basel ii self assessment

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Disclaimer

The information, data and approaches provided herein are an outcome of our research and content expertise. Although we referred to third party materials and

analysed their impact, however the content is the outcome of CCP's proprietary knowledge and is rightfully owned by us. This work is copyright protected and

legally privileged.

Please do not distribute this presentation without the prior written consent of Capital Calibration Partners or its authorized affiliates.

CCP has made best efforts to ensure that this material is complete in its entirety. However, we does not warrant its completeness or accuracy nor do we

warrant that the results obtained will be useful or will satisfy the all requirements.

Copyright © 2014 Capital Calibration Partners Inc.

Basel II: International Convergence of Capital Measurement and Capital StandardsAddressing the requirements of

Basel II: International Convergence of Capital Measurement and Capital Standards (BCBS issue June 2006)

Regulation Self-assessment

Prepared by: Capital Calibration Partners

Nov. 2014

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Contents

1 Why Capital Calibration Partners (CCP)?

Executive Summary

Basel II – First Pillar: Credit Risk Capital Charges

Basel II – First Pillar: Operational Risk Capital Charges

Basel II – Second Pillar: Supervisory Review

Basel II – Third Pillar: Market Discipline

Stakeholder selection for self assessment

Self assessment

Credit Risk

Market Risk

Economic Value Framework

Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Innovative approach

1. Terms and conditions apply

Capital Calibration Partners (CCP) is a management consulting firm that specializes in the financial

services content curation, content standardization and content roll-out

Regulation Self Assessment

(RSA)

Best Practice Benchmarking

(BPB)

Strategic Knowledge Transfer

(SKT)

3 practice themes

Also provide customized assistance in the following areas1:

• Production of content in MS Power Point based on client mandates

of off-site work

• Completion and rating of the Self-Assessment

• Development and design of a vision or requirements document,

e.g., User Vision Documents (UVD’s), Request for Information

(RFI), Request for Proposals (RFP’s)

For further assistance,

please contact CCP at:

[email protected]

Our RSA toolkits allow you to

objectively determine gaps due

to regulatory changes. We map

proven management consulting

approaches with regulatory

requirements

BPB’s self-diagnostic tools

would allow you to understand

how the ‘leading practice’

financial institutions are

influencing the changes across

the industry, and how such

changes are impacting your

organization

SKT provides you deep insights

into the “practitioners’

knowledge base”, that would

enable you to conceive complex

projects internally from design to

implementation

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Web based content distribution enables robust knowledge transfer

Helps kick-start development mandate in client organizations

Understand requirements

CCP Gap Analysis Undertake Self-Assessment

• Download CCP’s

proprietary content from

the website

• Share it with key process

owners, managers and

stakeholders

• Understand the

requirements and prepare

for the Self-Assessment

• Rate Self-Assessment to

benchmark your current

state

• CCP would collate the

results, validate the Self-

Assessment, understand

your needs and develop a

target state

Step 1Step 2

Step 3

Other optional services

include:

• Development of

implementation plan,

including a delineation of

external and internal

resources

• Development of a vision

document, roadmap or

requirements document

and Request for

Proposals (RFP’s)

CCP site downloads Separate quote

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We are uniquely well-qualified to help clients

The CCP team has experience in formative research, communication plans and

strategies, developing and disseminating materials, and utilizing traditional and

non‐traditional social marketing and communication strategies, including social

media

Our research and consulting teams undertake mandated and proprietary research,

focusing on regulatory publications (Basel, FSB), industry, academic journals and

practitioners interviews

Case Studies: CCP combines interviews, content analysis, engagement results and ‘pit-

falls’ to design content that addresses complex needs of today’s consulting, regulatory

and FS client organizations. This approach is particularly well suited to clients looking for

the “lessons learned” to avoid pitfalls since it pulls together multiple perspectives into one

“story”

Our production team creates and publishes the content on our website

In a nut shell, our proprietary web platform enables you to realize significant savings

Our consultants use a wide range of quantitative and qualitative approaches to ensure

a balance of rigor and practicality while developing the FS content

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Regulations are broadly organized around three broad dimensions: Design, Embed and Refine

We use the management consulting lens of best practices to develop approaches for the implementation of regulations

Basel II: International

Convergence of Capital

Measurement and Capital

Standards

Analyze regulation

Design dimension

Embed dimension

Process dimension

D

E

R

Map consulting approaches

Design

Embed

Refine

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Basel II represents a fundamental shift in banking regulation

Pillar 1

Minimum Capital

Requirements

Pillar 2

Supervisory Review

Of Capital Adequacy

Pillar 3

Market Discipline

Basel II Capital Accord

• Recognition of agency

ratings and internal ratings

• Recognition of internal

exposure and loss mitigation

estimates

• Explicit treatment of

Operational Risk

• Banks must assess

solvency relative to their risk

profile

• Supervisors review and

evaluate risk management

and capital management

practices

• Top 5-10 banks in each

country typically expected to

comply with IRB approach

• Improved disclosure of

capital structure and capital

adequacy

• Improved disclosure of risk

measurement and

management practices

• Improved disclosure of

risk profile

• More than ever before, risk

management is a true

competitive differentiator

• Regulators expected to

differentiate ‘add ons’ based

on quality of risk and capital

management

• Significant increase in

required regulatory role

• Banks required to release

much more information

about their risk profile

• Debt and share markets

increasingly able to

differentiate based on risk

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Basel II implications for emerging market banks

Overall, Basel II brought about a positive impact on the banking sector as a catalyst for improved MIS and better management of risks

However, there were some ‘unpleasant’ consequences as well, e.g.

• Increased capital requirements and funding costs for most emerging market (EM) banks, leading to pressure on ROE

• Significant investment requirements into compliance: IT, data, analytics, resources, etc.

• Procyclicality risk

In the post-B2 world, banks need to leverage compliance efforts into business benefits, to the greatest extent possible

This amounts to substantially upgrading the way that the bank measures and manages risk, capital, profit and value

Banks also need to be aware of common challenges and pitfalls of this long and costly process

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Basel II – Sovereign Capital Charges

Sovereigns – In a Nutshell

%

1. Inputs: average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5. (Moody’s rating applied if different from S&P)

Basel I

Type of

sovereign

Risk

Weight

OECD 0

Non-OECD 100

Basel II

Ex

tern

al

Ra

tin

gAA- or above

A

BBB

BB+ to B-

Below B-

Unrated

0

20

50

100

150

100

Standardised bank

risk weights

Co

un

try

Sample est. FIRB bank

risk weights1

Poland

Russia

Turkey

Bulgaria

Czech Republic

Hungary

25

68

141

100

24

24

Rating

A2/BBB+

Baa3/BBB-

B1/BB-

Ba1/BBB-

A1/A-

A1/A-

12Source: Text

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Sovereigns – Standardised Banks (¶¶ 53-59)

%

Risk weights for sovereign exposures:

Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated

Risk

Weight0 20 50 100 150 100

Risk weights may also be based on ECA risk scores

Claims on non-central government public sector entities based on corporate exposure risk weights

Claims on multilateral development banks have 0% risk weight if conditions are met, including: (i) majority of MDB’s ratings are AAA, (ii) significant portion of shareholders are AA- or better rated sovereigns, (iii) funding is in form of paid-in equity with little or no leverage, and (iv) conservative lending criteria

At national discretion, lower risk weight for banks’ exposures to their sovereign (or central bank) in domestic currency; if adopted, other regulators may permit same risk weight

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Sovereigns – IRB Banks (¶¶ 270-272)

Formula for exposure not in default:

Capital requirement for defaulted exposure equals greater of zero and difference between exposure’s LGD and bank’s best estimate of loss

Input characteristics (applicable to all types of exposures) (¶¶ 285-325):

• PD: internally determined one-year probability of default

• LGD:

FIRB: 45% (senior)/75% (subordinated); adjusted (LGD* = LGD x (E* / E) for CRM recognition

AIRB: own estimates; adjusted for CRM recognition

• EAD: not less than sum of (a) amount by which bank capital would reduce if exposure written-off fully and (b) specific provisions and partial write-offs

• M: 2.5 years for FIRB (6 months for repos); own est. for AIRB for each exposure; max. 5 years

0.12 × (1 – EXP (-50 × PD)) / (1 – EXP (-50)) +

0.24 × [1 - (1 - EXP(-50 × PD))/(1 - EXP(-50))]

Correlation (R) =

Maturity adjustment (b) = (0.11852 – 0.05478 × ln (PD))^2

Capital requirement (K) = [LGD × N [(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] –

PD x LGD] x (1 - 1.5 x b)^ -1 × (1 + (M - 2.5) × b)

Risk-weighted assets (RWA) = K x 12.5 x EAD

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Basel II – Bank Capital Charges

Banks – In a Nutshell

%

1. Using inputs of average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5.

2. Using inputs of rating agency values for PD, LGD of 10%, supervisory value for EAD and M of 2.5.

3. Internal PD estimate to be applied

Source: Text

Basel I

Type of

Bank

Risk

Weight

OECD 20

Non-OECD 100

Basel IIE

xte

rnal R

ati

ng

AA- or above

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

Unrated

20

50

100

100

150

100

Standardised

Option 1

Standardised

Option 2

20

50

50

100

150

50

Exte

rnal R

ati

ng

BB+ to B-

Below B-

Unrated3

FIRB est.

risk weights1

14-24

24-28

38-68

100-197

226

NA

AA- or above

A+ to A-

BBB+ to BBB-

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Banks – Standardised Banks (¶¶ 60-65)

%

2 options, selected by national regulator to apply for all banks in jurisdiction:


Risk

Weight20 50 100 100 150 100

• Option 2: At national discretion, banks risk weighted on basis of own external ratings (plus more favourable risk weight if claim maturity < 3 months)


Risk

Weight20 50 50 100 150 100

• Local currency reduction: National regulators may reduce by one notch risk weight of local currency bank debt having maturity of less than 3 months, subject to floor of 20%

• Exposures to securities firms treated as bank claims if regulatory arrangements comparable

• Option 1: Banks risk weighted one category below risk weights of banks’ sovereigns:

Source: Text 16

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Banks – IRB Banks (¶¶ 270-272)

Formulas for bank exposures same as for sovereign exposures, but with floor for PD of 0.03%

Effective floor of 16 to 48 basis points for highest quality credits (depending on maturity assumption) under Advanced IRB

• Generally, PD for high-quality bank debt will be below 0.03% floor (so floor must be used)

• More realistic 10% LGD for Advanced IRB bank (rather than 45% supervisor-imposed LGD for Foundation IRB banks) results in significant capital reductions

• Compare to 56 basis point floor for highest quality ABS

Source: Text 17

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Basel II – Corporate Capital Charges

Corporates – In a Nutshell

%

1. Using inputs of rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5.

2. Internal PD estimate to be applied

Source: Text

Basel I

Risk

Weight100

Basel IIE

xte

rnal R

ati

ng AA- or above

A

BBB+ to BB-

Below BB-

Unrated

20

50

100

150

100

Standardised

Option 1

Standardised

Option 2

100

100

100

100

100 Exte

rnal R

ati

ng

AA- or above

A

BBB

BB+ to B-

Below B-

Unrated2

FIRB est.

risk weights1

14-24

24-28

38-68

100-197

226

NA

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Corporates – Standardised Banks (¶¶ 66-68)

%

2 options, selected by national regulator to apply for all banks in jurisdiction:

Rating AAA to AA- A+ to A- BBB+ to BBB- Below BB- Unrated

Risk

Weight20 50 100 150 100

• Option 2: At national discretion, all corporates risk weighted at 100% without regard to external ratings

• SME Adjustment: 75% risk weight for unrated SME if exposure under €1 million and either treated by bank as retail or guaranteed by individual

• Includes claims on insurance companies

• Option 1: Corporates risk weighted as set out in following chart (supervisory authority to increase 100% risk weight for unrated corporates where warranted by higher default rates):

Source: Text 19

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Corporates – IRB Banks (¶¶ 270-274)

Formulas for corporate exposures same as for bank exposures, including floor for PD of 0.03%

Source: Text

SME Adjustment for firms setting total annual sales (S) at €50 million or and €5 million or more:

• Subject to national discretion, supervisors may allow banks to substitute total assets for total sales

• SME adjustment generates approx. 20% reduction in risk weights (depending upon original creditworthiness)

Correlation (R) = 0.12 × (1 – EXP (-50 × PD)) / (1 – EXP (-50)) +

0.24 × [1 - (1 - EXP(-50 × PD))/(1 - EXP(-50))] – 0.04 ×(1 – (S-5)/45)

Effective floor of 14% risk weighting for foundation IRB banks due to minimum PD of 0.03% representing a capital charge of 112 bps

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Basel II – Retail Capital Charges

1. PD and LGD inputs provided by bank (¶ 331); PD floor at 0.03%

2. Using PD of 3% and LGD of 80% and PD of 5% and LGD of 90%, respectively

3. Using PD of 5% and LGDs of 40% and 60%, respectively

Source: Text

Basel I

Risk

Weight100

Basel II

Generally

Default

75% if conditions met

From 150% to 50% depending

on level of specific provisions

against exposure

Standardised bank risk weights FIRB est. risk weights1

Credit cards

Other Retail

70-110 2

60-90 3

Retail – In a Nutshell

%

Internally determined PDs and

LGDs under Foundation IRB

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Retail – Standardised Banks (¶¶ 69-71)

Generally

• 75% risk weight if:

Exposure to individual or small business

Exposure takes form of revolving credit, line of credit, personal loan, lease, or small business facility (mortgage loan excluded to extent otherwise covered (see below))

Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one counterparty should exceed 0.2% of overall portfolio

Maximum aggregate counterparty exposure €1 million or less

• Effective floor of 600 basis points

Source: Text

Past Due

• Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows:

150% when specific provisions less than 20% of outstanding amount of exposure

100% when specific provisions 20% or more of outstanding amount of exposure

100% when the specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case

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Retail – IRB Banks (¶¶ 326-338)

Formula for qualifying revolving retail exposure not in default:

Source: Text

Formula for qualifying revolving retail exposure not in default:

When only drawn balances securitised, bank must hold required capital against unfunded commitment

0.04Correlation (R) =

LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 ×

G (0.999)] – PD × LGD

Capital requirement (K) =

K x 12.5 x EADRisk-weighted assets

(RWA)

=

0.03 × (1 – EXP (-35 × PD)) / (1 – EXP (-35)) + 0.16 × [1 -

(1 - EXP(-35 × PD))/(1 - EXP(-35))]

Correlation (R) =

LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 ×

G (0.999)] – PD × LGD



(RWA)

=

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Basel II – Real Estate Capital Charges

1. Subject to conditions

2. Reduced 50% risk weight possible, subject to conditions

3. Using PD of 1% and LGD of 10% and PD of 2% and LGD of 25%

4. Using PD range of 0.07% and 2.1% and LGD of 35%

Source: Text

Basel II

Standardised bank risk weights FIRB est. risk weights

Real Estate – In a Nutshell

%

Basel I

Type of

exposure

Risk

weight

Residential

Commercial

50

100

Residential

Commercial

35 1

100 2

Residential

Commercial

10-50 3

20- 90 4

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Real Estate – Standardised Banks

Residential Real Estate (¶¶ 72-73)

• 35% risk weight for exposures fully secured by mortgages on residential property occupied by the borrower or rented

• Strict prudential criteria (including loan to value ratios) determined by national regulators

• Supervisors may require increased risk weight if data warrant

• Effective floor of 280 basis points

Source: Text

Commercial Real Estate (¶ 74)

• Generally 100% risk weight, given experience in numerous countries with troubled credits over the past few decades

• However, 50% risk weight possible in certain markets if (among other conditions): (i) tranche not greater than lower of 50% of market value and 60% of mortgage lending value, (ii) losses on tranche do not exceed 0.3% in any year, and (iii) overall losses from commercial real estate in relevant market do not exceed 0.5% in any year

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Real Estate – IRB Banks

Residential Mortgages – Formula for exposure not in default (¶¶ 327-328):

Source: Text

High volatility commercial real estate (HVCRE) (¶¶ 280-284):

At national discretion, banks may assign preferential risk weights of 70% to “strong” and 95% to “good” where maturity is less than 2.5 years or supervisor determines bank’s underwriting criteria and other risk characteristics are substantially stronger

0.15Correlation (R) =

LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 ×

G (0.999)] – PD × LGD



(RWA)

=

Supervisory Rating Strong Good Satisfactory Weak Default

Risk Weight 95 120 140 250 0

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Basel II – Covered Bonds Capital Charges

1. Italy, Portugal, Sweden, UK

2. Requires rating of AAA to AA-

3. Requires rating of A+ to A- under Option 1 and rating of A+ to BBB- under Option 2

4. LGD of 12.5% required in CRD with PD floor of 0.03%. Using inputs PD as noted, LGD of 12.5%, supervisory value for EAD and M of 2.5.

