RMPG Learning Series CRM Workshop Day 1 session 2

IMaCS 2010Printed 11-May-11

Agenda for Day 1

Introduction of Participants

Introduction to Credit Risk

Lunch Break

Framework for Credit Risk Management

Overview of Basel Guidelines

Open Session/ Q&A


Principal objectives of the Basel Accord II

� Prudent capital regulation

� Scientific principles for bank supervision

� Use of market discipline for better focus on risk

• Better risk management• Financial Stability


Key inclusions in Basel II accord vis a vis Basel I accord of 1988

1. Credit risk: graded norms for capital adequacy

2. Market risk: setting aside capital for market risk

3. Operational risk: introduced for the first time

4. More emphasis on banks’ own internal methodologies, supervisory review and market discipline.

5. Flexibility, menu of approaches, incentives for better risk management


Basel II Accord

The #1 goal of Basel II Capital Accord is to align regulatory capital more closely with economic capital ...

… using the 3 “pillars” approach

#1#1


Basel II Accord

BASEL II CAPITAL ACCORD

1. MINIMUM CAPITAL REQUIREMENTS

2. SUPERVISORY REVIEW OF CAPITAL ADEQUACY

3. MARKET DISCIPLINE

� Sets minimum acceptable capital

� Credit risk tied to ratings� Public ratings� Internal ratings

� Explicit treatment of Operational (“Event”) Risk� Excludes

“Strategic & Reputation Risk”

� Based on 4 principles� Banks must assess

solvency relative to their risk profile

� Supervisors should review bank’s assessments

� Banks should hold in excess of minimum level of capital

� Regulators will intervene if capital levels deteriorate

� Increased disclosure of capital structure

� Improved disclosure of risk measurement and management practices

� Improved disclosure of risk profile

� Improved disclosure of capital adequacy


Credit risk: graded norms for capital adequacy

AA

%8.0

• In 1988 Basel I Accord, a loan to a AA rated corporate requires the same amount of capital as a loan to a B-rated corporate

Capital%

Capital

• In 2004 Basel II Accord, there are graded norms for capital adequacy

8.0 8.08.0

A BBB BB AA A BBB BB


Basel II - Options of Pillar 1 for Credit Risk

Complexity of Approach

1. Standardised approach

2. IRB - FoundationComponents- PD, LGD, EADPD will be defined by bank and LGD and EAD will be provided by the regulator. Regulators defined list of authorised securities.

3. IRB - AdvancedComponents- PD, LGD, EAD, Maturity. Based on experience and regulatory approval, Bank can define its own list of eligible securities.Subject to qualitative entry criteria

Components- Credit ratings of the borrowers rated by ECA. Weights are defined by regulator w.r.t.to the ECA rating. Regulators defined list of authorised securities

Capital A

llocation


Basel II Accord - Credit Risk Management Approaches

Standardised ApproachInternal Ratings Based (IRB)Foundation Approach

Internal Ratings Based (IRB)Advanced Approach

� Risk-weights set based on external risk ratings

� Treatment of collateral and guarantees set by supervisors

� Risk weights differentiated by internal credit risk ratings

� Bank estimating PD for their internal ratings

� Effect of risk mitigation parallel to that in the Standardised Approach

� Bank to estimate Loss Given Default (LGD)

� Bank to estimate Exposure At Default (EAD)

� Improved disclosure of risk measurement and management practices

� Improved disclosure of risk profile

� Improved disclosure of capital adequacy


Salient features of proposed Basel II Accord…(1)

� Claims on sovereigns and central banks will be risk weighted based on external credit

assessment

� However, at national discretion, a lower risk weightage may be applied to bank

exposures to their sovereign for loans in domestic currency

� Basel has proposed two approaches for measuring claims on banks

� Option 1: assign a risk weight one category less favourable than that assigned to

claims on sovereign of that country

� Option 2: Base the risk weights on the external credit assessment of the bank itself

