Quantitative Asset and Risk Management

Risk Controlling under Basel II and III

Prof.in (FH) Mag.a Silvia HelmreichProgramme Director „Quantitative Asset and Risk Management“03.04.2013

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Brief history of Basel II

January, 2013? postponedBasel III

July 1988Introduction of B1 Accord

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Three pillar structure of Basel II

• Three-pillar structure• Pillar 1-Minimum Capital Requirements

Revised capital adequacy ratio (McDonough ratio)

Menu of approaches for measuring credit, operational & market risk

IRB approach implementation & Transitional arrangements

• Pillar 2 – Supervisory Review Process ICAAP, economic capital, SREP

• Pillar 3 – Market Discipline

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Minimum Capital Requirements

Three Basic Pillars

Supervisory Review Process

Supervisory Review Process

Market Discipline

Market Discipline

Public disclosureRegulatory Reporting

Approval procedure for IRBICAAP, SREP

Credit RiskMarket RiskOperational Risk

Definition of regulatory capital remained unchanged Modifications to the denominator of the risk-based capital ratios

Covers credit, market & operational risks Increased flexibility & risk-sensitivity:

Menu of approaches for risk measurement Incentives for improved risk management

Pillar 1- Revised Capital Adequacy Ratio

Changed / NewUnchanged*

%8AssetsWeightedRisk

CapitalgulatoryRe

Identical to 1988 Accord

Includes operational risk

RWA for credit & operational exposures result from complex calculations

Tier 1 + Tier 2 +Tier 3

RWA for CR + 12.5*(Capital charge for MR +OR)=CAR

Tier 1 – Core capital =+ Permanent shareholders’ equity+ Disclosed reserves - Goodwill

Tier 1 ≥ Tier 2 + Tier 3

Tier 2 – Supplementary capital =+ Undisclosed reserves+ Asset revaluation reserves+ General provisions/general loan-loss reserves+ Hybrid capital instruments+ Subordinated term debt - Investments in financial subsidiaries & other financial institutions

Tier 3 (for market risk) = Short term subordinated debt

1988 Basel Accord - Regulatory Capital

5%9%86%

Risk Approaches

Credit risk Operational risk Market risk

Simple Standardised Basic Indicator Standardised

Intermediate Foundation IRB Standardised

Advanced Advanced IRB Advanced Measurement

Internal VaR Models

Increasing risk sensitivity & increasing internal data requirements

Standardised Approach

Similar to 1988 Accord Increased risk sensitivity:

use of external ratings to determine the risk weights

Risk weights determined by category of borrower 0-150%

Targeted at banks desiring a simplified capital framework

Few credit risk mitigants (CRM) recognised

Min capital requirement = Exposure * RW% * 8%

Foundation IRB Approach

5 exposures categories: corporates, sovereigns, retail, banks & equity

Bank’s own estimate of probability of default (PD)

Supervisors provide: the loss given default (LGD), exposure at default (EAD), maturity (M)

Not available for retail exposures More CRM recognised, including

the residential & commercial real estate (RRE/CRE) collateral

Advanced IRB Approach

5 exposures categories Bank’s own estimate for all

credit risk parameters (PD, LGD, EAD & M)

More restrictive minimum capital requirements

Highly reflects a bank’s individual risk profile

CRM recognised: physical & financial collateral, guarantees & credit derivatives, nettings

Subject to supervisory validation and approval

Appropriate for more complex institutions

Credit Risk Approaches

Increasing minimum capital requirements

Objectives: Ensure adequate capital to support all risks in a bank

Encourage the development/ use of better risk management techniques

Foster an active dialogue between banks & their supervisors => when deficiencies are identified, prompt action can be taken to reduce risk or restore capital

Pillar 2: Supervisory Review Process

Areas particularly suited for treatment under Pillar 2: Risks not fully captured by Pillar 1 (e.g. operational risk, credit concentration)

Risks not taken into account under Pillar 1 (e.g. interest rate and liquidity risks)

External factors (e.g. business cycle effects)

In essence, Pillar 2 recognises that no set of rules for capital requirements – even the more risk sensitive approaches included in Pillar 1 – can be relied on to capture all aspects of an individual bank’s risk profile.

Pillar II sets the framework for strategic capital management, and outlines the supervisory powers:

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Economic Capital(‚true‘ risk profile)

Economic View:Risk adjusted capital steering

Regulatory Capital(simplified risk profile)

Regulatory View: Stability/SolvencySide condition for capital steering

Equity Capital

View of Investors:Optimisation of RoE

Regulatory vs. Economic capital

Overall Picture

Graph for economic capital

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Expected loss: normal cost of doing business covered by provisions and pricing policyUnexpected loss: potential unexpected loss for which capital should be held – covered by economic capitalStress loss or residual loss potential: potential unexpected loss against which it is judged to be too expensivehold capital against. Unexpected losses of this extent lead to insolvency.

Source: Bluhm, C./Overbeck, L./Wagner, C. (2003): An Introduction to Credit Risk Modeling, London: CRC Press

ICAAP - Internal Capital Adequacy Assesment Process

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Within the institution’s internal governance framework, the ICAAP is a process to ensure that the management body (both supervisory and management functions):

•Adequately identify and measure the institution’s risks.•Hold adequate internal capital in relation to the institution’s risk profile.•Use sound risk management systems and develop them further.

