Presentation on theme: "Basel II and Standard & Poor’s Approach to Financial Institution’s Capital Adequacy Craig Bennett House keeping – due to finish, questions, genuine reason."— Presentation transcript:
1 Basel II and Standard & Poor’s Approach to Financial Institution’s Capital Adequacy Craig BennettHouse keeping – due to finish, questions, genuine reason to thankCreative open:Introduction: here to share RACF methodology, timing and useMay 20, 2008
2 Capital ratios “have been the focus of much attention, both internal and external, over recent months,” Chairman Royal Bank of Scotland Group, Tom McKillop.Britain’s second biggest lender announcing the sale of £12 billion shares to boost capital depleted by subprime write-downs and joint acquisition of ABN Amro for €72 billion.
3 Agenda Why do we need a different capital measure? S&P Risk-Adjusted Capital Framework conceptsInteractions with Basel II capital requirementsHow are we going to use Pillar IIIConcluding remarks
5 Two primary goals Enhance our quantitative and qualitative analysis Address inconsistencies in:Local regulations, including definition of regulatory capital;Risk measures;Regulatory options (incl. stress tests); andEconomic capital modelsIncorporate our different risk assessmentTrading book, equity portfolios, securitisation, etc.Opinion on credit marketsCorrelations / diversificationDevelopment a globally consistent risk adjusted measure to facilitate the assessment and comparison of capital adequacy as well as profitability.The Project has two main goals First : Develop a globally consistent risk adjusted measure that will facilitate the assessment and comparison of banks’ capital adequacy as well as profitability.Our ambition is to develop a globally consistent Basel II derived risk adjusted capital measures that will be possible to fine tune in order to reflect more precisely the specificities of banks individual risk profile.Second enhance our quantitative expertise by setting up expert teams responsible to develop methodologies to analyse the information embedded in banks quantitative models (Basel II, Stress tests, Economic capital models), train analysts;
6 Standard & Poor’s Applauds Basel II More comprehensive and risk sensitive thanBasel ILeverage ratioIncentive to develop better risk management systemsIncreased disclosure to the market should allow better market disciplineGlobal frameworkBut some issues remain …The Project has two main goals First : Develop a globally consistent risk adjusted measure that will facilitate the assessment and comparison of banks’ capital adequacy as well as profitability.Our ambition is to develop a globally consistent Basel II derived risk adjusted capital measures that will be possible to fine tune in order to reflect more precisely the specificities of banks individual risk profile.Second enhance our quantitative expertise by setting up expert teams responsible to develop methodologies to analyse the information embedded in banks quantitative models (Basel II, Stress tests, Economic capital models), train analysts;
7 Comparing different approaches will be difficult Differing methodologies employed impact results
8 Direct comparisons between IRB results could be misleading Database infrastructure and models are still unseasoned.
9 Transition period could last up to a decade Floors, grandfathering options (up to 2017)Technical challenges to move to advanced methodologiesTrend comparisons difficult due to continued changes in methodologiesMost bank’s will apply several methodologies at the same time
10 Trends in Basel II ratios will be complex to compare Transitional regulatory requirements and floors affect peer comparison
11 2. S&P Risk-Adjusted Capital Framework Concepts
12 A two stage process to calculate risk weighted assets Starting Point Benchmark Charges Approach (BCA)Based on publicly or already available informationGlobally consistent “industry capital charges” per risk class and regions through the implementation of “floors”Specific Charges Adjustments (SCA)Leveraging bank-specific data where available and satisfactoryReview of the information provided by the institutions and potentially adjust benchmark capital charges to reflect specificities of individual bank’s specificities risk profile compared to the industry average
13 Specific Case Adjustment Example Illustrative purposeCorporate portfolio average risk weight (after diversification) was reduced to 63.2% from 82.9% to reflect systematic hedging policyMarket risk risk-weighted assets (after diversification) was increased from $2.8 bn to $6.9 bn due to large specific risk not captured by the Value-at-RiskCorporate portfolio average risk weight was reduced to 79% from 88% reflecting non public geographic diversification detailsLarge portfolio of investment risk weight was reduced to 322% from 706% to reflect large proportion of low risk funds in the portfolio, such as Money Market type and rated Fixed Income funds
14 3. Interactions With Basel II Capital Requirements
15 Introduction of benchmark charges per Basel II Asset Class Floors to the regulatory capital charges to factor in:Standard & Poor’s different risk assessment; orUncertainty/lack of robustness of the institution’s internal data: orNon risk-sensitive standardized charges.Risk sensitivity maintained across several risk categories under BCAWe differentiate with 10 floor levels for each risk classOperational risk, a revenue based floor usedSimilar to Basel II standardized approach’Add-ons for above average model risk, legal risk or fraud risk; andIn some cases, such as custody, we use other metricsTrading riskLeverage VaR as least worstScaling the regulatory measure by a factor of three to align 1 year time horizon
16 S&P capital benchmark charges a function of BICRA score Bank industry country risk (BICRA) affects risk weight
17 The benchmark concept allows better comparability Future ratios driven by changes in methodologies
18 Capturing other risksIn addition to our adjustments to Basel II “Pillar I”, we will reflect the following factors into the adjusted RWAConcentration & Diversification (name; industry sector; geographic; asset class; risk types); andInterest rate risk in the banking bookA number of risks will not impact capital measures at this stageLiquidity and Funding risk; andReputation risk.
