basel ii implementation at absa: a case study presented by:andré blaauw

Basel Basel IIII implementation at Absa: A case study implementation at Absa: A case study

Presented by: André Blaauw

GM: Enterprise-wide Risk Management

Absa, South Africa

[email protected]

Risk Management Workshop Colombia: From Theory to ImplementationCartagena, Colombia16-19 February 2004

B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004 Slide 2

1. About the SA financial system2. About Absa3. Risk management history at Absa4. To B2 or not to B2?5. B2 implementation strategy6. Current B2 implementation status7. Delivering the B2 solution8. B2 / IFRS alignment 9. Early results

10. Local supervisor’s influence11. Industry collaboration12. Remaining issues and challenges13. Conclusion

AgendaAgenda

SA: South AfricaB2: Basel II Capital AccordIFRS: International Financial Reporting Standards


• Sophisticated by emerging market standards:– Well developed capital and money markets.

– Listed equities market (JSE) – total market capitalisation of approx 200 Billion USD.

– Large and liquid listed fixed income market (Bond Market Exchange).

– Formal equity and commodity futures and options markets (SAFEX).

– Large domestic interest rate- and FX OTC derivatives markets.

• Banking industry:– Dominated by 5 large banks – combined holds more than 90% of assets.

– Financial conglomerates – retail, commercial, investment banking, insurance, asset management, etc.

• Regulatory environment:– Banks are regulated by the central bank.

– Insurance, securities trading, asset management, etc. – regulated by the FSB.

1.1. About the SA Financial SystemAbout the SA Financial SystemJSE: Johannesburg Stock ExchangeSAFEX: South African Futures ExchangeOTC: Over-The-CounterFSB: Financial Services Board


• Absa Group Ltd.: – Domiciled in South Africa (SA)

– Listed on Johannesburg Stock Exchange (JSE)

– Controlling company of major banking and financial services group in SA

– Formed about nine years ago by merging four major South African financial services groups (Amalgamated Banks of South Africa Ltd.)

• Absa Bank Ltd.:– One of the 4 largest domestic banks in SA

– Market leader in retail banking: mortgages and electronic banking

• Geographical footprint:– Represented in 11 countries:

South Africa, Europe, Asia, Americas, Other sub-Saharan African countries

2.2. About AbsaAbout Absa

Who is Absa?


Absa Group Activities


Other Activities• Asset management• Property development• Pension payments

Absa Bank• Retail banking• Commercial banking• Corporate & Merchant banking• International operations• Africa banking operations

Absa Financial Services• Life insurance• Short-term insurance• Insurance broking• Trust & Investment services• Employee benefits

Contribution by Activity(% of Headline Earnings)

Personal banking 28.5%

Commercial banking 30.4%

Wholesale domestic banking 20.4%

International banking 3.2%

African operations 2.6%

Insurance and financial services 17.6%

Other -2.7%

100%

*31-Mar-2003


• 1994 first democratic elections: Ending SA's isolation from international community; Rapidly growing trade between SA and other African countries

• Tier 2 Banks liquidity crisis

• Micro-lending shake-up

• Mergers & acquisitions, and new market players

• Currency volatility


Salient features

Return on assets (ROA): 1.5% *31-Dec-2003

Assets: > ZAR 284 billion (>USD 50 billion) *30-Sep-2003

Return on equity (ROE): > 20% *31-Mar-2003

Capital adequacy range: 11% to 12% *31-Mar-2003

Permanent staff complement: > 32,000 *31-Mar-2003

Customers: ± 6 million

Branches & agencies: ± 1,200

Non-performing loan (NPL) ratio: ± 4%

Bad debt ratio: 0 .85%

Recent events in SA

• Black Economic Empowerment

• Financial Services Charter

• Banking the unbanked/unbankable

• King II report on Corporate Governance

• AC133 Accounting Standard (1 Jan 2003)(IAS 39 / FAS133 equivalent)

• Basel II Capital Adequacy Requirements


3.3. Risk management history at AbsaRisk management history at Absa

19961996 ALCO process fully established.

19971997

19981998

19991999

20012001

20022002

20032003

Trading book VaR implementation.

Active hedging programme for IRR commenced.

ERM approach initiated.

Re-engineering of credit decisioning platform completed.

Basel 2 programme initiated.

Basel 2 implementation gains momentum.ALCO: Asset & Liability CommitteeVaR: Value-at-RiskIRR: Interest Rate RiskERM: Enterprise-wide Risk ManagementEaR: Earnings-at-Risk

20002000 Earnings-at-Risk (EaR) framework implemented.


4.1 INTERNAL CONSIDERATIONS

4.1.1 Resource implications:– Significant investment in IT systems would be required.

– Data availability challenges.

