BASEL II and RISK MANAGEMENT

SUMMARY BASEL I – Merits and Weaknesses BASEL II - Objectives Risk Management and Basel II BASEL II – Structure of the New Accord PILLAR 1 PILLAR 2 PILLAR 3 BASEL II – Impact on business BASEL II – Implications BASEL II – Next Steps BASEL II – Timetable

BASEL I - MERITS: First BASEL Accord in 1988 introduced capital requirements for Credit Risk, followed by Amendment in 1996 for Market Risk.   The merits of the Old Accord: Substantial increases in capital ratios of internationally active banks; Relatively simple structure; Worldwide adoption; Greater discipline in managing capital; A benchmark for assessment by market participants.

BASEL I - WEAKNESSES : Uniform, ignoring individual risk profiles, based on size of the business; Only considered credit risk; No explicit recognition of operational or other risks; Does not assess capital adequacy in relation to a bank’s true risk profile; The OECD/non-OECD distinction does not properly address country risk; Does not provide proper incentives for credit risk mitigation techniques; Enables regulatory arbitrage through securitization etc.

BASEL II - OBJECTIVES : To maintain at least the current level of capital in the system; To enhance competitive equality; To emphasize the responsibility of directors and senior management; To focus on internationally active banks; To contain approaches to capital adequacy that are appropriately sensitive to the degree of risk involved in a bank’s positions and activities.

RISK MANAGEMENT AND BASEL II (1) : Risk Management Function Traditional View Modern View Risk management was perceived as: Return, risk and capital are linked A cost centre – placing constraints on revenue generators You must achieve an adequate return for the risks you are taking A reporting centre – with no operational responsibilities Risk management is evolving from the measurement of Risk to the integral management of risk Staffed with relatively lowly-skilled people

RISK MANAGEMENT AND BASEL II (2) : Risk Management Function Risk management has become a strategic competitive weapon allowing institutions to: measure their risk on a consistent global basis; calculate the risk-return performance of different business units; allocate scarce resources to their optimal use;   With the new BASEL Accord, Risk Management will become increasingly important within banks.

BASEL II – Structure of the New Accord : The considerably increased scope of the regulations in the New BASEL Capital Accord is represented in a framework of three complementary pillars that will help make the banking system SAFER, SOUNDER, and MORE EFFICIENT.   Pillar 1: Minimum Capital Requirement: Credit Risk, Market Risk, Operational Risk. Pillar 2: Increased Supervisory Review Segregation of duties and increased dialogue between banks and supervisors. Pillar 3: Market Discipline (Disclosure) Enhance quality of disclosures; Improved information and transparency.

PILLAR 1 – MINIMUM CAPITAL : Basel II establish minimum standards for management of capital on a more risk sensitive basis. BASEL I Ratio: BASEL II Ratio: Regulatory Capital -------------------------= >8 Weighted assets ---------------------------------------------- = >8% (Credit Risk+Market Risk+Operational Risk) It results that all types of risks must be quantified

Economic Capital = Unexpected loss - Expected Loss. PILLAR I – CAPITAL REQUIREMENTS FOR CREDIT RISK (1) : The old Accord: did not permit internal models; was extremely credit insensitive with fixed risk percentages applied to certain, pre-defined risk categories: 0%, 20%, 50%, 100%;  no perception of Economic Capital. The new Accord: EC is the true capital required to off-set Unexpected Losses. Losses on transactions are broken up into: Expected (in a statistical sense) losses Unexpected losses - Losses with a low degree of profitability Economic Capital = Unexpected loss - Expected Loss.

PILLAR I – CAPITAL REQUIREMENTS FOR CREDIT RISK (2): With the new Accord, Banks are allowed to choose one of the following three measurement approaches: The Standardized Approach: Risk weightings given for certain classes of instruments. B. The Internal Ratings Based (IRB) Approach: Risk weightings based on internal risk assessments; Can differentiate more finely between classes of risk; Takes additional risk factors into account. C. Advanced IRB.

