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Are Banks Ready for Basle IIand what are they preparing for…
Operational Risk
Denis PellerinSenior Vice-President
Operational and Market Risk ManagementNational Bank of Canada
Montreal, April 13, 2007
forThe Third International Conference on Credit and Operational Risks
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THIRD INTERNATIONAL CONFERENCE ON CREDIT AND OPERATIONAL RISK April 13, 2007 - by Denis Pellerin, Senior Vice-President – Operational and Market Risk Management 2
AGENDA
A. CANADIAN BANKS SITUATION– Major Banks Targeted Approach for Operational Risk– Implementation Time Frame– Implementation Context– Role of Regulators and Market Pressure
B. REST OF THE WORLD – Op. Risk Implementation Efforts– Targeted Approaches– Time Frame– Role of Regulators and Market Pressure
C. PROS AND CONS OF EACH APPROACH FOR OP. RISK– Basic approach– Standardised approach : manages the risk– Advanced approach : measures the risk
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A. CANADIAN BANKS SITUATION(a system highly concentrated)
A.1 Major banks targeted approach for Operational Risk
– 5 of the Big 6 are aiming for Standardized + 3 other.
– Most of them are also considering Advanced but no commitment.
– CIBC aims for Advanced, another did for a while.
– Banks have all implemented typical risk management framework.
– 5 of the Big 6 are subscribing to ORX.
– Usage of electronic tools to support RCSA rather limited.
– Interesting to note that all Big 6 are aiming for Advanced for credit.
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THIRD INTERNATIONAL CONFERENCE ON CREDIT AND OPERATIONAL RISK April 13, 2007 - by Denis Pellerin, Senior Vice-President – Operational and Market Risk Management 4
A. CANADIAN BANKS SITUATION
A.2 Implementation Time Frame
– In Canada, BASLE II starts on NOVEMBER 1st, 2007
– All the Big 6 have been working on their Op. Risk implementation for 8 – 10 years
– Big 6 “WILL BE READY”
– OSFI will deliver certification this summer
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A. CANADIAN BANKS SITUATION
A.3 Implementation Context
– During this time, several other regulatory or compliance driven initiative:
• Basle II Credit Risk
• Sarbane Oxley
• AML
• Reputational Risk Management
• Personal Information Privacy
• Pandemic Flu Preparedness
• Outsourcing Risk Management
and son on… and Operational Risk, of course…
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A. CANADIAN BANKS SITUATION
A.3 Implementation Context
– Produced Regulatory Fatigue :• Risk Managers
• Business Lines
– Confusions from BU as to who does what.
– Most of these initiatives are seen by business lines people as overlapping if not repetitive.
– As banks are about to go live with their Op. Risk Capital Model, will they focus on migrating to Advanced Status?
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A. CANADIAN BANKS SITUATION
A.3 Implementation Context (cont.) … Priority to convergence
– Initiative to integrate the various processes implemented to assess and improve internal control environment.
– Convergence main driver: Desire to simplify implementation by business lines (not quality or efficiency).
– Challenge is to preserve “quality” while integrating processes.
– One bank is piloting integrated Risk and Control Assessment Program.
– Other Banks at various preparation stages will all see more actions in the next 12 – 24 months.
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A. CANADIAN BANKS SITUATION
A.4 Role of Regulators and Market Pressure (layman terms for Pilars II and III)
– Implementing a regulatory capital model for Op. Risk is a regulatory driven initiative. Role of regulators is key for smooth implementation.
– OSFI is the main regulator of most banks implementing Op. Risk models.
– Material from Basle needs to be completed by regulators guidelines for efficient design.
– If this is new to banks, it is also new to regulators – they too had to learn.
– At first, OSFI didn’t have a dedicated team but eventually they put their act together and started to oversee implementation efficiently.
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A. CANADIAN BANKS SITUATION
A.4 Role of Regulators and Market Pressure (cont.)
Two streams – initiated 3 years ago:
1. Gap Analysis:• Consisting of analysis by individual banks to identify
framework shortfalls compared to OSFI and Basle Requirements
• Includes action plans and Timetable to fill in the gaps with regular monitoring
2. Three bench marking exercises: • Gross income mapping
• Loss data collection
• RCSA
• Very useful work also feeding into gap analysis
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B. REST OF THE WORLD (Not an accurate picture of the rest of the world…)
B.1 Targeted Approaches
– 3 different approaches to determine regulatory capital for Op. Risk : Basic – Standardized – Advanced.
– They represent a continuum from least to most sophisticated.
– But to get approval to utilise a given model, regulators require that actual risk management practices of op. risk be in line with the selected model. They are also positioned on a continuum.
– There are also unwritten rules :i. prioritize credit risk over operational risk;ii. to be Advanced for operational risk you need to be
Advanced for credit risk as well;iii. the opposite is not true.
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B. REST OF THE WORLD
B.1 Targeted Approaches (cont.)
– The amount of financial and human resources required to qualify for a given approach sharply increases as you go up the continuum.
– Natural tendency is for small banks to opt for Basic, midsize banks for Standardized and largest banks targeting Advanced.
– This is a general rule but there are exceptions. The most noticeable being large banks category:
• The largest banks’ group is made of banks with more than 200 G$;
• There are only approximately 40 banks that are aiming for Advanced (1 out of 3);
• 12 of them are American and had the Advanced approach imposed on them – somewhat disappointing – we will come back on this…
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B. REST OF THE WORLD
B.2 Time Frame
– Varying answers
– European banks generally target January 2008
– American authorities have postponed it by a year, January 2009
unless
– Are banks going to be ready? The vast majority will (confirmed by recent surveys)
– Timetable is set for Credit Risk. Gives Op. Risk implementation work ample time.
