Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February...

Risk Management Workshop Colombia: From Theory to ImplementationCartagena, Colombia16-19 February 2004

Case Study: South Africa on the road to Basel II

Pieter StrydomPartner, Ernst & Young, South Africa


Overview of presentation

Overview of presentation

Introduction: The banking sector in South Africa

Attitude towards Basel II in South Africa

Ernst & Young survey on Basel II readiness in South Africa

Developments in bank supervision at SARB

Developments at Bank A

Developments at Bank B


1. Introduction: The banking sector in South Africa

1.1 The banking sector in South Africa

48 banks in SA

15 in process of de-registering or closing down

7 with limited operations

19 remaining of which the big 5 represent 90% of market

Average Basel 1 Capital adequacy 12.6%

US$ bn Feb Nov Staff 2000 % 2003 % number Absa 23.9 17.8 41.2 18.7 31,400 Firstrand 21.9 16.4 39.7 18.0 35,400 Standard Bank 24.5 18.3 52.3 23.7 34,600 Nedcor 24.9 18.6 49.2 22.3 25,200 Investec 8.6 6.4 13.5 6.1 4,800 Sub Total 103.8 77.6 196.0 88.9 130,400 Other Banks 29.6 22.4 40.0 11.1 Total 133.7 100.0 220.3 100.0

1.2 Total Assets of Banks


2. Attitude towards Basel II in South Africa

2.1 Growing consensus

Basel I is outdated

Weakened link between risk and capital

Internationally active banks will be forced into Basel II by rating agencies

Basel II will reward excellence

Basel II fits in with risk management initiatives

2.2 Standards and codes

Standards and codes set by international bodies, and widely adopted, will provide:• useful basis for improved market functionality

• ‘benchmarks’ against which banks can be measured

• national practices to reduce ‘un-level playing fields’ and regulatory arbitrage

• markets forces and peer pressure will make adoption mandatory

• ‘soft law’, which can be more effective than ‘hard law’ enshrined in legislations

Basel II with its close link between risk and capital requirement is fully endorsed by banks in South Africa

2.3.1 Basel II is complex

Banking itself is becoming more complex

Risk management requirements are highly sophisticated (assigning equal risk weights to all loans is unrealistic)

Simplicity and greater risk sensitivity are not mutually compatible objectives

Banks with simpler business models have options under Basel II to reduce complexity

2.3.2 Basel II will reinforce pro-cyclical effect

Linking the regulatory charge to the quality of assets will bring them in line with the business cycle

This can lead to an increase in volatility of asset prices and loan interest with the potential danger of creating a ‘boom to bust’ cycle in credit markets

Banks may be encouraged to stop lending at a time when the real economy is most vulnerable

Pro-cyclical behaviour is already endemic and perhaps acceptable in order to establish a more risk sensitive capital regime

Countermeasure is to build excess capital in good times to have a margin of protection in a downturn

Capital requirements under Pillar 1 should be augmented by the capital requirements under Pillar 2 and Pillar 3 in order to reinforce the incentive to maintain a cushion of capital above the minimum

2.3.2 Basel II will reinforce pro-cyclical effect

2.3.3 Involvement of rating agencies

Limited penetration – 5%

Unique problems with listed exposures• Low trading volumes – volatile markets

• Duel listings – flow of funds

Lumpy exposures – concentration risk

Danger of herd thinking

2.3.4 Rating agency data sharing

Problem creating statistical pool to rate Medium Corporate Advances

Big banks extracting information on 10 000 account for 3 years on default and non default accounts – will provide a 90% statistical pool

To be given to one or more agencies to calculate the quantitative (theoretical) PD

Banks to use this PD as the quantitative basis to confirm their own qualitative PD

Next phase to pool information on LGD - but

2.3.5 Required capital of 10% compared to 8%

As a result of South Africa’s country rating of BBB, no local exposure can be rated above BBB before taking into consideration collateral

Banks believe continued use of capital adequacy of 10% don’t not make sense as their internal models already take into account the systemic volatility in the SA market – resulting in double counting of systemic risk of SA

