Christopher Irwin Taipei October 17, 2001 The Basel Challenge Christopher Irwin Taipei October 17, 2001

What Is Basel? A town in Switzerland? Headquarters of the Bank for International Settlements (BIS)? A Committee on Banking Supervision? A challenge for banks around the world? All of the above ...

The Basel Committee The Basel Committee is made up of central bankers and domestic bank regulators from 13 countries Responding to market demand for more and better information and better bank supervision Goal: improve capital sufficiency and safety of banking systems Consulting with major banks around the world about proposals to improve risk evaluation

Basel II Will ... Give banks an opportunity to reduce their cost of capital by improving risk management Change the competitive environment for banks: some will benefit, some won’t ... Affect markets for bank securities Change the role of bank regulators

3 Pillars of Financial System Stability Capital Safety & Soundness Market Discipline Supervision

Basel II - Capital Ratio Credit + Market + Operational Risk What’s new about this ? Substantial change in way credit risk is managed & recognised Introduction of operating risk

Basel II: the New Basel Accord Existing (1988) system is current BIS framework  Latest recommendations for Basel II are still under consultation: implementation expected in 2005  Maintains 8% minimum requirement for capital to risk-weighted assets  Aims to make the relationship between bank risk and capital more scientific  Will become part of regulatory system in many countries: will reward banks which have better risk controls  Will have extensive effects on bank capitalization and pricing: could improve macroeconomic efficiency

Basel II’s 2 Basic Approaches: Standardized * Adds more risk categories to current approach * Would rely on external credit assessments * Simpler to implement * Less differentiation of credit risk than IRB IRB (internal ratings based) * More exact measurement of risk * More expensive to implement * Most large US and European banks are expected to adopt this approach

The Standardized Approach Will basically decrease regulatory capital for high-rated credits, and increase it for riskier ones Risk weightings for types of borrower more sophisticated than before, but still pose problems: * it would be a mistake to assume equal government support for all public sector borrowers * giving unrated entities lower weightings than low-rated entities will decrease transparency * Mapping of public credit ratings to bank risk categories needs to be clearly established

Standardised Approach Risk Weights From Deduct capital 150 100 50 20 ABS Min 100 Basel II Basel I Current Corporate Unrated Below B- B+ TO BB+ BB- BBB+ BBB- A+ A- AAA AA-

Some Effects of Using Standardized approach: Supposed to have neutral effect on overall banking system capital, but may reduce capital allocated for credit risk Could encourage more lending to investment grade credits and more use of risk mitigation techniques such as credit derivatives More recognition given to collateral Problem: many small companies do not have public credit ratings Consistency may not be perfect, especially among different countries

Internal Ratings Based Approach Risk Weight is a function of; Default (PD) Loss Given Default (LGD) – after recognition of credit enhancements Maturity Risk Weights depend on type of exposure Foundation Approach v Advanced Approach * Estimate PD over 1 year- horizon for each risk grade

IRB Approaches Could improve matching of risk and capital if used carefully Both use internal ratings systems for default probability Would need good disclosure and historical data to be effective. *Basel recommends 1 year: 3 are probably necessary, ideally through a recession period Would be expensive to implement Would be difficult to apply to asset-backed securitization Existing internal credit scoring systems are probably too lenient * suggest systems are over-capitalized when probably only adequate

Foundation v Advanced IRB Internal Calc PD “W” Factor Benefit of credit enhancements Regulators EAD LGD Advanced Foundation

Foundation IRB  Foundation approach will be available to institutions who can provide documented default probabilities but not loss given default or estimated duration  That data will have to be provided by regulators -- thus imposing a heavy burden on them to determine accurate loss and recovery data

Advanced IRB  A very sophisticated approach: banks provide all data inputs on default probability and expected loss and duration -- subject to regulatory supervision and public disclosure  Use of quantitative credit models will grow in importance  Can take into account effect of new credit enhancements such as credit derivatives  Should enable sophisticated banks to use lower level of regulatory capital than unsophisticated banks

Evaluating Banks  Two options suggested by Basel Committee: * Discount sovereign rating one full category and apply to all banks * Use existing ratings on individual banks and give 50% risk weighting to unrated banks  Both options have problems: first would penalize strong banks, second would reward weaker banks.

Operating Risk Will Be Difficult to Measure * Three proposed approaches:  Basic indicator approach (BIA)  Standard approach (SA)  Internal measurement approach (IMA) * All approaches are sensitive to type and timing of data, and will need to be stress-tested * Committee currently recommends 20% weight: we feel 30% might be more accurate * Banks should be skeptical of the value of sophisticated models of operating risk: they are still unproven

Areas for Further Study--  Not much cost/benefit analysis has been done yet for the various approaches of risk measurement  Credit models for SME’s have been developed, but need more refinement -- especially for non-US markets  Recognition for collateral needs more sophisticated evaluation methods  Criteria for project finance and equity exposures still under study  IRB method could increase cyclical effects, especially if not applied to data for a whole economic cycle  Eligibility standards for external rating companies not clear yet.

Conclusion  New risk management methods will become part of modern financial institutions  Banks which are able to calculate and monitor their risk exposures should benefit from lower capital costs  2005 is not far away … now is not too early to develop internal systems to measure and monitor credit risk