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THIRD INTERNATIONAL CONFERENCE ON CREDIT AND OPERATIONAL RISK April 13, 2007 - by Denis Pellerin, Senior Vice-President – Operational and Market Risk Management 13
B. REST OF THE WORLD
B.2 Time Frame (cont.)
Other factor:
– The most delicate implementation is for Advanced Banks. This is for the biggest banks that have more financial and human resources.
– There will be few exceptions.
– Banks that are falling behind with their credit implementation program will not get regulatory clearance for operational risk model.
– Few smaller banks that decided to aim for standardized despite their small size.
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B. REST OF THE WORLD
B.3 Role of Regulators and Market Pressure
– Influence of regulators; a delicate topic.
– American authorities’ decision in the public domain.
– Generally speaking, regulators probably low key for Op.Risk – not the case for Credit.
– Large European banks felt strong market pressure.
– No pressure for smaller banks, yet…
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C. PROS AND CONS OF EACH APPROACH Views of a professional Op. Risk Manager on the 3 approaches
C.1 Basic Approach
– Major impact being increased of regulatory capital may be significant. Even the most sophisticated of them, with economic capital model, were probably carrying less than 15% for Op. Risk.
– Impact on competitiveness.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk
What it does:
– Prior to Basle II, Op. Risk was intuitive;
– After Basle II, Standardized approach will make them better risk managers.
Feature:
– Separate risk discipline;
– Transparent and disciplined;
– Consistent across all business lines.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk (cont.)
– Standardized model provides for capital to be calculated by multiplying Beta 12, 15 or 18% and gross income.
– Resulting capital hardly risk sensitive and delivers little benefits.
– Main benefit comes by implementing risk management framework:
• Op. Risk governance;
• Loss data collection;
• RCSA Program;
• Risk indicators.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk (cont.)
– Loss data collection• Increases awareness (specially for low impact)• Creates a demand for forward looking tools
– RCSA Program : BU managers• Assesses risks• Evaluates adequacy of controls• Implements action plans
– Risk indicators• Monitoring tool operating on continuous basis• Not necessarily accurate but directionally correct
– KRT • Supposed to offer capability to set risk limit or tolerances.
More work needed to demonstrate predictability and correlation.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk What it does…
Not only better management. Two other features:
– Decentralized : unlike Credit and Market Risk
• Central unit, define and design. No limit setting.
• BU implements, assumes ownership.
– Risk based : concentrates on important risks
• Op.Risk is everywhere.
• Most risks minor and frequently prohibitive to eliminate.
• BU are very good at addressing important risk.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk What it does… (cont.)
– BU don’t do it for the regulators.
– Respond to their needs.
– Value creation.
– Very different from other compliance work which is viewed as unproductive and cost of doing business.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk What it doesn’t do…
– No objective tools to set Op. Risk limit. Limit setting either reactive or subjective.
– Because:• Method requirements vague and unclear;
• KRI still primitive.
– Major Negative:• Capital calculation hardly risk sensitive;
• Might not produce a lower amount of capital than Basic;
• May produce irrational behaviour.
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C. PROS AND CONS OF EACH APPROACH
C.2 Standardized Approach – manages the risk What it doesn’t do… (cont.)
Conclusion:
– Brings better risk management;
– Contributes to value creation;
– Does not necessarily deliver lower capital – which should be expected from better management.
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C. PROS AND CONS OF EACH APPROACH
C.3 Advanced Approach – measures the risk What it does…
– Good management from Standardized.
– Requirement more demanding: aiming at better integrating management and measurement.
– Big plus is efforts to better measure capital requirement in a more risk sensitive manner.
– LDA provides for capital being determined by unexpected loss for each risk type.
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C. PROS AND CONS OF EACH APPROACH
C.3 Advanced Approach – measures the risk What it does… (cont.)
– You need to understand your severity distribution and impact distribution for each risk type.
– Results is regulatory capital by risk type and BU.
– This creates risk management possibilities:• Charging capital to businesses;
• Limiting capital to certain business lines.
– Another benefit is clearly capital reduction which is a very strong attraction to this method.
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C. PROS AND CONS OF EACH APPROACH
C.3 Advanced Approach – measures the risk What it doesn’t do…
– Scepticism amongst community of professional Op. Risk Managers.
– Explains why several large banks like HSBC are not implementing it, at least for now.
– The general view is that most of the benefits from better risk management comes with Standardized and to walk the extra mile for Advanced requires more assurance of capital reduction.
– No banks internal loss database contains the data required to estimate tail end of loss distribution.
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C. PROS AND CONS OF EACH APPROACH
C.3 Advanced Approach – measures the risk What it doesn’t do… (cont.)
– Regulators knew it but, to encourage banks to go Advanced, proposed means of filling the gaps.
– Scenario analysis : external loss database.
– Work is being done to make these processes more robust.
– Major obstacle not regulators but CFOs. Even if regulatory capital decreases, real capital will not.
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C. PROS AND CONS OF EACH APPROACH
C.3 Advanced Approach – measures the risk What it doesn’t do… (cont.)
Conclusion
– Advanced approach has great potential to bring to Op. Risk managers a really risk sensitive approach.
– In the short term, the availability of data is an important obstacle.
– I suggest that this be addressed progressively and, eventually, as internal loss database becomes more reliable, more banks will move to Advanced.
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Thank you!