basel 2 -deloitte

Basel II AIRB Implementation “Lessons in Progress”:

AlokAlok SinhaSinhaPrincipalPrincipalDeloitte & Touche LLPDeloitte & Touche LLP

Commercial Credit Risk Data, Measurement and Technology Challenges

Agenda

Basel II – Overview and Current Status

AIRB Credit Risk – Key Requirements / Implications

Closing Remarks

Major Pain Points and Challenges

Industry Impact

Basel Overview & Current Status

Background on the Basel Accord

• The Basel Committee on Banking Supervision operates under the Bank for International Settlements located in Basel, Switzerland– It was established by the central bank Governors of the G10

countries at the end of 1974 and meets four times a year

• In 1988 the Basel Committee issued the first Basel Accord– It quickly became clear that this ‘one size fits all’ approach was

inappropriate given the wide variety of banking institutions

• Market Risk Amendment introduced in 1996

• Significant regulatory capital arbitrage opportunities exist in Basel I

Basel II Timeline for US Implementation

2007 2008

Capital floor of:

80%

Parallel Preparation for implementation/Proposed Rulemaking

2004 20091999 – 2003 2005 2006 2010 2011

Basel I

BIS-Final rules issued

with

• Supervisory Guidance Expected

• Basel 1A NPR Expected

Today

95%90%

Basel II U.S. NPR

draft released

Basel I-A ANPR

Released

U.S. ANPR issued

Final NPR released for

comment

Basel II Introduces a Three Pillar Approach

Minimum Capital

Requirements

Minimum Capital

Requirements

Supervisory Review Process

Supervisory Review Process Market

DisciplineMarket

Discipline

• Menu of measurement approaches

• Increased reliance on internal processes and data

• Subject to extensive qualification requirements

• Supervisors to ensure sound internal processes and practices

• Thorough assessment of a Bank’s risk profile and capital position

• Define actions if risk and capital assessment deemed unsatisfactory

• Extensive reporting requirements

• Promote market discipline through transparency

Pillar 3

Pillar 2

Pillar 1

Economic Capital

Risk orientation: comprehensive

Distinguishes risk by credit quality (risk ratings, EDFs and credit scores)

Explicitly accounts for diversification

Businesses are assigned capital in proportion to economic risks they pose

Regulatory Capital (Basel I)

All risks are considered: credit, market, operational, ALM, country, etc.

No risk differentiation based on credit quality

Does not account for diversification

Considers credit and market risks

Economic Capital vs. Regulatory Capital

Minimum capital requirements (Tier I/Tier II) are based on broad system risk levels

Regulatory Capital (Basel II)

Credit risk quality differences captured

Considers credit, market and operational risks

Capital definitions and minimum capital levels largely unchanged

Distinguishes risks for a counterparty, relationship or transaction

Very limited risk sensitivity; broad brush structure Significantly increased risk sensitivity

Asset orientation Exposure orientation

Accounts for average diversification with broad exposure categories

Customized to institution’s risk tolerance

By definition, comparable across banks; limited value in the comparison

Applies same capitalization standard to all banks; hence comparable

Basel II is expected to lead to greater alignment between economic capital and regulatory capital

AIRB Credit Risk – Key Requirements

Qualification Requirements - Overview

Overall - to Qualify for IRB Approaches in

General

Specific, Separate – for LGD, EAD and Mitigants

Under Advanced IRB

MINIMUM REQUIREMENTS

RATING SYSTEM

• Separate Borrower Vs. Transaction Ratings

• Minimum of 8 grades

• Less than 30% of exposure in one grade

• Separate rating for legal entities

• Annual rating review

• Regulatory default definition

• Stress testing

• ……………

LGD

• LGD Rating Dimension

• Validation / Stress testing

• Use in Pricing Models

• Relationship w/ collateral • ……………

EAD• Specified by Facility Type• Forward looking• Consistent with experience• ………….

