Presentation on theme: "Risk Management and Regulatory Compliance"— Presentation transcript:
1 Risk Management and Regulatory Compliance Yan Wang, Ph.D.Senior EconomistThe World Bank
2 Outline Focus on Regulatory capital and Compliance Objectives of banking regulationOverview of statutory prudential requirements:Basel I and calculationsCredit risk charges for BS and OBS itemsFactor-in Capital charge in individual loan decisionsBasel II, three pillarsPillar 1, credit, market and operational riskPillar 2, and Pillar 3implications to Emerging Market Economies (EMEs)Link with accounting standards: Establishing consistency with corporate and statutory risk compliance and prudential standardsGood accounting practicesSummary
4 Objectives of Banking regulations To protect banks’ depositorsTo ensure the reliability of public good, ie. Money;To avoid systemic risk arising from domino effectsTo maintain a high level of financial efficiencyObjectivesToolsSystemic RiskConsumer ProtectionCapital StandardsYesyesDisclosure standardsAsset restrictionsAntitrust enforcementConflict-of-Interest rulesSource: Herring and Litan (1995)
5 A survey questionWhich of the following capital adequacy requirements have been implemented in your country?Risk-weighted capital adequacy ratio with only 4 risk buckets#1 and off-balance sheet capital chargesSimplified Standardized Approach (SSA) in Basel IIUse risk-weights under Standardized ApproachInternal Ratings-Based (IRB)Do you agree with the assessment below?
6 Compliance with Basic Core Principles is still Limited in Developing Countries: do you agree? There are 25 core principles for effective banking supervision (see one-page handout on the 25 core principles (IMF). We first focus on capital adequacy requirements. Here the compliance is higher among developing countries.Source: Powell (2004)
7 Why should Loan Officers care Capital adequacy requirements affectPricing of capital, by the degree of riskiness of your new loan/creditSelection of loan /credit products(on-balance sheet or off-balance sheet?)Economic Value Added of an additional project asEVA= profit – (capital x k)CA requirements affect capital and k (discount rate or cost factor)RAROC = EVA / capitalYour bottom line
8 Risk Management Philosophy Risk Management toolsReducing Process CostsCost of loosing businessReducing Financial CostsSustainabilityRMAutonomyDecision MakingRisk-Based pricingOptimizedCapitalAllocationContinuos ImprovementInitiation / MaintenanceCollection toolsEncourage usageof Credit ToolsCentralizedStrategyDecentralizedExecutionConsistent portfolio growth, with quality, in a controlled environment
9 General Supervisory Expectations Supervisory expectations concerning sound credit risk assessment and valuation for loansThe bank's board of directors and senior management are responsible for ensuring that the banks have appropriate credit risk assessment processes and effective internal controls commensurate with the size, nature and complexity of the bank's lending operations to consistently determine provisions for loan losses in accordance with the bank's stated policies and procedures, the applicable accounting framework and supervisory guidance.Banks should have a system in place to reliably classify loans on the basis of credit risk.A bank's policies should appropriately address validation of any internal credit risk assessment models.A bank should adopt and document a sound loan loss methodology, which addresses credit risk assessment policies, procedures and controls for assessing credit risk, identifying problem loans and determining loan loss provisions in a timely manner.A bank's aggregate amount of individual and collectively assessed loan loss provisions should be adequate to absorb estimated credit losses in the loan portfolio.A bank's use of experienced credit judgment and reasonable estimates are an essential part of the recognition and measurement of loan losses.A bank's credit risk assessment process for loans should provide the bank with the necessary tools, procedures and observable data to use for assessing credit risk, accounting for impairment of loans and for determining regulatory capital requirements.Supervisory evaluation of credit risk assessment for loans, controls and capital adequacyBanking supervisors should periodically evaluate the effectiveness of a bank's credit risk policies and practices for assessing loan quality.Banking supervisors should be satisfied that the methods employed by a bank to calculate loan loss provisions produce a reasonable and prudent measurement of estimated credit losses in the loan portfolio that are recognized in a timely manner.Banking supervisors should consider credit risk assessment and valuation policies and practices when assessing a bank's capital adequacy.