Source: Text

Basel II (CRD)

Standardised bank risk weights FIRB est. risk weights4

Covered Bonds – In a Nutshell

%

Basel I

Type of

exposure

EU Risk

Weight

UCITS

qualifying

Exceptions 1

10

20

PD of 0.03%

PD of 0.15%

4

10

Senior debt

RW

Covered bond

RW

20 2

10

50 3

20

100

50

150

100

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Basel II – Specialised Lending Capital Charges

Source: Text

Basel II

Standardised bank risk

weights (¶ 80)IRB bank risk weights (¶¶ 275-284)

Specialised Lending – In a Nutshell

%

Basel I

Risk

Weight

All 100Five Classes of Specialised Lending:

• Project finance

• Object finance

• Commodities finance

• Income-producing real estate

• High-volatility commercial real estate

Generally: For exposures other than HVCRE,

banks that do not meet requirements for estimation

of PD will map internal grades to five supervisory

categories (70% for strong, 90% for good, 115% for

satisfactory, 250% for weak and 0% for default) (¶

275)

At national discretion, supervisors may allow 50%

for “strong” and 70% for “good” if remaining

maturity less than 2.5 years or supervisor

determines underwriting or other risk characteristics

are substantially stronger (¶ 277)

All 100

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Basel II – Off Balance Sheet Items

Off Balance Sheet Items – Standardised Banks (¶¶ 82-89)

Off-balance sheet items converted into credit exposure equivalents using credit conversion factor (CCF)

Commitments

• Original maturity of up to one year: 20% CCF

• Original maturity in excess of one year: 50% CCF

• Unconditionally cancellable: 0% CCF

Source: Text

Securities lending

• Lending of bank securities or posting as collateral (including repo and reverse repo transactions): 100% CCF

Letters of Credit

• Short-term self-liquidating trade letters of credit: 20% CCF

Other commitments

• As specified in Basel I

Failed transactions

• As specified by national regulators

• Effect of failed transactions on off-balance sheet items subject to Basel/IOSCO review

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Basel II – Off Balance Sheet Items

Off Balance Sheet Items – IRB Banks (¶¶ 310-316)

Off-balance sheet items converted into exposure at default (EAD) input using credit conversion factor (CCF) under either foundation approach to EAD or advanced approach to EAD:

Source: Text

Foundation approach to EAD

• Types of instruments and CCFs same as for standardised approach (¶¶ 82-89) except for commitments, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs)

• CCF of 75% applicable to commitments, NIFs and RUFs regardless of maturity

• CCF of 0% if commitment unconditionally cancelable

Advanced approach to EAD

• Banks allowed to use own estimates of CCF if allowed to use internal estimates for EAD (¶¶ 474-478)

• But 100% CCF if required under foundation approach to EAD

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Basel II – Equity Capital Charges

1. For banking book exposures. National supervisors may exempt from IRB treatment for up to ten years particular equity exposures held at publication date of Basel II accord (¶ 267)

2. CRD has preferential treatment vs. Basel II Accord; supervisors may increase to 150% for venture capital and private equity investments (¶ 80

3. Inputs: average rating agency PDs, LGD of 90%, supervisory value for EAD and M of 5.

4. Under Basel II (¶ 353) a floor risk weight of 200% applies to listed equities

Source: Text

Basel II 1

Standardised bank

risk weights

Simple

Model 2

Equity – In a Nutshell

%

Basel I

Type of

exposure

Risk

Weight

Non-consol

equity100 Corporates

Banks

100 2

100

Securities

firms100

Co

mp

an

y

DaimlerChrysler

Siemens

Fresenius Med. Care

GE

Sony

Vivendi Universal

Bertlesmann

PD/LGD

Model 3Rating

290

290

290

290

290

290

290

92 4

81 4

264

32 4

82 4

195 4

120 4

A3/BBB

Aa3/AA-

Ba1/BB+

Aaa/AAA

A1/A

Baa3/BBB-

Baa1/BBB+

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Basel II – Equity Capital Charges

IRB Banks – Three Approaches

Simple risk method (¶¶ 344-345)

• CRD: 190% risk weight for diversified private equity exposures (not in Basel II)

• CRD: 290% risk weight for publicly traded exposures (300% in Basel II)

• CRD: 370% risk weight for all other holdings (400% in Basel II)

Source: Text

Internal models method (¶¶ 346-349)

• Taken from VaR models as 12.5 times difference between

99% percentile one-tail quarterly return and

Risk free rate over long-term sample period

• Floor: capital charge under simple risk model but using 200% (traded) and 300% (not traded)

PD/LGD method under CRD (¶¶ 350-361)

• Generally, use normal corporate exposure formulas if possible (results in risk weights substantially below 200% and 300% floor in Basel II)

If bank does not have sufficient information to use definition of default, then apply scaling factor of 1.5 to risk weights

Unfunded credit protection on equity exposure recognised, subject to LGD of 90%, with reduced LGD of 65% for private equity exposures

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Basel II – Non-Performing Loan Capital Charges

Source: Text

Basel II/CRD

Non-Performing Loans (NPLs) – In a Nutshell

%

Basel I

No uniform rules:

• In Europe –

combination of

general and specific

provisions

• In US five-tier

ranking system

derives capital

Standardised bank risk weights (¶¶ 75-78) IRB bank risk weights

• Generally: Unsecured portion of exposure

past due for more than 90 days, net of

specific provisions, risk weighted as follows:

150% when specific provisions less than

20% of outstanding amount of exposure

100% when specific provisions 20% or

more of outstanding amount of exposure

100% when specific provisions 50% or

more of outstanding amount of exposure,

with supervisory discretion to reduce risk

weight to 50% in such case

• Residential Mortgages: risk weighted at

100% net of specific provisions; at national

discretion risk weight reduced to 50% of

specific provisions 20% or greater

• Commercial Mortgages: unexpected loss

risk-weighted at 100%

• Generally: capital requirement for defaulted

exposure is equal to greater of zero and

difference between LGD (described in para.

468) and bank’s best estimate of expected

loss (¶ 272)

• Under IRB approach, for asset classes other

than securitisation, bank must compare (i)

total amount of eligible provisions with (ii)

total expected losses and deduct excess (if

any) of expected losses over provisions (¶ 43,

¶¶ 380-383)

• For securitisation exposures or the PD/LGD

approach for equity exposures, bank must

first deduct EL amounts under paras. 563 and

386, respectively (¶ 43)

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Non-performing loans – Generally

Essentials:

• Non-performing loan under Basel II is any loan that is past due for more than 90 days, but subject to national variation

• For purposes of defining secured portion of non-performing loan, eligible collateral and guarantees will be recognised as under CRM rules for performing loans

• Capital charges depend on level of specific provisions held against loan

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Non-performing loans – Standardised Approach

Unsecured non-performing loan:

• Unsecured portion of non performing loan will be risk-weighted as follows:

150% when specific provisions less than 20% of outstanding amount of exposure

100% when specific provisions 20% or more of outstanding amount of exposure

100% when specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case

Source: Text

Secured non-performing loan:

• Qualifying residential mortgage loans risk weighted at 100%, net of specific provisions. If such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion

• Commercial mortgages: unexpected loss risk weighted at 100%

• Non-performing loans fully secured by forms of collateral not recognized under Basel II (eligible financial collateral) risk weighted at 100% when provisions reach 15% of outstanding amount of loan

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Non-performing loans – IRB Approach

General Rules:

• Capital charges to cover unexpected losses

• Bank must cover expected losses with specific provisions

Source: Text

Consequences:

• Fixed LGD at 45% for non-retail assets and senior exposures may result in risk weights as follows:

565% when no specific provisions of outstanding amount of exposures

400% when specific provisions 20% of outstanding amount of exposure

0% when the specific provisions 50% or more of outstanding amount of exposure

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Non-performing loans – sample capital calculation

€100 million NPL

Source: Text

Specific Provisions 0% 30% >50% 80%

Net exposure 100 70 <50 20

Capital Charges

Basel I 8.0 5.6 3.2 1.6

Standardised Approach 12.0 5.6 1.6 0.8

IRB Approach 45.0 15.0 0.0 0.0

Advanced IRB Approach 30.0 0.0 0.0 0.0

Risk Weights

Basel I 100% 100% 100% 100%

Standardised Approach 150% 100% 50% 50%

IRB Approach 565% 270% 0% 0%

Advanced IRB Approach 380% 0% 0% 0%

Assumptions:

• Supervisory discretion allows use of 50% risk weight if exposure has specific provision of 50% or better

• LGD in Advanced IRB Approach is 30%

• IRB Approach and Advanced IRB Approach are approximated

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Non-performing loans – Originator´s point of view and market outlook

Motivations to sell non-performing loan portfolios:

• Reduce capital supporting non-performing loans

• Reduce negative carry by eliminating financing needs

• Shift capital and resources into more profitable businesses

• Optimize bank’s balance sheet

• Improve bank’s credit ratings

• Reduce operating costs due to smaller work-out departments

Source: Text

Market outlook

• Basel II will motivate banks to sell NPLs

• German NPL market estimated between €160 billion and €300 billion (Boersenzeitung 18.2.2005)

• German NPL market development to increase to estimated €20 billion this year and possible average of €15 billion per year after 2007 (Boersenzeitung18.2.2005)

• No capital charges required if investors not banks

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Basel II – Credit Risk Mitigation

1. Same as simple approach under Basel II for standardised banks (i.e., substitution)

2. Maturity of < one year

3. Subject to considerable change due to Basel/IOSCO review, including introduction of “double default” recognition for certain exposures rather than substitution approach

Source: Text

Basel II

Credit Risk Mitigation (CRM) – In a Nutshell

%

Basel I

Type of

exposure

Risk

Weight1

OECD

sovereign0

OECD

bank20

Non-OECD

bank 220

Standardised bank risk weights3

• Simple approach: Risk weight of CRM is

substituted for risk weight of unsupported

exposure

• Comprehensive approach: Adjust value of

both amount of exposure and value of CRM

with either supervisory or own-estimate

“haircuts”; adjust for maturity and currency

mismatches

IRB banks

• Generally: CRM reduces PD or

LGD inputs

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Credit Risk Mitigation – General Rules (¶¶ 109-210)

Protection

Buyer

• Determine capital as provided on following page, except determine capital pursuant to securitisation rules (following) if credit risk protection tranched(e.g., purchased derivatives

Protection

Seller

• Treat as cash position in underlying

Specific

Adjustments

• First to default and second to default protection (¶¶ 207-210)

• Proportional cover (¶ 190(c), ¶ 198))

• Maturity and currency mismatches: size of haircut depends on type of instrument, type of transaction and frequency of mark-to-market and remargining (¶ 135)

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Credit Risk Mitigation – Capital Calculation Method

Standardised

Banks

• Simple Approach (¶ 129, ¶¶182-185) Risk weight of CRM substituted for risk weight of unsupported exposure

(¶ 129) Subject to floor of 20%, with exceptions, e.g., core market participant

floor is 0%, subject to certain conditions (¶ 183)• Comprehensive Approach (¶¶ 130-138)

Supervisory or own-estimate haircuts adjust both amount of exposure and value of collateral received (¶ 130)

Further adjustments for maturity mismatches (square root of time formula) and currency mismatches (¶ 135)

• Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review (¶¶ 140-142, ¶¶189-193)

• VaR models permitted subject to supervisory approval (¶ 138, ¶¶ 178-181)• On-balance sheet netting recognised (¶ 139, ¶ 188)

IRB Banks• Generally

Collateral reduces PD or LGD input (reducing required capital) (¶¶ 289-307)

• Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review (¶ 301)

• VaR models permitted subject to supervisory approval (¶ 292)• On-balance sheet netting recognised (¶ 292)

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Credit Risk Mitigation - Eligible Financial Collateral

Eligible

Collateral

(¶¶ 145-146)

• Cash and gold

• Rated debt securities (sovereign BB- or higher; other BBB- or higher)

• Senior, unrated debt securities issued by bank if listed on recognised exchange and all other bank issues are BBB- or higher

• Equities included in main index or listed on recognised exchange

• UCITS/mutual funds where price quoted daily and UCITS/fund only invests in above instruments

• For IRB banks only: receivables, real estate and other collateral meeting minimum requirements (¶ 289)

• All items recognised as collateral in banking book can also be recognised in trading book

No

correlation

• Collateral must not have material positive correlation with underlying exposure (¶ 124)

First-to-

Default

Second-to-

Default

• First-to-default: recognised if bank obtains protection for entire basket, credit event triggers contract, and notional of underlying less than contract (¶¶ 207-208); regulatory capital relief for asset with lowest risk-weight in the basket

• Second-to-default: recognised if bank obtains first-to-default protection as above or if one asset already defaulted (¶¶ 209-210)

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Credit Risk Mitigation - Other Criteria

Recognition of credit derivatives (¶¶ 191-194)

• Legally binding documentation; direct claim on provider; irrevocable and unconditional

• Mandatory credit events not determined solely by protection provider: (a) failure to pay, (b) insolvency and (c) Restructuring (recognition up to 60% of underlying if no restructuring)

• If asset mismatch, underlying/reference obligation must be pari passu and protection must contain cross-default/cross-acceleration

• Cash settlement permitted if robust valuation process

• If protection purchaser’s right to transfer underlying subject to obligor consent, may not be unreasonably withheld

Source: Text

Eligible protection providers (¶ 195)

• Sovereigns, public sector entities, and banks and securities firms with lower risk weighting than underlying exposure (not SPEs)

Counterparty risk charges for OTC derivatives (¶¶ 186-187)

• Counterparty credit risk charge = [(RC + add-on) – CA] x r x 8% where: RC=replacement cost; add-on= as determined under Basel I; CA=volatility adjusted collateral amount; r=risk weight of counterparty

• Being changed to model-based approach under Basel/IOSCO review

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Basel II – Securitisation Capital Charges

Source: Text

Basel II

Securitisation – In a Nutshell

%

Basel I

Type of

exposure

Risk

Weight1

Generally 100

First loss Deduct

Unfunded <

1 year0

Standardised banks

Risk weights based on rating of

position. If exposure unrated, then

deduct from capital except in case of:

• Most senior exposure (look-through to

average risk weight of pool)

• Second loss position or better (look-

through to higher of 100% and highest

risk weight of pool)

• Liquidity facilities (credit conversion

factors depending on type and length of

liquidity commitment)

IRB banks

Hierarchy of approach:

