1. Risk Management Workshop Colombia: From Theory to Implementation
Basel II implementation at Absa: A case study
Presented by: André Blaauw
GM: Enterprise-wide Risk Management
Absa, South Africa
Risk Management Workshop Colombia: From Theory to Implementation
Cartagena, Colombia
16-19 February 2004

2. Agenda 1. About the SA financial system 2. About Absa
3. Risk management history at Absa
4. To B2 or not to B2?
5. B2 implementation strategy
6. Current B2 implementation status
7. Delivering the B2 solution
8. B2 / IFRS alignment
9. Early results
10. Local supervisor’s influence
11. Industry collaboration
12. Remaining issues and challenges
13. Conclusion
SA: South Africa
B2: Basel II Capital Accord
IFRS: International Financial Reporting Standards

3. 1. About the SA Financial System
JSE: Johannesburg Stock Exchange
SAFEX: South African Futures Exchange
OTC: Over-The-Counter
FSB: Financial Services Board
Sophisticated by emerging market standards:
Well developed capital and money markets.
Listed equities market (JSE) – total market capitalisation of approx 200 Billion USD.
Large and liquid listed fixed income market (Bond Market Exchange).
Formal equity and commodity futures and options markets (SAFEX).
Large domestic interest rate- and FX OTC derivatives markets.
Banking industry:
Dominated by 5 large banks – combined holds more than 90% of assets.
Financial conglomerates – retail, commercial, investment banking, insurance, asset management, etc.
Regulatory environment:
Banks are regulated by the central bank.
Insurance, securities trading, asset management, etc. – regulated by the FSB.

4. 2. About Absa Who is Absa? Absa Group Ltd.: Absa Bank Ltd.:
Domiciled in South Africa (SA)
Listed on Johannesburg Stock Exchange (JSE)
Controlling company of major banking and financial services group in SA
Formed about nine years ago by merging four major South African financial services groups (Amalgamated Banks of South Africa Ltd.)
Absa Bank Ltd.:
One of the 4 largest domestic banks in SA
Market leader in retail banking: mortgages and electronic banking
Geographical footprint:
Represented in 11 countries: South Africa, Europe, Asia, Americas, Other sub-Saharan African countries

5. Contribution by Activity (% of Headline Earnings)
2. About Absa
Absa Group Activities
Absa Bank
Retail banking
Commercial banking
Corporate & Merchant banking
International operations
Africa banking operations
Absa Financial Services
Life insurance
Short-term insurance
Insurance broking
Trust & Investment services
Employee benefits
Contribution by Activity
(% of Headline Earnings)
*31-Mar-2003
Other Activities
Asset management
Property development
Pension payments
Personal banking
28.5%
Commercial banking
30.4%
Wholesale domestic banking
20.4%
International banking
3.2%
African operations
2.6%
Insurance and financial services
17.6%
Other
-2.7%
100%

6. 2. About Absa Salient features Recent events in SA
Return on assets (ROA):
1.5%
*31-Dec-2003
Assets:
> ZAR 284 billion (>USD 50 billion)
*30-Sep-2003
Return on equity (ROE):
> 20%
*31-Mar-2003
Capital adequacy range:
11% to 12%
Permanent staff complement:
> 32,000
Customers:
± 6 million
Branches & agencies:
± 1,200
Non-performing loan (NPL) ratio:
± 4%
Bad debt ratio:
0 .85%
Salient features
Recent events in SA
1994 first democratic elections: Ending SA's isolation from international community; Rapidly growing trade between SA and other African countries
Tier 2 Banks liquidity crisis
Micro-lending shake-up
Mergers & acquisitions, and new market players
Currency volatility
Black Economic Empowerment
Financial Services Charter
Banking the unbanked/unbankable
King II report on Corporate Governance
AC133 Accounting Standard (1 Jan 2003) (IAS 39 / FAS133 equivalent)
Basel II Capital Adequacy Requirements

7. 3. Risk management history at Absa
1996
ALCO process fully established.
1997
Trading book VaR implementation.
1998
Active hedging programme for IRR commenced.
1999
ERM approach initiated.
2000
Earnings-at-Risk (EaR) framework implemented.
2001
Re-engineering of credit decisioning platform completed.
2002
Basel 2 programme initiated.
2003
Basel 2 implementation gains momentum.
ALCO: Asset & Liability Committee
VaR: Value-at-Risk
IRR: Interest Rate Risk
ERM: Enterprise-wide Risk Management
EaR: Earnings-at-Risk

8. 4. To B2 or not to B2? – Internal considerations
4.1.1 Resource implications:
Significant investment in IT systems would be required.
Data availability challenges.
Complex model requirements.
Ownership, co-ordination of efforts (Finance, IT, Risk).
4.1.2 B2 implementation cost and risk:
Estimated at 2.8% of annual Operating Expenditure, expensed over 5 years.
Capital saving benefits uncertain.
High risk of rework, due to regulatory process uncertainty.
4.1.3 Change management:
Changes to IT systems and business processes, policies and procedures.
Challenge to manage required change effectively.