10 Incentives to undercount risk Capital allocation affects measured profitability and creates tensions within the bankLine managers have incentives to understate riskManagers may like to influence system design to lower hurdlesBanks with a higher ratio of available capital to required capital can expect lower funding costsCompliance and risk management may have limited information on what happens in line unitsLine unit personnel may have incentives not to be forthcomingIf choices about internal risk measures influence the bank's IRB measures, required capital measures might be distortedInternal conflicts are important for several reasonsIf risk measurement is twisted, decisions may be poorCapital may be less than required for safety
11 II. International Regulatory Standards (Basel I) The 1988 Basel I Accord came into effect in 1992Goal: to provide a set of minimum capital requirements for commercial banks.Objective: promote the safety and soundness of the global financial system, and to create a level-playing field for internationally active banks.The Cooke ratio with only 4 risk bucketsThe risk-based capital charges attempted to create a greater penalty for riskier assets.
12 The 1996 Amendment Amendment separates the bank assets to Trading book: fin instruments for resale and marked-to-marketBanking book: loans valued at historical cost basisThe 1996 Amendment adds capital charges forThe market risk of trading book andThe currency and commodity risk of banking book
13 Risk Capital: definition Tier 1 capital or core capitalEquity capital or shareholders fundsDisclosed reserves: share premium, retained profits and general reservesTier 2 or supplementary capitalUndisclosed reservesAsset revaluation reservesLoan loss reservesHybrid debt capital instrumentsSubordinated term debt (5 years and plus)Tier 3 for market risk only- ST subordinated debt with a maturity of two years and plus
14 How to calculate Risk Capital Of the 8% capital charge for credit risk, at least 50% must be covered by tier 1 capitalEligible tier 1 capital for CR + allowed tier 2 capital >= Credit Risk Charge (CRC)For on-balance sheet risk charges:Where N is the notional amount of asset iSee table below
15 Risk capital weights by asset class (on-balance sheet) Weights (RW)Asset Type0%Cash heldClaims on OECD central governmentsClaims on central gov't in national currency20%Cash to be receivedClaims on OECD banks and regulated securities firmsClaims on non-OECD banks below one yearClaims on Multilateral development banksClaims on foreign OECD public-sector entities50%Residential mortgage loans100%Claims on the private sector (corporate debt, equity…)Claims on non-OECD banks above one yearReal estatePlant and equipment
16 Off-Balance Sheet Risk Charges Banks expose to credit risk from off-balance sheet (OBS) items like Letters of credit (LC), swapsThe Basel Accord computes a “credit exposure” through a credit conversion factors (CCFs). Identified 5 categories and CCFs (see next table)For the first four categories:
17 Credit Risk Charge (CRC) for OBS Example: CRC for letter of creditConsider a letter of credit of $1.5 million with a domestic export corporation. What is the credit risk charge (CRC) for this letter of credit?For LC, the CCF if 100%, rw for the private sector firm is 100%Credit exposure =ccf x notional =100% x 1.5 millionCRC charge=0.08x(100%x 0.5x C-exposure)= 0.08x 1 x0.5x 1.5million=0.06 million or 60,000
18 Factor-in Credit Risk Charge in loan decisions Compare the CRC for loan and LC or other OBS item [two examples]Monitor/ control credit exposureDecision on granting or not granting loansUse EVA of a project as a benchmark whereEVA= profit- (capital x k)Subtract a risk-based capital charge from profits as in a RAROC type systemIf the addition credit capital charge is higher, then the loan /contract is less worthwhile in term of RAROC.
19 Total Risk ChargeTotal risk charge is the sum of the credit risk charges (CRC incl both on-balance sheet and off-balance sheet items) plus the market risk charge (MRC).