3 Acceptable PD Calibration Approaches:- Bank’s internal historical default

experience- Mapping to external data (rating agency)- Statistical default models (KMV EDFs /

RiskCalc)

Banks are required to develop a one year PD measure for each borrower grade

Risk Mitigation Options • Collateral

– Financial Collateral (cash, securities, equity, etc.)– Non-Financial Collateral (property, equipment, etc.)

• Guarantees and Credit Derivatives– Standby L/Cs, financial guarantees, etc.– Credit default swap (CDS), Nth to default CDS, etc.

• Netting– Master netting agreements (OTC derivatives, repos, etc.)– On-balance sheet deposit netting

• Securitization*– Traditional, synthetic

Portfolio Management – Regulatory Capital Relief via Credit Derivative Hedging

• Types of eligible credit derivatives for capital relief– Single name CDS

– Nth to default CDS

– Total Return Swaps (TRS)

• Credit Derivative eligibility requirements summary– Legal enforceability in the relevant jurisdiction

– Explicit, irrevocable and unconditional contracts

– Full or pro-rata coverage of contractual payments

– Inclusion of relevant credit events (failure to pay, bankruptcy, etc.)

– Net income/credit losses accounting requirements for TRS

– Protection provider eligibility (e.g. highly rated financial firms for double default treatment)

– Application of haircuts: currency, maturity, restructuring

– Monitoring of wrong way, concentration and liquidity risks


• CDS Hedging Process and Data Implications– Assignment of CDS eligibility flags

– Linkage to reference obligors and assets

– Determination of net positions at reference obligor level

– Identification and matching of internal and external hedges

– Determination of qualifying capital hedges (PD substitution, double default, etc.)

– Maximization of capital relief through ‘optimal’ allocation of hedges

– Systematic identification and assessment of wrong-way, liquidity risks, etc.

– Lack of systematic access to legal agreement information (e.g. legal enforceability flags, etc.)


• CDS Hedging Example – Capital Calculations under Basel II (double default approach)

Exposure Credit DerivativePD 0.08% 0.02%ELGD 45% 40%Instrument Type Term Loan CDSAmount (USD) 1,500,000 1,500,000Term (yrs) 4 3Currency USD EUR

No restructuringImmediate Pay-out

N/AContract Terms

Assumptions

Haircuts Application

CDS Application

CDS Notional 1,500,000Mat. Mism. Haircut 27%Restr. Haircut 40%CCY Mism. Haircut 2%Haircut Adj. Notional 646,800

Amount RWAExposure 1,500,000 596,368

Covered Portion 646,800 46,001Uncovered 853,200 339,214

Total 385,215

RWA Savings 211,153RWA % Savings 35%

Synthetic Securitization / CLO considerations

• Basel II securitization framework:– Identification of exposures that are not considered as

‘securitizations’ by the businesses but qualify per Basel II

– Determination of the appropriate treatment requires consideration and understanding of several factors:

Product Type• Internal Assessment Approach (IAA) is only available for ABCP conduits• RBA can be used for investment securities of ABS, MBS, CMO; however most

structured products are not rated therefore cannot use RBA.

Eligibility• IAA requires the Bank’s internal rating methodologies to meet a number of

criteria; some products (e.g. Tender Option Bonds, Structured Investment Vehicles, etc.) can qualify as an ABCP program and can be eligible for IAA.

Data Availability • If underlying loan level data is not available (or its quality is questionable), the Supervisory Formula cannot be used

Materiality• The Bank can choose dollar-for-dollar deduction of unrated exposures that are

immaterial in size rather than sourcing and maintaining the required data for SF approach.