� Claims on corporate will be risk weighted based on external credit assessments: For

example AAA to AA- corporate will get a risk weightage of 20%, while A+ to A-will get a

risk weightage of 50%


Salient features of proposed Basel II Accord…(2)

� Retail portfolio will get a (lower) risk weightage of 75%

� Fully secured residential mortgage will get a risk weightage of 35%

� Off-balance sheet items under the standardised approach will be converted into credit

exposure equivalents through the use of credit conversion equivalents

� Financial Collateral, Guarantee & Derivatives are recognised as Risk Mitigation strategies


Measuring Credit Risk Capital - Standardised Approach

Minimum Credit Risk Capital requirement under Standardised Approach

is (E *) x Risk Weight x Regulatory capital requirement.

& E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]}

where:

E* - Exposure value after risk mitigation;

E - Current value of Exposure;

He - Haircut appropriate to the exposure

C - The current value of the collateral received

Hc - Haircut appropriate to the collateral

Hfx - Haircut appropriate for currency mismatch between the collateral & exposure


Measuring Credit Risk Capital - The way forward

� Standardised Approach

The New Basel Approach

� IRB Foundation Approach

• Internal estimation of Probability of Default (PD)

• Formula for estimation of Exposure at Default (EAD)

• Regulator to provide estimate of Loss Given Default (LGD)


Measuring Credit Risk Capital using IRB Foundation Approach

Security Data

Exposure DataRisk Scores

Data

PD

LGD Estimates

(From Regulator)

EAD Estimator(from Regulator)

TypeValue

(set by Regulator)

Maturity(from Regulator)

Capital Required

Computed


The three approaches differ in the source of the parameters, either external/regulatory predetermined or an internal estimate

Basel II - Options of Pillar 1 for Credit Risk Standardised approach

• Risk weights are calculated using external ratings set by the regulator

• Credit Risk Mitigation Techniques (CRMT) are defined by the regulator

• Mandatory standard as long as the Bank does not pass the approval for a more advanced approach

Maturity M

No explicit

recognition

EAD

Regulatory

predetermined

LGDPD

Implicitly predetermined by risk weights (RW)

set up by the regulator which are based on

external ratings

[ 1 ] [ 2 ] [ 3 ] [ 4 ]


Basel II - Options of Pillar 1 for Credit RiskStandardised approach - some possible constraints

Are external ratings available?

Will borrowers meet the requirements of rating agencies?

How many borrowers are already rated?

Are default events (according to the Basel II definition) triggered in the IT system?

How many agencies are accredited?

Is all the data needed for the use of Credit Risk Mitigation Techniques available in the IT-system?

Are the stipulated Credit Risk Mitigants sufficient?


Why should Banks look at IRB approach?

The standardised approach only recognises financial collateral. While traditionally, Banks have been seeking receivables & inventory as security to finance working capital requirements

Very few companies are rated by an external agency. Many countries do not have a rating agency

Banks that bring in early discipline of risk pricing assets are likely to benefit in the long run

1

2

3


Basel II - Options of Pillar 1 for Credit RiskFoundation IRB - barriers to overcome

Does the Bank have appropriate rating models with sufficient granularity to distinguish shades of grey in credit risk?

Availability and accuracy of Information

Appropriate models for various categories of borrowers e.g. Retail, SME, Corporate, Real Estate etc.

Regulator’s ability to provide LGD, EAD, Maturity information

Interfaces to IT systems to capture relevant information

Is all the data needed for the use of Credit Risk Mitigation Techniques available in the IT-system?

