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Risk Based Supervision under Basel II

Jeffrey Carmichael

CartagenaFebruary 16-18, 2004

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Colombia February 2004 Page 2Presentation: Jeff Carmichael

Outline

What is the risk based approach?How does it apply to banks?

How does it apply to regulation?How does it apply to supervision?Challenges arising from Basel II

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What is the Risk-Based Approach?

No universally-accepted definition Meaning depends on the situation

Most widely accepted proposition wouldbe that a risk-based approach requiresthat you:

Identify risks and apply resources where the risks are greatest

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1. How Does this Apply to Banking?

Major sources of banking risk: Credit Risk Market Risk Liquidity Risk Operational Risk Question: Which is the greatest risk?

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Experience Late 80s & Early 90s Widely agreed that credit risk is dominant -

experience in the 80s/90s was good reminder Developed markets - worst loan losses for 50

years Common characteristics:

o excessive exposures to individual borrowerso excessive exposures to sectors

o excessive reliance on collateralo poor credit evaluation

All arose primarily from credit risk

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RMA & FMCG Survey

Stock PricePerformance 89-97

Lower LoanLosses

Higher LoanLosses

Ave annual return 25% 16%

Risk (SD) 22% 44%

Sharpe Ratio .08 .02

Better Credit Mgt. = Higher & More Stable Returns

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Also Found ...

Payback to better risk management goesbeyond protecting share price

Returns to investing in risk management are

very high compared losses under best practice with

cost of improvements - suggested return of 1,000% over 10 years

helped better serve customer needs enabled better business decisions

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Main Advances Since Then

Improved data management Improved credit grading from one-dimensional

to two dimensional (PD and LGD)

Shift to portfolio risk assessment Credit risk modelling Risk-based pricing, provisioning and reward

structures Integrated risk management Risk-based capital allocation

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Motivation for Advances

Bankers remember the pain

Shareholders react to differential losses

Competition is increasing

The tools are available

There is more to lose (rewards are tied toperformance)

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2. Risk-Based Regulation

The central Pillar of bankingregulation is capital adequacy

Starting with the first Capital Accordin 1988 banking regulators beganimposing risk-weighted capitaladequacy requirement

The philosophy is straightforward -greater risk requires greater capital

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Interaction Between Regulationand Banking Practice

As noted - banks now allocate capital internally to activitiesand areas according to the risks taken

Not widespread before the first Basel Accord in 1988

Accord encouraged banks to think in terms of risk-basedcapital allocation

Since then, banks have generally gone well beyond the1988 Accord - hence one of the primary motivations forBasel II

Case for change is in the divergence between regulatorycapital and banks assessments of economic capital requiredfor risk - illustration .

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Economic Vs Regulatory Capital

A B0

5

10

15

20

25

30

35

0

5

10

15

20

25

30

35

CurrentProposed

Economic Capital (High Side)Economic Capital (Low Side)

%%

AAA AA BAA BB CCC-C

Basel I 8%

Economic

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The Challenge for Basel II

Need for greater risk sensitivity than Basel 1 and itsone size fits all Approach Need for a framework that is credible, sound and

reflective of industry practicesNeed to be more incentive compatible with desire of regulators to promote and enhance good credit risk managementProblem - there is no standardized approach agreedby industry for the measurement and management of credit risk (unlike market risk)

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The Outcome

A menu approach: Standardized (modified from Basel I); IRB Foundation IRB Advanced

Standardized is still blunt like Basel I IRB approaches are an attempt to approximatewhat the industry is doingIt stops short of allowing banks to use their ownmodels entirely for assessing capital adequacyIt allows banks to use some of the critical inputs totheir models (PD, LGD, EAD) but constrains theway they are combined to assess capital adequacy

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3. Risk-Based Supervision

Again the idea of a risk-based approach =apply resources where the risks are greatest

Thus a supervisor following a risk-basedapproach will attempt to:

Identify those banks in which risks are greatest

Identify within each bank those areas in whichrisks are greatest Apply scarce supervisory resources so as to

minimizing the overall regulatory risk

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Risk Rating Banks

Most regulators use some form of ratingsystem (e.g. CAMELS) for banks

Following the experience of banks manyhave moved to a two-dimensional gradingscale; e.g.