Major Pain Points & Challenges

Complexity of Basel II Implementation is Compounded by a Multiple Touchpoints and Dependencies

Risk Rating Systems

Risk Analytics

Problem Asset Mgt

Collateral Mgt

Economic Capital

CDS Hedging Process

Country Risk Mgt

Retail Scoring

Retail Segmentation

OTC Derivatives

Structured Products

Business Process Design

Information Flows & Controls

Credit MIS Design

Reference Data Mgt

Technology Program Mgt

Data Quality & Integrity

Reporting Systems: Financial, Risk Mgt.

and Regulatory

Data & Information Modeling

Architecture – Logical,

Physical and Application

Credit to Finance Reconciliations

Legal Entity Rules Interpretation

Governance, Oversight & Controls

Guarantees

Repo Style Transactions

Systems

Structured Finance Systems

Collateral Mgt

Systems

Legal Netting Rules

Regulatory Accounting

Supervisory Processes

Deposit Systems

Methodologies Processes Technology Operations Reporting

Multi-jurisdictional solution design

Data Maintenance

and Mgt.

Data Privacy & Secrecy Laws

Fin. Acctg

Regulatory Review

Private Equity Investments

Internal Reviews and Audit

RWA Calculation Engine Design & Implementation

Operational Loss Data, Measurement

and Modeling

Internal Audit, Validation and

Compliance Testing Programs

Change Management, Communication and

Training

Regulatory Compliance Processes

LOB Credit Policy Regulatory Reporting

Operational Risk Mgt

Technology & Operations

Corporate Treasury

Derivatives Technology

Credit Risk Mgt Finance Loan

AdministrationPortfolio

ManagementFinance

OperationsCorporate

Accounting Internal Audit

REQUIREMENTS

BANK FUNCTIONS

DATA DATA

DATA

Basel II Enterprise Program Profile

• Basel II program characteristics at core US and large global banks– Huge in scale, scope and complexity

– Multiple threads and workstreams

– Matrixed accountability structure

• Programs span diverse constituencies that do not often speak the same “language”– Challenging task to communicate the “implications” and “impacts” of

requirements

• While Basel II will end up as a regulatory directive, investments in improved risk and business management are at the core of severalrequirements

• Implementation activity is accelerating within significant technology, change management involvement– IA is keeping a close watch

Some Key Observations and Lessons to Date

• Largest banks (and experts) under estimated the complexity (and costs)

• Excessive focus on some narrow areas

• 80/20 solutions for Basel II will not work

• Current Risk to Finance reconciliationprocesses untenable under Basel II

• Limited applicability of vendor solutions

• Project Management – Single Biggest Challenge

• Linear approach

• Traditional PMO point of view or

• Excessive reliance on Risk Analysts to drive PMO

• Limited success in leveraging Economic Capital systems for operational implementation

• Largest banks (and experts) under estimated the complexity (and costs)

• Excessive focus on some narrow areas

• 80/20 solutions for Basel II will not work

• Current Risk to Finance reconciliationprocesses untenable under Basel II

• Limited applicability of vendor solutions

• Project Management – Single Biggest Challenge

• Linear approach

• Traditional PMO point of view or

• Excessive reliance on Risk Analysts to drive PMO

• Limited success in leveraging Economic Capital systems for operational implementation

• Project Management Lessons

1. Top Down with an end to end view

2. Structured Approach– Clear definition of ownership and

accountability

– Balance “Risk” vs. “Finance” roles

– Detailed project planning

3. Coordination and Communication– Front office, middle office and back office

– Involvement of appropriate constituents

• Integrity of the Information Architecture

• Credit MIS Design and Data Model

• Qualification “data” vs. computation “data” attributes

• Operating Model - regulatory process and governance

• Revisit short cuts from prior merger “integration” projects

• Project Management Lessons

1. Top Down with an end to end view

2. Structured Approach– Clear definition of ownership and

accountability

– Balance “Risk” vs. “Finance” roles

– Detailed project planning

3. Coordination and Communication– Front office, middle office and back office

– Involvement of appropriate constituents

• Integrity of the Information Architecture

• Credit MIS Design and Data Model

• Qualification “data” vs. computation “data” attributes

• Operating Model - regulatory process and governance

• Revisit short cuts from prior merger “integration” projects

Surprise

Exploring role of Economic Capital systems/processes in Basel II Implementation

• Role and Contribution of Economic Capital Systems – Drives consistency in risk definitions and risk measurement approaches

