1. FSVC/Central Bank of Libya Seminar - January 2009 1 Day 3 Establishing a Modern Risk Management Department Basel II and Bank Risk Management Garrett R. Glass

2. FSVC/Central Bank of Libya Seminar - January 2009 2 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three Prepared by Garrett R. Glass

3. FSVC/Central Bank of Libya Seminar - January 2009 3 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach (1988) 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk 6. Trading Book/ Market Risk (1996) Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three Basel I

4. FSVC/Central Bank of Libya Seminar - January 2009 4 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach Notional Amounts x Risk Weights = Risk Assets Investment Banks Treated Like Banks Off-Balance-Sheet Assets Get New Risk Weights Acceptable Collateral Expanded 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

5. FSVC/Central Bank of Libya Seminar - January 2009 5 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 3. Credit Risk – Internal-Ratings Based Approach Calculate Probabil- ity of Default; Loss Given Default; Exposure at Default; Effective Maturity New Risk Weights and Parameters Assets Now in 5 Categories Securitised Assets Provide Deductions 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

6. FSVC/Central Bank of Libya Seminar - January 2009 6 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 4. Securitisation Framework New standardised table provides risk weights for most securities Banks can use internal measures with approval 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

7. FSVC/Central Bank of Libya Seminar - January 2009 7 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk New capital charge but excludes legal and reputation risk Basic Indicator Approach = 15% charge on gross annual income Standardised Approach looks at 8 businesses, and 12% - 18% charge on income of these businesses Advanced Approach only with approval 6. Trading Book/ Market Risk Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

8. FSVC/Central Bank of Libya Seminar - January 2009 8 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk 6. Trading Book/ Market Risk Book must have daily MTM and S/T horizon Position limits and liquidity controls required Mark to model allowed if used prudently Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

9. FSVC/Central Bank of Libya Seminar - January 2009 9 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Helps banks improve risk management Captures risks and risk factors not in Pillar I (such as business cycle effects) Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

10. FSVC/Central Bank of Libya Seminar - January 2009 10 BIS Capital Adequacy Framework – Basel II 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Market Discipline Judges quality and type of public informa- tion Greater disclosure leads to less capital Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three

11. FSVC/Central Bank of Libya Seminar - January 2009 11 Challenges to Basel II from Credit Crisis 1.Tier 1, 2 and 3 Capital ratios were inadequate 2.Off-balance-sheet assets not counted correctly 3.Securitisation seen as a benefit, not a risk or cost 4.Liquidity risk not incorporated 5.Systemic risk not captured, measured or managed

12. FSVC/Central Bank of Libya Seminar - January 2009 12 Challenges to Basel II from Credit Crisis 6.Parallel banking structure not brought into system (investment banks, securities firm, hedge funds, private equity, insurance companies) 7.Mark to market leads to Ponzi finance (demand for ever greater volumes of business to meet growth targets) 8. Mark to model abused: –Models too complex and opaque (black boxes) –Over reliance on quantitative assumptions of market behavior –Data non-existent or limited

13. FSVC/Central Bank of Libya Seminar - January 2009 13 Challenges to Basel II from Credit Crisis 9.Monetary policy issues: –No controls over growth in fiat currency (paper/electronic money); inflation was targeted but inflation measurements were altered, giving false impression of inflation risk –U.S. eliminated M3 –U.S. claimed it was impossible to identify or control asset bubbles 10.Reliance on public debt ratings to determine risk categories is questionable now that ratings agencies have shown that their rating system is flawed

14. FSVC/Central Bank of Libya Seminar - January 2009 14 Challenges to Basel II from Credit Crisis 11. Pro-cyclical banking culture as economy expands _ Credit pricing and covenant standards weaken _ Maturities are extended _ Products become more complex and harder to value _ Increased profitability leads to demands for higher growth rates _ Risk managers lose power to line managers _ Regulators reduce their oversight and vigilance _ Impossible to shut down a profitable but high/risk business

15. FSVC/Central Bank of Libya Seminar - January 2009 15 Areas of Basel II Framework Likely to be Revised 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk 6. Trading Book/ Market Risk Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three Areas likely to be revised

16. FSVC/Central Bank of Libya Seminar - January 2009 16 Areas of Basel II that Libyan Banks Can Implement 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach 3.Credit Risk – Internal-Ratings Based Approach 4. Securitisation Framework 5. Operational Risk – Basic Indicator or Standardised Approach 6. Trading Book/ Market Risk (1996 Accord only) Supervisory Review Market Discipline Setting Minimum Capital Requirements Pillar One Pillar Two Pillar Three Libyan Central Bank may implement Pillar II Opinion of author only!