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Basel II implementation at Absa: A case study Presented by:André Blaauw GM: Enterprise-wide Risk Management Absa, South Africa Risk.

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Presentation on theme: "Basel II implementation at Absa: A case study Presented by:André Blaauw GM: Enterprise-wide Risk Management Absa, South Africa Risk."— Presentation transcript:

1 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 February 2004

2 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 2 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 Agenda SA:South Africa B2:Basel II Capital Accord IFRS:International Financial Reporting Standards

3 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 3 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. 1.About the SA Financial System JSE:Johannesburg Stock Exchange SAFEX:South African Futures Exchange OTC:Over-The-Counter FSB:Financial Services Board

4 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 4 Absa Group 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 2.About Absa Who is Absa?

5 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 5 Absa Group Activities 2.About Absa Other Activities Asset management Property development Pension payments 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) Personal banking28.5% Commercial banking30.4% Wholesale domestic banking20.4% International banking3.2% African operations2.6% Insurance and financial services17.6% Other-2.7% 100% *31-Mar-2003

6 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 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 2.About Absa Salient features 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% *31-Mar-2003 Permanent staff complement:> 32,000 *31-Mar-2003 Customers:± 6 million Branches & agencies:± 1,200 Non-performing loan (NPL) ratio:± 4% Bad debt ratio:0.85% Recent events in SA 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 7 3.Risk management history at Absa 1996 ALCO process fully established Trading book VaR implementation. Active hedging programme for IRR commenced. ERM approach initiated. Re-engineering of credit decisioning platform completed. Basel 2 programme initiated. 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 2000 Earnings-at-Risk (EaR) framework implemented.

8 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 8 4.1INTERNAL CONSIDERATIONS 4.1.1Resource implications: – Significant investment in IT systems would be required. – Data availability challenges. – Complex model requirements. – Ownership, co-ordination of efforts (Finance, IT, Risk) 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 Change management: – Changes to IT systems and business processes, policies and procedures. – Challenge to manage required change effectively. 4.To B2 or not to B2? – Internal considerations

9 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide Other compliance requirements: – AC133 (IFRS), AML, etc Business benefits: – Enhanced reputation. – Improved control environment, information integrity, etc. – Tools to improve operational and process efficiencies Enhancing risk management framework: – Opportunity to further embed risk-reward management culture in decision making. 4.To B2 or not to B2? – Internal considerations 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 10 4.To B2 or not to B2? – External considerations 4.2EXTERNAL CONSIDERATIONS: EMERGING MARKETS ACCEPTANCE 4.2.1Cross border capital flows: – – Improved transparency of SA banks’ risk profiles and best practices benchmark compliance could improve ratings. – – Improved capital inflows could result Unintended consequences: – – Higher capital requirements volatility in emerging markets. – – More challenging for banks to maintain profitability due to combined impact of AC133 and B 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 11 4.To B2 or not to B2? – Conclusion 4.3CONCLUSION – 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 12 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. 5.B2 Implementation Strategy IRB:Internal Ratings Based

13 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 13 CP1 Jan CP2 May OIS3 Dec CP3 Apr Final Accord Jun Legislative Process Parallel Run Full Implementation Jan Programme Timeline Regulatory Timeline Current B2 Implementation Status Gap/Impact Analysis Pre requisite systems Methodologies and data Measurement Models Operationalisation Programme Management Awareness/Communication Change Enablement Quality & Compliance Assurance Process and organisation Planning/mobilisation Systems integration B2/IFRS alignment

14 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 14 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 7.Delivering the B2 solution

15 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 15 Group Risk Committee B2 Programme SteerCo ACMB B2 SteerCo CRMO B2 SteerCo Group Finance B2 SteerCo Group Finance B2 SteerCo ERM B2 SteerCo B2 Credit Risk Work Streams B2 Capital & Disclosure Work Streams B2 Capital & Disclosure Work Streams B2 Market Risk Work Streams B2 Market Risk Work Streams B2 Operational Risk Work Streams B2 Operational Risk Work Streams (Chairman: FD) B2 Credit Risk Project Management B2 Credit Risk Project Management 7.Delivering the B2 solution (Board Risk Committee) Programme management: Governance Structure

16 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 16 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 7.Delivering the B2 solution

17 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 17 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 7.Delivering the B2 solution PD:Probability of Default SMEs:Small and Medium sized Enterprises LGD:Loss Given Default EAD:Exposure At Default

18 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 18 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) 7.Delivering the B2 solution

19 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 19 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. 7.Delivering the B2 solution

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

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

22 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 22 Significant enhancement required to existing processes for B2 Minor enhancement required to existing processes for B2 7.Delivering the B2 solution Legend: Risk Management Framework Enhancement– Credit Risk

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

24 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 24 OversightAssuranceComplianceDisclosure Board and Senior Management: Oversight Compliance assessment Audit reports Capital Allocation Set and enforce limits Risk Management Unit: Measure, Monitor, Control, Report Risk appetite Position taking functions 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 Capital requirements for equity risk: Equities in the banking book under the internal models approach (VaR). Portfolio Management Risk Mitigation Set Policies Capital + Risk Measurement Significant enhancement required to existing processes for B2 Minor enhancement required to existing processes for B2 Legend: Risk Management Framework Enhancement– Market Risk 7.Delivering the B2 solution

25 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 25 Capital Management Regulatory Reporting Public Disclosure Risk-Adjusted Performance Measurement Portfolio Risk Measurement Capital Requirement Projections Portfolio Limit Monitoring Group Risk Profile Reporting Structuring Models & Methodologies Deal Origination Service Delivery Operations Management IT / Information Management Customer Relationship Management Market Segmentation and Targeting Strategic Planning Collateral Management Provisioning Risk Assessment Allocate Risk Ratings Risk Pricing Quantitative Risk Measurement Risk Mitigation Exposure Monitoring Recovery Risk Management Set Risk Policies Set Risk Appetite Monitor Risk Profiles Obtain Assurance & Ensure Compliance Board Risk Committees Group Finance Enterprise RM Risk Underwriting SBUs Capital adequacy management framework 7.Delivering the B2 solution

26 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 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 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 29 Accord Implementation SteerCo Accord Implementation SteerCo Risk Management Disclosure Compliance Economic Impact Senior Bank Executives Bank Supervision Heads Senior Bank Executives Bank Supervision Heads 10.Local Supervisor’s Influence Data issues Model validation Consolidated response to BIS proposals Co-ordinated QIS Data issues Model validation Consolidated response to BIS proposals Co-ordinated QIS

30 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide Industry Collaboration Credit loss data pooling Industry has taken initiatives … Operational loss data pooling SME default data (in progress) SME LGD data (next phase) Still under discussion Issues: context, confidentiality, etc.

31 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 31 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. 12.Remaining issues and challenges – Pillar 2 clarity

32 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 32 Static LGD, EAD and term assumptions. Non-linear sensitivity to credit quality changes. 12.Remaining issues and challenges – Pro-cyclicality B2 Credit Capital Risk Weight Curve

33 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 33 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. 12.Remaining issues and challenges – Pro-cyclicality

34 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 34 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. 12.Remaining issues and challenges – Model validation

35 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 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. “ ” CAR:Capital Adequacy Requirements Moody’s Investors Services

36 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 36 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. 13.Conclusion

37 B2 implementation at Absa: A case study, AJ Blaauw — Cartagena, 18 February 2004Slide 37 Victor Hugo


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