• If exposure rated must determine risk

weight based on ratings based approach

(RBA)

• If unrated exposure to ABCP conduit may

use internal assessments approach (IAA) if

conditions met

• If unrated exposure may use supervisory

formula approach (SFA) if can determine

inputs (including using top down

methodology)

• If unrated exposure and RBA, IAA and SFA

unavailable, may use exceptional “look

through” approach with regulator consent

on temporary basis for liquidity facilities

• Otherwise, must deduct unrated exposure

from capital

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Securitisation – Standardised Banks – Ratings Based Approach

%

1. Originating banks must deduct BB+ to BB- exposures (¶ 569)

Source: Text

Long Term RatingsShort Term Ratings

Standardised bank risk weights (¶ 567) Standardised bank risk weights (¶ 567)

Exte

rnal R

ati

ng

AA- or above

A

BBB

BB+ to B-

Below B-

Unrated2

20

50

100

350 1

Deduct

Deduct

Exte

rnal R

ati

ng

A-1/P-1

A-2/P-2

A-3/P-3

All other ratings/

unrated

20

50

100

Deduct

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Securitisation – Standardised Banks

Except as provided below, unrated securitisation exposures must be deducted (¶ 567)

Most senior exposures (¶¶ 572-573)

• If the most senior tranche is unrated, the bank that holds or guarantees that position may “look through” to the underlying pool to determine the risk weight (and may assign a risk weight equal to average of risk weight assigned to exposures in underlying pool), provided that the composition of the pool is known at all times

Second loss positions or better (¶¶ 574-575)

• Qualifying exposures provided by sponsor banks in ABCP programs that are in second loss position or better may apply a risk weight equal to the greater of (x) 100% and (y) the highest risk weight assigned to any exposure in underlying pool, but only if:

The first loss position provides significant credit protection

The associated credit risk is investment grade or better

The bank holding the exposure does not hold the first loss position

Eligible liquidity facilities (¶ 576)

• Banks may apply risk weight to eligible liquidity facilities equal to highest risk weight assigned to any exposure in underlying pool

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Liquidity facilities (¶¶ 579-580)

Generally

• 20% credit conversion factor (CCF) for eligible liquidity commitments with an original maturity of one year or less

• 50% CCF for eligible liquidity commitments of more than one year

• 100% CCF for all other liquidity commitments, including rated commitments

Increase from 0% under Basel I

• Regulators believe liquidity absorbs more than just liquidity risks

Credit conversion factor of 0% theoretically possible if:

• Commitment qualifies as “eligible liquidity”

• Commitment can only be drawn if general market disruption (i.e., where more than one SPE across different transactions is unable to roll over maturing commercial paper – i.e., not as result of impairment in credit quality of specific SPE or its pool)

• Commitment must be secured by underlying assets and rank pari passu with conduit’s securities

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“Eligible Liquidity” (¶ 578)

Documentation must identify and limit circumstances of draw, and amounts drawn must be limited to amount likely to be repaid from underlying assets and seller-provided credit enhancement

No incurred losses should be covered and draw should not be automatic

Asset quality test should not cover defaulted assets as defined in paragraphs 452-459 (including receivables more than 90 days past due unless extended up to 180 days by national regulators); if funding based on rating of underlying asset, it must be rated at least investment grade at time of draw

Facility cannot be drawn after all applicable credit enhancement to which liquidity facility has access has been exhausted

Repayment of draws must not be subordinated to interests of any conduit security holder

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Overlapping Exposures (¶ 581)

• For example, if conduit sponsor provides programme-wide liquidity and credit enhancement to ABCP conduit:

If funding one exposure precludes funding the other exposure, sponsor need not hold capital against both exposures

Instead, for overlapping portion sponsor should hold capital against exposure with highest credit conversion factor

• Query

How to allocate partial credit enhancement

How to allocate programme-wide credit enhancement

Eligible servicer advances (¶ 582)

• Servicers may contractually agree to advance cash to insure uninterrupted payments to investors if full reimbursement right is senior to other claims

• At national discretion, CCF of 0% for facility cancellable without prior notice

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Securitisation – IRB Banks

Options

• IRB bank must calculate capital on basis of:

External ratings pursuant to ratings based approach (rba)

Inputs into supervisory formula (sf) approach

Internal assessments approach (IAA)

• Cap: If IRB would require more capital for securitisation exposure than had the position not been securitised, bank may use IRB capital requirement for underlying exposures (¶ 610)

Hierarchy (¶ 609)

• IRB bank must use ratings based approach (RBA) to calculate capital if external rating or inferred rating available

• Where RBA not available, bank may use SF or IAA if available

• Where neither RBA nor SF or IAA are available, bank may use look-through approach (see below) in paragraph 639

• Otherwise, position must be deducted

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Securitisation – IRB Banks – Ratings Based Approach

%

Source: Text

Long Term RatingsShort Term Ratings

IRB bank ratings-based risk weights (¶¶ 616) IRB bank ratings-based risk weights (¶¶ 615)

Exte

rnal R

ati

ng

Exte

rnal R

ati

ng

A-1/P-1

A-2/P-2

A-3/P-3

All other

ratings/

unrated

7

12

60

Deduct

Most senior Base case Non-granular

12

20

75

Deduct

20

35

75

Deduct

Most senior Base case Non-granular

7

8

10

12

15

18

20

25

35

AAA

AA

A+

A

A-

BBB+

<BB- or unrated

BBB

BBB-

BB+

BB

BB-

12

20

35

20

35

50

35

35

50

60

100

250

75

100

250

75

100

250

425

650

Deduct

425

650

Deduct

425

650

Deduct

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IRB bank may use IAA if conditions satisfied

• Only available for exposures to ABCP programmes

• Internal assessments mapped to equivalent external ratings and exposures assigned resulting risk weights

• Supervisor may suspend bank’s use of IAA until deficiencies (if any) are corrected

Conditions

• ABCP issued by conduit must be externally rated

• Internal assessment must be based on ratings criteria for each asset type and be equivalent of investment grade when exposure is funded

• Bank’s supervisors must be satisfied that internal ratings meet required criteria in paragraphs 90-108 and with relevant external ratings criteria

• Bank must show that internal criteria matches external criteria

Internal Assessments Approach (¶¶ 619-622)

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Conditions (cont’d)

• Supervisor may, if warranted, disallow any seller provided recourse, guarantees or excess spread or any other first loss enhancement

• Internal assessment must identify gradations of risk that can be mapped to external ratings gradations

• Internal assessment process, and particularly stress factors, must be at least as conservative as publicly available ratings criteria from rating agencies rating ABCP programme:

Bank must choose most conservative of two or more external criteria if two or more criteria apply

Bank must not choose only ratings agencies with less restrictive methodologies to rate ABCP programme and must keep up with methodology changes

Bank cannot use a non-public ratings methodology but may consider more conservative non-publicly available methodology

For new or unique transactions, bank may discuss applying IAA with supervisor

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Conditions (cont’d)

• Internal and external auditors, a rating agency, or bank’s internal credit review or risk management function must perform regular reviews of internal assessment process; if internal reviews are used, they must be independent of ABCP business line

• Bank must track and adjust internal processes over time

• ABCP programme must have credit and investment guidelines (which should cover issues specified by supervisor)

• Credit analysis of seller’s risk profile must be performed

• ABCP programme must have minimum asset eligibility criteria that exclude defaulted assets, limit concentrations, limit asset tenor, etc.

• ABCP programme should have collections processes established that consider operational capability and credit quality of servicer, lockbox arrangements, etc.

• All sources of risk must be considered (including credit and dilution)

• Structural features must be included such as wind down events

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Capital charge determined under supervisory formula (see following page) on basis of five inputs (with 56 basis point floor):

• Regulatory capital of exposure if held on balance sheet (KIRB

)

• Degree of credit enhancement supporting exposure (L)

• Exposure’s thickness (T)

• Effective number of exposures in the securitised pool (N)

• Pool’s exposure-weighted average loss given default (LGD)

Definition of KIRB

• KIRB

is ratio (expressed as a decimal) of

The IRB capital requirement for the underlying exposures in the pool to

The notional amount of such exposures

• For structures involving SPE, all SPE assets must be included in pool, including residual interests (such as a cash collateral account)

• Reserves against assets in pool do not reduce notional amount of the pool in determining KIRB, but can count as credit enhancement

Supervisory formula approach (¶¶ 623-636)

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• IRB Capital charge = greater of (a) 0.0056 and (b) (S [L+T] – S [L])

• S[L] = L if L<= KIRB, else,

• S[L]= KIRB +K[L] –K[KIRB] +(d. KIRB /ώ )(1- exp(ώ *(KIRB – L)/ KIRB))

Where

• h=(1- KIRB /LGD)N

• c= KIRB /(1-h)

• v =((LGD- KIRB) KIRB +0.25(1-LGD) KIRB )/N

• f=((v + KIRB 2 )/(1-h) – c 2 ) + (((1- KIRB) KIRB – v )/(1-h) τ )

• g=((1-c)c)/f -1

• a=gc

• b=g(1-c)

• d=1-(1-h)(1-Beta[KIRB, a,b])

• K[L]=(1-h)((1-Beta[L,a,b]L+ Beta[L,a+1,b]c)

• Beta [L,a,b] refers to the cumulative beta distribution with

• parameters a and b evaluated at L,

• τ =1000 and ώ = 20

Supervisory Formula (¶¶ 624-626):

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Generally

• Eligible” liquidity facilities only drawn in event of general market disruption (as defined in ¶ 580) have a 20% CCF

• Otherwise, all liquidity facilities have 100% CCF; 100% CCF permits IRB banks to provide multi-year liquidity or “structured” liquidity without additional capital requirements

Determination of capital

• If facility is externally rated, bank may rely on rating provided it uses 100% CCF

• If facility is unrated, bank may use IAA if qualifying

• If facility is unrated and IAA unavailable, bank must determine KIRB either using “bottom-up” approach or “top-down” approach and apply SF

“Look-through” procedure

• If not practical to use “bottom-up” or “top-down”, bank may, on an exceptional basis and subject to supervisory approval, temporarily apply highest risk weight of pool under standardised approach to individual exposures covered by eligible liquidity facility

• In such a case, the bank must use 50% CCF for commitments of one year or less and 100% for commitments in excess of a year, or 20% CCF for market disruption liquidity

Liquidity facilities (¶¶ 637-639)

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Top-Down Approach (¶¶ 362-373)

• For use in determining KIRB in SF

• Generally

Top-down approach available provided bank’s programme complies with criteria for eligible receivables and minimum operational requirements

Intended mainly for asset-backed securitisation exposures, but may also be used for appropriate on-balance sheet exposures

Eligible Corporate Receivables (¶¶ 241-243)

• Eligible corporate receivables must satisfy following conditions for application of top-down approach:

Bank has not directly or indirectly originated receivables (and has purchased them from unrelated third parties)

Receivables generated on arms length basis (and not subject to inter-company contra accounts)

Purchasing bank must have claim on all proceeds from pool or a ratable interest

National supervisors to develop concentration limits

• Recourse to seller does not automatically disqualify transaction as long as cash flows from assets are primary source of repayment (plus certain other requirements)

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Inferred Ratings (¶¶ 617-618)

• When following conditions are met, bank must attribute inferred rating to unrated exposure:

Reference rated exposure must be subordinate in all respects to unrated exposure

Credit enhancements must be taken into account in determining subordination (for example, if reference position benefits from third party guarantee but unrated position does not, then latter may not be assigned inferred rating)

Maturity of reference position must be equal to or longer than that of unrated position

Inferred rating must be updated continuously to reflect changes in external rating of reference position

External rating must satisfy general requirements for recognition of external ratings in securitisation transactions

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Basel II – Early Amortisation Structures

Securitisation – Early Amortisation Provisions

Originating banks are required to hold capital against investors’ interests in a securitisation when

• It sells assets into a structure containing an early amortisation feature and

• The exposures sold are of a revolving nature

Banks are not required to apply the early amortisation rules to:

• Replenishment structures where the underlying exposures do not revolve and the early amortisation ends the bank’s ability to add new exposures

• Transactions of revolving assets containing early amortisation features that mimic term structures (i.e., where the risk does not return to the originating bank)

• Structures securitising credit lines where the investors remain liable to fund future draws by borrowers after amortisation events

• The early amortisation clause is triggered solely by events unrelated to the performance of the pool or the originator

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Applicable capital charge

• equals (1) the notional amount of the investors’ interest times (2) the applicable credit conversion factor times (3) the risk weight for the underlying credits

• But capitalised assets (such as future margin income) are treated separately and will typically be deducted from capital

Capped at the greater of:

• The capital required for retained securitisation exposures

• The capital required had the exposures not been securitised

Applicable credit conversion factor based on whether

• The amortisation is “controlled” or “non-controlled”

• The securitised exposures are (i) uncommitted retail credit lines that are unconditionally cancellable or (ii) any other type of exposure

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A “controlled” amortisation must meet the following conditions:

• The originator has in place a capital/liquidity plan to ensure it has sufficient capital and liquidity if early amortisation occurs

• Throughout the transaction, including the amortisation period, there is a pro rata sharing of interest, principal, expenses, losses and recoveries based on the balances of receivables outstanding at the beginning of each month

• The amortisation period fixed by the bank is sufficient for 90% of the total debt outstanding at the beginning of the period to have been repaid or to have been recognised as in default

• The pace of repayment is not any more rapid than would be allowed under straight-line amortisation over the period fixed as described above

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Credit conversion factors (CCF)

• For structures with controlled amortisation

0% to 40% for uncommitted retail lines (see next page)

90% for committed retail lines

90% for all non-retail lines (whether committed or uncommitted)

• For structures with non-controlled early amortisation

0% to 100% for uncommitted retail lines (see next page)

100% for committed retail lines

100% for all non-retail lines (whether committed or uncommitted)

For uncommitted retail credits

• Calculate two points:

The point at which the bank is required to trap excess spread (or 4.5% above the early amortisation trigger if no trapping)

The three month average excess spread for the transactions

• Divide the excess spread level by the trapping point and look up the CCF for the transaction on the following page

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3 month average excess

spread as % of trapping

point

CCF for Uncommitted

Retail Exposures in

Controlled Structures

CCF for Uncommitted

Retail Exposures in Non-

Controlled Structures

133.33% or more 0% 0%

Less than 133.33% to 100% 1% 5%

Less than 100% to 75% 2% 15%

Less than 75% to 50% 10% 50%

Less than 50% to 25% 20% 100%

Less than 25% 40% 100%

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Basel II – Trading Book Capital Charges

Trading Book – In a Nutshell 1

1. Paragraph references in materials below on trading book are to 1996 Market Risk Amendment (MRA) unless otherwise noted

Basel I (1996 Market Risk

Amendment)Basel II (MRA; Accord ¶¶ 864-718)

Minimum capital requirement:

• Credit risk requirements under regulatory capital rules, excluding debt and equity securities in trading book and all positions in commodities, but including credit counterparty risk in trading book or banking book, plus

• Capital charges for specific risk and general market risk under either standardised measurement method or internal models method (or combination thereof)

Essentially unchanged, except for revisions to:

• Definition of trading book: “positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book”

• Basic requirements for trading book treatment: clearly documented trading strategy; positions actively monitored and managed on trading desk; position limits set and monitored; positions marked to market at least daily; positions reported to senior management

• Capital charges for specific risks in connection with interest rate risk (see below)

• Specific risk capital charge offsets for positions hedged by credit derivatives (see below)

• New counterparty credit risk charges for OTC derivatives, repo-style and other transactions booked in trading book, and adjusted add-on factors for single name credit derivatives (see below)