PF - probability of failure

CGF - (systemic) consequences given failure

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Example - PAIRS

APRA Reviewed developments in US, UKand Canada

Developed PAIRS system (Probability andImpact Rating System)

As in banking - risk grading system shouldnot eliminate subjectivity but the discipline

imposed by a structured approach shouldincrease objectivity Back up with peer review and quality control

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Conceptual Framework for PF

Inherent Risk

Management& Control

Capital Support

Risk of Failure PF _

_

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The Structured Approach

The Impact rating is based largely on size - withsome management over-ride if needed PF x Impact (CGF) = index of supervisory

attention The Index of Supervisory Attention is

exponential from 1 to 56,000 The Index is grouped into:

Normal Oversight Mandated Improvement Restructure

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Supervisory Attention Grid

'PAIRS' PROBABILITY RATING

LOW MEDIUM HIGH EXTREMEI low highM MANDATED

P EXTREME NORMAL OV ERSIGHT IMPROV EME NT RE STRUCTURE RE STRUCTAP C MANDATEDA T HIGH NORMAL OVERSIGHT IMPROVEMENT RESTRUCTURIR R MANDATED

S A MEDIUM NORMAL NORMAL OVERSIGHT IMPROVEMENT RESTRUCTUTI MANDATEDN LOW NORMAL NORMAL IMPROVEMENT RESTRUCTURG

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Beyond Risk Grading

Risk-based supervision requires better risk grading to identify the institutions posing thegreatest risks

It also requires targeted inspections andinvestigations It requires judgement and graduated

supervisory responses This is where Basel II has focused its

attention through Pillar 2

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Pillar 2 - Supervisory Review

Philosophy:

1. Pillar 1 Capital Framework is only an

approximation - it is not entirelycomprehensive

2. Capital is critical in mitigating risk but itis not the only relevant factor - a bank should have sound processes andprocedures for measuring, monitoringand managing risk

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Supervisory Review Process

Use tools available to assess how accuratelyPillar 1 matches minimum capital with riskstaken by the bank

Use tools available to understand how stronga banks processes & procedures are and howwell they are implemented

Use supervisory judgement to imposeadditional supervisory requirements(including capital) where residual risk isexcessive

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Assessing the Adequacy of a Bank sCapital

Principle 1: Banks should have a process forassessing capital relative to risks and a strategy formaintaining it

Supervisors: Review the risk assessment processes for relevance and

comprehensiveness - does the bank recognise other riskssuch as interest rate risk?

Identify inconsistencies Check that management is engaged Assess application and controls - are processes

followed? Require stress tests

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Specific Guidance

Interest Rate Risk in the banking book Operational Risk

Definition of default Risk mitigation Concentration Risk Securitization

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Demands Related to IRB

Banks that choose IRB need to meet a seriesof demanding qualifying and validationcriteria

These have been set out in detail by the BaselCommittee - along with guidance about whatand how to check

The on-going monitoring of the

appropriateness and application of thesemodel-based risk management processes is afundamental part of Pillar 2 supervisoryreview - especially stress testing

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Responding to Assessed Risks

Principle 2: Supervisors should takeenforcement action if not satisfied with a

banks approach to risk management Principle 3: Supervisors should expect banks

to hold above the minimum and should beable to require them to do so

Principle 4: Supervisors should interveneearly to prevent capital falling through theminimum

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Is Pillar 2 Really Anything New? To the extent that Pillar 2 emphasises:

Assessment of risks Supervisory judgement & discretion Active enforcement

It is just an extension of the already growing risk-based approach to supervision

It does provide detailed guidance - but manycountries already exercised this type of approach

Problem was - not all countries could! Pillar 2 formalises the central role of flexibility Without that flexibility Basel II is a waste of time

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Summary The risk - based approach is about identifying risks and

devoting resources to where they will be most effective inreducing risks

This approach is as critical in banking as it is in regulationand supervision

In regulation it requires that capital requirements are greaterwhere risks are greater

In supervision it requires supervisors to: Assess where the risks are greatest Intervene and enforce standards flexibly where the risks are greatest

Pillar 2 of Basel II provides a framework for the assessmentand intervention process

Pillar 2 is a fundamental component of Basel II

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Thank You

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Risk-Based Supervision:

Challenges under Basel II

ARMICHAELONSULTING Pt Ltd

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