1. Risk Management and Regulatory Compliance
Yan Wang, Ph.D.
Senior Economist
The World Bank

2. Outline Focus on Regulatory capital and Compliance
Objectives of banking regulation
Overview of statutory prudential requirements:
Basel I and calculations
Credit risk charges for BS and OBS items
Factor-in Capital charge in individual loan decisions
Basel II, three pillars
Pillar 1, credit, market and operational risk
Pillar 2, and Pillar 3
implications to Emerging Market Economies (EMEs)
Link with accounting standards: Establishing consistency with corporate and statutory risk compliance and prudential standards
Good accounting practices
Summary

4. Objectives of Banking regulations
To protect banks’ depositors
To ensure the reliability of public good, ie. Money;
To avoid systemic risk arising from domino effects
To maintain a high level of financial efficiency
Objectives
Tools
Systemic Risk
Consumer Protection
Capital Standards
Yes
yes
Disclosure standards
Asset restrictions
Antitrust enforcement
Conflict-of-Interest rules
Source: Herring and Litan (1995)

5. A survey question
Which 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 charges
Simplified Standardized Approach (SSA) in Basel II
Use risk-weights under Standardized Approach
Internal 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 affect
Pricing of capital, by the degree of riskiness of your new loan/credit
Selection of loan /credit products
(on-balance sheet or off-balance sheet?)
Economic Value Added of an additional project as
EVA= profit – (capital x k)
CA requirements affect capital and k (discount rate or cost factor)
RAROC = EVA / capital
Your bottom line

8. Risk Management Philosophy
Risk Management tools
Reducing Process Costs
Cost of loosing business
Reducing Financial Costs
Sustainability RM
Autonomy
Decision Making
Risk-Based pricing
Optimized
Capital
Allocation
Continuos Improvement
Initiation / Maintenance
Collection tools
Encourage usage
of Credit Tools
Centralized
Strategy
Decentralized
Execution
Consistent portfolio growth, with quality, in a controlled environment

9. General Supervisory Expectations
Supervisory expectations concerning sound credit risk assessment and valuation for loans
The 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 adequacy
Banking 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 bank
Line managers have incentives to understate risk
Managers may like to influence system design to lower hurdles
Banks with a higher ratio of available capital to required capital can expect lower funding costs
Compliance and risk management may have limited information on what happens in line units
Line unit personnel may have incentives not to be forthcoming
If choices about internal risk measures influence the bank's IRB measures, required capital measures might be distorted
Internal conflicts are important for several reasons
If risk measurement is twisted, decisions may be poor
Capital may be less than required for safety

11. II. International Regulatory Standards (Basel I)
The 1988 Basel I Accord came into effect in 1992
Goal: 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 buckets
The 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-market
Banking book: loans valued at historical cost basis
The 1996 Amendment adds capital charges for
The market risk of trading book and
The currency and commodity risk of banking book

13. Risk Capital: definition
Tier 1 capital or core capital
Equity capital or shareholders funds
Disclosed reserves: share premium, retained profits and general reserves
Tier 2 or supplementary capital
Undisclosed reserves
Asset revaluation reserves
Loan loss reserves
Hybrid debt capital instruments
Subordinated 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 capital
Eligible 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 i
See table below

15. Risk capital weights by asset class (on-balance sheet)
Weights (RW)
Asset Type 0%
Cash held
Claims on OECD central governments
Claims on central gov't in national currency
20%
Cash to be received
Claims on OECD banks and regulated securities firms
Claims on non-OECD banks below one year
Claims on Multilateral development banks
Claims on foreign OECD public-sector entities
50%
Residential mortgage loans
100%
Claims on the private sector (corporate debt, equity…)
Claims on non-OECD banks above one year
Real estate
Plant and equipment

16. Off-Balance Sheet Risk Charges
Banks expose to credit risk from off-balance sheet (OBS) items like Letters of credit (LC), swaps
The 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 credit
Consider 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 million
CRC 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 exposure
Decision on granting or not granting loans
Use EVA of a project as a benchmark where
EVA= profit- (capital x k)
Subtract a risk-based capital charge from profits as in a RAROC type system
If the addition credit capital charge is higher, then the loan /contract is less worthwhile in term of RAROC.