Validation of relevant Models


Exercise # 1(a): Credit Risk Capital Calculation -Standardised approach (Basel II)

� Situation> Two Borrowers have approached the bank for a line of Credit

· Borrower ‘X’ - Amount Rs. 5,000,000· Borrower ‘Y’ - Amount Rs. 5,000,000

> Risk ratings of the Borrowers ‘X’ is “A” and ‘Y’ is “BBB”> Risk Weights as per Basel II are :Credit assessment AAA to AA- A+ to A- BBB+ to B- Below B-

(or Un-rated)Risk Weights 20% 50% 100% 150%

> The Bank has taken collateral from Borrower ‘Y’ of:> Foreign Currency deposit (US Dollar) - 50,000 ≅ Rs.2,250,000 (USD=Rs.45/)

> Compute the following:(a) Risk Weighted Exposures (taking account of applicable haircuts) and (b) Credit risk capital for each of the exposures of the Bank


Solution # 1(a): Risk Capital Calculation - Standardised approach (Basel II)

Computation Borrower ‘X’ Borrower ‘Y’Q.1. Risk Weighted Credit Exposures to the Bank

a. Loan Amount 5,000,000 5,000,000

b. Borrower Credit Risk Rating A BBB

c. Collateral N/A Obtained

c.1. Estimated value of eligible financial collateral: 2,250,000

Foreign currency deposit (FCD): 2,250,000

d. Risk Weights (as per Basel II and Regulator) 50% 100%

e. Current value of exposures (E) d * a 5,000,000 5,000,000

f. Applicable Hair cuts N/A 8% for FCD

e.1. Adjusted Exposure after Haircuts (E*) (ie., max {0, [E x (1 + He) 5,000,000 2,930,000

Basel II - 8% haircut for F.C.deposits as collateral – C x (1 – Hc – Hfx)]})

Q.2. Credit Risk Capital

f. Risk weighted exposure e * d 2,500,000 2,930,000

g. Regulatory Risk Capital 8% 8%

h. Credit Risk Capital f * g 200,000 234,400


Exercise # 1(b): Credit Risk Capital Calculation -Standardised approach

� Situation> Two Borrowers have approached the bank for a line of Credit

· Borrower ‘X’ - Amount Rs. 5,000,000· Borrower ‘Y’ - Amount Rs. 5,000,000

> Risk ratings of the Borrowers ‘X’ is “A” and ‘Y’ is “BBB”> Risk Weights as per Central Bank are :Credit assessment AAA AA A BBB& below Unrated

Risk Weights 20% 50% 100% 150% 100%

> The Bank has taken collateral from Borrower ‘Y’ of:> Foreign Currency deposit (US Dollar) - 50,000 ≅ Rs.2,250,000 (USD=Rs.45/)

> Compute the following:(a) Risk Weighted Exposures (taking account of applicable haircuts) and (b) Credit risk capital for each of the exposures of the Bank


Solution # 1(b): Risk Capital Calculation - Standardised approach

Computation Borrower ‘X’ Borrower ‘Y’Q.1. Risk Weighted Credit Exposures to the Bank

a. Loan Amount 5,000,000 5,000,000

b. Borrower Credit Risk Rating A BBB

c. Collateral N/A Obtained

c.1. Estimated value of eligible financial collateral: 2,250,000

Foreign currency deposit (FCD): 2,250,000

d. Risk Weights (as per Basel II and Regulator) 100% 150%

e. Current value of exposures (E) d * a 5,000,000 5,000,000

f. Applicable Hair cuts N/A 8% for FCD

e.1. Adjusted Exposure after Haircuts (E*) (ie., max {0, [E x (1 + He) 5,000,000 2,930,000

Basel II - 8% haircut for F.C.deposits as collateral – C x (1 – Hc – Hfx)]})

Q.2. Credit Risk Capital

f. Risk weighted exposure e.1 * d 5,000,000 4,395,000

g. Regulatory Risk Capital 9% 9%

h. Credit Risk Capital f * g 450,000 395,550


Standardised Vs. Internal Model approaches

01.6

8

16A

AA

AA A+ A-

BB

B

BB

+

BB

- B

CC

C

RATING

New standardized model Internal rating system

12

1 2 3 4 4.5 5 5.5 6 76.5

ICRA :

Illustration :Risk weight for AAA rating is 20%. And regulatory capital is 8%. So, the percentage of exposure to be set aside for capital is 20% * 8% = 1.6%.


What can a Bank do to cope with “Losses” arising from Credit Risk?

