PeruBasel II implementation

Setiembre 2009

APEC

Experience in Basel II implementation

The SBS has reinforced a regulatory framework to enable firms making an appropriate identification, evaluation, treatment and control of risks.

Basel II implementation process is progressing quite well in Peru:Changes in the General Law allow the application of capital requirements to credit, market and operational risk according to Basel II.A regulatory framework for the implementation of Basel II has been made available to the public (publications and pre announcing of new rules)

2

Main changes in Banking LawDL 1028

Minimum capital requirements for credit, market and operational risks (Pillar I of Basel II)Increase of the minimum capital ratio and maintenance of suitable additional buffer, according to entities’ risk profile and the business cycle (Pillar II of Basel II) Definition of capital structure and proposal of limits on its composition (Basel) Information transparency (Pillar 3 of Basel II)Transparency: Obligation to pre announce new rules regarding capital requirement and loan loss reserves.

Implementation Schedule

April 2009

Opening application to Operational risk

(OR) - ASA

July 2009

Capital requirement: CR: no change MR: Standardized

approachOR: Basic approach

Opening application to advance models: VaR,

IRB, AMA

July 2010

Capital requirement:

CR: standardized approach

F irs t year F rom the s econd year F irs t year S econd year T hird year

P arallel calculation

During the validation proces s After finis hing the validation proces s

----- 95% 90% 80%

90% 80% -----

T rans ition towards the implementation of internal

models */

B as ic IR B and Internal models of market ris k

Advanced models of credit ris k and/or O perational

ris k

P arallel calculation

P arallel calculation

PeruBasel II implementation:

Pillar I: Credit risk

Definition of Portfolios

Basel II Peru

Regulatory Portfolios

Corporate + 50MM€ Corporate + 200MMS/. of sales

SME corp. between 5MM€ and50MM€

Big firms betweenMore than 20MMS/. of sales and 200MMS/. of sales

Medium firms More than 300MS/. of debt and until 20MMS/. of sales

SME retail under 5MM€

Small firms Between 20MS/. and 300MS/. of debt

Retail Until 20M S/. of. debt

Change of WeightsCurrent Law:

Basel IBasel II Peru CR regulation

Commercial loans 100% 100% unless an issuer assessment applies. (20%)

Leasing 50% 100% unless an issuer assessment applies. (20%)

Special Regime until Dec-12

Debt instruments 100% According to external ratings

Retail, includingRevolving consumptionNon revolving consumption

100% 100%

Mortgage 50% 50%, until the guaranteed portion

Shares 100% 300% - 400%

Change of Weights

Current LawBasel I

Basel II Peru CR regulation

Peruvian sovereign in local currency and Central Bank exposures

0% 0%

Peruvian sovereign in foreign currency 0% according to formula (do not include reserves in CB)

Rest of sovereigns 0% - 20% According to external ratings

SUNAT 100% 20%

Public and private Financial System institutions

20% According to external ratings

Mivivienda (mortgage program supported by government)

0% 20% stock.According to institutional external ratings for new

credits

Other changes that affect capital requirement

Current LawBasel I

Basel II Peru CR Regulation

Use of mitigators Do not allow its use Recognition of financial collaterals and guarantees

Use of credit conversion factors

Through internal rules Through public rules

Recognition of provisions in capital

Until 1% of standard credits

1.25% RWA

Settlement and delivery risk - Between 100% and 1000%

Default definition - 90 days, affects risk weights (150% if specific loan loss reserves < 20% of debt, except mortgages)

Use of internal models - Requires supervisor approvalFundamental and advanced models

Sovereign exposures

Weight factors of Sovereign exposures of foreign countries are found in the Accord according to international risk rating agencies.

Sovereign exposures referred only to Central Banks and Central Government exposures. The rest of public institutions will be treated as corporates.

Peruvian local currency sovereign exposures, as well as local and foreign currency reserves and other Peruvian Central Bank operations have a weight factor of 0%.

Peruvian foreign currency sovereign exposures (except reserves), will have a weight factor according to the following formula:

0,

11.1

1maxfactorweight 32Pe

1-month tat capital regulatorymonth tat currency foreign in exposuressovereign P

11

Credit conversion factors (CCF)

Basel I Basel II Peru CR Regulation

Confirmations of self-liquidating irrevocable trade letters of credit up to one year, when the issuing bank is a high rating foreign financial system institution according to the CB.