19. Total Risk Charge
Total 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 banks
Advanced IRB to be available end 2007
Simultaneous operation of Basel I and Basel II until 2008
United States pursuing a somewhat different course
Implementing only advanced Internal Rating-based (IRB) approach
Mandatory only for the most advanced / top banks
Other authorities can proceed at their own pace

21. Basel II: Three Pillars
Disclosure
Recommended disclosure for
Capital structure
Risk exposure
Capital adequacy
“Market Forces”
Pillar 1
Capital Requirements
“Quantitative”
Credit risk
Market risk
Operational risk
Pillar 2
Supervisory Review
Consistent review process
Intervene timely
Risks not covered in pillar 1
External factor
“Qualitative”

22. Pillar 1: Minimum Capital Requirements
Capital requirements will have greater flexibility and reflect bank risk
Some banks will be allowed to assess risk internally, subject to approval
There will be a (new) explicit capital charge for “operational risk”
Risk unassociated with intrinsic asset values
Expected to comprise 20% of requirement
Overall regulatory capital is not expected to change, but may increase or decrease for individual banks

23. Approaches for Assessing Credit Risk
Simplified Standardized Approach (SSA)
Standardized Approach
Foundation Internal Ratings-Based (IRB)
Advanced IRB

24. 1. Simplified Standardized Approach (SSA)
Closest to Basel I
Some minor modifications
Use Export Credit Agency ratings to calculate required capital for sovereign risk exposure
Available on OECD web site
Corporate capital still at 8%
Capital requirement for operational risk
Uses Basic indicator approach
15% of gross annual operating income
Other 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 regulators
Risk weights depend on borrower identity
Two methods of assigning risk weights
One category below rating of headquarter country
External risk weighting of institution
For EME it is tricky as ratings for many firms are not available –some tips here
Risk mitigating factors also incorporated

26. Risk Weights Under Standardized Approach
AAA to AA-
A+ to A-
BBB+ to BBB-
BB+ to B-
Below B-
Unrated
Claims on Sovereigns 0%
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 tips
Quality of the collateral
Easiness in enforcing the collateral given default –legal and liquidity issues
Any 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 approach
Banks can use their own estimates of loan default probabilities
Probabilities are combined with standard estimated of losses given default to determine value-at-risk
Advanced approach
Banks estimate value-at-risk as well
Limited to most sophisticated banks

29. Regulatory Impact
Overall capital requirements expected to be unchanged on average
Calibrated to “Standard loan”
1% default probability, 2.5 years maturity, 45% loss given default
8% capital requirement
Capital requirements will be increasing in credit risk assessments
Capital Requirements will also be adjusted for credit risk concentration
Excessive exposure to a single borrower subject to additional capital requirement
Exceptionally low exposure can lead to reduction at discretion of domestic regulator

30. Numerical Example $10 billion loan
Basel I: Capital Requirement $800 million
Basel II:
If the loan is healthy: Capital Requirement $100 million
If Bad loan: Capital Requirement $4.5 billion
Bottom 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 risk
On average, will offset reduced requirement on rated loans under standardized approach
But may not be offset for EMEs with many unrated firms
Operational Risk also has three alternative methods /approaches
Basic Indicator
Standardized
Advanced Measurement
Basel II Accord Total Risk Charge is

32. Pillar 2: Supervisory Review
Committee confirmed the need for supervisory review in addition to minimum capital requirements
Supervisors will determine soundness of internal processes used to assess capital adequacy and bank risk
Intervention under conditions where violations are found

33. Four key principles
Banks are responsible for assessing capital adequacy
Supervisors role in assessing internal monitoring of bank
Banks are normally expected to operate with capital above regulatory minimum
Supervisors 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 banks
Proposals provide guidance on disclosure
Capital structure
Risk Exposure
Control Environment
Self-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 1
Banks operate in diverse environment cannot benefit
Capability to provide fair regulation that is not uniform
Differences btw regulatory constraint and RM
The coherence btw new regulation and new accounting rules
This slide can be skipped.

36. Implementation of Basel
To implement Basel II the banks require expensive projects with long lead times
Train staff
Gather historical loss data
Build risk models
Improve IT systems
Implement policies and procedures
One 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 principles
Questions:
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 Accounting
A 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 LOANS
Recognition, discontinuing recognition and measurement
4) 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 measurement
7) 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 loans
9) 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 allowance
11) The aggregate amount of specific and general allowances should be adequate to absorb estimated credit losses associated with the loan portfolio.
Income recognition
12-13) A bank should recognize interest income on an unimpaired loan on an accrual basis. [Shortened]
PUBLIC DISCLOSURE
14-23) 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 1993
Role of senior management
Marking derivatives to market on a daily basis
Measuring market risk
Performing stress simulations
Investing and funding forecast
Independent market risk mgmt
Measuring credit exposure
Independent 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. Summary
Financial regulations are crucial to reduce systemic risk and protect consumers. Recent examples during the financial market turmoil
CRC affect your loan/pricing decision and your bottom-line
Compliance with Basel I as well as SSA approach
Implications for individual loans / credit products/contracts
The principles of Basel II should be considered by EME: three pillars. Most country uses SSA approach
Pros and cons of Basel II are discussed
Challenges of implementation are discussed
Established the Link between compliance with accounting standards
A list of good accounting practices are provided
Countrywide Financial: what has failed? discussion

46. Countrywide Financial (CFC)
Over-exposure to sub-prime mortgage instruments. Bought by BoA in Jan08 at $4bn