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Risk Management Workshop Colombia: From Theory to Implementation

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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

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