• Create a level playing field to assess businesses and activities affected by different risk forms

– Incorporates Bank’s risk tolerance objectives in capital measure

– Brings focus and attention to “first order” data elements required for quantification

– PD, LGD, EAD data histories and calibration• Have proven very valuable starting point for Basel II

• Serves as the foundation for RAROC, value based performancemanagement and strategic decision support– Primary role is management reporting

• The 80/20 rule works for economic capital– Provides directionally correct and reasonably consistent results to support

key decision making

Limited success in leveraging economic capital systems for Basel II “operational” implementation

• From a process and controls perspective, most bank economic capital systems would be considered “immature” or ad hoc

– Systems were not designed and developed with a view to support external or regulatory reporting

– Focus has been on methodology, analytics and assumptions, not so much on controls, review, reconciliation and documentation

– “data” was considered good enough for risk modeling

• Minimum Basel II qualification criteria were never focus of economic capital systems

– Risk ratings systems, corporate governance and oversight, credit process and policies, etc.

• Basel II regulatory view of risk continues to differ from economic capital view in several areas

– Securitizations, repo-style transactions, credit hedging, OTC derivatives

– In many aspects, regulatory model would be a simplification of EC model

• Pillar II (supervisory review) and Pillar III (reporting/disclosure)

protection_provider

PK,I1 protection_provider_id

protection_provider_nameguarantor_typestandalone_grade_protection_providerrating_protection_providerdefault_grade_protection_provider

crm

I2 crm_id

FK2,I4,I6 outstanding_idFK1,I3,I1 crm_haircuts_idFK3,I5,I8 protection_provider_id

loss_given_defaultprobability_defaultrwa_crm_portioncrm_currencycollateral_typecrm_term_out_dateallocated_exposurecash_flaggold_flagsenior_debt_flagliquidity_approved

I7 index_iducits_flagmutual_funds_flagdaily_price_flagCRM_typecredit_derivative_typecollateral_amountcredit_protection_valuesupervisory_input_OCexchange_id

FK4 tranche_idFK2 obligor_id

collateral_fair_value

deposit

PK,I5 deposit_id

FK2,I2,I3 exposure_iddepositnet_ag_flag_ddeposit_maturity_date

FK1,I1,I4 crm_haircuts_iddeposit_currency

FK2 obligor_id

portfolio

PK portfolio_type

int_portfolioRWA_expected_lossRWA_unexpected_lossasset_classint_asset_classallowance_spec_chaprov_portfolioprov_def_surpl

securitization_tranche

PK,I4 tranche_id

FK1,I1,I3 securitizations_ide_tranchebank_interest_in_trancheexposure_seniorityindividual_tranche_ratingtranche_of_interest

obligor

PK,I1 obligor_id

obligor_nameprobability_default_obligorasset_classint_asset_classSDBC_exemption_flagstandalone_gradedefault_gradeobligor_gradeborrower_group_sizeborrower_group_total_assetsborrower_group_turnover

outstanding

PK,FK6 obligor_idPK,I2 outstanding_id

FK1,I3,I1 outstanding_haircuts_idFK4 netting_idFK5 facility_id

nominal_exposurenotional_principal_amountadd_on_derivative_typeexposure_reporeplacement_costexposure_abs_net_positionexposure_abs_net_fxoutstanding_currencyreporting_datevaluation_typeshort_term_exposure_typeresidual_value_risk_flagresidual_lease_valueLPperiod-tDfactor-tfair_value_leaseeffective_maturityt_derivativeloss_given_defaultLGD_Business_typeEADc_percent_poolrwa_outstanding