2.3.6 Capital requirements for SMEs

SMEs are essential to build the economy in developing countries

Additional capital requirements for advances to SMEs can be used to convince government agencies to provide additional collateral or support in order for a bank to make these advances

2.3.7 Cross border investments in Africa

Cross border implementation of Basel II for SA banks with investments in various African countries

Not all of these African countries have the regulatory environment or capacity to enable local banks to reap any regulatory benefit in line with the host country

2.3.8 Cost of implementing IRB and AMA

Be positive – a large portion of the cost would have been incurred in order to enhance risk management procedures and should not be blamed on Basel II

Bank regulators will need to take steps as their own additional costs (internal and external) will escalate in order to do model evaluation, etc.

2.3.9 Operational risk

Infant stage AMA might result in implementing one of the standardised approaches

Gross income as the driver for operational risk capital is open for debate

The ‘double whammy’ effect of high margin advances (to cater for high delinquency) will cause a higher credit capital charge and a higher capital charge on the high interest margin

Data sharing on operational risk is problematic

2.3.10 Ability of Regulator to cope

In order for the Big 5 banks to implement the IRB approaches from inception in 2007

• process from ‘Guidelines to Regulations’ to be completed• political approval process to be completed

Big 5 banks see little benefit in a standardised approach as there is no fit to their risk management structures

Big 5 banks believe standardised approaches can be seen as ‘Basel 1.2’ and not as Basel II


3. Ernst & Young survey on Basel IIreadiness in South Africa

3.1 Introduction to survey

Timing: Second quarter 2003

Population • 48 banks in SA • 15 in process of de-registering or closing down• 7 with limited operations• 19 remaining, of which 12 participated

Methodology first used in Luxembourg

3.2 Summary of results

Banks are partly prepared

Re-evaluation of the way business is conducted

Banks will be ready for implementation

Technology seen as the major problem/expense

3.3 Key challenges

Data collection

Improvement of credit environment

Implementation costs

Regulatory uncertainty

Skills availability

Disclosure requirements

3.4 Opportunities

Integrated risk management approach

Align regulatory and economic capital more closely

Better understanding of their business

Improve investor relations

Improve market discipline

3.5 Results per question

Awareness of regulations

Awareness Monitor Quantify Integrate

Organisational structure


Reporting Awareness Monitor Quantify Integrate

Compliance with Basel II


Capital allocation Awareness Monitor Quantify Integrate

Basel II Action Plan Awareness Monitor Quantify Integrate

Technology Awareness Monitor Quantify Integrate

3.6 Tier structure model

Capabilities Awareness Monitor Quantify Integrate Tier 1 Tier 2 Tier 3 Tier 4 Risk Culture/ Regulation Awareness

Weak awareness of risk management issues

Informed management issues

Clear understanding of risk challenges

Risk culture drives decision-making

Organisational Structure

Individual departments covering various aspects of risk (e.g. Internal Audit)

Credit/operational risk committee

Credit/operational risk function, with head reporting to CFO

Risk Officer responsible for market, credit and operational risk reporting to CEO!

Reporting Ad-hoc external reporting

Internal reporting driven by external reporting

Recurring Internal reporting

Frequent internal reporting drives decision-making

Compliance of Operational Risk and Credit Risk

Basic Approach Standard Approach

Operational risk capital allocated for each business line. Probability of default calculated for each obligor

Advance measurement for operational risk internal rating base for credit risk

Regulatory capital is a driver for developing stopping and acquiring activities

Capital Allocation

Undefined capital allocation

Allocation based on regulatory capital

Allocation based on economic capital

Capital consumption drives strategic decisions specific insurance, risk transfer and activities development