9. 4. To B2 or not to B2? – Internal considerations
4.1.4 Other compliance requirements:
AC133 (IFRS), AML, etc.
4.1.5 Business benefits:
Enhanced reputation.
Improved control environment, information integrity, etc.
Tools to improve operational and process efficiencies.
4.1.6 Enhancing risk management framework:
Opportunity to further embed risk-reward management culture in decision making.
AC133: Accounting standard AC133, “Financial Instruments: Recognition and Measurement”, a recent addition to South African GAAP and local equivalent of IAS39 / FAS133.
IFRS: International Financial Reporting Standards
AML: Anti-Money Laundering

10. 4. To B2 or not to B2? – External considerations
4.2 EXTERNAL CONSIDERATIONS: EMERGING MARKETS ACCEPTANCE
4.2.1 Cross border capital flows:
Improved transparency of SA banks’ risk profiles and best practices benchmark compliance could improve ratings.
Improved capital inflows could result.
4.2.2 Unintended consequences:
Higher capital requirements volatility in emerging markets.
More challenging for banks to maintain profitability due to combined impact of AC133 and B2.
4.2.3 Benefits to banking and financial system:
Improved risk management practices could lead to reduced systemic risk and improved market perception.
More efficient utilisation of capital employed in the banking system.
Growth in risk transfer instruments promoted.
Industry consistent disclosure.
Improved corporate governance through board and senior management oversight requirements.
Complements supervisor’s risk based approach.

11. 4. To B2 or not to B2? – Conclusion
Reputational risk of non-compliance too high.
Large retail base should lead to reduced capital requirements.
Positive spin-offs.
Benefits outweigh costs.
B2 should be viewed as an opportunity to enhance competitive position. B2
No B2

12. 5. B2 Implementation Strategy
Absa’s goal:
To be fully B2 compliant by January 2007
B2 approach aspirations:
Retail credit exposures: IRB Advanced
Corporate credit exposures: IRB foundation
Operational Risk: Advanced measurement approach
Some subsidiaries will be excluded from Group adopted approach based on materiality and will follow standardised approach.
IRB: Internal Ratings Based

13. 6. Current B2 Implementation Status
Final Accord
Jun
Full Implementation
Jan
CP1
Jan
CP2
May
OIS3
Dec
CP3
Apr
Legislative
Process
Parallel
Run
Regulatory Timeline 01 02 03 04 05 06 07
Planning/mobilisation
Gap/Impact Analysis
Pre requisite systems
Methodologies and data
Measurement Models
Programme Timeline
B2/IFRS alignment
Systems integration
Process and organisation
Operationalisation
Programme Management
Awareness/Communication
Change Enablement
Quality & Compliance Assurance
2001
2002
2003
2004
2005
2006
2007

14. 7. Delivering the B2 solution
Planning, programme mobilising and governance
Oversight by Board
Group program SteerCo
Work stream structures with clearly defined outputs
Programme sponsorship
Budgeting, priority setting, etc.
IT strategy alignment
Subject expertise

15. 7. Delivering the B2 solution
Programme management: Governance Structure
Group Risk Committee
(Board Risk Committee)
B2 Programme SteerCo
(Chairman: FD)
ACMB B2 SteerCo
CRMO B2 SteerCo
Group Finance
B2 SteerCo
ERM B2 SteerCo
B2 Credit Risk Work Streams
B2 Capital &
Disclosure
Work Streams
B2 Credit
Risk Project
Management
B2 Market Risk
Work Streams
B2 Operational Risk
Work Streams

16. 7. Delivering the B2 solution
Communication and Awareness
Ongoing
Board member training programmes
Interpreted B2
External training
Core group with requisite expertise
Training material
B2 knowledge base
Ongoing impact analysis and communication of results

17. 7. Delivering the B2 solution
Models: Credit Risk
PD:
Corporates: KMV
SMEs: Moody’s RiskCalc (SA default database)
Retail: Own development based on internal default experience related to application and behavorial scoring (TRIAD)
Specialised lending: Slotting criteria
Banks and sovereigns: Derived from internal to external rating mappings
LGD Retail:
Own development based on internal recovery experience
EAD Retail:
Own development based on internal draw down experience
Capital measurement:
Pillar 1: SAP Bank Analyser
Pillar 2: Own development in SAS
PD: Probability of Default
SMEs: Small and Medium sized Enterprises
LGD: Loss Given Default
EAD: Exposure At Default