The ICAAP should be embedded in the institution’s business andorganisational processes, and not simply regarded as an addonthat permits the management body to ‘tick a box’ and indicate that supervisory expectations nominally have been met.

Basic ICAAP requirements/components

• Securing capital adequacy – risk strategy– Banks should define a risk strategy which contains– descriptions of its risk policy instruments and objectives

• ICAAP as an internal management tool• Obligation of banks / proportionality• Responsibility of the management• Assessment of all material risks• Processes and internal review procedures

– ongoing development

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Structure of bank regulation in Austria

• Institution of banking regulation:– FMA (Financial Market Authority): directives and regulations

– OeNB (Austrian National Bank): responsible for analyses and bank audits

– BMF (Ministry of Finance): Elaboration of legislative proposals

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BMF (Ministry of

Finance)

FMA (Financial

Market Authority)

OeNB(Austrian National

Bank)

Responsible for protection of the stability of the financial markets

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ICAAP-SREP interaction

Source: CEBS CP 3: Application of the Supervisory Review Process under Pillar 2

Pillar 3: Market Discipline

Objective: Promote market discipline through greater transparency and significant volume of quantitative and qualitative disclosure requirements to allow market participants to assess the capital adequacy of the institution

Disclosure requirements:1. Scope of application – unconsolidated and consolidated level of the banking group2. Capital structure (Tier 1, 2 & 3)3. Capital adequacy (capital requirements for credit, operational & market risk; risk based capital

ratios)

4. Risk exposures & assessment - to ensure that banks disclose adequate information on the risks they face and the techniques they use to measure and manage those risks Disclosures for key banking risks in the banking book as well as for credit risk mitigants The nature and the extent of the disclosures would vary depending on whether a bank uses

standardised risk-assessment methodologies or more sophisticated internal based methodologies

Disclosure is the mechanism by which the Basel Committee aims to enhance the role of financial market participants in monitoring banks.

Pillar 3 tries to encourage safe and sound banking practices through effective disclosure in order to reinforce minimum capital regulation (Pillar 1) and supervisory review process (Pillar 2)

Pillar 3: Market Discipline and Disclosure

Market

Market Discipline:

Indirect pressure to improve Risk

Management and capital adequacy

Bank

Scope of application, Capital Structure,

Taken Risks, Adequacy of Capital Resources

Disclosure

Public

• For investors

• For clients

• For competitors

• Either in the annual report

• or in risk report in the internet

Pillar 3 : Disclosure: public and non public

Closed (Non-public)

• To the regulator

• COREP (quarterly)

• CA Template (monthly)

• B3: New Liquidity Templates

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Pillar 3: Public Disclosure - Content

Content

PurposeRisk managment for different risk classesCapital structure (Tier 1, 2, 3)Minimum capital requirementCounterparty riskCredit and dilution riskUse of credit risk standardized approachSpecial vehicle finance, investment and other assetsOhter risk categoriesInternal models for market riskOperational riskInvestments outside the trading bookInterest rate risk outside the trading bookSecuritizationDisclosure if using the internal rating based approach (credit risk)Disclosure if using credit risk mitigation

Adobe Acrobat Document

Disclosure Report

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New Regulations: Basel III

Exercises learned from Financial crisis – from Basel II to Basel III

• Better quality of equity capital

• Procyclical effects of the banking system

• Definition of equity capital: uncontrolled growth of „financial innovations“ (e.g. hybrid core capital)

BCBS (2010): Basel III: A global regulatory framework for more resilient banks and banking systems

EU (July 2011): CRD IV and CRR (Package)

More liquidity reserves – there were no international standards for liquidity risks

Guidelines on Liquidity reporting: http://www.eba.europa.eu/Publications/Consultation-Papers/All-consultations/2012/EBA-CP-2012-05.aspx

21Quelle: Basel III Denkerkreis, Finance Trainer International, Wien, Daniel Zuberbühler, 15. Oktober 2010

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Effects of capital conservation and anticyclical buffer on Minimum capital requirement

 Tier 1 - common equity less regulatory adjustments

Tier 1 capital Total capital

Minimum requirement 4,5% 6,0% 8,0%

capital conservation buffer 2,5%

Minimum requirement plus capital conservation buffer 7.0% 8,5% 10,5%

Margin for the countercyclical buffer 0-2,5%

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Characteristics of the two buffers

1. Capital Conservation Buffer: in good times profit is used to build this buffer.In stress times used to absorb losses. Minimum requirements have to be kept also in bad times.Fixed at 2,5%Restrictions for dividends payouts and redemptions

2. Anticyclical Buffer: to limit excessiv loan grwothvariable based on macro ecomomic development (0 – 2,5%): e.g. deviation from the long-term tendency of the ratio loan volume to GDPIf there is „normal“ growth of loans the buffer = 0

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Restructure of equity capital

• Tier 1 Capital of Basel II is now devided into• „Common Equity Tier 1 Capital“ of highest quality (share premium

and retained earningsand• „ Additional Tier 1 Capital“ with lower quality

GOING CONCERN

• Tier 2 Capital (e.g. savings, and issued bonds)GONE CONCERN

• Tier 3 Capital for market risk is not applicable anymore under Basel III