Action Plan No resources allocated

Action plan set-up) Cost/benefit analysis for each approach

Budget allocated

Technology Inadequate IT solutions to meet the Basel II requirements

IT action plan to meet the Basel II requirements

IT solutions implementation

Integrated IT solutions for credit/operational/market risk management

3.7 Methodology used

Traditional Baseline

Awareness

Monitor

Quantify

Integrate

Operational Risk

Reliance on internal audit

Operational Risk manager

Comprehensive indicators

Comprehensive loss database

Reliance on quality of people and culture

Top-down eco-nomic capital models

Consolidated reporting

Risk-based economic model

Credit Risk

Current exposure only based on MtM or book values

Current exposure based on expected loss

Potential exposure simulated at transaction level

Potential exposure simulated at portfolio level

Risk-adjusted return linked to compensation Insurance linked with risk analysis and capital

Static limit based on nominal amount

Static limit based on expected loss

Multi-dimensional hierarchy

Dynamic limit borrowing and lending


Developments inbank supervision at SARB

(Website resbank.co.za)

Accord Implementation Forum

Credit RiskGroup

Market RIskGroup

Operational RiskGroup

Risk ManagementSub-Committee

Pillar I

Regulatory FrameworkSub-Committee

DisclosureSub-Committee

Pillar III

Economic ImpactSub-Committee

Steering Committee *

4.1 SARB structured workgroups

4.2 SARB Implementation Plan

4.2.1Strategic plan• To address issues regarding work streams, project plans,

implementation measures, regulation approval process, staffing, funding, etc.

4.2.2 Position paper• Due February 2004 to indicate the approach SARB will take in

implementing Basel II in SA

• Comments to be coordinated through workgroups

4.2.3 Compilation of Regulations• Use the regulatory work group to give guidance on the content

of the regulations

• Legal department of SARB will write regulations

• First draft regulations for standardised approaches submitted for approval by end of 2004

• In the interim work with banks on the IRB and AMA approaches to develop regulations at a later stage

4.2.4 Readiness assessment• First one in November 2003 on Basel II

• To be repeated after June 2004

• Basel II readiness subject of all trilateral meetings


4.2.5 Test data• Gave 5 banks the names of 10 corporate clients (includes high

quality and volatile) and the description of a retail portfolio

• Requested the PD for each corporate loan, the PD for the retail portfolio, the capital requirement for both portfolios and a description of models

• Results were consistent PD’s for high quality corporate exposures

• However, PD’s for volatile corporate exposures and the retail portfolios were not sufficiently consistent

• Next phase to investigate reasons for inconsistent results


4.2.6 Model validation• Believe will be able to go a long way in doing model

validation byo getting information from the various banks

o benchmarking the results o requesting banks to use different assumptions in their model

• Model evaluation will start early o based on sensitivity testing

o using different assumptions

o on different models

o of different banks

• Coordinate the model validation with other Regulators


4.2.7 Economic impact• An economic impact study will be initiated under the

Economic Impact Workgroup to evaluate the effect on the economy to use Basel II – looking at

o The effect of the lower capital requirement on residential mortgages

o The effect of the SA 10% capital requirement versus the international minimum of 8%

o Capital requirement for lending to SMEs

o The extent of ‘Double whammy’ on high margin lending



5. Developments at Bank A

5.1 Attitude towards Basel II

Bank already has an economic capital model in line with Basel II principles

Started internal credit rating models from 1999

As bank operating internationally it needed an investment rating which makes implementation of Basel II compulsory

Performance bonuses are based on return on economic capital above a hurdle rate

5.2 Goals for Basel II

Advance IRB for retail credit

Foundation IRB for corporate credit

Advance measurement approach for operational risk – if at all possible

5.3 Responsibility for Basel II

Basel II falls under capital management

Operating division is responsible for own economic capital management

Economic capital is calculated on Basel II principles

Bonus is based on economic capital – divisions therefore already optimising their economic capital by using Basel II principles for credit risk

Divisions fully aware that they manage risk and that capital management only measures risk

Basel II not a project but the day-to-day responsibility of business units as it adds value to the risk management process

5.4 Initiative - Operational risk

Don’t agree with basic indicator approach or use of gross income to calculate the capital charge