FK3,I6 securitizations_idFK2,I7 tranche_id

partial_write_offspecific_provisiondefaulted_assets_flagspecialised_lending_eligibility_flagVaR backtest_exceptionVaR flagsecuritization_purchase_discount

securitizations

PK,I1 securitizations_id

spe_idexpected_maturitycurrency_codeearly_amortization_flagearly_am_controlled_flagearly_am_uncommitted_flagearly_am_retail_flagexcess_spread_trapping_pointearly_amortization_trigger3_month_average_excess_spreadclean_up_call_indicatorclean_up_call_exercise_pointbank_chosen_formulamfmi_securitization

oustanding haircuts

PK,I1 outstanding_haircuts_id

internal_haircut_flaginternal_exposure_haircutinternal_currency_haircutissue_rating_of_debt_security_outstandingrating_agency_outstandinginstrument_type_outstandingissuer_type_outstanding

crm_haircuts

PK,I1 crm_haircuts_id

days_between_remarginingrating_agency_collateralissue_rating_of_debt_security_collateralinstrument_type_collateralissuer_type_collateraltransaction_typebank_holding_periodinternal_collateral_haircutbank_holding_period_haircut

cashflow

PK,I1 cashflow_id

FK1,I3,I2 outstanding_idfees_cashflowinterest_cashflowprincipal_cashflowcashflow_period

FK1 obligor_id

provisions

tier_2_Limitallowance_gen

Basel II Credit Risk Logical Data Model

Last Update: 02 October 2003

Obligor

Asset Securitization

Credit Risk Mitigation

Outstandings Data

Provisions

netting

PK netting_id

netting_enforceablenetting_contractnet_exposure

facility

PK facility_id

facility_maturity_datefacility_start_datefacility_term_out_date

derivatives

PK derivative_id

FK2 securitizations_idspe_idderivative_counterparty_idderivative_counterparty_ratingnotional_amounte_swap_m2madd_on_factorderivative_maturity

liquidity_facility

PK liquidity_facility_id

program_wide_flagFK2 securitizations_idFK1 tranche_id

spe_idliquidity_provider_idliquidity_facility_ratingeligible_liquidity_facilityeligible_liquidity_facility_md_flagliquidity_facility_seniorityliquidity_facility_line_amounte_ccf_liquidity_facilityliquidity_facility_maturity

credit_enhancement

PK credit_enhancment_id

FK1 securitizations_idtranche_idspe_idcredit_enhancement_provider_idcredit_enhancement_provider_ratingcredit_enhancement_senioritye_ccf_credit_enhancementcredit_enhancement_maturity

This diagram illustrates attribute groupings and high-level relationships. These will be fullydefined in the Analyse Phase.

Transition From Logical Model to Physical Model…..

• Linkage of Facilities to Borrowers

• Multi Borrower Facilities

• Multiple Ratings for Same Borrower

• Borrower Legal Hierarchies

• Credit Product to Account Mappings

• Consistent Product Hierarchies

• Legal Hierarchies vs. LOB Hierarchies

• Collateral, Guarantees and Hedges

• Identification of Structured Finance Facilities • ABCP Conduits

• Credit Support

• Standby Letter of Credit

• Tax driven securitization structures etc

• Risk Mapping of the Balance Sheet

…is Uncovering Significant Credit Data Issues

Some sample implementation pain points

Internal Historical Data, especially LGD and EAD

CDS Hedging Process for Qualification and Application of Rules

Structured Finance / Securitization Products

Securitization Data Infrastructure

Banking Book vs. Trading Book (overlaps)

Collateral data capture and reporting

Repo-Style Transaction Data Capture / Netting Rules etc.