� Broadly, there are two types of losses arising from credit risks:

� Expected loss

� Unexpected loss


What is Expected Loss?

Time (years)

Range of Loss

Expected Loss

Credit Loss (Rs.)

Expected Loss


time

Unexpectedloss

Exp

ecte

d lo

ss (

loss

rat

e)

• expected default prob

• recovery rates

• default correlation

expected loss

loanexposure

Probability of default

100% lessrecovery rate

= X X

Calibration ofinternal ratings

Industrybenchmarks

Quality of bank’s data

Expected Loss


Credit Risk model flow

Inputs Outputs

Defaultrates

Exposure

ExpectedLoss

Unexpected Loss

Credit RiskCapital

Portfolioconcentration

Defaultcorrelations

Recovery rate


Expected and Unexpected Losses - Fundamental Concepts

Fre

quen

cy

Magnitude of loss

Expected Credit Loss (1)

Maximum

Credit lossPotential unexpected loss against

which it is too expensive to hold equity

(1) Pricing should

cover this element

(2) Capital should

be held against this

Unexpected Credit

Loss (2)


Economic Capital

Fre

quen

cy

Expected Credit Loss (1)

Unexpected Credit

Loss (2)

Economic capital should

cover Unexpected credit losses

and non-priced / under-

provisioned part of expected

loss

Economic Capital


- Collect & Organize Customer Data- Introduce data infrastructure- Train Staff

Data & Infrastructure

Stage 1

- Build Internal Ratings systems - Estimate Default Probabilities- Facility ratings/transaction rating with LGD measures

ObligorRisk Mgmt

Stage 2

- Estimate regulatory capital - Measure RAROC- Reporting to Senior Management

PortfolioReporting

Stage 3

Stages in the IRB approach to Credit Risk Management Solutions


- Collect & Organize Customer Data- Introduce data infrastructure

Data & Infrastructure

Stages in the IRB approach to Credit Risk Management Solutions - Stage 1

Key Issues:

� Clearly articulate what data to collect

� Identify the best source of the data

� Build interfaces to pick-up data

Project Background & Compatibility with Basel II norms


- Build Internal Ratings systems - Estimate Default Probabilities

ObligorRisk Mgmt


Key Issues:

� Understanding credit behaviour

� Ability to identify variables that predict default



- Estimate regulatory capital - Measure RAROC- Reporting to Senior Management

PortfolioReporting


Key Issues:

� Understanding Basel recommendations and RBI requirements

� Knowledge of business, regulatory and reporting requirements



Proposed Basel III Guidelines

The key elements of the proposed Basel III guidelines include the following:

� Definition of capital made more stringent, capital buffers introducedand

Loss absorptive capacity of Tier 1 and Tier 2 Capital instrument of

Internationally active banks proposed to be enhanced

� Forward looking provisioning prescribed

� Modifications made in counterparty credit risk weights

� New parameter of leverage ratio introduced

� Global liquidity standard prescribed

The Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the minimum core

capital requirement of 4.5%) be created by banks. Although the committee does not view the capital

conservation buffer as a new minimum standard, considering the restrictions imposed on banks and also

because of reputation issues, 7% is likely to become the new minimum capital requirement.


Regulatory Capital Adequacy Levels—Proposed Norm under Basel III

Proposed Basel -III Norm

Common equity (after deductions) 4.5%

Conservation buffer 2.5%

Countercyclical buffer 0-2.5%

Common equity + Conservation buffer + Countercyclical buffer

7-9.5%

Tier I(including the buffer) 8.5-11%

Total capital (including the buffers) 10.5-13%

Regulatory Capital = Core Capital + Capital Conservation Buffer + Countercyclical buffer (if any)


DISCUSSIONS


All the contents of the presentation are confidential and

should not be published, reproduced or circulated without the

written consent of IFC, Bangladesh Bank and IMaCS.

RMPG Learning Series CRM Workshop Day 1 session 2

Economy & Finance

Transcript of RMPG Learning Series CRM Workshop Day 1 session 2