Presentation on theme: "Risk Management Workshop Colombia: From Theory to Implementation"— Presentation transcript:
1 Risk Management Workshop Colombia: From Theory to Implementation Basel II implementation at Absa: A case studyPresented by: André BlaauwGM: Enterprise-wide Risk ManagementAbsa, South AfricaRisk Management Workshop Colombia: From Theory to ImplementationCartagena, Colombia16-19 February 2004
2 Agenda 1. About the SA financial system 2. About Absa 3. Risk management history at Absa4. To B2 or not to B2?5. B2 implementation strategy6. Current B2 implementation status7. Delivering the B2 solution8. B2 / IFRS alignment9. Early results10. Local supervisor’s influence11. Industry collaboration12. Remaining issues and challenges13. ConclusionSA: South AfricaB2: Basel II Capital AccordIFRS: International Financial Reporting Standards
3 1. About the SA Financial System JSE: Johannesburg Stock ExchangeSAFEX: South African Futures ExchangeOTC: Over-The-CounterFSB: Financial Services BoardSophisticated 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 SAFormed 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 SAMarket leader in retail banking: mortgages and electronic bankingGeographical footprint:Represented in 11 countries: South Africa, Europe, Asia, Americas, Other sub-Saharan African countries
5 Contribution by Activity (% of Headline Earnings) 2. About AbsaAbsa Group ActivitiesAbsa BankRetail bankingCommercial bankingCorporate & Merchant bankingInternational operationsAfrica banking operationsAbsa Financial ServicesLife insuranceShort-term insuranceInsurance brokingTrust & Investment servicesEmployee benefitsContribution by Activity(% of Headline Earnings)*31-Mar-2003Other ActivitiesAsset managementProperty developmentPension paymentsPersonal banking28.5%Commercial banking30.4%Wholesale domestic banking20.4%International banking3.2%African operations2.6%Insurance and financial services17.6%Other-2.7%100%
6 2. About Absa Salient features Recent events in SA Return on assets (ROA):1.5%*31-Dec-2003Assets:> ZAR 284 billion (>USD 50 billion)*30-Sep-2003Return on equity (ROE):> 20%*31-Mar-2003Capital adequacy range:11% to 12%Permanent staff complement:> 32,000Customers:± 6 millionBranches & agencies:± 1,200Non-performing loan (NPL) ratio:± 4%Bad debt ratio:0 .85%Salient featuresRecent events in SA1994 first democratic elections: Ending SA's isolation from international community; Rapidly growing trade between SA and other African countriesTier 2 Banks liquidity crisisMicro-lending shake-upMergers & acquisitions, and new market playersCurrency volatilityBlack Economic EmpowermentFinancial Services CharterBanking the unbanked/unbankableKing II report on Corporate GovernanceAC133 Accounting Standard (1 Jan 2003) (IAS 39 / FAS133 equivalent)Basel II Capital Adequacy Requirements
7 3. Risk management history at Absa 1996ALCO process fully established.1997Trading book VaR implementation.1998Active hedging programme for IRR commenced.1999ERM approach initiated.2000Earnings-at-Risk (EaR) framework implemented.2001Re-engineering of credit decisioning platform completed.2002Basel 2 programme initiated.2003Basel 2 implementation gains momentum.ALCO: Asset & Liability CommitteeVaR: Value-at-RiskIRR: Interest Rate RiskERM: Enterprise-wide Risk ManagementEaR: 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 StandardsAML: Anti-Money Laundering
10 4. To B2 or not to B2? – External considerations 4.2 EXTERNAL CONSIDERATIONS: EMERGING MARKETS ACCEPTANCE4.2.1 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 B18.104.22.168 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.B2No B2
12 5. B2 Implementation Strategy Absa’s goal:To be fully B2 compliant by January 2007B2 approach aspirations:Retail credit exposures: IRB AdvancedCorporate credit exposures: IRB foundationOperational Risk: Advanced measurement approachSome 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 AccordJunFull ImplementationJanCP1JanCP2MayOIS3DecCP3AprLegislativeProcessParallelRunRegulatory Timeline01020304050607Planning/mobilisationGap/Impact AnalysisPre requisite systemsMethodologies and dataMeasurement ModelsProgramme TimelineB2/IFRS alignmentSystems integrationProcess and organisationOperationalisationProgramme ManagementAwareness/CommunicationChange EnablementQuality & Compliance Assurance2001200220032004200520062007
