Risk Management and Regulatory Compliance Yan Wang, Ph.D. Senior Economist The World Bank ywang2@worldbank.org

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

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)

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?

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)

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

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

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.

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

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.

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

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

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

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

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:

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

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.

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).

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

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”

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

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

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)

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

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)

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

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

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

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

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

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

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”

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

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.

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

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.

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

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.

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

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)

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

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

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?

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

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