18. 7. Delivering the B2 solution
Models: Operational Risk
Quantitative operational loss modeling: Algorithmics
Qualitative measurement – self-assessment surveys: Horizon (JP Morgan)
Models: Market Risk
Trading book: Algorithmics
Equity investments: Algorithmics
IRR in banking book: Kamakura (being evaluated)

19. 7. Delivering the B2 solution
Data Collection Strategy
Retail credit loss data:
Data collection efforts commenced some time ago.
Four years of historical data available already.
SME credit loss data:
Data pooling arrangement with peer group initiated.
Corporate, sovereign, banks credit loss data:
Insufficient data availability in local market.
Statistical model approach to be followed.
Calibrated to international default experience.
Operational risk:
Historical data available for frauds and some loss events.
Data collection efforts for remaining loss types have commenced.
Data pooling arrangement with peer group under discussion.
Centralised financial transaction database:
Development in progress.

20. 7. Delivering the B2 Solution
Integrated Credit Risk System
STRATEGY optimiser
CAPITAL ALLOCATION engine
PROVISIONING engine
PORTFOLIO engine R O A C
DI Formatter
EAD
Recovery
Rating
Simulators
BIS CAPITAL engine
PRICING engines
Economic Scenario Generator
EL-UL Engine
Interface Layer
LGD engine
EAD engine
Loan valuation engine (AC133)
Fixed Property
Moveable Property
Finance Securities
Concurrent Creditors
LGD Estimators
External
Retail Business Client
Corporate Client Financial Institution
Sovereign Unlisted
PD Estimators
Banking Book
Trading Book
PFE Calculators
Credit conversion Factors
Haircut Engine
Ratings Calibrator
Fixed Property
Moveable Property
Finance Securities
Concurrent Creditors
Recovery Statistics
Retail Client
Business Client
Corporate Client
Limits/Exposure
Collateral
Management
Application Scoring  Judgmental
Behavioral scoring  FES
Rating Systems
Customer/Product Systems
Slide 20

21. 7. Delivering the B2 solution
Integrated Operational Risk System
OPRISK CAPITAL allocation
OPRISK PERFORMANCE management
Operational Risk Analysis and Modeling
INTEGRATED OPRISK PROFILE dashboard
Operational Risk Profile Integration 1
Interface Layer 1 2 3
RISK INDICATORS
QUANTITATIVE OPRISK data
QUALITATIVE OPRISK data 1 2 3
Industry Database
Economic Crime Profile
Loss/Events Database
Assurance Compliance
Qualitative Operational Risk
Profile Alignment
Indicator Monitoring
Indicator Identification
Business Units
ERM
Sourcing
Business Units
ERM
Sourcing
Loss/Event Capturing
Loss/event Validation
Business Units
ERM
Sourcing
Enterprise Operational Risk Framework Version 3.1
Slide 21

22. 7. Delivering the B2 solution
Risk Management Framework Enhancement– Credit Risk
Significant enhancement required to existing processes for B2
Legend:
Minor enhancement required to existing processes for B2

23. 7. Delivering the B2 solution
Risk Management Framework Enhancement– Operational Risk
Compliance
assessment
Audit
reports
Board and Senior Management Oversight
Oversight
Assurance
Compliance
Disclosure
Risk appetite
Approved capital
Profile Alignment
Modeling
Capital
Measurement
Capital
Allocation
Performance
Management
Mitigation
Strategies
Enterprise Operational Risk Management
Indicator
Database
Loss Event
Database
Qualitative
Database
Information Sourcing
Sources
Business Units
Sources
Industry Database
Public Sources
External Research
Sources
Business Units
Fraud Related Events
Sources
Control Self-Assessments
Compliance profiles
Performance
Management
BU Strategies
BU Operational Risk Management
Reducing
operational losses
Effective and efficient
internal control
Business process
reengineering
Significant process changes in progress
Legend:
Minor process changes in progress
Slide 23

24. 7. Delivering the B2 solution
Risk Management Framework Enhancement– Market Risk
Compliance assessment
Board and Senior Management: Oversight
Oversight
Audit reports
Assurance
Compliance
Disclosure
Risk appetite
Capital +
Risk
Measurement
Capital
Allocation
Set and
enforce limits
Set
Policies
Risk Management Unit: Measure, Monitor, Control, Report
Portfolio
Management
Risk
Mitigation
Position taking functions
Significant enhancement required to existing processes for B2
Legend:
Minor enhancement required to existing processes for B2
Existing Risk Management Framework unchanged.
Interest Rate Risk in the Banking Book does not attract a minimum Pillar 1 capital charge, but supervisory review process requires disclosure of economic value sensitivities relative to capital.
Computation of capital for position risk in the trading book: Compliance with Capital Adequacy Requirement (1998) represents compliance to Basel II. Absa had its internal model approved for the computation of position risk capital in the trading book in 1998.
Capital requirements for equity risk: Equities in the banking book under the internal models approach (VaR).

