Regulatory Convergence under Post Basel II: some comments

1
Regulatory Convergence under Post Basel II some
comments

• Giovanni Majnoni
• Contractual Saving Conference
• Washington, DC, May 1, 2002

2
The Second Consultative Document

• The January 2001 Consultative Document is over
  600 pages long (against the 26 pages of the 1988
  Capital Accord the 62 pages of the March 2000
  Consultative Document). Why is it more complex?
• From one to three approaches (Standardized,
  Foundation IRB, Advanced IRB).
• From one to three pillars (Capital, Supervisory
  Review, Market Discipline)
• Better definition of additional sources of risk
  (operational risk interest risk in banking books)

3
The present (tentative) timetable

• October 2002 A new Quantitative Impact Study
  (QIS3) will be launched to supplement the
  information gathered in the two previous
  exercises
• Early 2003 review of results from the QIS3
• Spring 2003 release of a third Consultative
  Document
• Late 2003 (?) Finalization of the new Capital
  Accord.
• 2006 (?) - Implementation of the new Accord

4
A still evolving regulatory design

• More extensive coverage of expected losses
• Operational risk reduction from a 20 to a 12
  charge and possibly even further under the
  advanced measurement option
• Greater recognition of collateral and receivables
  
• Modified risk weight curve for corporate,
  sovereign, inter-bank, residential mortgage and
  other retail exposures
• Forthcoming paper on securitization.

5
A still evolving regulatory design

• An example of the changes deriving from the
  ongoing calibration exercise
• Capital charges for a corporate exposure with
  default probability equal to 20 was equal to
  over 50, in the second Consultative Paper and
  has been brought down to 30 in the November 2001
  risk weights revision.

6
The two challenges of the revised Capital Accord

1. To provide a new definition of regulatory capital
   more in line with the risk exposure of banking
   books. By reducing the misalignment between
   economic and regulatory capital a risk based
   capital regulation should reduce the perverse
   incentives to keep in the banking books only the
   riskier assets.
2. To provide a regulatory framework for banks with
   different levels of sophistication and banking
   systems at different levels of developments.

7
Three building blocks (pillars)

• The first Pillar is represented by the specific
  minimum capital requirement regulation.
• The second pillar recognizes the importance of
  supervisory review as a tool for encouraging
  banks to improve their risk management.
• The third pillar is represented by market
  discipline. It is therefore related to disclosure
  initiatives intended to increase the level of
  transparency of the banks risk and capital
  position

8
Pillar 1 the Standardized approach

• New risk weighting for corporate
• The 150 risk bucket applies to
• BB- rated assets (previously B-)
• Unsecured portion of assets past due gt90 days
• High risk equity (venture capital other).

1988 June 1999 June 1999 January 2001 January 2001
100 AAA to AA- A to B Below B- Unrated 20 100 150 100 AAA to AA- A to A- BBB to BB- Below BB- Unrated 20 50 100 150 100
9
Pillar 1 the Internal Rating Based (IRB)
approach.

• The IRB builds on internal credit risk rating
  practices. It represents the innovative
  elements of the new proposal.
• Two major options
• The simpler foundation IRB
• The more complex advanced IRB.
• Banks must meet an extensive set of eligibility
  standards (qualitative requirements) to use the
  IRB approach

10
The structure of IRB approach (1).

• It relies on rating systems differentiated by
  borrowers and by facilities.
• Breakdown of bank portfolio into six categories
• Corporate Sovereign BankRetail Project
  finance Equity.
• Required parameters for assessing the risk
  exposure (the amount of potential credit losses)
• Probability of Default (PD) for any of the six
  categories.
• Losses in the event of default defined as Losses
  Given Default (LGD).
• A measure of actual credit risk exposure called
  Exposure At Default (EAD).
• Maturity (M) of the credit instrument.
• Expected losses (EL) are equal to PDxLGDxEAD.

11
The structure of IRB approach (2).

• A common notion of default based on the
  occurrence of any of the following events
• determination that the obligor is unlikely to pay
  its debt obligation
• Realization of a credit loss event (charge-off,
  specific provision)
• More than 90 days past due on any credit
  obligation
• The obligor has filed for bankruptcy.

12
Pillar 2 3

• The Supervisory Review Process, defined in Pillar
  2, is based on the following four principles
  defined in the spirit of the Core Principles of
  Banking Supervision. They require bank
  supervisors to
• check that the organizational structure of a bank
  matches the complexity of the chosen approach
• review periodically banks internal capital
  adequacy assessments and strategies
• request banks to operate above the minimum
  solvency ratio
• intervene at an early stage to prevent capital
  depletion.
• The Market Discipline, defined in Pillar 3, is
  based on an extensive set of disclosure
  requirements of banks portfolio composition by
  risk categories, of portfolio composition.

13
Issues in regulatory convergence

• What capital charges on contracts designed to
  unbundle and transfer risk?
• An example is the provided by the suggested
  treatment of insured operational risk. One of the
  proposed approaches suggested not to recognize it
  fully in order to reduce contagion across
  different segments of the financial system.
• More generally, what capital requirements on
  insured positions.
• How to insure regulatory convergence now that
  Basel II will shift away from the previous level
  playing field approach?
• Where misalignements of capital requirements are
  larger providing incentives to asset shifting
  from bank to insurance (or viceversa) within the
  same holding group?