Not clearly defined 20%

Performance bonds, bid bonds and warranties to guarantee satisfactory completion of a project

Not clearly defined 50%

Guarantees , bank acceptances, rest of trade letters of credit, rest of letters of guarantee

Not clearly defined (100%)

100%

Credit lines 0% Between 0% and 50%

The regulation considers fundamental IRB (FIRB) and advanced IRB (AIRB)Parameters are required to be calculated taking into account a complete business cycle (independently of the minimum period of observations)

Internal Models (IRB)

Definition of Default

Past due loan for more than 90 daysRetail debtors: by operation Non retail debtors: by debtor

Debt instruments are considered in default since the first day of delay after the settlement period.Change to a restructuring situation In the last 5 years, the debtor or the operation has registered more than one change in contract conditions (unless the firm can make a better estimation of its change to a default situation)The firm considers that the debtor is unable to partially or totally fulfill its obligations according to the agreement .

Leaving default

From the moment of non default, punctually fulfillment of liabilities for 12 consecutive months. During this period, the debtor will be able to register a maximum delay of 7 consecutive days and a maximum accumulated delay of 25 days (unless the firm can make a better estimation of the change to a non default situation)The firm considers that the debtor is able to fulfill all its obligations. This condition will be valid only when the reason of non fulfillment is due to qualitative criteria.

PeruBasel II implementation:

Pillar I: Market risk

Current Methodology

Firms will be able to calculate capital requirement for market risks through one of the following ways:1. Standardized Method2. Internal Models3. Combination of standardized method and internal models. It must be considered that each type of risk should be evaluated

using only one method. Changes in regulation

Inclusion of interest rate risk measurement in trading book and commodities risk measurement, as part of the standardized method.Use of internal models with previous authorization of the SBS.

Trading book for market risk capital requirement

SBS will consider the following instruments as part of trading book:a) Instruments registered in trading bookb) The following instruments registered in available-for sale category:

DebtCDBCRPSovereign bonds (VAC-bonds not included)Global bondsBrady bonds

Equity:IGBVL sharesMutual funds (at least 70% of the fund in shares)

a) Speculative derivativesb) Derivatives that hedge a and b investmentsc) Commodities

PeruBasel II implementation:Pillar I: Operational risk

Capital requirement for operational risk

Firms must use one of the following methods.

a. Basic indicator approach – BIA (function of net income)b. Alternative Standardized approach - ASA (function of net income by business

lines, except retail and commercial banking lines) c. Advanced measurement approaches – AMA (probabilistic calculations)

The use of ASA or AMA requires express authorization of the SBSBasel II established methodologies are followed.

Operational Risk

Gradual implementation of operational risk requirement:

SBS would expect that during the implementation, entities are able to meet the requirements to apply to ASA, and thus avoid the application of 100% according to BIA.

Jul 2009 Jul 2010 Jul 2011

40% 50% 100%

Peru:Implementation of pro-cyclical loan loss

reserves

Regulatory reform of the SBS

Foreign exchange credit risk regulation

January 2005

Resolution N° 0041-2005 Regulation for foreign exchange credit risk management

Sets minimum prudential standards with respect to granting redits in foreign currency , as an additional component for defining the ability to pay.

To that effect, minimum requirements in managing this risk are defined. In case of not satisfying those requirements, additional provisions are set.

May 2005 CIRCULAR Nº B- 2145 -2005 F- 0485 -2005CM- 0332 -2005CR- 0201 -2005EAF- 0229 -2005EDPYME- 0117 -2005

Over-borrowing regulation

September 2006

S.B.S. ResolutionNº 1237 -2006 Regulation for retail debtors debt overhang risk management.

Stipulates that firms must establish policies regarding granting, amendment and revision of revolving credit lines, including explicit standards and measures to include over-borrowing of retail debtors in credit

evaluation. Additionally, sets minimum requirements for management of retail debtors over-borrowing. Additional provisions will be established on the unused portion of retail revolving credit lines if requirements are not fulfilled.