– Complex model requirements.

– Ownership, co-ordination of efforts (Finance, IT, Risk).

4.1.2 B2 implementation cost and risk:– Estimated at 2.8% of annual Operating Expenditure, expensed over 5 years.

– Capital saving benefits uncertain.

– High risk of rework, due to regulatory process uncertainty.

4.1.3 Change management:– Changes to IT systems and business processes, policies and procedures.

– Challenge to manage required change effectively.

4.4. To B2 or not to B2? – Internal considerationsTo B2 or not to B2? – Internal considerations


4.1.4 Other compliance requirements:– AC133 (IFRS), AML, etc.

4.1.5 Business benefits:– Enhanced reputation.

– Improved control environment, information integrity, etc.

– Tools to improve operational and process efficiencies.

4.1.6 Enhancing risk management framework:– Opportunity to further embed risk-reward management culture in decision making.

4.4. To B2 or not to B2? – Internal considerationsTo B2 or not to B2? – Internal considerations

AC133: Accounting standard AC133, “Financial Instruments: Recognition and Measurement”, a recent addition to South African GAAP and local equivalent of IAS39 / FAS133.

IFRS: International Financial Reporting Standards

AML: Anti-Money Laundering


4.4. To B2 or not to B2? – External considerationsTo B2 or not to B2? – External considerations

4.2 EXTERNAL CONSIDERATIONS: EMERGING MARKETS ACCEPTANCE

4.2.1 Cross border capital flows:– Improved transparency of SA banks’ risk profiles and best practices benchmark compliance

could improve ratings.– Improved capital inflows could result.

4.2.2 Unintended consequences:– Higher capital requirements volatility in emerging markets.– More challenging for banks to maintain profitability due to combined impact of AC133 and B2.

4.2.3 Benefits to banking and financial system:– Improved risk management practices could lead to reduced systemic risk and

improved market perception.– More efficient utilisation of capital employed in the banking system.– Growth in risk transfer instruments promoted.– Industry consistent disclosure.– Improved corporate governance through board and senior management oversight

requirements.– Complements supervisor’s risk based approach.


4.4. To B2 or not to B2? – ConclusionTo B2 or not to B2? – Conclusion

4.3 CONCLUSION– Reputational risk of non-compliance too high.

– Large retail base should lead to reduced capital requirements.

– Positive spin-offs.

– Benefits outweigh costs.

– B2 should be viewed as an opportunity to enhance competitive position.

B2B2 No B2No B2


• Absa’s goal:

To be fully B2 compliant by January 2007

• B2 approach aspirations:

– Retail credit exposures: IRB Advanced

– Corporate credit exposures: IRB foundation

– Operational Risk: Advanced measurement approach

Some subsidiaries will be excluded from Group adopted approach based on materiality and will follow standardised approach.

5.5. B2 Implementation StrategyB2 Implementation Strategy

IRB: Internal Ratings Based


CP1Jan

CP2May

OIS3Dec

CP3Apr

Final Accord

JunLegislative Process

ParallelRun

Full ImplementationJan

2001 2002 2003 2004 2005 2006 2007

Pro

gra

mm

e T

ime

lin

eR

eg

ula

tory

T

ime

l in

e

01 02 03 04 05 06 07

6.6. Current B2 Implementation StatusCurrent B2 Implementation Status

Gap/Impact Analysis

Pre requisite systems

Methodologies and data

Measurement Models

Operationalisation

Programme Management

Awareness/Communication

Change Enablement

Quality & Compliance Assurance

Process and organisation

Planning/mobilisation

Systems integration

B2/IFRS alignment


Planning, programme mobilising and governance

• Oversight by Board

• Group program SteerCo

• Work stream structures with clearly defined outputs

• Programme sponsorship

• Budgeting, priority setting, etc.