Developed qualitative and self assessment information

Created lost data base for purposes of optimising insurance cost

Data base to combine all these under development

Will keep operational capital charge centrally and allocate by transfer pricing system

Operational risk only monitored centrally but managed by individual business units

5.5 Regulator – positive view

The Regulator has various methods to evaluating models• Benchmarking• Comparisons of assumptions• Same data through different models

No need to verify detailed workings of models

5.6.1 General

Banks in non-investment rated countries should consider the benefit to implement Basel II other than on a standardised approach (benefit in risk management measures not in Capital savings)

Banks should be allowed a maximum of 15% of group assets not to be subject to the IRB approach, subject to confirmation by the Regulator to prevent cherry picking of assets

5.6.2 General

A staged rollout period to allow for credit portfolios to be measured under IRB from 2007 to 2010 (in line with the UK proposal)

In the interim Basel I would be used on the portfolios not yet rolled out

The requirements in terms of IAS 39 on provisions are not in line with Basel II although they have some common data requirements

5.7 Warning

Concerned that a false confidence in statistically quantification of risk can cause potential market distortions

The bank will continue to use its internal ratings and only use external ratings as a point of reference and investigate any differences more than three notches

Basel II only measures risk – risk must continued to be managed at operational level

5.8 Negotiation with Government

The bank also believes that Basel II will assist in negotiations with Government regarding the extension of credit to certain sectors of the economy as the ‘black box’ effect of pricing of credit risk can be reduced

The bank used the principles of Basel II to calculate credit risk price as the basis of negotiations with Government for the purchase of a portfolio of advances from a bank in distress

5.9 Disclosure under Pillar III

This bank is very active in the Disclosure Workgroup

Already completed discussion documents to:

• compare disclosure requirements under Basel II with the accounting disclosures required under the various banking-related GAAP statements

• compile a suggested disclosure model for banks in order to comply with both Basel II and with GAAP


6. Developments at Bank B

6.1 Attitude towards Basel II

Fully supports Basel II and sees it as a natural development of risk management

Integrated Basel II in the business plans of business units in order to use

• advance IRB for retail credit

• foundation IRB for other credit risk

• standardised approach for operational risk

• migrate to advance operational risk approach in future

6.2.1 Project - Risk rating models

Model development and validation

Scorecard development and validation

Approval by Regulator

6.2.2 Project - Data collection and integration

Default data

Exposure data (for EAD)

Collateral data (for LGD)

Default data (for PD)

6.2.3 Project - Operational risk

Framework

Tool selection and implementation

Risk assessment

Key risk indicator

Incident management

Capital calculation (AMA methodology)

6.2.4 Project - Regulatory relationship management

25 regulators

Various countries

Varied satisfaction levels

6.3.1 Challenge - Program management

Sustaining momentum given negative international utterances on Basel II

Co-ordinating complex initiatives

Getting budget approval for initiatives

Getting sufficient specialised skills (risk, IT and programme management)

Other priorities – specifically anti-money laundering

6.3.2 Issue - Non-South African operations

Strategy for implementation

Approval process duplication with other regulators

Alignment of systems

Is group-wide system feasible?

6.4.1 Concerns Regulator

Will Regulator allow • capital to go below 10%• deviation between big banks • Some of the big 5 banks to use models and others not

(only 1 bank has a market risk model approved)

Time available to• Approve credit models• Development of regulations

o Regulations for standardised approach developed firsto Later development of regulation for advanced approacheso Both to be completed long before 2007

Number of resources at Regulator

6.4.2 Concerns General

SA was an early adopter of IAS39 (Recognition and Measurement of Financial Instruments) – substantial problems were experienced with this

The combined volatility effect of IAS 39 and Basel II on capital should be considered

Are we underestimating the effect of implementing Basel II considering the spend by international banks?

Are we arrogant to think that we will be able to do the same with a substantially smaller spend?


END OF PRESENTATION

Risk Management Workshop Colombia: From Theory to Implementation Cartagena, Colombia 16-19 February...

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