August 2008

S.B.S. ResolutionNº 6941 -2008New Regulation for retail debtors debt overhang risk management

How does Accumulation Rule work?

The variable component of procyclical loan loss reserves will be activated in the following situation:

The average GDP growth rate YoY of the last 30 months passes from less than 5% to 5% or more.

When the average GDP growth rate YoY of the last 30 months is over 5%, and the average GDP growth rate YoY of the last 12 months is higher by 200 basic points to this same indicator calculated a year earlier.

When the average GDP growth rate YoY of the last 30 months is over 5%, and 18 months had elapsed since the procyclical rule was deactivated

How does Decumulation Rule work?

The accumulation rule will be deactivated in the following situations:

The average GDP growth rate YoY of the last 30 months passes from a level equal or greater than 5% to one less than this threshold.

The average GDP growth rate YoY of the last 12 months is lower by 400 basic points to this same indicator calculated a year earlier.

Reserve rates for credits in standard category

Types of credit Fixed component

Variable component

Corporate credits 0.7% 0.4%

Credits for large firms 0.7% 0.45%

Credits for medium firms 1.0% 0.3%

Credits for small firms 1.0% 0.5%

Retail credits 1.0% 0.5%

Revolving consumption credits 1.0% 1.5%

Non revolving consumption credits 1.0% 1.0%

Mortgage loans for housing 0.7% 0.4%

Procyclical rule evolution

30 months

0%

5%

10%

15%

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

PBI (var. %) Promedio 30 meses umbral 5%Average GDP growth rate 30 months Threshold 5%

Procyclical rule evolution

12 months

-12%

-8%

-4%

0%

4%

8%

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

variación anual de PBI (Prom. 12 meses) umbral -4% umbral 2%

-3.98%

Threshold 2%Threshold -4%Average GDP growth rate 12 months

The Banking System has S/. 916 millions of loan loss reserve buffer and S/. 4 134 millions of capital buffer

5 0196 755 7 886

9 304 9 151778

1 0471 222

1 442 1 418

1 098

901

1 488

1 386 2 716

0

2 000

4 000

6 000

8 000

10 000

12 000

14 000

Dic-2006 Dic-2007 Jun-2008 Dic-2008 Jun-2009

Banking System: Total Capital(Millions of S/.)

Minimum regulatory capital Prudential capital required by the SBSVoluntary capital

1 958 2 118 2 284 2 3862 733

454553

233375 355

369

363

0

500

1 000

1 500

2 000

2 500

3 000

3 500

4 000

Dic-2006 Dic-2007 Jun-2008 Dic-2008 Jun-09

Banking System: Total loan loss reserves(Millions of S/.)

Required reserves Procyclical reserves Voluntary reserves

PeruBasel II implementation:

Pillar II

Additional capital buffer

• In Peru, the additional buffer is a function of the type of institution (10.5% for commercial banks, 14% for microfinance institutions). This indicator is not very sensitive to risk.

• Regulatory capital should consist of:1. Minimum capital : Pillar I2. Additional capital: Should be determined based on the institution's risk

and business cycle .3. Additional capital according to ICAAP

.,max reqadditionalKKK PillarIICAAPregulatory

PillarIICAAPregulatory KKK ,max

Business cycle indicator

Decumulates

Accumulates

How should the additional capital requirement be calculated in terms of risk profile and economic cycle?

Business lines

Participation (%)

Risk weight by business line(according to stress testing)

Risk indicator

L1 P1% W1 P1%*w1

L2 P2% W2 P2%w2

L3 P3% W3 P3%w3

L4 P4% W4 P4%w4

… … … …

Ln Pn% Wn Pn%wn

TOTAL 100% - ΣPi%*wi = H

Total indicator shocks micmacroecono

,

gPD

LGDPDPDfW

stress

turndownciclestress

How should the additional capital requirement be calculated in terms of risk profile and economic cycle?