14 7. Delivering the B2 solution Planning, programme mobilising and governanceOversight by BoardGroup program SteerCoWork stream structures with clearly defined outputsProgramme sponsorshipBudgeting, priority setting, etc.IT strategy alignmentSubject expertise
16 7. Delivering the B2 solution Communication and AwarenessOngoingBoard member training programmesInterpreted B2External trainingCore group with requisite expertiseTraining materialB2 knowledge baseOngoing impact analysis and communication of results
17 7. Delivering the B2 solution Models: Credit RiskPD:Corporates: KMVSMEs: Moody’s RiskCalc (SA default database)Retail: Own development based on internal default experience related to application and behavorial scoring (TRIAD)Specialised lending: Slotting criteriaBanks and sovereigns: Derived from internal to external rating mappingsLGD Retail:Own development based on internal recovery experienceEAD Retail:Own development based on internal draw down experienceCapital measurement:Pillar 1: SAP Bank AnalyserPillar 2: Own development in SASPD: Probability of DefaultSMEs: Small and Medium sized EnterprisesLGD: Loss Given DefaultEAD: Exposure At Default
19 7. Delivering the B2 solution Data Collection StrategyRetail 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.
22 7. Delivering the B2 solution Risk Management Framework Enhancement– Credit RiskSignificant enhancement required to existing processes for B2Legend:Minor enhancement required to existing processes for B2
23 7. Delivering the B2 solution Risk Management Framework Enhancement– Operational RiskComplianceassessmentAuditreportsBoard and Senior Management OversightOversightAssuranceComplianceDisclosureRisk appetiteApproved capitalProfile AlignmentModelingCapitalMeasurementCapitalAllocationPerformanceManagementMitigationStrategiesEnterprise Operational Risk ManagementIndicatorDatabaseLoss EventDatabaseQualitativeDatabaseInformation SourcingSourcesBusiness UnitsSourcesIndustry DatabasePublic SourcesExternal ResearchSourcesBusiness UnitsFraud Related EventsSourcesControl Self-AssessmentsCompliance profilesPerformanceManagementBU StrategiesBU Operational Risk ManagementReducingoperational lossesEffective and efficientinternal controlBusiness processreengineeringSignificant process changes in progressLegend:Minor process changes in progressSlide 23
24 7. Delivering the B2 solution Risk Management Framework Enhancement– Market RiskCompliance assessmentBoard and Senior Management: OversightOversightAudit reportsAssuranceComplianceDisclosureRisk appetiteCapital +RiskMeasurementCapitalAllocationSet andenforce limitsSetPoliciesRisk Management Unit: Measure, Monitor, Control, ReportPortfolioManagementRiskMitigationPosition taking functionsSignificant enhancement required to existing processes for B2Legend:Minor enhancement required to existing processes for B2Existing 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).
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 AccordIFRS: International Financial Reporting Standards
27 9. Early results Capital impact Ongoing capital impact measurement. As of December 2003:Overall: Estimated 5% capital savingRetail credit portfolios: Significant (30%+) capital savingSMEs: Slight increaseCorporate : IncreaseBanks: Significant increaseOperational risk capital: 7% increase (preliminary AMA)Early indication of further capital relief from EL / UL amendment.AMA: Advanced Measurement ApproachEL / 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 ManagementLTV: Loan-To-Value
29 10. Local Supervisor’s Influence Accord ImplementationSteerCoSenior Bank ExecutivesBank Supervision HeadsRisk ManagementDisclosureComplianceEconomic ImpactData issuesModel validationConsolidated response to BIS proposalsCo-ordinated QIS
30 11. Industry Collaboration Industry has taken initiatives …Credit loss data poolingOperational loss data poolingSME default data (in progress)SME LGD data (next phase)Still under discussionIssues: 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 CurveStatic 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 RatingsHigher 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 allocationBetter risk-adjusted pricing.“”Moody’s Investors ServicesCAR: 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.