1. Brian Boyle – Ernst & Young PRMIA Panel Discussion: Basel II Update September 26, 2005

2. Agenda Basel Refresher Basel II Regulatory Landscape Basel II Timeline
Remaining Open Issues
Current State of Industry
Basel II: Other Challenges

3. Brief History
1988 Basel Accord: G-10 central banks agree to apply common minimum capital standards to banking industries
Basel I not applied directly but through national or transnational rules (U.S.: Capital Adequacy Guidelines, EU directive: CAD or Capital Adequacy Directive)
Basel I now applied to virtually all countries with internationally active banks (approx. 100 countries)
1996: Market Risk Amendment
2001: First Consultative Paper
June 2004: “International Convergence of Capital Measurement and Capital Standards: a Revised Framework”

4. Basel II - Components of the Framework
Credit risk
Operational risk
Market risk
Banks review own capital adequacy
Supervisors evaluate bank assessments
Increased disclosure given reliance on internal assessments

5. Basel II Regulatory Landscape
QIS 4
Undertaken on a best efforts basis by 26 U.S. banks in early 2005 and attempted to quantify the effects of the Basel II proposals on banks’ required capital levels
Regulators noted that results indicated an unexpectedly large decline in overall required capital as well as a wider than expected dispersion of key parameter estimates by participating banks
Aggregated QIS 4 results released by regulators as part of recent Congressional hearings on Basel II
European Institutions
European regulators have indicated that all three Basel II approaches (Standardized, Foundation and Advanced) will be permitted
Parallel run for banks adopting the Standardized and Foundation Internal Ratings-Based (IRB) approaches will begin in January Those banks that wish to adopt the Advanced IRB approach will begin their parallel run in January 2007 and “go live” in 2008
SEC’s CSE Framework
Released in June 2004, this framework establishes a voluntary alternative method for broker-dealers to compute regulatory capital charges and embodies many of the risk management principles of Basel II
The CSE/Basel II timetable is more compressed for investment banks than for U.S. commercial banks. Applications have been submitted (some already approved) to the SEC for treatment under the CSE, with the SEC engaged in reviews throughout 2005
Final U.S. Guidance
U.S. Regulators announced in April a delay in the release of the Notice of Proposed Rulemaking (NPR), expected to be released in June 2005
NPR will provide key guidance to banks for finalizing their Basel II implementation efforts
No revised date for release has been officially announced but is expected 4Q05-1Q06
U.S. Qualification Process
Institutions are required to file formal notice with their primary regulator of intent to use the “advanced approach” 18 months prior
Advanced approach must apply across all “material business lines”. Exemption of non significant business lines and asset classes requires supervisory approval
Supervisory review of the parallel run will provide the basis for the qualification decision. Parallel run requires:
Full implementation of models, methodologies and systems
Use of “reliable and well-established” data sets
Quarterly reporting to regulators
An institution’s Basel II implementation plan also will be a critical feature in the qualification process:
Must include a self assessment of current status in meeting standards, gap analysis and remediation plan
Needs to be board approved and filed with federal regulators by third quarter of 2005
Must demonstrate that adequate resources have been budgeted and made available

6. Implementation Timeline

7. Remaining Open Issues Implementation Timing in U.S.
Basel II implementation timetable called into question with the announced delay in the release of the NPR
U.S. regulators are expected to impose a 6- to 12-month “parallel processing” requirement for the advanced credit, market and operational regulatory capital methodologies that will drive consolidated U.S. reporting under Basel II
Current indications are that the required parallel processing period will begin between January 1, 2007 and July 1, 2007 and end with live processing on January 1, 2008
Home/Host Responsibilities
Basel II will not lead to a flawlessly consistent banking framework due to legal and market differences across jurisdictions.
Firms may be subject to redundant and uncoordinated reviews by multiple regulatory jurisdictions
The Basel Accord Implementation Group group has developed a dozen case studies for supervisors using live examples

8. Current State of Industry
General
Regulators initially indicated that there would be 10 mandatory Basel II banks in the U.S. - due to merger activity, this number has dropped to 7 mandatory banks. However, many opt-in banks are beginning to make firmer commitments to Basel II
Mandatory and opt-in firms have developed baseline implementation plans and established a Basel II program management structure. These firms are now focused on meeting US qualification requirements
Current state assessment
Gap analysis
Remediation plans
U.S. regulators are beginning on-site visits, focusing on overall Basel II preparedness
U.S. firms are responding to requests for information from host supervisors
Firms are examining ways to link regulatory initiatives -- SOX, ORM, Compliance -- to drive cost efficiencies
Credit Risk
Implementation of dual ratings assignment and quantification methodologies for wholesale exposures
Refinement of segmentation framework and parameter estimates quantification methodology for retail exposures
Enhancement of internal controls related to model/process validation and Board and senior management oversight
Build/augmentation of data warehouse capabilities to collect historical default and loss data for credit portfolios, and input data for rating assignment models
Building risk weighted asset calculator
Enhancement of systems for internal reporting and public disclosure
Focus on the integration of risk and finance data
Operational Risk
Review of operational risk management framework and organizational structures
Institutionalization of loss data collection processes, normalizing external data
Refocus on self assessment process, key indicators and risk reporting
Assessment of first iteration of operational risk quantification models
Review of economic capital calculation and allocation process

9. Basel II: Other Challenges
Bifurcated approach to Basel II in the US may result in added complexity and cost for foreign banks that elect to use the foundation approach in their home country
One year head start, in terms of reduced regulatory capital, for firms using the standardized and foundation approach (2007 start) compared to firms using the advanced approaches (2008 start)
The Fed is studying Basel II effects on competitiveness of processing banks, mortgages, small business lending, consolidation and credit card lending
Level and Diverse Playing Field
Consistency between Accounting Standards and Basel II
Inconsistency in definitions between US GAAP and IAS accounting standards and Basel II. Conflicting definitions could lead to multiple sets of data and reporting requirements
Key areas of overlap are definitions of default and impairment, trading book and valuation of exposures, disclosures, and capital management
Loss Given Default Stress Testing
Banks that adopt the advanced IRB approach will need to consider stress scenarios (economic downturns) in estimates of Loss Given Default

10. Basel II: Other Challenges (cont’d)
Variety of data requirements across business lines
Ability to manage data across legal entities (geographically) when most firms manage according to business line (functionally)
Quantification of rating systems
Operational risk data availability and relevance and scaling of external data
Establishing data collection standards and performing independent testing
Data Integrity Issues
Disclosure Requirements
Lack of guidance regarding disclosure requirements
Amount of disclosure should be commensurate with the size, risk profile, and complexity of the firm's operations
Risk management framework should be disclosed in a manner which allows investors and counterparties to determine whether a firm effectively identifies, assesses, monitors, and controls/mitigates risk
Materiality Thresholds
Need to determine when a subsidiary, business line or asset class is considered material
Expectation that firms will develop more risk sensitive techniques for allocating capital

11. Contact Information
Brian J. Boyle
Manager
Ernst & Young LLP
(212)

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