1. The World Bank Superintendencia Bancaria Banco de la Republica Colombia Asobancaria Building a Technology Framework to Meet the Basel II Requirements Risk Management Workshop C OLOMBIA : From Theory to Implementation Cartagena, Colombia February 16, 2004 Presented by David M. Rowe, Ph.D. Executive Vice President for Risk Management SunGard Trading and Risk Systems

2. Agenda 1. Introduction – A Brief History of the Basel Accord 2.Data Issues and Technology Challenges 3.Support for Broader Trends in Risk Management 4.Solution Components to Manage Credit Risk Under Basel II 5.Importance of Communication

3. Basel Capital Accord – Brief History U.S. Bank Capital Ratios – 1935 - 1988 Depression thru WWII Post-War Recovery thru early 1960s Mid-60s thru Mid-70’s Mid-70s thru Late-80’s

4. Basel Capital Accord – Brief History Basel 1 Proposed: 1986 Effective: 1988 Credit Risk

5. Basel Capital Accord – Brief History Basel I 1986 – Proposed minimum regulatory capital requirements for banks. 1988 – Capital requirements came into effect with minimum capital rising to 8% of risk adjusted assets by the end of 1992. The capital calculation was intended to distinguish among assets by risk class, but did so in only the crudest fashion.

6. Overview of risk weights The Basel I Approach Claim Sovereigns Assessment Corporates Comm. Banks OECDNon-OECD 0%100% 20% 100% OECDNon-OECDAll 50% Multi-National Development Banks All Secured Residential Mortgages Required data could largely be derived from financial reporting systems.

7. Basel Capital Accord – Brief History Bank Capital Ratios – 1935 - 1988 Depression thru WWII Post-War Recovery thru early 1960s Mid-60s thru Mid-70’s Mid-70s thru Late-80’s

8. Basel Capital Accord – Brief History Bank Capital Ratios – 1935 - 1998 Depression thru WWII Post-War Recovery thru early 1960s Mid-60s thru Mid-70’s Mid-70s thru Late-80’s Late-80s forward

9. Basel Capital Accord – Brief History Basel 1.5 Proposed: 1993 Effective: 1998 Credit Risk + Market Risk Basel 1 Proposed: 1986 Effective: 1988 Credit Risk

10. Basel Capital Accord – Brief History April, 1993 –Initial “prescriptive” proposal. April, 1995 –Proposed allowing use of internal market risk models for calculation of regulatory capital (subject to supervisory review and approval.) Jan 1, 1998 -Market risk amendment took effect with internal VaR models as a major source of risk estimates. Basel I Market Risk Amendment

11. Basel Capital Accord – Brief History Basel 1.5 Proposed: 1993 Effective: 1998 Credit Risk + Market Risk Basel 1 Proposed: 1986 Effective: 1988 Credit Risk Basel 2 Proposed: 1999 Effective: 2007 Credit Risk (Enhanced) + Market Risk (No change) + Op Risk (New) Key sources of required work for affected banks.

12. Agenda 1. Introduction – A Brief History of the Basel Accord 2.Data Issues and Technology Challenges 3.Support for Broader Trends in Risk Management 4.Solution Components to Manage Credit Risk Under Basel II 5.Importance of Communication

13. Data Fragmentation System Integration tends to be along internal regions and products.

14. Data Fragmentation Credit Risk data requirements cut directly across existing system fragmentation.

15. Data Fragmentation Credit Risk data requirements cut directly across existing system fragmentation.

16. Data Fragmentation Credit Risk data requirements cut directly across existing system fragmentation.

17. Data Fragmentation Credit Risk data requirements cut directly across existing system fragmentation.

18. Overview of risk weights Credit Risk - Standardised Approach Claim Sovereigns Assessment Option 1 Option 2 Corporates Banks AAA to AA- A+ to A- BBB+ to BBB- BB+ to B-Below B-Unrated 0%20%50%100%150%100% 20% 50% 100% 50% 100% 150% 100% 50% AAA to AA- A+ to A- BBB+ to BB- Below BB-Unrated Required data must come from risk systems.

19. Credit Risk - IRB Approach Regulatory capital = EAD x risk weight (f [PD, LGD, M]) x 8% This implies an even greater need for data from risk systems rather than just financial systems. Regulatory capital = EAD x risk weight (f [PD, LGD, M]) x 8% Estimation of Probability of Default (PD) Foundation IRB Estimation of Exposure at Default (EAD) Estimation of Loss given Default (LGD) Advanced IRB Regulatory capital = EAD x risk weight (f [PD, LGD, M]) x 8%

20. The First Challenge: Data Integration Consolidating exposure across products, regions and systems (by obligor or by risk characteristics.) Maintaining clean and consistent legal entity and facilities definition data. Integrating collateral, guarantees and other credit enhancement data with items 1 and 2. Collection and maintenance of external historic data (market data, industry defaults, etc.) Providing audit trails and reconciliation to source systems. Archive facilities to refine analysis and validate results. Proper data security to limit unauthorized access.

21. The Second Challenge: Analytics Implementation of multiple sophisticated credit ratings models. –Scoring or Merton-style models for PD. –Behavioral models for EAD. –Structural and external conditions models for LGD. Advanced economic capital allocation framework (Pillar II.)