Transitioning information from front office to risk data repositories

Credit MIS to General Ledger Reconciliations

Legal Entity Reporting in different jurisdictions

Future state operating model for regulatory reporting

Data Quality (in risk MIS and Finance)

End to end testing

Basel II driven transformation can lead to long term benefits

Common Data &

Definitions

Qualification

Methodology & Analytics

Calculation Requirements

• Specific disclosure reports• Additional data requirements

• Data flows and control processes• Calculation engine• Roles and responsibilities

• Required and optional process changes

• Recognition of credit risk mitigants

• Data attributes• Data quality• Data model• Data definitions

• Calibration techniques• Treatment choices and options• Risk modeling

• Governance and controls• Process and policy• Historical data

• Integration with current regulatory reporting

• Local legal entity requirements• Parallel run of Basel I and Basel

II

Transformational

Initiatives

CREDIT

FINANCE

TECHNOLOGY

OPERATIONS

C

U

R

R

E

N

T

S

T

A

T

E

T

A

R

G

E

T

O

P

E

R

A

T

I

N

G

M

O

D

E

L

Efficient Credit Process:

Underwriting

Approvals

Risk Rating

Administration

Credit Review

Active Portfolio Management:

Limit Monitoring

Risk Reporting

Problem Asset Mgt

Hedging Strategy

Tactical Rebalancing

Value Realizatio

Pricing

Business Unit Profitability

Relationship Profitability

Targeting

Strategic Positioning

Reconcilable Views

Consistent Hierarchies

High Quality Data

Process Requirements

Implementation of RWA Requirements

Integration with Regulatory Reporting

Pillar 3 Reporting Requirements

Common Data &

Definitions

Qualification

Methodology & Analytics

Calculation Requirements

• Specific disclosure reports• Additional data requirements

• Data flows and control processes• Calculation engine• Roles and responsibilities

• Required and optional process changes

• Recognition of credit risk mitigants

• Data attributes• Data quality• Data model• Data definitions

• Calibration techniques• Treatment choices and options• Risk modeling

• Governance and controls• Process and policy• Historical data

• Integration with current regulatory reporting

• Local legal entity requirements• Parallel run of Basel I and Basel

II

Transformational

Initiatives

CREDIT

FINANCE

TECHNOLOGY

OPERATIONS

C

U

R

R

E

N

T

S

T

A

T

E

T

A

R

G

E

T

O

P

E

R

A

T

I

N

G

M

O

D

E

L

Efficient Credit Process:

Underwriting

Approvals

Risk Rating

Administration

Credit Review

Active Portfolio Management:

Limit Monitoring

Risk Reporting

Problem Asset Mgt

Hedging Strategy

Tactical Rebalancing

Value Realizatio

Pricing

Business Unit Profitability

Relationship Profitability

Targeting

Strategic Positioning

Reconcilable Views

Consistent Hierarchies

High Quality Data

Process Requirements

Implementation of RWA Requirements

Integration with Regulatory Reporting

Pillar 3 Reporting Requirements

Industry Impact

Basel II vs. Basel I – Winners and Losers

Investment-grade corporate lending

Retail banking, and secured residential real estate lending, esp. residential mortgages

Lending against financial assets and collateralized lending

Short-term lending – i.e. trade finance

Hedged (CDS) or guaranteed credit exposures

Lower Capital Charges

Lending to emerging markets (perhaps excluding “advanced” ones)

Non-investment grade corporate lending, sub-prime retail lending, project finance and lease finance

Significant equity investments; equity investments to hedge funds

Operationally intensive businesses – asset management, clearing, trust and custody

Higher Capital Charges

Prime brokerage (business with hedge funds)

Credit card ABS programs or conduit facilities

Potential trends

• Greater alignment between EC and Regulatory capital– Some unintended consequences are possible

– Possible integration for management reporting

– Fewer opportunities for capital arbitrage

• Data Quality improvement– Reduced noise in credit data

– Consistency

– Greater objectivity in credit assessment

• Improved AQ and Concentration reporting

• Streamlined regulatory reporting process

Competitive Landscape• A-IRB banks vs. Basel 1A banks• Banks vs. unregulated finance companies• US vs. European banks

– Leverage ratio requirement– Adoption timing differences

• Impact on average capital levels for banks– 1. Markets– 2. Markets– 3. Markets– 4. Rating agencies– 5. Regulatory minimum requirements

basel 2 -deloitte

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