• IT strategy alignment

• Subject expertise

7.7. Delivering the B2 solutionDelivering the B2 solution


Group Risk CommitteeGroup Risk Committee

B2 Programme SteerCo

B2 Programme SteerCo

ACMB B2 SteerCo

ACMB B2 SteerCo

CRMO B2 SteerCo

CRMO B2 SteerCo

Group Finance B2 SteerCo

Group Finance B2 SteerCo

ERM B2 SteerCo

ERM B2 SteerCo

B2 Credit Risk Work Streams

B2 Credit Risk Work Streams

B2 Capital &Disclosure

Work Streams

B2 Capital &Disclosure

Work StreamsB2 Market Risk Work Streams

B2 Market Risk Work Streams

B2 Operational Risk

Work Streams

B2 Operational Risk

Work Streams

(Chairman: FD)

B2 CreditRisk Project Management

B2 CreditRisk Project Management


(Board Risk Committee)

Programme management: Governance Structure


Communication and Awareness

• Ongoing

• Board member training programmes

• Interpreted B2

• External training

• Core group with requisite expertise

• Training material

• B2 knowledge base

• Ongoing impact analysis and communication of results



Models: Credit Risk• PD:

– Corporates: KMV– SMEs: Moody’s RiskCalc (SA default database)– Retail: Own development based on internal default

experience related to application and behavorial scoring (TRIAD)

– Specialised lending: Slotting criteria– Banks and sovereigns: Derived from internal to external rating mappings

• LGD Retail: – Own development based on internal recovery experience

• EAD Retail: – Own development based on internal draw down experience

• Capital measurement:– Pillar 1: SAP Bank Analyser– Pillar 2: Own development in SAS


PD: Probability of DefaultSMEs: Small and Medium sized EnterprisesLGD: Loss Given Default EAD: Exposure At Default


Models: Operational Risk• Quantitative operational loss modeling: Algorithmics

• Qualitative measurement – self-assessment surveys: Horizon (JP Morgan)

Models: Market Risk

• Trading book: Algorithmics

• Equity investments: Algorithmics

• IRR in banking book: Kamakura (being evaluated)



Data Collection Strategy• Retail credit loss data:

– Data collection efforts commenced some time ago.– Four years of historical data available already.

• SME credit loss data:– Data pooling arrangement with peer group initiated.

• Corporate, sovereign, banks credit loss data:– Insufficient data availability in local market.– Statistical model approach to be followed.– Calibrated to international default experience.

• Operational risk:– Historical data available for frauds and some loss events.– Data collection efforts for remaining loss types have commenced.– Data pooling arrangement with peer group under discussion.

• Centralised financial transaction database:– Development in progress.


Fixed Property

Moveable Property

Finance Securities

Concurrent Creditors

Fixed Property

Moveable Property

Finance Securities

Concurrent Creditors

R

O

R

A

C

CAPITAL ALLOCATION

engine

PRICING engines

Cre

dit

conv

ersi

on

Fac

tors

DI FormatterPROVISIONING engine

EL-UL Engine

Ratings Calibrator

EAD engine LGD engine Loan valuation engine (AC133)

PORTFOLIO engine

STRATEGY optimiser

Interface Layer

BIS CAPITAL engine

ExternalRetail Business ClientCorporate Client Financial InstitutionSovereign Unlisted

PD Estimators

Application Scoring Judgmental

Behavioral scoring FES

Rating Systems

LGD Estimators

Hai

rcu

t

En

gin

e

Recovery Statistics

Eco

no

mic

S

cen

ario

G

ener

ato

r

EAD

Recovery

Rating

Simulators

Banking BookTrading Book

PFE Calculators

Retail ClientBusiness Client Corporate Client

Limits/Exposure

Customer/Product Systems

7.7. Delivering the B2 SolutionDelivering the B2 Solution

Collateral

Management

Integrated Credit Risk System

Slide 20

Assurance Compliance

Qualitative Operational Risk

Business Units

ERM

Sourcing

Indicator Identification

Indicator Monitoring

Economic Crime Profile

Industry Database

Interface Layer

Business Units

ERM

Sourcing

Business Units

ERM

Sourcing

Loss/Events Database

Lo

ss/e

ven

t

Val

idat

ion

Lo

ss/E

ven

t

Cap

turi

ng

Profile Alignment

Enterprise Operational Risk Framework Version 3.1

RISK INDICATORS

QUANTITATIVE OPRISK data

QUALITATIVE OPRISK data

1 2 3

11 2 3

Operational Risk Profile Integration

Operational Risk Analysis and ModelingINTEGRATED OPRISK

PROFILE dashboard

OPRISK PERFORMANCE management

OPRISK CAPITAL allocation


Integrated Operational Risk System

Slide 21


Oversight

Board and Senior Management

OversightAssurance Compliance DisclosureAudit

reports

Complianceassessment

CapitalMeasurement

Capital Allocation

Set Concentration Limits

Portfolio Performance

Portfolio Optimization Support

Enterprise Credit Portfolio Risk Management

Risk appetiteApproved capital

SBU Strategies

Segment Credit Policies

Concentration limits

Credit Ratings

UnderwritingSegment

MonitoringCredit Risk Mitigation

Loan Origination

Approval requests

LimitsPrices per rating

Segment Credit Risk

Management

Debt Recovery

Collateral Management

RecoveryWorkoutProvisions

Collateral Values

SBUs

Origination

Credit Portfolio Management

Significant enhancement required to existing processes for B2

Minor enhancement required to existing processes for B2


Legend:

Risk Management Framework Enhancement– Credit Risk

Oversight Assurance Compliance Disclosure

Capital Measurement

Capital Allocation

Sources• Business Units• Fraud Related Events

Profile Alignment

Sources• Control Self-Assessments• Compliance profiles

Sources• Business Units

BU Strategies

Board and Senior Management Oversight

Enterprise Operational Risk Management

BU Operational Risk Management

Information Sourcing

Complianceassessment

Auditreports

Risk appetiteApproved capital

Performance ManagementModeling

Indicator Database

Loss Event Database

Qualitative Database

Reducing operational losses

Effective and efficient internal control

Business process reengineering

Performance Management

Mitigation Strategies

Sources• Industry Database• Public Sources• External Research

Slide 23

Significant process changes in progress

Minor process changes in progressLegend:

7.7. Delivering the B2 solutionDelivering the B2 solutionRisk Management Framework Enhancement– Operational Risk


Oversight Assurance Compliance DisclosureBoard and

Senior Management: Oversight

Compliance assessment

Audit reports

Capital Allocation

Set and enforce limits

Risk Management Unit: Measure, Monitor, Control,

Report

Risk appetite

Position taking functions

• Existing Risk Management Framework unchanged.

• Interest Rate Risk in the Banking Book does not attract a minimum Pillar 1 capital charge, but supervisory review process requires disclosure of economic value sensitivities relative to capital.

• Computation of capital for position risk in the trading book: Compliance with Capital Adequacy Requirement (1998) represents compliance to Basel II. Absa had its internal model approved for the computation of position risk capital in the trading book in 1998.

• Capital requirements for equity risk: Equities in the banking book under the internal models approach (VaR).

PortfolioManagement

Risk Mitigation

Set Policies

Capital +Risk

Measurement

Significant enhancement required to existing processes for B2

Minor enhancement required to existing processes for B2Legend:

Risk Management Framework Enhancement– Market Risk7.7. Delivering the B2 solutionDelivering the B2 solution


Capital Management

Capital Management

Regulatory Reporting

Regulatory Reporting

Public Disclosure

Public Disclosure

Risk-Adjusted Performance Measurement

Risk-Adjusted Performance Measurement

Portfolio Risk Measurement Portfolio Risk Measurement

Capital Requirement Projections

Capital Requirement Projections

Portfolio Limit

Monitoring

Portfolio Limit

Monitoring

Group Risk ProfileReporting

Group Risk ProfileReporting

StructuringStructuringModels &Methodologies

Models &Methodologies

Deal Origination

Deal Origination

Service DeliveryService Delivery

Operations ManagementOperations

ManagementIT / Information

ManagementIT / Information

Management

Customer Relationship Management

Customer Relationship Management

Market Segmentation and Targeting

Market Segmentation and Targeting

Strategic PlanningStrategic Planning

Collateral Management

Collateral Management ProvisioningProvisioningRisk

AssessmentRisk

Assessment

Allocate Risk

Ratings

Allocate Risk

Ratings

Risk PricingRisk

Pricing

Quantitative Risk

Measurement

Quantitative Risk

Measurement

Risk Mitigation

Risk Mitigation

Exposure Monitoring Exposure

Monitoring

Recovery Risk

Management

Recovery Risk

Management

Set Risk

Policies

Set Risk

Policies

Set Risk Appetite

Set Risk Appetite

Monitor Risk Profiles

Monitor Risk Profiles

Obtain Assurance & Ensure

Compliance

Obtain Assurance & Ensure

ComplianceBoard Risk Committees

Group Finance

Enterprise RM

Risk Underwriting

SBUs

Capital adequacy management framework7.7. Delivering the B2 solutionDelivering the B2 solution


8.8. B2 / IFRS alignmentB2 / IFRS alignment

• Overlap between IFRS and B2.

• Common data requirements.

• Common valuation models.

• Provisioning / capital interrelationship.

• Capital adequacy implications of fair value adjustments.

• B2 / IFRS development strategy to ensure consistency in risk and financial performance measurement.

• Common validation needs.