Basel/IOSCO review will change trading book treatment significantly

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Capital Requirement

Definition of Capital (MRA Intro., II.1 – I.2)

• At discretion of national regulators banks may employ third tier of capital for sole purpose of meeting proportion of capital requirements for market risks

• Tier 3 capital limited to 250% of bank’s tier 1 capital required to support market risks; tier 2 capital may be substituted for tier 3 capital up to same 250% limit subject to overall limits for tier 2 capital in Basel II Accord

• For subordinated debt to be eligible as tier 3 capital it must be available to absorb losses in event if insolvency and must at minimum:

Be unsecured, subordinated and fully paid up

Have original maturity of at least two years

Not be repayable prior to maturity date unless bank’s supervisor agrees

Be subject to lock-in clause stipulating that neither interest nor principal may be paid at maturity if payment would cause bank to fall below minimum capital requirements

Calculation of Capital (MRA Intro., II.3 – I.4)

• Bank must first calculate capital for credit risk, and only afterwards calculate market risk requirement

Capital requirement to be met on continuous basis – at close each business day (MRA Intro., I.14)

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Standardised Measurement Method – Interest rate risk

Specific risk (MRA Part A.1.I; Accord ¶ 710)

• Specific risk charge:

Source: Text

• Offsetting restricted to matched positions in identical issue (including positions in derivatives); no offsetting if issuer same but not same issue

• “Government” category includes all forms of government paper

• “Qualifying” category includes securities rated investment grade by at least two recognised rating agencies or (subject to supervisory approval) unrated but either of comparable investment quality (standardised banks) or rated equivalent by bank’s internal systems and exchange listed (IRB banks) (Accord ¶ 712)

• National regulatory may impose higher specific risk charge on “other” category and/or disallow offsetting

Government:

AAA to AA- 0.00%

A+ to BBB-

0.25% (residual term to final maturity 6 months or less)

1.00% (residual term to final maturity between 6 and 24 months)

1.60% (residual term to final maturity exceeding 6 months)

Other rating 8.00%

Qualifying

0.25% (residual term to final maturity 6 months or less)

1.00% (residual term to final maturity between 6 and 24 months)

1.60% (residual term to final maturity exceeding 6 months)

Other 8.00%

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Generally

• Two methods: maturity method and duration method

• Capital charge is sum of four components: net short or long position; small proportion of matched positions in each time band (vertical disallowance); larger proportion of matched positions across different time bands (horizontal disallowance); net charge for positions in options

Maturity method

• Opposite positions of same amount in same issue may be omitted from framework

• Positions weighted by prescribed price sensitivity factor

• Partial offset (10% capital charge) for weighted longs and shorts in each time band

• Two rounds of horizontal partial offsetting between time bands pursuant to prescribed scale

Duration method

• Calculate price sensitivity on basis of prescribed interest rate change depending on maturity

• Slot resulting sensitivity measures into duration-based ladder within time bands

• Subject long and short positions to 5% vertical disallowance

• Carry forward net positions for horizontal offsetting as above

Source: Text

General market risk (MRA Part A.1.II)

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Interest rate derivatives (MRA Part A.1.III)

• Convert derivatives into positions in relevant underlying subject to specific and general market risk charges as above

• Futures: treated as combination of long and short position in notional government security

• Swaps: treated as two notional positions in government securities with relevant maturities

• No specific risk charge for most interest rate derivatives

• General market risk charge generally same as for cash positions, subject to exemption for very closely matched positions in identical instruments

Counterparty credit risk charge add-on factors for single name credit derivative (Accord ¶ 707)

• If reference asset is qualifying: 5% for protection buyer and 5% for protection seller

• If reference asset is not qualifying: 10% for protection buyer and 10% for protection seller

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Offsetting for interest rate derivatives (MRA Part A.1.III)

• Banks may exclude long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity, and may fully offset a matched position in a future or forward and its underlying

• If choice of underlying deliverable instruments (e.g., cheapest-to-deliver), offset only permitted if future or forward move in close alignment

• Offset may be allowed for opposite positions in same category of instruments if same underlying, same nominal value and same currency – e.g., futures (identical products maturing within 7 days of each other); swaps and forward rate agreements (identical reference rate and coupon within 15 basis points); limits on next interest fixing date

• No offsetting for positions in different currencies

But modified by Accord (see next page)

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Specific risk capital charges for positions hedged by credit derivatives (Accord ¶¶ 713-718)

• No specific risk capital charge for either side of the position if values of full legs always move in the opposite direction and generally to the same extent (e.g., identical instruments; long cash position hedged by total rate of return swap with exact match between reference obligation and underlying)

• 80% specific offset recognised when value of two legs always moves in opposite direction but not broadly to same extent (e.g., long cash position hedged by credit default swap or credit-linked note with exact match between reference obligation and underlying); to extent that transaction transfers risk, 80% risk offset for side with higher capital charge and zero specific risk requirement on other side

• Partial allowance where value of two legs usually moves in opposite direction (e.g., asset mismatch between reference and underlying)

• Otherwise, specific risk capital charge for both sides of transaction

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Standardised Measurement Method – Equity position risk

Specific risk and general market risk (MRA Part A.2.I)

• Specific risk charge

Defined as bank’s gross equity position, calculated on national market-by-market basis

8% unless portfolio both liquidity and well-diversified, in which case 4%

• General market risk charge

Defined as difference between sum of longs and sum of shorts, also calculated on national market-by-market basis

8%

Equity derivatives (MRA Part A.2.II)

• Convert derivatives into positions in relevant underlying

• Matched positions may be fully offset

• Index risk: Further capital charge of 2% against net long or short position in index contract comprising diversified portfolio of equities to cover factors such as execution risk

• Arbitrage: Additional 2% capital charge in qualifying futures-related arbitrage strategies may be applied only to one index with opposite position exempt from capital charge

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Standardised Measurement Method – Foreign exchange risk

Two processes (MRA Part A.3)

• Measure exposure in single currency position

• Measure risks inherent in mix of long and short positions in different currencies

Measuring positions in single currency (MRA Part A.3.I)

• Measured by summing: net spot position (including interest earned but not received, expenses accrued, and expenses not yet accrued but certain); net forward position; guaranties certain to be called and likely to be irrevocable; net future income/expenses not yet accrued but already fully hedged (at bank discretion); net delta-based equivalent of total book of foreign currency options

• Positions taken to hedge capital ratio may be excluded if “structural” (non-dealing) nature, applied consistency, does no more than protect bank capital ratio

Measuring foreign exchange risk (MRA Part A.3.II)

• Two alternatives:

“shorthand” method treating all currencies equally – capital charge is 8% times overall net open position determined by converting nominal amount (or net present value) of net position in each currency into reporting currency

internal models approach (see below)

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Standardised Measurement Method – Commodities risk

Generally (MRA Part A.4)

• Defined as physical product which is or can be traded on a secondary market

• More complex and volatile, and less liquid

• Variety of additional risks, including basis risk (risk that relationship between prices of similar commodities varies over time); interest rate risk (risk of cost of carry); forward gap risk (risk that forward price may change other than due to interest rate changes)

• Three options: models (see below); measurement system; simplified approach

Measurement system (maturity ladder) approach (MRA Part A.4.II)

• Express commodity position in standard unit of measurement (barrel, etc.)

• Convert net position at current spot rates into national currency

• Assess capital charge against matched long and short positions in specified time bands and specified spread rates

• Residual net positions in nearer time banks may be carried forward to offset exposures in later time bands, subject to surcharge equal to 0.6% of net position carried forward

• 15% capital charge against resulting long or short position

Simplified approach (MRA Part A.4.III)

• Same capital charge for directional risk as under measurement approach

• Additional capital charge of 3% of gross positions in each commodity for basis risk, interest rate risk and forward gap risk

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Standardised Measurement Method – Options

Generally (MRA Part A.5)

• Banks with purchased options only permitted to use simplified approach

• Otherwise, use either one of the intermediate approaches (see below) or internal model (see below)

Simplified approach (MRA Part A.5.I)

• Long cash and long put, or short cash and long call: Capital charge is market value of underlying multiplied by sum of specific and general market risk charges for underlying less amount option is in money (if any) bounded by zero

• Long call or long put: Capital charge is lesser of (a) market value of underlying multiplied by sum of specific and general market risk charges for underlying and (b) market value of option

Delta-plus (intermediate) approach (MRA Part A.5.II)

• Options reported as position equal to market value of underlying multiplied by delta

• Delta-weighted capital charge: Determined pursuant to Parts A.1 through A.4 depending on whether option underlying is debt security or interest rate instrument (Part A.1), equity (Part A.2), foreign exchange and gold (Part A.3) or commodities (Part A.4)

• Additional capital charges for gamma (measuring rate of change of delta) and vega(measuring sensitivity of value of option to change in volatility)

Scenario (intermediate) approach (MRA Part A.5.II) (for more sophisticated banks)

• Capital charge determined by calculating changes in option value at various points along “grid” of ranges of changes in option portfolio’s risk factors

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Internal models method (MRA Part B)

Generally (MRA Part B.1)

• Conditional upon explicit approval of supervisor

Conditions to use of internal model (MRA Parts B.2 – B.7)

• Qualitative standards: independent risk control unit; integration with day-to-day risk management of bank; trading limits; compliance function; stress-testing; back-testing; external validation; independent review

• Quantitative standards: value-at-risk calculated daily (to 99th percentile, one-tailed confidence interval; with instantaneous price shock equivalent to 10 day movement in prices); update data sets no less frequently than every three months; no particular type of model prescribed (but must accurately capture option risks); discretion to recognise empirical correlations within broad risk categories; daily calculation of capital requirement; multiplication factor based on supervisor judgment of quality of bank’s risk management system

• Market risk factors: risk measurement system that models yield curve (interest rate risk), foreign exchange exposures (foreign exchange risk), market movements in equities (equity risk), convenience yield (commodities risk)

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Basel II – Operational Risk Charges

Defined as risk of loss from inadequate or failed internal processes, people and systems, or from external events (¶ 644)

Examples of risks covered

• Internal and external fraud

• Legal risks

• Damages to customers

• Losses arising out of labour, health and safety, diversity, personal injury, etc.

• Damage to physical assets

• Business interruption

Examples of risks not covered

• Reputational risk

• Strategic errors

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Basel II – Operational Risk Charges

Basic Indicator Approach (¶¶ 649-651)

• 15% of bank’s average annual gross income over previous three years

Standardised Approach (¶¶ 652-654, ¶¶ 660-663)

• Capital charge for each of 8 business lines calculated against average annual gross income for business line times:

18% for corporate finance (15% transitional charge within EU if major activity)

18% for trading and sales (15% transitional charge within EU if major activity)

12% for retail banking

15% for commercial banking

18% for payment and settlement

15% for agency services

12% for asset management

12% for retail brokerage

Advanced Measurement Approach (¶¶ 655-659, ¶¶ 664-679)

• Calculated on basis of internal operational risk management system approved by national regulator

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Basel II – Supervisory review

Source: Text

Four key principles of supervisory review (¶¶ 725-760)

Principle 1

Banks should have process for assessing overall capital adequacy in relation to risk profile and strategy for maintaining capital levels. Five main features of rigorous process:• Board and senior management oversight• Sound capital assessment• Comprehensive risk analysis (credit risk, operational risk, market risk, interest

rate risk in banking book, liquidity risk, other risk)• Monitoring and reporting• Internal control review

Principle 2

Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied.

Principle 3 Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum

Principle 4 Supervisors should seek to intervene at early stage and require rapid remedial action

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Specific issues (¶¶ 761-778)

• Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk

• Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach, definition of default used to determine PD and/or LGD and EAD, residual risk, credit concentration risk and operational risk

Other issues (¶¶ 779-783)

• Supervisory transparency and accountability: Supervisors should make publicly available criteria used in review of banks’ internal capital assessments

• Enhanced cross-border communication and cooperation: Basel Committee supports pragmatic provision of close and continuous dialogue between industry participants and supervisors, as well as between supervisors (without changing legal responsibilities of national regulators).

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Economic substance: Supervisory capital requirements may vary from those specified in First Pillar if would not adequately and sufficiently reflect risks of exposure

Maturity: Supervisors will review documentation to ensure that maturity mismatches not artificially created to reduce capital requirements

Correlation: Supervisors may review banks’ assessment of actual correlations between assets in pools and how that is reflected in capital calculation; with ability to increase capital if correlation not appropriately reflected

Significant risk transfer: Although securitisation may occur for reasons other than risk transfer (i.e., funding), where risk transfer is insufficient or non-existent supervisors can deny capital relief

Market innovations: Supervisors can take account of new features either through First Pillar changes in minimum capital requirements or Second Pillar supervisory action

Implicit Support: If banks engage in implicit support more than once, supervisors must require disclosure and may apply one or more of (a) refusing further capital relief for securitised assets, for period of time or permanently, (b) applying conversion factor to all securitised assets so as to hold capital against them, or (c) requiring banks to hold capital in excess of minimum requirements

Source: Text

Supervisory review process for securitisation (¶¶ 784-807)

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Residual risks: Supervisors will expect banks to consider expected losses in economic capital, as those losses not usually transferred in securitisation

Call provisions: May not be used to absorb losses or asset deterioration; supervisors may require review of bank’s decision to call prior to exercise

Early amortisation: Supervisors should review how banks internally measure, monitor and manage risks associated with securitisations of revolving facilities; following factors should be considered when analysing excess spread triggers:

Interest payments by borrowers on underlying receivables

Other fees and charges to be paid

Gross charge-offs

Principal payments

Recoveries on charged-off loans

Interchange income

Interest paid on investors’ certificates

Relevant macro-economic factors

Source: Text

Supervisory review process for securitisation (¶¶ 784-807)

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Basel II – Disclosure (Securitisation)

Objective (¶¶ 809-810)

• Impose market discipline on banks by requiring disclosure of key information relevant to banks’ risks and capital

Qualitative Disclosures for Securitisation (¶ 820, Table 8)

• Bank’s objectives for, and roles played by it in, securitisation process

• Bank’s accounting objectives for securitisation

Whether treated as sales or financings

Whether bank recognises gain on sale

Key assumptions used by bank for valuing retained interests

Bank’s treatment of synthetic securitisations

• Names of rating agencies used by bank and types of exposures rated by each agency

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Basel II – Disclosure (Securitisation)

Quantitative Disclosures for Securitisation (¶ 820, Table 8)

• Total outstanding exposures securitised by bank subject to securitisation framework

• For exposures securitised by bank subject to framework (in each case broken down by exposure type):

Amount of impaired/past due assets

Losses recognised by bank during current period

• Aggregate amount of securitisation exposures retained or purchased by bank, broken down by exposure type

• Aggregate amount of securitisation exposures retained or purchased by bank, broken down by “reasonable number” of risk bands (deducted exposures disclosed separately)

• Aggregate amount of securitised revolving exposures segregated by originator’s interest and investors’ interest

• Summary of current year’s securitisation activity, including aggregate amount of exposures securitised and gain or loss on sale, by asset type

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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Stakeholder selection

The self assessment is a bottom up process, aiming to reach bank-wide convergence on key compliance topics, providing assurance to senior management and the supervisor

Several groups of participants & stakeholders are therefore relevant to the process: Total outstanding exposures securitised by bank subject to securitisation framework

• Risk / rating / credit managers on the ground to do the leg-work on gathering strengths and weaknesses

• Risk / policy owners and business line risk managers to sign off on the content for individual compliance items

• Group Risk (or equivalent) to challenge the output

• Internal audit to challenge the process (including the list of participants)

• CRO to acknowledge and sign off on the outcome

• CEO / CFO / CRO to sign the Basel 2 application file

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Stakeholder selection credit risk compliance (I)