Ranges of H Minimum capital Requirement adjusted to risk

(Base: 10%)

Capital requirement according to supervisor assessment of ICAAP

Good (I,II) Bad (III,IV,V)

H1 – H2 11.5% 11.5% 11.5%*(1+ α1)

H2 – H3 12% 12% 12%*(1+ α2)

H3 – H4 13% 13% 13%*(1+ α3)

H4 – H5 14% 14% 14%*(1+ α4)

… … … …

H(n-1) – H(n) 17% 17% 17%*(1+ αn)

αi = weight adjustment according to ICAAP evaluation

Peru:Impact of Basel II implementation

Timing of implementation of law 1028

Today JUL 2009 JUL 2010

JUL 2010 JUL 2011

JUL 2011 JUL 2012

JUL 2012 JUL 2013

RWA adjustment

(CR, MR)1 0.96 0.96 0.98 1

(OR) adjustment Ø 0.4 0.4 0.5 1

Inverse of capital ratio

including additional

requirement

10.5 banks 11 11 ?? ??

14.3 IMFNB 14.3 14.3 ?? ??

New methodology

Evolution of Capital Ratio (Banking sector)

Ratio de Capital: BANCA MULTIPLE

Ene-09, 11.93

11.12

11.69

9.59.8

10

11

10.5

9.19.4

9.8

7

8

9

10

11

12

13

14

Jul- 2005 Jul- 2006 Jul- 2007 Jul- 2008 Jul- 2009 Jul- 2010 Jul- 2011 Jul- 2012

Ratio de capital Ratio minimo Req prudencial Ajuste calendario

Rop

Rop ajustado

Ajuste APR

OR

Adjusted OR

RWA adjustment

Capital ratioMinimum ratio

Prudential requirement

Scheduled adjustment

Evolution of Capital ratio (microfinance institutions)

Ratio de Capital: IMFNB

16.41

18.47

Ene-09, 19.07

109.89.5

14.3

9.89.49.1

7

9

11

13

15

17

19

21

23

Jul- 2005 Jul- 2006 Jul- 2007 Jul- 2008 Jul- 2009 Jul- 2010 Jul- 2011 Jul- 2012

Ratio de capital Ratio minimo Req prudencial Ajuste calendario

Rop

Rop ajustado

Ajuste APR

Adjusted OR

OR

RWA adjustment

Capital ratioMinimum ratio

Prudential requirement

Scheduled adjustment

Banking sector capital (S/. MM)December 2008

CAPITAL BANCA MULTIPLE MILES DE S/.

0

12,131,574

-

12,000,000

CAPITAL REQUERIDO PATRIMONIO EFECTIVO

Minimum req.

9,313,961

Additional req.1,380,510

Minimum req.9,831,794

Prudential req. 1,552,389

Additional Req.864,188

Initial Situation

Final Situation

Required capital regulatory capital

Prudential req.1,438,003

Microfinance institutions capital (S/. MM)December 2008

CAPITAL IMFNB MILES DE S/.

0

1,600,792

-

1,600,000

CAPITAL REQUERIDO PATRIMONIO EFECTIVO

Minimum req.

766,574

Prudential req.438,042

Additional req.

398,212

Minimum req.825,874

Prudential req.417,284

Additional req.

362,824

(December 2008)Initial Situation

Final Situation

Required capital regulatory capital

Capital ratio according to portfolio growth scenarios: banking sector

0%

15%

42.63%

Portfolio growth

RWA (+ OR, +growth)Capital Ratio=---------- Reg. capital (+ earnings capitalization +reserves of standard credits (+growth) )

Ratio de Capital: Banca Multiple

11

15.31

13.46Ene-09, 11.93

9.1

10.5

8

9

10

11

12

13

14

15

16

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Ratio de capital Ratio minimo Req prudencialCapital ratioMinimum ratio

Prudential requirement

Capital ratio according to portfolio growth scenarios: microfinance institutions

0%

20%

43.83%

Portfolio growth

RWA (+ OR, +growth)Capital Ratio=---------- Reg. capital (+ earnings capitalization +reserves of standard credits (+growth) )

Ratio de Capital: IMFNB

20.00

16.92

14.30

Ene-09, 19.07

9.1

8

10

12

14

16

18

20

22

24

26

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Ratio de capital Ratio minimo Req prudencialCapital ratioMinimum ratio

Prudential requirement

PeruBasel II implementation

Setiembre 2009

APEC