• Ownership.B2: Basel II Capital Accord

IFRS: International Financial Reporting Standards


9.9. Early resultsEarly results

Capital impact

• Ongoing capital impact measurement.

• As of December 2003:

Overall: Estimated 5% capital savingRetail credit portfolios: Significant (30%+) capital savingSMEs: Slight increaseCorporate : Increase Banks: Significant increaseOperational risk capital: 7% increase (preliminary AMA)

• Early indication of further capital relief from EL / UL amendment.

AMA: Advanced Measurement ApproachEL / UL: Expected Loss / Unexpected Loss


9.9. Early resultsEarly results

Strategic implications

• Protecting the Retail base.

• Increased focus on Wealth Management services.

• Increased focus on CRM.

• Reviewing LTV lending criteria for some Mortgage segments.

• Reviewing speculative grade Corporate lending criteria.

• Increased focus on customer retention.

• Consider risk-based product re-pricing (declining capital needs over loan life).

CRM: Customer Relationship Management

LTV: Loan-To-Value


Accord Implementation

SteerCo

Accord ImplementationSteerCo

Risk ManagementRisk Management DisclosureDisclosure ComplianceCompliance Economic ImpactEconomic Impact

• Senior Bank Executives• Bank Supervision Heads

• Senior Bank Executives• Bank Supervision Heads

10.10. Local Supervisor’s InfluenceLocal Supervisor’s Influence

• Data issues• Model validation• Consolidated response to BIS proposals• Co-ordinated QIS

• Data issues• Model validation• Consolidated response to BIS proposals• Co-ordinated QIS


11.11. Industry CollaborationIndustry Collaboration

Credit loss data pooling

Industry has taken initiatives …

Operational loss data pooling

• SME default data(in progress)

• SME LGD data(next phase)

• Still under discussion

• Issues: context, confidentiality, etc.


• Judgmental approach to Pillar 2 – strong reliance on supervisor expertise.

• Economic capital measurement assumptions for interest rate risk in banking book.

• Measurement issues and assumptions for risks not covered under Pillar 1 – eg. Liquidity risk.

• Capital stress testing methodology.

• Capital buffer requirements.

• Credit concentration risk measurement approaches.

• Risk diversification treatment in buffer determination.

12.12. Remaining issues and challenges – Pillar 2 clarityRemaining issues and challenges – Pillar 2 clarity


0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

AA

A

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B B-

CC

C+

CC

C

CC

C-

CC C D

S&P Rating

Ris

k W

eig

ht

• Static LGD, EAD and term assumptions.• Non-linear sensitivity to credit quality changes.

12.12. Remaining issues and challenges – Pro-cyclicalityRemaining issues and challenges – Pro-cyclicality

B2 Credit Capital Risk Weight Curve


• Absa’s capital requirement would have increased by over 30% under a

B2 regime in the aftermath of the 1998 Emerging Markets Crisis.

• Problem exacerbated by dynamic internal rating systems.

• Capital stress testing/planning simulation model capability.

• Buffer management.

• Ongoing capital attribution analysis.

• Hedge capital fluctuations.

12.12. Remaining issues and challenges – Pro-cyclicalityRemaining issues and challenges – Pro-cyclicality


• Supervisory approach to model validation.

• Statistical validation (backtesting, out of sample testing, etc.) not feasible in all areas.

• Benchmarking.

• Mapped ratings.

• Methodology reviews.

• Pragmatic approach.

• Ongoing validation strategy.

• Rating agents.

12.12. Remaining issues and challenges – Model Remaining issues and challenges – Model validationvalidation


12. Remaining issues and challenges – Capital level & Ratings12. Remaining issues and challenges – Capital level & Ratings

Long-term Impact of Basel II on Bank Ratings

• Higher CAR won’t necessarily lead to upgrade, and cutting capital because of a higher CAR could lead to a downgrade.

• But better data on risk profile will be considered, and better risk management a positive:

– Better asset allocation

– Better risk-adjusted pricing.

““

””CAR: Capital Adequacy Requirements

Moody’s Investors Services


• B2 benefits outweigh costs.

• Plethora of model tools and data availability is improving.

• Strong programme management required for successful implementation.

• Industry collaboration critical.

• Communication and education – bank management, investors, stakeholders, etc.

• Key role of Regulator: To be pro-active on issues - reduce uncertainties.

13.13. ConclusionConclusion


Victor Hugo

basel ii implementation at absa: a case study presented by:andré blaauw

Documents

b2 implementation strategy6

banks of south africa

financial services17

aj blaauw cartagena

2004b2 implementation

sa financial system2

south africab2

financial conglomerates