• Common standards applied across client

Harmonised default definition

Rating philosophy (calibration, downturn)

Segmentation (hierarchy, mapping methodology)

• Perimeter complete and systematic, coverage sufficient

• Adequate PD model design and development

Data used for model development

Model design / methodology

Model performance

• Adequate LGD / EAD model design and development

Data used for model development

Model design / methodology

Model performance

• Model validation and backtesting defined and rolled out

Process defined, documented, rolled out

Technical procedures defined, documented, adhered to

Source: Text

Split by

function

Methodology & Models


• Perimeter complete and systematic, coverage

sufficient


• Adequate EAD/LGD model design and

development

• Model validation and backtesting defined and

rolled out

Systems & Data

• Model infrastructure in place and working

• Adequate data management and storage

• Adequate data processing (and reconciliation)

Model use and policies

• Rating policies complete & enforced

• Models used, no systematic gaming

• Model output used in management

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Split by

function




sufficient



development


rolled out

Systems & Data








Stakeholder selection credit risk compliance (II)


Models correctly coded, deployed, accessible


Data accuracy and consistency is ensured

Data is stored such that both auditability and future model development ensured


Global policies on data cleaning / treatment exist and enforced

Systems in place to ensure completeness of data submitted for the calculation

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Split by

function




sufficient



development


rolled out

Systems & Data








Stakeholder selection credit risk compliance (III)


Policies on the use of models and the use of model ratings exist and are adhered to


Rating models are used, leading to high rating coverage

Rating overrides are acceptable, signalling user acceptance

There is no systematic “gaming” of the rating systems


Risk parameters (PD, EAD, LGD) are used in the management of the bank, through some or all of the following applications:

� Credit decision

� Delegation of authority

� Pricing

� Monitoring

� Limit setting

� Provisioning

� Economic Capital

� Internal Credit Reporting

� Other

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Stakeholder selection credit risk capital calculation (I)

• Clear assignment of responsibilities between departments

Formal agreements in place

Governance structure in place and working

• Completeness of sourcing ensured

Material entities are included in the calculation

Gaps in product / geographical coverage are actively followed up

Adequate parameter coverage

• Clear policy on data format, adhered to

A clear policy in place and communicated

Sourcing entities adhere to policy

• Data quality control exists and is enforced

Problems in the data are reliably detected

Corrections are made (in good time)

• Full audit trail exists along the calculation chain

Source: Text

Complete and accurate sourcing






Complete and working calculation chain

• Fully industrialised process, with acceptable run time

• Operated by adequately trained internal resources

• Documentation in place

• Fully defined integrity and DQ standards in place and enforced

– sufficient data storage

• Effective error handling in place – ensuring system stability

• Results are of a quality that allows sign off

• Sign-off process defined and working

Ability to reconcile risk and accounting

• Technical link exists, with functioning mapping

• Ability to make visible and explain differences

• Ability to fully reconcile using conservative placeholders

Ability to produce the required internal and external reporting

• Systems / templates in place and working



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Stakeholder selection credit risk capital calculation (II)


Chain architecture clearly defined

Calculation process clearly defined and communicated

Run-time suits business needs



• Fully defined integrity and DQ standards in place and enforced – sufficient data storage

Calculation problems are reliably detected

Corrections are made (in good time)

Data storage is sufficient




Acceptance of results clearly defined

Sign-off process defined and timetabled

Source: Text
























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Stakeholder selection credit risk capital calculation (II)


Process covers all material portfolios

Accounting and risk data can be mapped to each other


Differences between the risk and the accounting data are flagged

The source of these differences can be traced and explained


All missing exposures receive a placeholder

Placeholders lead to a conservative outcome

Source: Text
























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Stakeholder selection credit risk capital calculation (IV)


Systems and templates are in place to generate the required reporting



The process of accepting and signing off the results is worked out and timetabled

Source: Text
























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Stakeholder selection Operational risk compliance dimensions (I)

• All 4 key elements integrated

Internal data

External data

Scenario analysis

BEICFs

• Perimeter and coverage sufficient

Perimeter definition includes all material entities

Sufficient actual coverage against target

• Sound mapping methodology

Ability to map loss / accounting data to business lines

• Clear and harmonised definitions and classifications

Guidelines and policies provide clarity around the definition of all ORM toolbox elements

• Sound and consistent governance and policy

Source: Text

Overall framework


• Perimeter and coverage is sufficient




Risk Self Assessments

• Adequate approach to risk self assessments

• Consistent and effective implementation

• Management use of the RSAs

Data collection

• Comprehensive collection of internal and external data

• Staff adequately trained

• Use and follow up processes in place

IT infrastructure

• Robust systems in place

• Systems rolled out, with interfaces to other systems

Capital model

• Well reasoned modelling philosophy

• Validation approach exists and is implemented

• Model implemented, easy to use, transparent

• Stable output, appropriate allocation, buy-in from business

• Model output used for management purposes

KRIs

• Clearly identified for major risks, explicit links to risks

• Embedded in business, triggering actions

Mitigation

• Effective risk mitigation activities in place

• Reporting enables management use of ORM framework

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Stakeholder selection Operational risk compliance dimensions (II)


RSAs fully reflect the organization structure and the nature of its operational risks

Adequate use of multiple data sources

Control factors taken into account

Sound methodology for assessing extreme scenarios


Comprehensive identification and understanding of biggest risks

Consistent and correct classification

The level of detail is balanced and reflective of the business complexity

Effective control of output


Reporting in place

Management actions triggered

Source: Text

Overall framework










Data collection




IT infrastructure



Capital model






KRIs



Mitigation



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Stakeholder selection Operational risk compliance dimensions (III)


Internal loss data being gathered and stored in a detailed format for subsequent re-use

Data gathering is carried out as a continuous process and with limited time from discovery to reporting


Data collection staff have received sufficient training to ensure high-quality data collection


Recorded losses are reported, brought to the managements’ attention and trigger management action

Source: Text

Overall framework










Data collection




IT infrastructure



Capital model






KRIs



Mitigation



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Stakeholder selection Operational risk compliance dimensions (IV)

• Robust internal systems in place

Data collection systems run in a stable production environment

Access rights are clearly defined


Data collection systems are linked with each other to avoid manual duplication of inputs

Source: Text

Overall framework










Data collection




IT infrastructure



Capital model






KRIs



Mitigation



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Stakeholder selection Operational risk compliance dimensions (V)

• Well reasoned modelling philosophy Mixture of bottom-up calculation and

allocation to suit formal group and BU upfront goals

Assumptions understandable to non-technical staff and signed off by senior management

• Validation approach exists and is implemented Full, ongoing validation of all framework

elements, documented Assumptions behind key parameters

independently reviewed Quantitative output subject to validation

• Model implemented, easy to use, transparent Top-down build structure that encompass

specific bottom-up collected data Model can reflect (quickly) any business

practice changes Model clearly documented Run-time suits business needs

• Stable output, appropriate allocation, buy-in from business Full sensitivity analysis documented and

audited Appropriate allocation / diversification Drivers of capital formally agreed with BUs

and linked to modelling• Model output used for management purposes

Reporting in place to share output with management

Source: Text

Overall framework










Data collection




IT infrastructure



Capital model






KRIs



Mitigation



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Stakeholder selection Operational risk compliance dimensions (VI)

• Clearly identified KRIs for major risks, with explicit links to them

Picked to represent the Bank’s biggest risks

Limited number, maintaining focus


Reporting in place, processes in place to ensure certain results trigger management action


Business continuity planning complete


Source: Text

Overall framework










Data collection




IT infrastructure



Capital model






KRIs



Mitigation



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Contents


Executive Summary






Self assessment

Credit Risk

Market Risk


Operational Risk

Business Risk

Pillar II

2

3

4

5

6

7

8

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2

Basel II – First Pillar: Credit Risk Capital Charges3

Basel II – First Pillar: Operational Risk Capital Charges4

Basel II – Second Pillar: Supervisory Review5

Basel II – Third Pillar: Market Discipline6

Stakeholder selection for self assessment7

Self assessment8

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Key to Graphics

Graphic Description / Notes

• Basic (B) → Industry Standard (IS) → Best Practice (BP) scale

• Current positioning of your Group.

• Basel II compliance assessment: This should be used to indicate, whether at this point in time your Group is not compliant (NC), partially compliant (PC) or fully compliant in comparison to the targeted approach (i.e. Standardised, IRB Foundation, IRB Advanced for credit risk) regarding a certain category

• For asset classes where X-Bank holds few or no positions, N/A signifies that not meeting compliance criteria would not jeopardise the overall compliance position

• Explicit Basel II requirement based on the Internal Ratings Based Approach for Credit Risk and the Advanced Measurement Approaches for Operational Risk {Key for paragraph references: without code = The New Basel Capital Accord, November 2005; Code PMCR = Principles for the Management of Credit Risk (September 2000); Code PMSIRR = Principles for the Management and Supervision of Interest Rate Risk (July 2004), Code SPMSOR = Sound Practices for the Management and Supervision of Operational Risk (February 2003), Code AMR = Amendment to the Capital Accord to Include Market Risk (1998 update to January 1996)}

NC PC FC

B IS BP

Bold text

N/A

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Credit Risk: Methodology & Measurement

Customer/

Counterparty

Evaluation

NC PC FC

Group PositioningIndustry Standard Best PracticeBasic

• Judgement-based or simple

quantitative grading tools

• Ordinal grades have meaning

within segments, but not across

(i.e. no calibration to master

scale)

• 5-6 performing grades per

segment

• No empirical or statistical

validation or back-testing

• Mainly quantitative scorecards,

often using vended rating

models

• Ordinal rating mapped

individually to PD or external

ratings

7-8 performing grades (404)

• Judgmental validation by expert

panel in addition to statistical

validation

• Ad hoc migration analysis and

back-testing

• Sometimes calibrated to Group-

wide master scale

• Corporates

• Tailored internal rating model with both

quantitative and qualitative inputs (411)

• Development based on actual default

history, expert input or external ratings as

benchmark

• Possibly complement with vended

solutions, e.g. EDF model when

appropriate

• Specialised Finance

• Internal rating tool possibly using a

simulation-based approach (411)

• General

• Separation of borrower (PD) and facility

(LGD, EAD) (396)

• Model results are mapped to cardinal

scale (PDs) (397)

• Central tendency calibration (461-463)

• Extensive statistical validation during

development phase (420)

• Routine migration analysis, back-testing

and revalidation of model power (417 &

441)

• Master scale, with at least 15 performing

grades

• Customisation of rating model to reflect

local market conditions and accounting

conventions (389)

NOTE: Basel II

effectively making

current best practice

industry standard

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Credit Risk: Methodology & Measurement (Cont’d)

Exposure

Measurement

NOTE: Basel II

effectively making


industry standard

Industry Standard Best PracticeBasic

• Ad hoc manual measurement of

aggregate exposure

• Limited treatment of overdraft

facilities / uncommitted lines

• Current value of derivatives

exposures only

• Notional measurement with

basic/ regulatory credit

conversion factors

Some validation with

internal experience

• Explicit treatment of EAD for overdrafts

and uncommitted lines (474 - 479)

• Expected exposure and maximum likely

exposure profiles for derivatives

incorporating netting and collateral effects

(309, 317)

• Values validated with historic data (478)

NC PC FC

• No consistent grouping of

collateral into types

• Generic values used for LGD

with no validation to bank

experience

• Crude LGD estimate, typically

based on collateral value at

origination (not at default) or

only using collateral type, but

not collateral amount

• Some validation to bank

experience

• Guarantees and covenants incorporated

into analysis (332, 480)

• LGD calculation based on economic loss

(468)

Write-off amount, time to recover and

administrative costs all used in

calculation

Based on internal data (431, 470)

• Spreadsheet-based portfolio

aggregation

Questionable quality /

aggregation of input data

Data cohorted at BU level

Little / no recognition of

correlation and

concentration effects

• Minimal portfolio analysis,

typically confined to exposures

and ‘quality’ monitoring

• Incomplete Group view

• Central Portfolio Model (CPM)

(spreadsheet or vended)

Bottom-up measurement on

customer / transaction level

Recognition of correlation

and concentration effects

• Complete Group view

(incorporating interaction effects

between portfolios)

• Rudimentary sensitivity /

scenario testing capabilities

(434–437)

• Vended or in-house bespoke

parameterised CPM

Detailed cohorting by risk

characteristics

Thorough treatment of correlations

between counterparties, industries

and geographies

Ability to ‘condition’ losses based on

macro-economic scenarios

Incorporation of securitizations

Explicit treatment of interest rate risk

Option to use value based modelling

NC PC FC

Credit

Mitigation

NOTE: Basel II

effectively making


industry standard

NC PC FC

Portfolio

Analysis

Group Positioning

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Credit Risk: Data, IT & Reporting

Data Availability/

Capture

NOTE: Basel II

effectively making


industry standard


• No firm-wide counterparty ID

• Aggregate exposures manually

compiled at business unit level

• Limited availability of / access

to historical data

• Ad-hoc data capture

• Firm-wide counterparty ID

• Relevant data are available on a

customer / product level

• Historical data available for part

of customer base

• Basic risk information

systematically captured;

connection between

customer/transaction data and

collateral/recovery data is only

partially possible

• Firm-wide risk data warehouse with

consistent counterparty ID

• Automatic aggregation (quasi-online) of

exposure for all customers, products,

divisions etc

• Historical data available across entire

portfolio (429, 430)

• Full customer / risk information

systematically captured and stored for

central analysis (429, 430):

Customer data

Transaction data

Collateral and recovery information

which are connectable to transactions

/ customers

Financial data (e.g. from annual

reports, tax authorities)

Segment specific data

NC PC FC

• Limited reporting of exposure

below portfolio level

• Firm wide write-offs and

delinquencies reporting monthly

• Segment-level EL reporting

• Monthly reporting of business

unit risk and exposure

• Monthly reporting of product

level write-offs and arrears

• Cohort-level EL reporting

• Quarterly risk reports containing

concentration analyses

• (Monthly) reporting of product level

exposure, risk and concentrations (439,

440, 743)

• (Monthly) reporting of product level write-

offs and arrears

• EL/ economic capital reporting to senior

management (743)

• Systematic stress test reporting

Reporting

NOTE: Basel II

effectively making


industry standard

NC PC FC

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Credit Risk: Processes & Policies

Portfolio

Management/

Limit Setting


• Simple exposure limits in place,

based on subjective judgement

• No formal sector limits

• Passive portfolio management

• More complex exposure limits

based on simple quantitative

analysis for:

Counterparties

Countries

Sectors


• Exposure limits based on sophisticated

analysis of full portfolio effects (770-777)

• Intra BU limits backed up by BU portfolio

model

• Active portfolio management capabilityNC PC FC

Corporate

Governance

NC PC FC

NOTE: No specific

Basel II requirements

regarding this area

• Risk and price incorporated

subjectively into approval

decision

• No formal risk based pricing

• Pricing linked to counterparty

rating (linked to PD), often

based on ‘pricing grid’ - paper

based

• Basic economic capital-based

pricing tools

• Strictly enforced price floors

• Risk-based pricing using EL, economic

capital and fully loaded costs

• Full relationship-based pricing

• Detailed process guidelines, explicit

‘override’ structure

Pricing

• Responsibility for the design or

selection, implementation and

performance of the internal

rating systems lies with an

independent credit risk control

unit (441,442)

• Internal audit performs annual

reviews on the system and

independent checks on

processes and numbers (443)

• The credit policy, rating system

and its uses are approved by

the Board or subcommittee

(438)

• Senior Management needs to

demonstrate understanding and

needs to work with credit control

function to discuss and improve

the rating process (439)

• Same as Industry Standard

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Credit Risk: Processes & Policies (Cont’d)

Credit Approval

Process


• Fully subjective underwriting

process

• No clear delegation process

• No real collateral valuation as

part of credit approval process

• Incomplete relationship view

• Committee-intensive process

with some delegation

• Process differentiated by facility

size

• Analysis of value of collateral in

approval process

• Business unit level aggregated

view taken

• Extensive documentation of

process and procedures

• Internal ratings and other credit

parameters must play an

essential role in the credit

approval process and bank

must have a credible track

record of their use (444, 445)

• Completion or approval of rating

assignment and review

conducted by a unit that does

not directly stand to benefit from

the extension of credit (424)

• Industry Standard as outlined to the left

and:

• High delegation of decision authority;

strict definition of overrides etc.