25. Capital adequacy management framework
7. Delivering the B2 solution
Capital adequacy management framework
Set
Risk Appetite
Monitor
Risk Profiles
Obtain Assurance & Ensure Compliance
Board Risk Committees
Capital Management
Regulatory Reporting
Public Disclosure
Risk-Adjusted Performance Measurement
Group Finance
Models &
Methodologies
Portfolio Risk Measurement
Capital Requirement Projections
Portfolio
Limit
Monitoring
Group Risk Profile
Reporting
Structuring
Enterprise RM
Risk
Underwriting
Set Risk
Policies
Risk Assessment
Allocate
Risk
Ratings
Risk
Pricing
Quantitative Risk Measurement
Risk
Mitigation
Exposure Monitoring
Collateral Management
Provisioning
Recovery
Risk Management
Strategic Planning
Market Segmentation
and Targeting
Deal
Origination
Service
Delivery
Operations Management
IT / Information Management
Customer Relationship Management
SBUs

26. 8. B2 / IFRS alignment Overlap between IFRS and B2.
Common data requirements.
Common valuation models.
Provisioning / capital interrelationship.
Capital adequacy implications of fair value adjustments.
B2 / IFRS development strategy to ensure consistency in risk and financial performance measurement.
Common validation needs.
Ownership.
B2: Basel II Capital Accord
IFRS: International Financial Reporting Standards

27. 9. Early results Capital impact Ongoing capital impact measurement.
As of December 2003:
Overall: Estimated 5% capital saving
Retail credit portfolios: Significant (30%+) capital saving
SMEs: Slight increase
Corporate : Increase
Banks: Significant increase
Operational risk capital: 7% increase (preliminary AMA)
Early indication of further capital relief from EL / UL amendment.
AMA: Advanced Measurement Approach
EL / UL: Expected Loss / Unexpected Loss

28. 9. Early results Strategic implications Protecting the Retail base.
Increased focus on Wealth Management services.
Increased focus on CRM.
Reviewing LTV lending criteria for some Mortgage segments.
Reviewing speculative grade Corporate lending criteria.
Increased focus on customer retention.
Consider risk-based product re-pricing (declining capital needs over loan life).
CRM: Customer Relationship Management
LTV: Loan-To-Value

29. 10. Local Supervisor’s Influence
Accord Implementation
SteerCo
Senior Bank Executives
Bank Supervision Heads
Risk Management
Disclosure
Compliance
Economic Impact
Data issues
Model validation
Consolidated response to BIS proposals
Co-ordinated QIS

30. 11. Industry Collaboration
Industry has taken initiatives …
Credit loss data pooling
Operational loss data pooling
SME default data (in progress)
SME LGD data (next phase)
Still under discussion
Issues: context, confidentiality, etc.

31. 12. Remaining issues and challenges – Pillar 2 clarity
Judgmental approach to Pillar 2 – strong reliance on supervisor expertise.
Economic capital measurement assumptions for interest rate risk in banking book.
Measurement issues and assumptions for risks not covered under Pillar 1 – eg. Liquidity risk.
Capital stress testing methodology.
Capital buffer requirements.
Credit concentration risk measurement approaches.
Risk diversification treatment in buffer determination.

32. 12. Remaining issues and challenges – Pro-cyclicality
B2 Credit Capital Risk Weight Curve
Static LGD, EAD and term assumptions.
Non-linear sensitivity to credit quality changes.

33. 12. Remaining issues and challenges – Pro-cyclicality
Absa’s capital requirement would have increased by over 30% under a B2 regime in the aftermath of the 1998 Emerging Markets Crisis.
Problem exacerbated by dynamic internal rating systems.
Capital stress testing/planning simulation model capability.
Buffer management.
Ongoing capital attribution analysis.
Hedge capital fluctuations.

34. 12. Remaining issues and challenges – Model validation
Supervisory approach to model validation.
Statistical validation (backtesting, out of sample testing, etc.) not feasible in all areas.
Benchmarking.
Mapped ratings.
Methodology reviews.
Pragmatic approach.
Ongoing validation strategy.
Rating agents.

35. 12. Remaining issues and challenges – Capital level & Ratings
Long-term Impact of Basel II on Bank Ratings
Higher CAR won’t necessarily lead to upgrade, and cutting capital because of a higher CAR could lead to a downgrade.
But better data on risk profile will be considered, and better risk management a positive:
Better asset allocation
Better risk-adjusted pricing. “ ”
Moody’s Investors Services
CAR: Capital Adequacy Requirements

36. 13. Conclusion B2 benefits outweigh costs.
Plethora of model tools and data availability is improving.
Strong programme management required for successful implementation.
Industry collaboration critical.
Communication and education – bank management, investors, stakeholders, etc.
Key role of Regulator: To be pro-active on issues - reduce uncertainties.

37. Victor Hugo