19 Accounting for diversification / concentration Diversification / concentration is one of the most sensitive factors of loss distributionsResults from the International Association of Credit Portfolio Managers (IACPM) ISDA study 2006It is not differentiated in Basel II Pillar I, which assumes that portfolios are diversified and exposures granular
21 How are we going to use Pillar III Pillar III disclosure will also allow us to enhance our analysis of a bank’s risk profileExpect a far richer disclosure of risk attributesOur intention is to store systematically this information in a S&P internal risk database, and use it for our analysis of bank’s risk profile.Pillar III risk disclosure will allow us to roll out our global Risk Adjusted Capital Framework (RACF)The more granular the information, the more we will be able to factor in diversification benefits.
23 Bank responses could potentially impact rating levels Some banks might seek to ‘spend’ the regulatory benefits of Basel IICapital buybacksHigher growthWe will assess such changes in capital policy closelyBasel II merely changes the measurement of risk but not the economic risk itselfWe will use our new adjusted RWA to assess banks’ risk adjusted capital adequacy and profitabilityIt is not a change in criteria (no rating changes expected as a consequence of the implementation of this framework)Is the quantitative transcription of our current qualitative opinion on banks risk adjusted capitalizationCapital is just one rating factor among othersBusiness profile analysis, strategy, risk management, earnings, liquidity, market risk, credit risk, etc…are equally important factors.
24 Capital is just one rating factor among others Other factors are equally important
25 Conclusion: smoothing the transition to Basel II Benchmarking toolInternal (against bank’s own data)External (against other banks and other banking systems)Transparent frameworkProvide much more insight on the drivers of S&P opinion on capitalOpportunity to have more structure dialogueConsistent over time, across banks and geographiesNeutralise impact of Basel II methodologiesNational discretions, grandfathering options, etc.Bank’s internal estimatesLess volatile than Basel II
26 Appendix 1. Pillar III Best Practice Disclosure
27 Pillar III disclosure – Credit risk What could be best practice?Breakdown by relevant risk classesMortgage, consumer, revolving, etc.Public sector loans should be separately identifiedWithin corporate loans (break down by other sub-asset class if relevant)For each risk classExposure at default: before and after credit risk mitigation (we consider that disclosure on CRM is too limited)Breakdown per significant geographic area, with disclosure of weighted average Probability of Default, Loss Given Default and Capital allocated.Industry sector breakdownDisclosure of amount of impaired loans as well as realized losses/expected loss for each significant risk class would also be a useful risk indicatorSingle name concentration indicator
28 Pillar III disclosure – Operational Risk What could be best practice?Breakdown of capital charge for each risk factor with explanations of the major drivers behind these chargesBreakdown for each business lineMagnitude of the largest operational risk losses and event typeThese disclosures would also contribute to the development of a better operational risk culture and awareness of analysts and investors
29 Pillar III disclosure – Trading Risk What could be best practice?Definition of trading book / banking book perimeterDisclosure of Specific risk componentCapital required, concentration indicator (size of top three contributors to specific risk), breakdown of EAD in the trading book per risk bucket, and incremental default risk measureDisclosure of key characteristics and drivers of regulatory approved Value-at-Risk measuresContribution of risk factors, diversification benefits, maximum/minimum/average VaR during the year, results of VaR back testingInformation on Stress tests and or expected shortfall as complementary measuresAmount of assets which are fair valued based on mark to model in the absence of reliable observable market prices.Comprehensive analysis of valuation methodologies and assumptions should be disclosed
30 Pillar III disclosure – Equity Portfolios What could be best practice?Separate disclosure of:Listed and unlisted exposures;Identification of book and current value;Methodology used to determine current value;Geographic breakdown; andConcentration issues, when relevant (sector, geographic, single name).
31 Pillar III disclosure – Securitisation and Pillar II risks Securitization frameworkExtensive disclosure would be necessaryVolume of securitization performed broken down per type of asset securitized with the details and amounts of retained portions and other supporting factorsFor Pillar II risks - extensive disclosure should be providedInternal capital assessment process, including identification and quantification of key risk factors not factored in Pillar IInterest rate risk in the banking book200bp parallel shock impact on NAV and interest incomeWhen calculated, sensitivity analysis to multiple interest rate scenarios, including slope curve changesQualitative and quantitative disclosure on the metric used, including the underlying assumptions and model parameters
33 Related Publications on RatingsDirect 2007 Transition To Basel II Creates a Need For A Consistent , Comparable Measure of Bank Capital, February 21, 2008Implication For Japanese Banks of Basel II Pillar III Disclosure, December 11th, 2007Latin American Banks In Dissimilar Stages Of Implementation Of Basel II, October 4th, 2007Greater Basel II Pillar III Disclosure would Enhance Transparency and Comparability In the Global Banking Sector, July 10, 2007FAQ: Building Standard & Poor's Risk-Adjusted Capital Framework, June 5, 2007Financial Institutions Group Provides More Transparency Into Adjustments Made To Bank Data, April 26, 2007Japan’s Banks Rethink Fund Investments As Basel II Dawns, February 20, 2007Where do the Key Formulas Come From?, February 15, 2007Basel II In EU Gives Banks Greater Incentive To Invest In High-Quality Fixed-Income Funds, January 3, 2007
34 Main contacts Asia-Pacific Craig Bennett, Melbourne,Ritesh Maheshwari, Singapore,Naoko Nemoto, Tokyo,Yuri Yoshida, Tokyo,EuropeBernard de Longevialle, Paris,Elie Heriard Dubreuil, Paris,Thierry Grunspan, Paris,Nick Hill, London,Harm Semder, Frankfurt,Renato Panichi, Milan,Unites StatesChuck Rauch, New York,Tanya Azarchs, New York,Vicky Wagner, New York,Simon Kam, New York,Latin AmericaCarina Lopez, Buenos Aires,Angelica Bala, Mexico,
35 Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.
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