• Process differentiated by risk

• Detailed analysis of collateral by type in

the credit process

• Full relationship view of economic capital

/ economic profit used for larger

exposures

Counterparty

Credit

Monitoring /

Provisioning

NC PC FC

NOTE: Basel II largely

in line with current

industry standard

NC PC FC

• No automatic customer credit

monitoring after initial approval

process

• Some monitoring for larger

customers

• Qualitative assessment for

general provisioning

• Passive treatment of delinquent

credits

• At least annual review of

customer credit quality and

portfolio delinquency rates (425,

427)

• Specific provisioning based on

qualitative assessment

• Monthly analysis of delayed

payments for certain products

• Recovery process optimised to

ensure maximum recovery

rates.

• Early warning systems of deteriorating

credit quality

• Active management of watchlist using

specialised personnel

• Dynamic forward-looking provisioning

based on EL driven by output from rating

distributions / portfolio models

• Specific provisioning triggered by rating

(linked to PD) downgrades

• Recovery process treated as profit centre

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2






Self assessment8

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Customer/

Counterparty

Evaluation







scale)


segment





models



ratings




validation


back-testing


wide master scale

Mid market / SME

• Tailored internal rating models with both

quantitative, qualitative as well as

behavioural inputs (411)


history

General


(LGD, EAD) (396)


scale (PDs) (397)





and revalidation of model power (417,

441)


grades



conventions (389)

NC PC FC

NOTE: Basel II

effectively making


industry standard

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Exposure

Measurement

NOTE: Basel II

effectively making


industry standard



aggregate exposure




exposures only



conversion factors


internal experience






(309, 317)


NC PC FC





experience







experience




(468)



calculation



aggregation





correlation and














between portfolios)



(434–437)


parameterised CPM


characteristics



and geographies






NC PC FC

Credit

Mitigation

NOTE: Basel II

effectively making


industry standard

NC PC FC

Portfolio

Analysis

Group Positioning

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Data Availability/

Capture

NOTE: Basel II

effectively making


industry standard






to historical data






of customer base



connection between



partially possible





divisions etc






Customer data

Transaction data



/ customers




NC PC FC















440, 743)


offs and arrears


management (743)


Reporting

NOTE: Basel II

effectively making


industry standard

NC PC FC

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Portfolio

Management/

Limit Setting








analysis for:

Counterparties

Countries

Sectors





model


Corporate

Governance

NC PC FC

NOTE: No specific


regarding this area



decision

No formal risk based pricing



based on ‘pricing grid’ - paper

based


pricing tools

• Strictly enforced price floors



• Full relationship-based pricing

• Detailed process guidelines, explicit


Pricing






unit (441,442)








(438)







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Credit Approval

Process



process








size


approval process


view taken














• Industry Standard as outlined to the left

and:

• High delegation of decision authority;

strict definition of overrides etc.



the credit process



exposures

Counterparty

Credit

Monitoring /

Provisioning

NC PC FC



industry standard



process


customers




credits




427)







rates.


credit quality









NC PC FC

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2






Self assessment8

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Customer/

Counterparty

Evaluation







scale)


segment





models



ratings




validation


back-testing


wide master scale

Banks



• Application even for externally rated

counterparties

• Calibration based on external information

(external ratings and bond spreads) as

well as internal expert opinion

Non banking financial institutions (NBFIs)



• Separate models for (life/non-life)

insurance companies and funds,

broker/dealers


counterparties

• Calibration based on external information

(external ratings and bondspreads) as

well as internal expert opinion

General


(LGD, EAD) (396)


scale (PDs) (397)






441)


grades



conventions (389)

NC PC FC

NOTE: Basel II

effectively making


industry standard

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Exposure

Measurement

NOTE: Basel II

effectively making


industry standard



aggregate exposure




exposures only



conversion factors


internal experience






(309, 317)


NC PC FC





experience







experience




(468)



calculation



aggregation





correlation and














between portfolios)



(434–437)


parameterised CPM


characteristics



and geographies






NC PC FC

Credit

Mitigation

NOTE: Basel II

effectively making


industry standard

NC PC FC

Portfolio

Analysis

Group Positioning

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Data Availability/

Capture

NOTE: Basel II

effectively making


industry standard






to historical data






of customer base



connection between



partially possible





divisions etc






Customer data

Transaction data



/ customers




NC PC FC















440, 743)


offs and arrears


management (743)


Reporting

NOTE: Basel II

effectively making


industry standard

NC PC FC

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Portfolio

Management/

Limit Setting








analysis for:

Counterparties

Countries

Sectors





model, as appropriate

• Active portfolio management capability

(within BU and group)

• Financial Institutions typically distinct

entity within Corporate BU or individual

Business Unit

NC PC FC

Corporate

Governance

NC PC FC

NOTE: No specific


regarding this area



decision

• No formal risk based pricing



based on ‘pricing grid’;

sometimes still paper based


pricing tools



• Full relationship-based pricing (where

appropriate, e.g. Insurance companies)

Pricing






unit (441,442)








(438)







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Credit Approval

Process



process








size


approval process


view taken














• High delegation of decision authority



the credit process



exposures

Counterparty

Credit

Monitoring /

Provisioning

NC PC FC



industry standard



process


customers




credits




427)







rates.


credit quality









NC PC FC

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2






Self assessment8

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Customer/

Counterparty

Evaluation







scale)


segment





models



ratings




validation


back-testing


wide master scale

Banks and Sovereigns




counterparties

Large Corporates


Tailored internal rating model with both



history, expert input or external ratings as

benchmark

• Possibly complement with vended

solutions, e.g. EDF model when

appropriate

Mid market / SME

• Tailored internal rating models with both

quantitative, qualitative as well as

behavioural inputs (411)


history

General


(LGD, EAD) (396)


scale (PDs) (397)






441)


grades



conventions (389)

NC PC FC

NOTE: Basel II

effectively making


industry standard

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Exposure

Measurement

NOTE: Basel II

effectively making


industry standard



aggregate exposure




exposures only



conversion factors


internal experience






(309, 317)


NC PC FC





experience







experience




(468)



calculation



aggregation





correlation and














between portfolios)



(434–437)


parameterised CPM


characteristics



and geographies






NC PC FC

Credit

Mitigation

NOTE: Basel II

effectively making


industry standard

NC PC FC

Portfolio

Analysis

Group Positioning

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Data Availability/

Capture

NOTE: Basel II

effectively making


industry standard






to historical data






of customer base



connection between



partially possible




exposure across countries for all

customers, products, divisions etc






• Customer data

• Transaction data

• Collateral and recovery information which

are connectable to transactions /

customers

• Financial data (e.g. from annual reports,

tax authorities)

• Segment specific data (e.g. for real

estate)

NC PC FC















440, 743)


offs and arrears


management (743)


Reporting

NOTE: Basel II

effectively making


industry standard

NC PC FC

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Portfolio

Management/

Limit Setting








analysis for:

Counterparties

Countries

Sectors





model

• Active portfolio management capability,

international exposures used for strategic

diversificationNC PC FC

Corporate

Governance

NC PC FC

NOTE: No specific


regarding this area



decision

No formal risk based pricing



based on ‘pricing grid’;

sometimes still paper based


pricing tools



• Full relationship-based pricing; defined


Pricing






unit (441,442)








(438)







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Credit Approval

Process



process








size


approval process


view taken














• High delegation of decision authority



the credit process



exposures

• Organisational setup differs, either

distinct ‘Business Unit’ with dotted

reporting lines to Corporate etc. or

specific expertise within relevant

business units

Counterparty

Credit

Monitoring /

Provisioning

NC PC FC



industry standard



process


customers




credits




427)







rates.


credit quality









NC PC FC

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2






Self assessment8

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Country and Transfer Risk: Methodology & Measurement

Treatment of

Country Risk


• Use of agency ratings and ECA

scores (55)

• Rudimentary/no treatment of

country transfer risk in

economic capital framework

• Internal country rating mapped

to PD and complemented by

agency ratings and ECA scores

(462)

• Annual review process (425)

• Country risk economic capital

calculated as overlay to credit

risk

• Country and transfer risk are

captured through the same

model

• Some double counting of risk of

consecutive customer and

country default

• Internal country rating mapped to PD and

complemented by agency ratings, ECA

scores and bond spreads (462)

• Annual review process (425)

• Country and transfer risk are captured

through different models or different

calibrations of the same model

• Country risk economic capital calculated

as overlay to credit risk

• Calibrated to ensure no double counting

NC PC FC

NOTE: Basel II

effectively making


industry standard


aggregate exposure

• Straightforward methodology for

country exposure

• Current utilization used as EaD

• Straightforward methodology for country

exposure

• Current utilization used as EaD

Exposure

Measurement

NC PC FC





experience

• LGD for country risk is

determined by Basel II values

• LGTE (=loss given transfer

event) not directly modelled



• LGTE is explicitly modelled using historic

data

• Sovereign LGD different from LGTE

Credit

Mitigation

NC PC FC

• Transfer risk is not included in

the credit portfolio model

• Transfer risk is partially included

in the credit risk calculations

Treatment as an additional

exposure

Treatment through separate

model

• Transfer risk is explicitly modelled using a

bottom up approachPortfolio

Analysis

NC PC FC

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Country and Transfer Risk : Data, IT & Reporting

Data Availability/

Capture


• Country risk component is not

stored in the system

• Relevant risk data are stored on

a customer / transaction level

• Country risk component is not

separately stored in the system

• All country and transfer risk components

are stored on a customer / transaction

level

NC PC FC

• No reporting for transfer risk • Country risk is reported through

simple report (e.g. foreign

exposures split by country,

rating, etc.)

• No reporting for transfer risk as

a separate risk category

• Separate reporting (using ECAP

framework) for transfer risk within the

monthly risk reports

NC PC FC

Reporting

Group Positioning

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Limit Setting






analysis




• Incorporation of cross-country sector

concentrations


Country - level

Credit

Monitoring

/Provisioning



industry standard

NC PC FC

• Country Risk not incorporated

in credit approval or pricing












• (Regulatory requirements; additionally:

• Country (Transfer) Risk incorporated in

approval and pricing process, either as

part of the capital charge or as a cost

item

Approval

Process and

Org.

Governance

NC PC FC

• No automatic monitoring after

initial approval process

• Some monitoring for larger risk

areas






427)


country ratings and other

qualitative and quantitative risk

assessments


credit quality




(linked to PD) downgrades (either on

country or obligor basis)

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2






Self assessment8

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Recognition


• Only partial recognition of

counterparty credit risk in the

trading book

• Partial recognition of

counterparty credit risk for OTC

derivatives transactions, repo-

style and other transactions

booked in the trading book

through the Basel II framework

(702)

• Recognition of counterparty credit risk for

OTC derivatives transactions, repo-style

and other transactions booked in the

trading book through the Basel II

framework (702)NC PC FC

NOTE: Basel II

effectively making


industry standard

• Inclusion of counterparty credit

risk using a simplified

framework:

EaD is defined as in the

Basel II document, i.e.

replacement cost plus add-

on

Static LGD

• Inclusion of counterparty credit

risk in the credit portfolio model

• Simplified consideration of

netting agreements

• Granular measurement of counterparty

credit risk within the portfolio context

using relevant risk drivers (e.g.

incorporation of an interest rate model)

• Netting agreements are explicitly

incorporated in the model

Portfolio

Analysis

NC PC FC

• Usage of Basel II framework

with haircuts set by the

regulator (e.g.186 for OTC

derivatives)

• Usage of Basel II framework

with haircuts set by the

regulator (e.g.186 for OTC

derivatives)

• Calculation of haircuts for repo-

style transactions using an

internal VaR-model (178)

• Usage of Basel II framework with haircuts

set by the regulator (e.g.186 for OTC

derivatives)

• Calculation of haircuts for repo-style

transactions using an internal VaR-model

taking correlations and netting

agreements into account (178)

Exposure

Measurement /

Credit Mitigation

NC PC FC

NOTE: Basel II

effectively making


industry standard

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Data Availability/

Capture


• Basic risk components are

captured on standalone system


• Product level information stored

in the market risk data base


of customer base


systematically captured





divisions etc





central analysis (429, 430)

NC PC FC

• No reporting of counterparty

credit risk in the trading book








• Monthly) reporting of product level


440, 743)


offs and arrears


management (743)


NC PC FC

Reporting

Group Positioning

NOTE: Basel II

effectively making


industry standard

NOTE: Basel II

effectively making


industry standard

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Contents


Market Risk


Operational Risk

Business Risk

Pillar II

Corporate

Division

Credit Risk

Corporate

1. Corporate Wing

2. Commercial Wing

Financial

Institutions

International

Activities

Country

Risk

Credit Risk

in Trading

Retail

Executive Summary2






Self assessment8

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Customer/

Counterparty

Evaluation


• Basic risk pooling (using risk

related factor(s)) by Expected

Loss AND/OR

• Uncalibrated (i.e. not linked to

probabilities of default)

scorecard, potentially multi-

purpose



• Application and behavioural tool

on facility level


back-testing


wide master scale

• Each exposure must be

assigned to a pool (401, 402)

• Internal rating tool tailored to Retail (395)

Using both application and

behavioural data

Separation of borrower (PD) and

facility (LGD, EAD) (401 & 402)

Development based on actual

defaults


scale - central tendency calibration




of PD calibration, and revalidation of

model power (417, 441)

• Calibration of all tools to master scale

• Well-defined bankwide validation process

• Each exposure must be assigned to a

pool (401, 402)

NC PC FC

NOTE: Basel II

effectively making


industry standard


aggregate exposure





conversion and k-factors


internal experience


and uncommitted lines (336, 337)


Exposure

Measurement

NC PC FC

NOTE: Basel II

effectively making


industry standard

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Credit

Mitigation




• Basic risk pooling (using risk

related factor(s)) by Expected

Loss AND/OR



experience



origination (not at default)

• Some validation experience

• Guarantees incorporated into analysis

(332, 480)


(468)



calculation

Based on internal data (473)

NC PC FC

• Credit risk in retail is not

included in the credit portfolio

model

• Central portfolio model (CPM)


High-level cohorting of input

data along main risk

characteristics

Simple recognition of

correlation and


Retail part is included in a

high level fashion (e.g.

through beta-distribution,

inverse normal, or using

historic loss levels on

business unit level)

Rudimentary stress testing


parameterised CPM

• Retail credit risk is included in a pooled

fashion taking the average risk

parameters (i.e. PD, LGD, correlation

within pool, industry, number of

counterparties in the pool) as well as

volatility of the pool into account

• Stress testing based on consistent,

group-wide macroeconomic shock

framework

NC PC FC

Portfolio

Analysis

Group Positioning

NOTE: Basel II

effectively making


industry standard

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Data Availability/

Capture






to historical data



• Basic framework for

identification of

connected/correlated credit

risks


of customer base


systematically captured





divisions etc





central analysis (429, 433)

• Banks must retain data on the pools to

which the exposure was assigned over

the year prior to default and the realised

outcomes on LGD and EAD (433)

NC PC FC










• Pool-level EL reporting

• Monthly) reporting of product level


733, 734, 735)


offs and arrears (433)

• EL/ economic capital reporting (743)

• Systematic stress test reporting (434-

437)

NC PC FC

Reporting

Group Positioning

NOTE: Basel II

effectively making


industry standard

NOTE: Basel II

effectively making


industry standard

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Pricing


• Pricing purely against the market • Basic Segmentation • Pricing underpinned by economic capital-based

analysis

• Partial risk-based pricing for mortgages

• Detailed segmentation (e.g. by product, customer

etc.)