20 III. Intro to Basel II BCBS finalized Basel II in June 2004 Implementation started in 2007 to EU banksAdvanced IRB to be available end 2007Simultaneous operation of Basel I and Basel II until 2008United States pursuing a somewhat different courseImplementing only advanced Internal Rating-based (IRB) approachMandatory only for the most advanced / top banksOther authorities can proceed at their own pace
21 Basel II: Three Pillars DisclosureRecommended disclosure forCapital structureRisk exposureCapital adequacy“Market Forces”Pillar 1Capital Requirements“Quantitative”Credit riskMarket riskOperational riskPillar 2Supervisory ReviewConsistent review processIntervene timelyRisks not covered in pillar 1External factor“Qualitative”
22 Pillar 1: Minimum Capital Requirements Capital requirements will have greater flexibility and reflect bank riskSome banks will be allowed to assess risk internally, subject to approvalThere will be a (new) explicit capital charge for “operational risk”Risk unassociated with intrinsic asset valuesExpected to comprise 20% of requirementOverall regulatory capital is not expected to change, but may increase or decrease for individual banks
24 1. Simplified Standardized Approach (SSA) Closest to Basel ISome minor modificationsUse Export Credit Agency ratings to calculate required capital for sovereign risk exposureAvailable on OECD web siteCorporate capital still at 8%Capital requirement for operational riskUses Basic indicator approach15% of gross annual operating incomeOther modest changes(lending to sovereign in own vs. foreign currency)
25 2.Standardized Approach for Credit Risk Assessment Banks allocate their exposures to “risk buckets” defined by regulatorsRisk weights depend on borrower identityTwo methods of assigning risk weightsOne category below rating of headquarter countryExternal risk weighting of institutionFor EME it is tricky as ratings for many firms are not available –some tips hereRisk mitigating factors also incorporated
26 Risk Weights Under Standardized Approach AAA to AA-A+ to A-BBB+ to BBB-BB+ to B-Below B-UnratedClaims on Sovereigns0%20%50%100%150%Claims on Banks Option 1 (rating refers to sovereign)Claims on Banks Option 2 (rating refers to bank)
27 What if ratings are not available? Tricks and tipsQuality of the collateralEasiness in enforcing the collateral given default –legal and liquidity issuesAny guarantees /insurance?Export credit rating available?Enterprise credit registry / information available?Develop your own risk weights tables to be reviewed by regulators
28 3. IRB Approaches to Credit Risk Assessment Foundation-based approachBanks can use their own estimates of loan default probabilitiesProbabilities are combined with standard estimated of losses given default to determine value-at-riskAdvanced approachBanks estimate value-at-risk as wellLimited to most sophisticated banks
29 Regulatory ImpactOverall capital requirements expected to be unchanged on averageCalibrated to “Standard loan”1% default probability, 2.5 years maturity, 45% loss given default8% capital requirementCapital requirements will be increasing in credit risk assessmentsCapital Requirements will also be adjusted for credit risk concentrationExcessive exposure to a single borrower subject to additional capital requirementExceptionally low exposure can lead to reduction at discretion of domestic regulator
30 Numerical Example $10 billion loan Basel I: Capital Requirement $800 millionBasel II:If the loan is healthy: Capital Requirement $100 millionIf Bad loan: Capital Requirement $4.5 billionBottom Line: Extensive sensitivity to credit risk under the new program
31 B. Operational Risk Basel II Accord Total Risk Charge is Basel II also includes a capital requirement for operational riskOn average, will offset reduced requirement on rated loans under standardized approachBut may not be offset for EMEs with many unrated firmsOperational Risk also has three alternative methods /approachesBasic IndicatorStandardizedAdvanced MeasurementBasel II Accord Total Risk Charge is
32 Pillar 2: Supervisory Review Committee confirmed the need for supervisory review in addition to minimum capital requirementsSupervisors will determine soundness of internal processes used to assess capital adequacy and bank riskIntervention under conditions where violations are found
33 Four key principlesBanks are responsible for assessing capital adequacySupervisors role in assessing internal monitoring of bankBanks are normally expected to operate with capital above regulatory minimumSupervisors should intervene into problem banks at an “early stage”
34 Pillar 3: Market Discipline Disclosure is necessary for market participants to assess the risk profile and capital adequacy of banksProposals provide guidance on disclosureCapital structureRisk ExposureControl EnvironmentSelf-discipline“Bailing in” of private sector
35 Pros and Cons of Basel II Creates more risk-sensitive capital charges for credit risk and incl operational risk – benefits banks with large portfolios and high grade corporate credits.Criticisms of Basel II:Growing gap between best practice and pillar 1Banks operate in diverse environment cannot benefitCapability to provide fair regulation that is not uniformDifferences btw regulatory constraint and RMThe coherence btw new regulation and new accounting rulesThis slide can be skipped.
36 Implementation of Basel To implement Basel II the banks require expensive projects with long lead timesTrain staffGather historical loss dataBuild risk modelsImprove IT systemsImplement policies and proceduresOne of their first steps is to ask “what will the supervisors accept?” So, it is country specific
37 Implementation Challenges Systems Changes: Many banks have recently revamped their rating systems to be two-dimensional; others are preparing for this fundamental change. Most have little experience with this approach.Experts Versus Models: Commonly used expert-judgment based systems may be used, but may face a challenging hurdle in meeting supervisory standards.Rating Philosophy: Banks must more fully articulate their rating approach (not just “point-in-time” or “through-the-cycle”) and reflect that choice in other aspects of the rating system.Accuracy and Validation: Banks must work to develop appropriate tests of ratings accuracy; the exact nature will depend on details of each bank’s rating philosophy.
