credit Risk. Far more sophisticated approach
  than current Basel 1 Accord
• Operational Risk. New capital charge
• Market Risk. Modified version of current rules.
  Defined by the Trading Book Review, 2005

5
Legal Framework

• The BIS Framework Document, published July 2005,
  known as Basel 2, is an agreement of Central
  Bankers only. It has no legal status
• In the EU the legal authority derives from the
  Capital Requirements Directive (CRD), September
  2005 - not identical with Basel 2
• In the UK the Rules are implemented by the FSA
  Prudential Source Book (BIPRU) - not identical
  with CRD

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3 Approaches to Credit Risk

• Standardised Approach (SA), a modified version of
  Basel 1. Generally regarded as suitable only for
  smaller banks
• Foundation Internal Ratings Based Approach
  (FIRBA)
• Advanced Internal Ratings Based Approach (AIRBA)

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3 Approaches to Operational Risk

• Basic Indicator (capital based on 15 of income).
  Suitable only for smaller banks
• Standardised (capital based on 12 to 18 of
  income depending on risk of individual business
  lines)
• Advanced Measurement (capital assessed using the
  Banks operational risk models)

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Timings for Credit Approaches

• Standardised Approach and Foundation IRB
  Approach From 1 January 2007. Must be in place
  by 1 January 2008
• Advanced IRB Approach From 1 January 2008
• IRB Approaches have experience requirements for
  the use of ratings and a 1 year parallel run
• US has delayed until 2009 at the earliest, but
  delay in the EU considered unlikely

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Basel 2 Credit Parameters

• Probability of Default (PD)
• How likely is it that the customer will default
  in a 12 month period?
• Exposure at Default (EAD)
• What will exposure to the customer be at default?
• Loss Given Default (LGD)
• How much of the exposure at default will be lost?

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IRB Foundation re Advanced

• For Foundation IRB banks estimate only PD for
  non-retail exposures. EAD and LGD are set by the
  regulators. For retail exposures banks estimate
  all 3 parameters
• For Advanced IRB banks estimate PD, LGD and EAD
• Advanced is, therefore, more costly, more complex
  and subject to higher quality standards but
• It is intended that there should be capital
  incentives for banks to adopt more comprehensive
  and accurate measures of risk

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Credit Risk associated with an exposure is a
function of the characteristics of both borrower
and facility
Credit Risk of Transaction
Borrower characteristics
Facility characteristics
How much exposure do you have to this facility?
What would you expect to lose on this facility if
the customer defaults?
Who are you lending to?
Probability of Default (PD - )
Exposure at Default (EAD - )
Loss Given Default (LGD - )
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Expected Loss

• Long run average of losses in a portfolio
• Analysis should be based on at least one full
  economic cycle (but most UK banks do not have the
  data)
• Is not part of capital calculation, but is a cost
  to the business.
• Is expected by Basel 2 to be covered by
  provisions. Any difference between EL and
  provisions must be explained and a capital
  adjustment may be necessary

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Components of Expected Loss

• 12 month Probability of Default (PD)
• Loss Given Default (LGD)
• Exposure at Default (EAD)
• PD x LGD x EAD Expected Loss

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Examples of Expected Loss
Expected Loss () / ()
Probability of Default ()
Loss Given Default ()
Exposure at Default ()

x
x
PD - 0.07
LGD - 39.5
EAD - 2.8m
784 0.028
x
x

LGD - 24
470 0.017

x
x
LGD - 11
216 0.01
x

x
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Unexpected Loss

• Part of Regulatory and Economic Capital
  Calculation
• Is a function of PD, LGD, EAD plus Loss
  Volatility
• Level is determined by complex algorithms
• For Regulatory Capital algorithms are set by the
  regulator

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Expected Unexpected Loss
Portfolio 1
Portfolio 2
Source Moodys KMV
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Examples of Basel 2 RWA and Capital Calculations
Maturity
PD ()
EAD ()
LGD ()
Credit Risk Basel II Formula
Maturity
EAD
PD
LGD
EL
RWA
Capital
2.5 Years
2.8m
7bp
39.5
784
599,977
47,998
24
470
359,986
28,799
11
216
164,994
13,199
1.2
39.5
13,440
2,451,210
196,097
24
8,064
1,470,726
117,658
11
3,696
674,083
53,927
Total Capital RWA8
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Outstanding Issues

• Downturn LGD/EAD. The Rules require estimates to
  be based on downturn experience. UK data not
  available for many portfolios. Uncertainty re
  what will be acceptable
• Governance. Draft FSA Rules require material
  aspects of credit rating systems to be signed off
  by a main Board member. Practicality under
  discussion
• Stress Testing. Draft FSA Rules require banks to
  stress ratings for a 1 in 25 year event.
  Practicality for large banking groups under
  discussion with the FSA

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Outstanding Issues (2)

• Use Test. Banks are required to use Basel 2 risk
  measures in their day to day business but the
  level of conservatism required by the Regulators
  creates challenges in some areas
• Home/Host. Balance of responsibility between
  home and host regulators not always clear,
  especially outside EU. Implications of the US
  delay not fully defined
• Pillar 2. Practicalities of the Internal Capital
  Adequacy Assessment Process (ICAAP) unclear

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Summary

• Banks and other financial institutions must move
  to Basel 2 by 1 January 2008. Some will already
  be parallel running
• Higher quality business will attract more capital
  than at present and vice versa
• Many financial institutions are upgrading risk
  management processes to meet the new demands
• Some uncertainties but, in the EU at least, it
  will happen