22. Credit Exposure Map Retail Commercial Pre-Settlement Settl. Term Revol. Unsecured Illiquid Coll. Liquid Coll.

23. Additional Information and Analytics Mkt Data Vols & Correl Static Data Default Analytics Exposure Analytics LGD Analytics Legal & Netting Guarantees, Cr Derivatives and Other Credit Risk Mitigants Credit Ratings

24. Credit Exposure and Supporting Data Retail Commercial Pre-Settlement Settl. Term Revol.

25. Typical Existing Data Links Line Unit 1 Line Unit 5 Line Unit 6 Line Unit 7 Line Unit 8 Line Unit 2 Line Unit 3 Line Unit 4 Control Unit 4 Control Unit 3 Control Unit 2 Control Unit 1 Control Unit 5

26. Ideal Data Linkage Configuration Line Unit 1 Line Unit 5 Line Unit 6 Line Unit 7 Line Unit 8 Line Unit 2 Line Unit 3 Line Unit 4 Control Unit 4 Control Unit 3 Control Unit 2 Control Unit 1 Control Unit 5 Content translation XML Protocols FpML, NTM... Middleware MQSeries, MINT... Bridging operating systems & network protocols Delivery and routing Semantic Adapters  Central repository for portfolio data and analytics

27. Practical Data Linkage Configuration Line Unit 1 Line Unit 5 Line Unit 6 Line Unit 7 Line Unit 8 Line Unit 2 Line Unit 3 Line Unit 4 Control Unit 4 Control Unit 3 Control Unit 2 Control Unit 1 Control Unit 5 Content translation Central repository for portfolio data and analytics Bridging operating systems & network protocols Delivery and routing Middleware Data Mapping & Consolidation Software

28. Agenda 1. Introduction – A Brief History of the Basel Accord 2.Data Issues and Technology Challenges 3.Support for Broader Trends in Risk Management 4.Solution Components to Manage Credit Risk Under Basel II 5.Importance of Communication

29. Evolution of Credit Risk Management Credit Underwriting 1985 Portfolio Management Credit Underwriting Today Credit risk management was dominated by careful underwriting. The watchword tended to be “We only make good loans.” A portfolio management overlay. Underwriting data feed portfolio management. Few data flow the other way. Portfolio management is mainly strategic.

30. Evolution of Credit Risk Management Portfolio Management Credit Underwriting Today A portfolio management overlay. Underwriting data feed portfolio management. Little data flows the other way. Portfolio management is mainly strategic. In 5 to 15 Years Portfolio Management Credit Underwriting Data flow both ways. The frequency and speed of data exchange accelerates dramatically. Portfolio analysis becomes a tactical decision support tool.

31. Data Map – Wholesale Finance Retail Commercial Pre-Settlement Settl. Term Revol.

32. Support for Tactical Decisions Proposed Credit Facility RAROC Implications (Including Portfolio Effects) - Current RAROC - Credit Enhancement Options - RAROC Sensitivity - Minimum Terms

33. Data Map - Trading Credit Retail Commercial Pre-Settlement Settl. Term Revol.

34. Simulation-Based Trading Credit Exp. Limit Query Trading Systems Trade Entry Portfolio Trade Data Fast Analytic Exposure Calculator Before & After Exposure Profiles and Limits Marginal Credit Loss and Credit Capital Charges Real-Time Process Credit Risk Server Summary Trade Data Middleware & XML Messages

35. Agenda 1. Introduction – A Brief History of the Basel Accord 2.Data Issues and Technology Challenges 3.Support for Broader Trends in Risk Management 4.Solution Components to Manage Credit Risk Under Basel II 5.Importance of Communication

36. Needed Components for a Basel II Credit Solution Data Consolidation and Quality Control Credit Rating Models (PD, EAD, LGD) Credit rating workflow static customer data financial statements credit ratings Operational credit systems environment Loans, limits, exposure analytics, etc. IRB regulatory and economic capital calculations & validation framework Internal and external reporting

37. Basel II Credit Risk Architecture Overview Exposures Collateral Exposures Trading/Banking Book (Corp./Banks/Sov.) Banking book: SME / Retail Book Credit system Collateral B2 Capital Calculator Internal Credit Rating Systems PD, EAD, LGD Ratings and Loss Data Regulatory Capital Calculations Regulatory Reporting Regulatory Capital Validation Framework Regulatory Validation Reports Historical Data Analysis Internal Reporting Economic Capital Calculations Economic Capital Allocation Tactical Decision Support B2 Data Consolidator

38. Buy vs. Build & the Software Life Cycle Software has a life cycle like all other products CommoditizedProprietary Breadth of Usage All Few Cost High Low maturity Dangerous Position YouCompetitors

39. Agenda 1.Introduction – A Brief History of the Basel Accord 2.Data Issues and Technology Challenges 3.Support for Broader Trends in Risk Management 4.Solution Components to Manage Credit Risk Under Basel II 5.Importance of Communication

40. The Third Challenge: Communication Keeping the credit underwriters on board. Providing information support for informed credit judgments. Make validation constructive not threatening. The motto should be: Technology in Support of Sound Judgment