CIA Annual Meeting LOOKING BACK…focused on the future

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 2 Preparing for Basel II A case study at Royal Bank of Canada Canadian Institute of Actuaries St. John’s Newfoundland June 29, 2005

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 3 Outline 1. Context and Caveats 2. Elements of Basel II in place 3. Work to be Done 4. Final Tally 5. Challenges and Opportunities

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 4 Context and Caveats Discussion will centre around the non- retail credit portfolio. Viewpoint is that of a business person, not a Basel project manager. RBC, like other major Canadian banks, must use the Internal Ratings Based (“IRB”) - most advanced approach.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 5 Elements of Basel II in place Our rating philosophy was agreed on in concept. The time horizon over which we rate the probability of default of obligors is a hybrid between so-called “point in time” and “through the cycle” years.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 6 Elements of Basel II in place 2 Dimensional Rating System (for most obligors). We estimate the probability of default (PD). Then separately estimate the loss given default (LGD). Account and risk managers assign: a borrower risk rating (BRR) which is quantified by a PD LGD.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 7 Elements of Basel II in place 5 years experience with estimating parameters required for Basel II regulatory capital calculation, for our internal economic capital model. PD, LGD, UGD. Economic capital is our internal estimate of the amount of equity capital required to cover unexpected credit losses to a level consistent with our desired AA debt rating. Economic capital is a risk metric used extensively in limit setting and pricing.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 8 Elements of Basel II in place Some internal data. Migration database with 5 years of history of BRR ratings changes on loans in excess of $5MM – required for PD estimation. Some loss history for loans in excess of $5MM – required for LGD estimation.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 9 Elements of Basel II in place Some elements of validation in place: Developmental logic for risk rating systems well documented. Experimented with replication. Validation – “Banks must have a robust system in place to validate the accuracy and consistency of rating systems, processes, and the estimation of all relevant risk components”. (Basel para 500)

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 10 Work to be Done to be Basel II Compliant Formally adopt and document our hybrid rating philosophy and ensure all rating methodologies are in in agreement with it. Determine what constitutes a rating system and how many to have. Trade off between homogeneity of obligors using a certain methodology, and validation effort required.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 11 Work to be Done to be Basel II Compliant Quantification. Articulate and document how we will go about the quantification process: What are our data standards Processes to follow when using internal and external data Refresh requirements.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 12 Work to be Done to be Basel II Compliant Data!!!! Biggest challenge. Migration database: – major backfilling required – revisit methodology – storage and systems upgrades.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 13 Work to be Done to be Basel II Compliant Data!! (continued) – Loss Given Default. Need to calculate realized economic loss on every defaulted obligation. Economic loss is the loss associated with a defaulted facility by discounting the cash flows, including material direct and indirect costs, from the date of default to the end of the recovery process. Need to revisit discount rate and cost allocation methodology and definition of “end of recovery”. Need to allocate losses to loss drivers – collateral, position in debt structure, intensity of monitoring, industry.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 14 Work to be Done to be Basel II Compliant Data !! (continued) – Usage Given Default. Obligors have committed, undrawn facilities. Need to estimate how much an obligor will draw if they default. We currently use all external data (one loss driver – credit quality), need to collect our own and backfill.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 15 Work to be Done to be Basel II Compliant Validation – need to develop and implement specific validation protocols for each rating system. Protocols will: be both statistical and non statistical. Will change over time. Need to prove: 1) the discriminatory power of our rating systems (can we predict defaults from non defaults) and 2) we have calibrated correctly (we have the right PD, LGD and UGDs). Need to ensure validation results fed back into rating system design and parameter estimation.

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 16 Work to be Done to be Basel II Compliant Only touched on highlights – many other issues including, but not limited to: Some rework of our LGD system (need to introduce a “loss severity rating” or LSR to rank order loss drivers). Ensure compliance for various specialty products like repos, securities, finance, project finance, securitization. Trading book issues. Treatment for risk mitigation. Operational risk issues. Capital calculation engine itself. Reporting (Pillar 3).

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 17 Currently 200 people working on Basel II, will peak at just under 300 in late Most Canadian banks spending between $50 and 200 million. We are spending approximately $100 million. Average time – 30 months. Most definitely not a trivial exercise. Final Tally

CIA Annual Meeting Session 4405 LOOKING BACK…focused on the future 18 Challenge and Opportunity Clichéd but true. Challenges huge resource requirement in a time of expense control. Short time frame (implementation year end 2006 – parallel run). Opportunities Almost everything Basel II requires is something we would have done eventually. Forces us to do it more quickly. Raises the bar and compresses the time frame.