• Fully subjective underwriting process

using unparameterised bureau scores



• Internal ratings play an essential role in

the credit approval process and credible

track record of usage (444, 445)

• Process differentiated by facility size

• Line of Business unit level aggregated

view taken


assignment and review conducted by a

unit that does not directly stand to benefit

from the extension of credit (424)

• Industry standard as outlined to the left; additionally::

• Approval process is highly automated (driven by

internal rating model)

• Overrides involve high delegation of decision

authority


• Full relationship view of economic capital / economic

profit used for larger exposures

NC PC FC

Credit Approval

Process

Group Positioning

NOTE: No specific Basel II

requirements regarding

this area

• No automatic customer credit monitoring

after initial approval process

• Some monitoring for larger customers

• Qualitative assessment for general

provisioning

• Passive treatment of delinquent credits

• At least annual review of customer credit

quality and portfolio delinquency rates

(425, 427)

• Specific provisioning based on qualitative

assessment

• Monthly analysis of delayed payments for

certain products (e.g. credit cards)

• Recovery process optimised to ensure

maximum recovery rates.

• Industry Standard as outlined on the left; additionally:

• Early warning systems of deteriorating credit quality

• Active management of watchlist using specialised

personnel

• Dynamic forward-looking provisioning based on EL

driven by output from rating distributions / portfolio

models

• Specific provisioning triggered by rating (linked to PD)

downgrades


NC PC FC

Counterparty Credit

Monitoring/

Provisioning

NOTE: Basel II largely in

line with current industry

standard

NC PC FC

Corporate

Governance

• Responsibility for the design or selection,

implementation and performance of the

internal rating systems lies with an

independent credit risk control unit (441-

442)

• Internal audit performs annual reviews on

the system and independent checks on


• The credit policy, rating system and its

uses are approved by the Board or

subcommittee (438)



involvement (439)

• Responsibility for the design or selection,

implementation and performance of the internal rating

systems lies with an independent credit risk control

unit(441-442)

• Internal audit performs annual reviews on the system

and independent checks on processes and numbers

(443)

• The credit policy, rating system and its uses are

approved by the Board or subcommittee (438)

• Senior Management needs to demonstrate

understanding and involvement (439)

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Contents



Operational Risk

Business Risk

Pillar II

Credit Risk

Executive Summary2






Self assessment8

Market Risk

Trading Banking Book

(incl. Investments)

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Market Risk: Methodology & Measurement

VaR

Methodology


• Spreadsheet parametric VaR • Combination of Parametric,

Monte Carlo and Historical VaR

• VaR information reported

includes:

Group-wide VaR

Decomposition of VaR

Close-out adjusted VaR

• Regular back-testing (AMR

B.2.b)

• Combination of Parametric, Monte Carlo

and Historical VaR

• VaR information reported includes:

Group-wide VaR

Decomposition of VaR

Close-out adjusted VaR

• Complex pricing processes for options

and exotic derivatives explicitly modelled

(AMR B.4.h)

• Regular back-testing (AMR B.2.b)

NC PC FC

• Regulatory Capital

• Linear sensitivity testing

• Economic capital based on

closed formulae

Deriving P&L distribution

Confidence level

Annualization factor

Management intervention

• No break-down to BU

• Complete sensitivity analysis

and ad hoc scenario analysis at

business unit level

• Monte Carlo simulation

Confidence level

Time horizon

Management intervention

• Breakdown to BU & desk level

• Daily firm-wide & desk-level stress testing

(Quasi-real time stress grids for option

books)

• Stress scenarios tied to probability of

occurrence and account for correlations

between factors

• One year scenarios for estimating

economic capital

Economic Capital

Calculation

(& Stress Testing)

NC PC FC

• No diversification taken into

account

• Limited decomposition of risk

along dimensions like desk &

asset class

• Diversification within BU’s

• Decomposition of risk along

dimensions like desk, asset

class, geography & position

• Diversification fully taken into account

• Hot Spot, Best Hedge

• Best Replicating Portfolio Construction

Aggregation &

Portfolio Analysis

NOTE: No specific


regarding this area

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Market Risk: Data, IT & Reporting

Quality of Data

(for Economic

Capital

Calculation)


• Market data from traders and

brokers

• Manual collection & analysis of

data

• Market data from independent

sources

• Automated data collection &

manual analysis feeds

• Data sets updated at least every

three months (AMR B.4.e)

• Risk factors cover interest rates,

exchange rates, equity prices

and commodity prices with

appropriate granularity (AMR

B.3)

• Market data automatically collected from

independent sources

• Central warehouse for firm-wide market

and position data & automatic analysis

feeds

• Data sets updated daily

• Risk factors cover interest rates,

exchange rates, equity prices and

commodity prices with appropriate

granularity (AMR B.3)

NC PC FC

• Weekly/daily risk reports at

business unit level

• Risk reports prepared by

Treasury

• Ad-hoc discussions

• Weekly/daily risk reports at

business unit level

• Risk reports prepared by

independent unit

• Regular business unit risk

management meetings

• Market risk is aggregated & managed

across all BUs

• Daily risk reports at business and desk

level with appropriate summaries to

senior management

• Regular business unit risk management

meetings

• Real time systems enable scenario

analysis across entire book at any time

Reporting

NOTE: No specific


regarding this area

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Market Risk: Processes & Policies

Risk

Management

Organisation


• No formal separation between

risk taking and risk

management functions

• Independent management of

market risk in business units

• Centralisation of market risk

measurement

• Independence of risk

management compensation

from trading results

• Annual review of overall market

risk management process by

independent audit (AMR B.2.h &

B.6)

• Close integration of model into

risk management process (AMR

B.2.d)

• Risk reports prepared by financially

independent unit (AMR B.2.a)

• Give brief daily narrative reports in risk

profiles to traders and Senior

Management (active involvement) (AMR

B.2.a & B.2.c)

• Clear separation of risk taking & risk

assessment (AMR B.2.a)

• Annual review of overall market risk

management process by independent

(internal & external) audit (AMR B.2.h &

B.6)

NC PC FC

• Senior Management sets all

limits

• Soft limits

• Limits in terms of exposure due

to pre-defined sensitivity

analysis

• Notional & Duration limits

• Risk Management sets all limits

• Granular & aggregate VaR

limits

• Hard limits with link to

compensation

• Limit violations automatically

generate reports

• Limits based on risk

management models; limits well

understood by management

and traders (AMR B.2.e)

• Documentation of procedures,

controls and methodology (AMR

B.2.g)

• Regulatory requirements outlined to the

left; additionally:

• Risk Management sets BU limits. BU

distributes limits among desks

• Establishment and storing of global and

regional limits

• Target VaRStress test results used for

strategic decisions (limit allocation)

• Granular & aggregate VaR limits

• Limits set on tolerance for losses

• Limit violations automatically generate

hedges

• Routine and rigorous programme of

stress testing; results to be reflected in

policies and limits (AMR B.2.f)

Limit Setting

Responsibility

and Limit Policy

NC PC FC

• Minimum documentation in

place before trading is allowed

• Complete documentation and

authorisation from legal

department in place

• Internal software and settling

procedures set before trading is

allowed

• Complete documentation and

authorisation from legal department in

place

• Internal software and settling procedures

set before trading is allowed

• Price, valuation and risk models validated

New Product

Sanctioning

Process

NOTE: No specific


regarding this area

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Contents



Operational Risk

Business Risk

Pillar II

Credit Risk

Executive Summary2






Self assessment8

Market Risk

Trading Banking Book

(incl. Investments)

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ALM Risk: Methodology & Measurement

Transfer Pricing &

Separation of Hedgeable/

Unhedgeable Risk


• Not all products fully transfer priced • Full transfer pricing • Full transfer pricing

• Storage of transfer price on deal level



this area

• Embedded options are not modelled • Simple measurement of embedded

options

• Embedded options are modelled using Monte Carlo

• Capture interaction(s) between:

Product balances

Administered rates

Modelling of

Customer Behaviour



this area

• Parallel shift in yield curve

Sensitivity analysis

Standardised rate shock

(PMSIRR 60)

• ‘Worst case’ assumptions for real estate

& equity

• Diversification benefits are not

accounted for

• Forecasts of future interest rates

incorporate a sufficiently large change

(PMSIRR 49)

• All material sources of IRR are covered

(repricing, yield curve, basis and option)

(PMSIRR 43)

• Stress testing includes ‘worst-case’

scenarios (PMSIRR 60)

• Scenario analysis with associated

probabilities

- Shift/twist

• IRR is modelled separately for each

currency with a significant exposure

(PMSIRR 53)

• For equity and real estate,

1-year volatilities are derived and ‘Worst

case’ is linked to confidence interval

• Variance/covariance approach for taking

diversification into account

Additional to industry standard:

• Historical stress testing including major events

• Monte Carlo generated interest rate scenarios

• For equity and real estate, 1-year volatilities are

derived and ‘Worst case’ is linked to confidence

interval; incl. stress testing

Modelling of Asset

Classes

& Aggregation of

Risk Classes

NC PC FC

NOTE: Currently ALM risk

is treated only under Pillar

II

• Basis point sensitivity testing (764: shock

of 200bp)

• Portfolio revaluation based on simplifying

assumption of revaluation and stress

tests

• IRR measurement systems assess

effects of rate changes on both earnings

and economic value (economic capital)

(PMSIRR 44)

• Capital held is commensurate with IRR

(PMSIRR 75)

• Full portfolio revaluation based on Monte Carlo and

historical simulation

• IRR measurement systems assess effects of rate

changes on both earnings and economic value

(economic capital) (PMSIRR 44)

• Capital held is commensurate with IRR (PMSIRR 75)

Economic Capital

Calculation

NC PC FC

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ALM Risk: Data, IT & Reporting

Quality of Data


• Manual collection from

standalone spreadsheets held

at business units

• Infrequent (monthly) or no

aggregation of some business

units

• Benchmarking for equity/ real

estate

• Automated data feeds from all

business unit front end systems

to ALM unit providing data for

stress testing and limit

monitoring

• Commercially available external

data used to parameterise risk

models

• Volatility figures for real estate

and equity extracted from

external sources;no further

analysis

• Daily cashflow position for mapping onto

zero-coupon yield curve

• Bespoke market information collected

and used to parameterise risk models

• Volatility figures for real estate and equity

are based on extensive analysis of

various time windows; trend analysis, etc.

• Monthly reporting of limit

utilisation and sensitivity

analysis

• Funds solvency is not

monitored by group risk

management

• Monthly reporting of exposure,

limit utilisation, duration and

VaR from business units to ALM

unit

• Funds solvency is monitored,

but not regularly by group risk

management

• Board of Directors approve IRR

management policies;

Board/subcommittee and senior

management regularly review

IRR (PMSIRR 27, 28, 31)

• Regular review by independent

audit (PMSIRR 68)

• Weekly reporting

• Economic capital reporting

• Stress test reports based on

macro economic scenarios

• Funds solvency is regularly monitored by

group risk management

• Board of Directors approve IRR

management policies;

Board/subcommittee and senior

management regularly review IRR

(PMSIRR 27, 28, 31)

• Regular review by independent audit

(PMSIRR 68)

Reporting/

Oversight

NC PC FC

Note: Automated data

feeds are not

necessarily a

requirement for

calculation of economic

capital but useful for

better management

NOTE: Currently ALM

risk is treated only

under Pillar II

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Market Risk: Methodology & Measurement

Limit Setting


• ‘Soft’ or no position target set

• Limits based on local metrics

• Limit methodology consistent

with simple exposure metrics

• No limits set for investment of

with-profit funds (investments

with implicit options)

• Single group-wide limit (with

allocation as appropriate) which

considers potential impact to

earnings and value of economic

capital (PMSIRR 57)

• Limits for IRR must be

established and enforced, and

should ensure that exceptions

receive prompt management

attention (PMSIRR 54, 56)

• Guidelines set for investment of

with-profit funds

• Industry Standard as outlined to the left;

additionally:

• Explicit position target set

• Loss limits combined with exposure limits

to enable dynamic management

intervention

• Limits set for investment of with-profit

funds

• Responsible for internal transfer

pricing policy

• Input to rate setting/changes in

administered rates

• Localised management

• Detailed daily risk reporting

• Support product structuring and

pricing

• Work with asset and liability

units for new product

development

• Centralised management with

ability to aggregate risks,

insurance and bank separate

• Provide pricing signals and assistance to

business units to redesign products in

order to achieve desired funding profile

• Centralised management with ability to

aggregate risks, insurance and bank are

aggregated for benefiting from natural

hedges across these businesses

• Actively manage group risk/reward profile

based on economic capital

A/L Mismatch

Management

NOTE: No specific


regarding this area

NC PC FC

• Performance targets not linked

to size of risk positions

• Regular measurement of

gapping profit

• ‘Cost of hedge’ analysis

• Cost of hedge’ analysis

• Performance Measurement consistent

with ALM policy (e.g. active risk

taking/profit centre vs. passive

management of risk within defined

parameter space)

Performance

Measurement

NOTE: No specific


regarding this area

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Contents



Operational Risk

Business Risk

Pillar II

Credit Risk

Executive Summary2






Self assessment8

Market Risk

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Operational Risk: Methodology & Measurement

Operational Risk

Awareness


• Currently no explicit recognition

• Implicit concern confined to

those directly involved - Audit,

Insurance, Group level execs

• Driven by future regulatory

compliance

• Wider conceptual

acknowledgement across BUs

and central functions of the

need to explicitly assess

operational risk

• BUs cooperate in self-

assessments, although may not

fully buy-in

• Extent of awareness largely a

function of top level impetus /

initiative

• Group-wide acknowledgement of need to

explicitly assess and manage Op Risk

(SPMSOR 11, 660 - 663)

• Clear definition of activity process maps

in BUs enabling identification of process

interfaces / point sources for ex-ante

mitigation (SPMSOR 18, 660 - 663)

• Systematic tracking of observable

symptoms e.g. volume/error rates by

activity (SPMSOR 25, 670 - 673)

• Currently not quantified

• Regulatory capital proposed

• Varying standards of

methodology & approach to

quantifying Operational Risk

capital - combining regulatory

benchmarks & internal

approaches

• Some analysis of external loss

events

• No relevant adjustments to

multiple data sources

• Simplistic (e.g. cost base)

allocation methodology (causing

inconsistency across BUs)

• Unsystematic aggregation

• Clear formulaic link between targeted

rating and required capitalisation (669 f)

• Methodology in place for systematic

adjustments to external data relevant to

bank profile & translation of modelled loss

distribution to required economic capital

(665, 669 f, SPMSOR 23)

• Sophisticated quantitative allocation

methodology to identified BUs (e.g.

through scorecards) with consistent

grading scale and interactive process

(SPMSOR 25)

Analysis/

Methodology

Framework

NC PC FC

NOTE: Basel II

effectively migrating

industry standard

towards current best

practice

NOTE: Basel II (AMA)


industry standard


practice

NC PC FC

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Operational Risk: Processes & Policies