Value-at-Risk (VaR) is the most popular internal model. PILLAR I – CAPITAL REQUIREMENTS FOR MARKET RISK (1) : The Old Accord: Concentrated purely on Interest Rate Risk; Based upon either maturity or duration bands; Amended to include FX and Equity Risks. Value-at-Risk (VaR) is the most popular internal model.

PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (1) : Required for the first time. Rolled opaquely into credit charge under the old Accord.   Definition: The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. This includes legal risk, but not strategic and reputational risk as regulators recognise the difficulties of measuring indirect losses.

PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (2): BASEL II pointed out the following operational risks:   Business disruption and system failures; External fraud; Integration problems; Lack of training and controls; As well as the necessity of Business Continuity Plan and Disaster Recovey Plan.

PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (3) The New Basel Capital Accord requires a capital charge of 15% of economic capital for the operational risk.(there are discussions to reduce this percentage) Banks are allowed to choose one of the following three measurement approach:    The main challenge in the area of operational risk consist in setting up an efficient IT infrastructure to monitor and measure the operational risk. Basic Indicator Approach Standardised Approach Advanced Measurement Approach

BASLE II – PILLAR 2 - INCREASED SUPERVISORY REVIEW Key premise: Supervisors should be able to require (penalize) banks to hold capital above the minimum. Pillar 2 stresses: Banks must develop their own internal models, based on evolving best practice; Supervisory must conduct regular review to ensure adequate capital if review fails, supervisor should increase capital charge. Hence, responsibility for adequate capital rests with the bank’s management. Pillar 2 intended to encourage development and use of better risk management practices.

BASLE II – PILLAR 3 – MARKET DISCIPLINE (1) Two types of disclosures: Mandatory disclosures: group approach of BASEL II, amount ad quality of group capital, extensive informations regarding the measurement methods of risks, etc. Supplementary disclosures, at request of regulator. Concerns: Disclosure overload – too much information; Enforceability in some jurisdictions; Timeliness; Auditability and its link with IAS; Cost; Market response to disclosure of perceived bad news.

BASEL II – IMPACT ON BUSINESS (1) Credit and Operational Risk Data becomes a valuable asset.  Need of sophisticated measurement tools (credit, market and operational risk).  High investments in Risk Management methodologies, systems and people   

BASEL II – IMPACT ON BUSINESS (2) Capital will be increasingly a scarce resource: As capital providers demand fair returns; Businesses will be charged on their contribution to total risk capital; Assets will be allocated on that basis; Hence risk measures will be on the same level as profit measures, especially as more complex risks are being captured. Banks need to check BASEL II impact on: Future Business, Strategy and Objectives; Competitors; Capital Charge. Risk Management become an important senior management issue.

BASEL II - IMPLICATIONS The new capital requirements specified in the New Basel Capital Accord have important implications for the bank. BASEL II represents a major improvement compared to BASEL I but the most difficult part is to implement it. Its implementation requires a considerable human and financial effort i.e. methodological changes, new software, new hardware capacities, training, etc.  The new regulations requires changes in the general structure and process organization within banks.

BASEL II – NEXT STEPS In our country it will take some time until BASEL II will be transformed into law and take effect. Due to the complexity of the challenge, banks should use the time available and start taking steps now. The tasks with the highest priority (, the structure of the database, and the basis of the exposure calculation) – should be developed first. Defining the data requirements for operational systems; Creating the database containing historical data; Employing qualified personnel; Adapting the training programs to the New Capital Accord Requirements; 5. New legislation to be issued in line with BASEL II requirements (NBR already started by issuing Norma 17/2003 related to Credit Institutions’ Internal Control, Management of Significant Risk and nternal Audit).

BASEL II - TIMETABLE Consultative documents finalized Data Collection Starts Start of 2006 Commencement of BASEL II in parallel with BASEL I Approval/ Validation by the regulatory bodies 2007 Commencement of the New Accord

- THE END -