38 IV. Link with Accting Standards Safety and Quality of Loans depends on sound generally accepted accounting practices consistently applied. Basle Committee has prepared a lit of sound practices. (Next Slide)Int’l Accting Standard Committee (IASC)/ IASB has been revising principlesQuestions:How many of these are applied in your country, in your institution, in your bank and by you?Has the accounting association in your country issued guidance? Are all IASC standards applied or only some?What are the risks of not having good accounting practices?Three primary concerns are a) the adequacy of an institution's process for determining allowances, b) the adequacy of the total allowance and c) the timely recognition of identified losses through either specific allowances or charge-offs.Link this to the examples
39 Good Accounting Practices Foundations for Sound AccountingA bank should adopt a sound system for managing credit risk.Judgments by management relating to the recognition and measurement of impairment should be made in accordance with documented policies and procedures that reflect such principles as consistency and prudence.The selection and application of accounting policies and procedures should conform with fundamental accounting concepts.
40 Good Accounting Practices (Cont’d) ACCOUNTING FOR LOANSRecognition, discontinuing recognition and measurement4) A bank should recognize a loan, whether originated or purchased, in its balance sheet when the bank becomes a party to the contractual provisions that comprise the loan.5) A bank should remove a loan (or a portion of a loan) from its balance sheet when the bank realizes the rights to benefits specified in the contract, the rights expire or the bank surrenders or otherwise loses control of the contractual rights that comprise the loan (or a portion of the loan).6) A bank should measure a loan, initially, at cost, which is the fair value of the consideration given for it.Impairment - recognition and measurement7) A bank should identify and recognize impairment in a loan or a collectively assessed group of loans when it is probable that the bank will not be able to collect, or there is no longer reasonable assurance that the bank will collect, all amounts due according to the contractual terms of the loan agreement. The impairment should be recognized by reducing the carrying amount of the loan(s) through an allowance or charge-off and charging the income statement in the period in which the impairment occurs.8)A bank should measure an impaired loan at its estimated realizable value
41 Good Accounting Practices (Cont’d) Restructured troubled loans9) A bank should recognize a loan as a restructured troubled loan when the lender, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider.10) A bank should measure a restructured troubled loan by reducing its recorded investment to net realizable value, taking into account the cost of all concessions at the date of restructuring. The reduction in the recorded investment should be recorded as a charge to the income statement in the period in which the loan is restructured.Adequacy of the overall allowance11) The aggregate amount of specific and general allowances should be adequate to absorb estimated credit losses associated with the loan portfolio.Income recognition12-13) A bank should recognize interest income on an unimpaired loan on an accrual basis. [Shortened]PUBLIC DISCLOSURE14-23) A bank should disclose information about the accounting policies and methods followed to account for loans and the allowance for impairment. (shortened)
42 Accounting Standards: IAS 39 IAS 39 establishes principles for recognizing, measuring, and disclosing information about financial assets and financial liabilities.A good understanding of this standard is absolutely necessary for any loan officer.If you know IAS 39 then you can ask the right risk questions
43 V. Best practices going beyond II 24 sound RM practices: G-30 report in 1993Role of senior managementMarking derivatives to market on a daily basisMeasuring market riskPerforming stress simulationsInvesting and funding forecastIndependent market risk mgmtMeasuring credit exposureIndependent credit risk mgmt function
44 Risk Management and Compliance Key Operational Questions Who has the ownership of credit risk function and framework.?What are the responsibilities for the management of credit-related work groups?Is there a credit portfolio group, credit modeling team, credit risk policy and reporting teams?The credit portfolio group --- Does it support the credit officer by complementing a typically rather transaction-focused view with monitoring expected and unexpected losses of the credit book, reviewing provisions, etc?Who is responsible for compilation and risk reporting, including information on limit excesses, counterparty ratings, exposures, concentrations, etc.Who oversees supervision of credit data quality, process and delivery of all critical credit risk information to various stakeholders and the board?Who deals with external credit bodies such as rating agencies and regulators.Who has ownership of credit processes, including limit setting, provisioning, credit stress and scenario testing and calculating capital requirements.Is there benchmarking of performance of credit risk functions between business units?
45 SummaryFinancial regulations are crucial to reduce systemic risk and protect consumers. Recent examples during the financial market turmoilCRC affect your loan/pricing decision and your bottom-lineCompliance with Basel I as well as SSA approachImplications for individual loans / credit products/contractsThe principles of Basel II should be considered by EME: three pillars. Most country uses SSA approachPros and cons of Basel II are discussedChallenges of implementation are discussedEstablished the Link between compliance with accounting standardsA list of good accounting practices are providedCountrywide Financial: what has failed? discussion
46 Countrywide Financial (CFC) Over-exposure to sub-prime mortgage instruments. Bought by BoA in Jan08 at $4bn