Target

Setting


• No targets set for operational

risk losses

• Events accepted as routine

errors or as that which cannot

be mitigated against

• Rough/arbitrary group

expectation of operational

losses

• Where BU allocation attempted,

largely arbitrary, imposed top-

down

• Performance against targets not

really assessed or utilised for

review

• Looked upon as exercise for

determining rough level of

‘provisions’

• Joint decision between Group & BUs on

Operational Loss target (on the basis of

identified risk drivers)

• Feedback loop into periodic target review

(also concerning best practice control

processes)NOTE: No specific


regarding this area

• No formal capitalisation/ control

mechanisms

• Confined to minimal regulatory

compliance

• Annual procedural compliance

review

• Error detection through audit

(mostly high frequency/low-

severity errors)

• Audit & compliance

enforcement, focusing on major

areas (high risk or volume)

• (Conceptual) contingency

planning e.g. disaster recovery

plan, crisis management team

• Event-driven (reactionary)

adjustments to control policies

• Ex-post error detection - no

early warning signals

• Ad-hoc and largely reactionary

audit of controls

• Comprehensive quality assurance & risk

mitigation/control programs (SPMSOR

31)

• Consistent capture of operational loss

events (SPMSOR 25)

• Quality / error detection systems for early

warning signals (SPMSOR 27)

• Compliance & performance assessed by

independent central function with

explicitly linked penalty / reward system

(SPMSOR 16,21)

• Audit policies reflecting audit outcomes

and external benchmarking (666 e, 666 f,

SPMSOR 16, 29)

• Continuous model validation (663e)

• Pro-active scan for internal and external

changes (SPMSOR 15)

Controls

NC PC FC

NOTE: Basel II


industry standard


practice

• Standard external policy

undertaken

• More selective policies based

on recognised / identified risk

sources

• Adjustments in reaction to

events (ex-post)

• Recognition of Insurance as a means of

countering operational risk, which needs

to be integrated with risk control /

mitigation and capital allocation (677,

678, SPMSOR 36)

NC PC FC

NOTE: Basel II effectively

migrating industry

standard towards current

best practice

Insurance

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Contents



Operational Risk

Business Risk

Pillar II

Credit Risk

Executive Summary2






Self assessment8

Market Risk

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Business Risk: Processes & Policies

Methodology


• Business Risk not calculated • Business Unit specific

benchmarks and high-level

diversification assumptions

used

OR

• Business Unit level income

volatility estimates and intra BU

diversification via high level

VAR/COVAR calculations

• Analogue Approach used or

accounting data (not fully

sanitised)

• Inter and intra BU diversification

accounted for at various levels of detail

(product categories) based on

sanitised/adjusted accounting data

• Typically VAR/COVAR approach

• Income and Cost volatility captured

• Historical data covering, continuously, a

complete business cycle (or pieces

thereof, adjusted appropriately)

NOTE: No specific


regarding this area

• Not applicable • High level analysis of

breakdown and drivers

• Detailed analysis of risk drivers and

potential concentrations

• Sensitivity tests as part of a group-wide

macro-economic shock scenario

framework

• Pro-cyclicality and impact of changes in

the business cycle

Analysis

NOTE: No specific


regarding this area

• Not applicable • Reported as part of overall

Economic Capital figures

• Basic analysis of risk drivers

• Detailed reporting by line of business

• Risk driver and diversification benefit

analysis

• Management at group and BU-level

through portfolio steering and targeted

segment entry/exit where possible and

otherwise appropriate

Reporting

NOTE: No specific


regarding this area

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Contents



Operational Risk

Business Risk

Pillar II

Credit Risk

Executive Summary2






Self assessment8

Market Risk

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Economic Value: Methodology

Risk Based

(Economic)

Capital and

Aggregation


• Top-Down Economic Capital

Model and Framework for major

risk types (Credit, Market,

Operational)

• Aggregation via simple

summation or high-level

benchmarks used to account

for inter and intra risk

diversification

• Group-wide economic risk

framework covering all

economic risks (implied by 731,

732)

• Granular assessment of market

(VAR) and credit risk (CPM)

• Quantification of inter and intra

risk diversification benefits;

VAR/COVAR approach to

aggregation

• Stressed correlations used for

scenario analyses

• Simplifying distribution

assumptions made for some

risk types

• Multi-year capital calculations

on the basis of one-year results

and basic assumptions about

portfolio migration

• Group-wide, comprehensive economic

risk framework (implied by Basel II: 731,

732)

• Multi-period credit capital model

• Fully integrated simulation engine for

estimating aggregate distribution function

or use of suitably parameterised copulas

• Extensive impact analyses and stress

tests on the basis of macro-economic

factors and consistently defined

scenarios/shocks

• One period view based on

reasonably accurate parameter

estimates

• Sensitivity analysis

• Basic multi-period view

incorporating simple

prepayment and other

behavioural assumptions

• Reasonably accurate parameter

forecast (e.g. qualitative, based

on expert judgement)

• New business modelled on the

basis of simplified assumptions,

not linked to economic forecasts

• Multi-period view incorporating

behavioural models for prepayment and

other optionalities linked to bank-wide

stress tests and scenario analyses

• Accurate and robust parameter forecast

ranges (risk parameters and discount

rate) based on macro-economic analyses

• Forecast of new business on the basis of

group strategy and models of the

economic environment

Multi-period / One

period view

NC PC FC

• No fully risk-adjusted P&L • RAROC and EP used

categorically; not tailored to

specific type of evaluation (e.g.

investment project vs. BU

performance comparison)

• Differentiated use of performance metrics

• Multi-period Economic Profit (SVA, AVA)

used as the primary metric for decision

making purposes

• RAROC used for high-level differentiation

and selected comparison purposes

Economic Profit

vs RAROC

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Economic Value: Processes & Policies

Budgeting and

Strategic

Planning


• Accounting based measures

used for budgeting

• Market share or revenue

oriented top-off the house

planning

• Little consultation with the

Business Units

• No scenario-based forecasts or

impact assessment

• Strategic decisions based on

simple market analyses or

revenue forecasts

• Little or no regulatory capital

forecasting and management

• Strategic planning and group-

wide budgeting primarily in

accounting terms, or only high

level EP target set at group

level

• Planning as an iterative process

with the Business Units

• Scenario analyses and group-

level impact assessment

• Risk-based planning in

organisational silos, no

comprehensive risk/capital

framework and lack of

consistency in risk assessment

capabilities across the group

• Reactive regulatory and

economic capital management

• Group-level EP or Shareholder Value

Added (SVA) targets (also communicated

to the markets)

• Well-defined risk appetite (730)

• Cascading of EP targets to BU or product

category level (in some cases to segment

and customer grade) in an iterative,

consultative process between Group

Risk, Group Centre and the BUs

• Strategic planning based on in-depth

analyses of value generation across the

portfolio and evaluation of

market/expansion strategies

• Bottom-up Economic Capital used as a

portfolio steering tool

• Sophisticated scenario analysis and BU-

level impact assessment

• Group-wide communication phrased in

terms of economic value creation

• Pro-active capital planning and

management (729)

• Revenue or market share

oriented performance metrics

• Crude differentiation by Line of

Business

• Little or no account taken of

portfolio riskiness

• Large number of metrics and

targets to be met

• Accounting-type profit or RoE

targets

• Implicit consideration of portfolio

quality (via provisions or write-

offs)

• Differentiated targets by

products and/or customer types

• Potentially, high level EP targets

• Full Economic P&L at Business Unit and

sometimes CRM level

• Differentiated Economic Profit or RAROC

targets

• Portfolio quality explicitly accounted for

via EL and Economic Capital

• Multi-period targets; strong Shareholder

Value Added (SVA) / VBM focus

• Small number of pertinent metrics other

than EP targets (e.g. tactical: market

share etc.)

Risk Adjusted

Performance

Measurement

NC PC FC

• Traditional accounting

profitability measure

• Economic Pricing incorporating

Expected Loss (EL) and

Economic Capital charges

• Limited use of other account

information

• Customer Value (CVM) based pricing

incorporating both economic perspectives

as well as all other available customer

information (cross-sell, expected

behaviour etc.)

Pricing

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Economic Value: Data, IT, Reporting and Areas of Application

IT Infrastructure


• No centralised data warehouse or

only legacy mainframe-type

systems

• Risk-information silos (BU level)

• IT-dominated information handling

and retrieval; lack of access for

business level analysts

• Data often held by analysts in

spreadsheets and Access

databases (‘Data Queens’)

• Simple Excel models

• Central data warehouse containing

the majority of data relevant to

bottom up risk assessment (risk

parameters, ratings) and results

(e.g. allocated capital figures)

OR

• Well-defined extraction and load

processes to retrieve data and feed

it to the relevant tools/models

• Data readily accessible for analysis

throughout the organisation (e.g.

Excel interface)

• Custom-built or vended solutions for

risk modelling (e.g. credit, market

risk etc.)

• Extensive modelling based on Excel

with database access

• Industry Standard as described to the left;

additionally:

• All relevant data and output held centrally with

fully automated data feeds for relevant models

• Data and analysis results standardised across

the group (including subsidiaries) and readily

accessible

• Standardized reports generated automatically

• Accounting focused reporting,

insufficient representation of

economic results

• Misaligned use of metrics; lack of

clear communication regarding

meaning of to businesses and

senior management by group risk

function

• Lack of standardised layouts used

across the group and/or

subsidiaries

• Redundant reporting and

‘information overload’; lack of focus

and targeted provision of

information to enable decision

making

• Accounting and Economic/VBM

focused reports

• Diversity of formats and excessive

information provision to senior

management

• Some automation in report

production

• Standardised format

• Clearly structured and concise risk

management reports for senior management

with consistently defined levels of detail

• Automated production of standard reporting

sections supplemented by relevant ad-hoc

analyses

• Risk Dashboard & related online tools with

drill-down capabilities for senior management

Reporting

• No real VBM framework • Group and BU Level, limited

application at product category or

customer level

• Pervasive use across group and areas of

application (Performance Measurement,

Pricing, Strategy evaluation etc.)

Area of Application

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Contents



Operational Risk

Business Risk

Pillar II

Credit Risk

Executive Summary2






Self assessment8

Market Risk

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Pillar II: Overview

This area of the Basel II Accord is primarily concerned with regulatory supervision

It comprises of several sections, covering, most notably, four ‘principles of supervision’:

• Reduce capital supporting non-performing loans

• Reduce negative carry by eliminating financing needs

• Shift capital and resources into more profitable businesses

• Optimize bank’s balance sheet

• Improve bank’s credit ratings

• Reduce operating costs due to smaller work-out departments

While explicit requirements are only detailed in the first principle, other areas of the document imply minimum standards of documentation and senior management involvement and education

Pillar II also covers a number of areas that warrant particular supervisory review, thus designating current industry standard (or best practice) as a future regulatory requirement

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Pillar II: Principle 1 – Capital Adequacy and Risk Profile

1. Basel II effectively defines current Best Practice as the future industry standard.

Board &

Management

Oversight

Group PositioningRequirements1

• Need to understand nature and level of all material

risks (728)

• Set risk tolerance and appetite (730)

• Ensure capital adequacy (728)

• Decide overall strategy with regards to capital

sources and expenditures (729)

• Set policies and procedures (730)

NC PC FC

Sound Capital

and

Comprehensive

Risk

Assessment

• Policies and procedures need to ensure

identification, measurement and reporting of all

material risks (731)

• A process must relate capital to the level of risk,

capital adequacy goals to risk and strategy and

business plan (731)

• Internal controls, reviews and audit to ensure

integrity of management process (731)

• All material risks faced by the bank need to be

addressed (732)

• Credit Risk based on detailed rating systems and

with respect to concentrations etc. (734, 735)

• Operational Risk (736, 737)

• Market Risk (738)

• Structural Interest Rate Risk (739, 740)

• Liquidity Risk (741)

• Other risks; not necessarily on a quantitative basis

(742)

NC PC FC

Monitoring,

Reporting and

Internal Control

Review

• Evaluate level and trend of material risks, in

particular (743):

Sensitivity analysis of key assumptions, checks

for reasonableness

Compliance with capital adequacy goals (current

and future, with respect to the bank’s strategy)

• Produce reports for senior management and board

(743)

• Board has responsibility that management institutes

adequate control and compliance policies (744)

• Periodic reviews to ensure integrity, accuracy and

reasonableness (745):

Capital assessment vis-à-vis nature, scope and

complexity of operations

Risk Concentration

Accuracy and completeness of data inputs

Validity of scenarios

Stress testing and analysis assumptions

NC PC FC

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Pillar II: Principles 2 – 4, Guidelines for the regulator

Principle 2:

Review process

• Stipulates regular supervisory reviews

through (746):

On-site examinations or inspections

and off-site reviews

Discussions with management

Periodic reporting

• Review of risk assessment adequacy (748)

• Assessment of capital adequacy (749):

Target levels & monitoring

Composition of Capital

Provision for unexpected events

• Assessment of the control environment

(751, 752)

• Review of compliance with minimum

standards (753 – 755)

Principle 3:

Beyond

minimum

requirements

• Supervisors should expect banks to

operate above the minimum regulatory

capital levels

• The accord recognises that there may be

several reasons why banks may choose to

do so (757):

Strategic / Rating

Buffer for normal business fluctuations

Cost aspect

• Supervisors are required to consider the

appropriateness of the capital level in

respect to the particular market

environment

Principle 4:

Early

Intervention

• The accord dictates close monitoring and

early intervention to prevent capital levels

from falling below minimum

• Supervisors may choose from a number of

corrective actions, such as (759):

Intensified monitoring

Restriction of dividend payments

Immediate raising of additional capital

• The Accord also stresses that additional

capital may not be a permanent solution

but that the bank should be put in a better

position to assess and manage its risks

(760)

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Pillar II: Specific Issues

Pillar II mentions a range of specific areas warranting particular supervisory scrutiny

While not stipulating requirements for banks’ systems and procedures explicitly, they implicitly refer to a range of models and processes generally considered as current industry standard. In particular:

• Structural Interest Rate Risk (762 – 764): Not captured under Pillar I, but recognised as significant, thus warranting close supervision and implying sound systems and management practice

• Review of Stress Tests in Credit Risk (765): Stress tests should be part of a consistent bank wide review and planning framework

• Impact of changes in the definition of default (766): Implies that all relevant data should be captured and readily available for modelling purposes

• Additional risks introduced through Credit Risk Mitigation (767 – 769): Requires sound collateral management and assessment systems as well as documented (and sound) management processes to adjust capital figures appropriately

• Credit Risk Concentration (770 – 777): Concentration is explicitly mentioned as the single most important cause of problems. Sound assessment implies some form of Credit Portfolio Model (CPM) and accompanying stress and scenario testing. N.B. The accord recognises that concentration risk can also occur other than in terms of single-name or segment exposure.

• Operational Risk (778): The Basic Indicator and Standardised approach should be seen as a guidance; appropriateness vis-à-vis the market and other banks should be reviewed

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Disclaimer

The information, data and approaches provided herein are an outcome of our research and content expertise. Although we referred to third party materials and

analysed their impact, however the content is the outcome of CCP's proprietary knowledge and is rightfully owned by us. This work is copyright protected and

legally privileged.

Please do not distribute this presentation without the prior written consent of Capital Calibration Partners or its authorized affiliates.

CCP has made best efforts to ensure that this material is complete in its entirety. However, we does not warrant its completeness or accuracy nor do we

warrant that the results obtained will be useful or will satisfy the all requirements.

Copyright © 2014 Capital Calibration Partners Inc.

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basel ii self assessment

Economy & Finance