The Baham as Association of Com pliance Officers Sem inar Novem ber - - PowerPoint PPT Presentation

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The Baham as Association of Com pliance Officers Sem inar

Novem ber 1 5 , 2 0 0 6

The I m plications of Basel I I

• n Banking in the Baham as

Steve Patterson Head of Credit Risk RBC, Baham as & Caribbean

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Agenda The Evolution of Basel I I Highlights of Basel I I RBC’s Approach to Basel I I Regional I m plications Questions

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Basel I I Evolution

Basel nam ed after Basel, Sw itzerland, hom e of Bank of I nternational Settlem ents ( “BI S”) BI S Mission Statem ent “ Excellence in Service to Central Banks and Financial Authorities”

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Basel I I Evolution

The BI S

Aim s at prom oting m onetary and financial

stability Acts as a forum for discussion and cooperation am ong central banks and the financial com m unity Acts as a bank to central banks and international organizations

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Basel I I Evolution

History of the BI S

• Established in 1 9 3 0

1 . to handle reparation paym ents

im posed on Germ any after the First W orld W ar 2 . to provide Central Banks w ith an institutional forum for cooperation

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Basel I I Evolution

History of the BI S

1 9 3 0 ’s “The Great Depression”. Central Bank m eetings continued although w ith understandable lim itations I n 1 9 3 9 , w ith Advent of Second W orld W ar, all m eetings suspended, BI S rem ained neutral 1 9 4 4 Bretton W oods Agreem ent called for abolition of BI S, w ith Bretton W oods fram ew ork, I MF and W orld Bank taking over Central banks in Europe favored keeping BI S alive

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Basel I I Evolution

History of the BI S

Bretton W oods era saw international m onetary system based on freely convertible currencies at fixed but adjustable exchange rates Rem oval of foreign exchange controls facilitated free trade and BI S played significant role in assisting w ith this in Europe BI S continued to play roll in coordinating crisis m anagem ent am ong central banks ( gold price, reserve currencies & other m onetary im balances)

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Basel I I Evolution

History of the BI S

By the early 1 9 7 0 ’s, value of the dollar determ ined by m arkets, m arked the end of the Bretton W oods system Bretton W oods legacy is one of institutionalized cooperation am ong central banks I n 1 9 7 3 EEC put lim its on exchange rate fluctuations betw een participating European currencies ( “Snake m echanism ”) & BI S appointed agent for it European Monetary System introduced in 1 9 7 9 w ith BI S responsibilities rem aining

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Basel I I Evolution

History of the BI S

1 9 7 0 s saw grow th of international financial m arkets and cross-boarder m oney flow s Collapse in 1 9 7 4 of Bankhaus Herstatt in Germ any and Franklin National Bank in the US prom pted G1 0 central bank governors to set up Basel Com m ittee on Banking Supervision I n 1 9 8 8 this Com m ittee issued the Basel Capital Accord introducing a credit risk m easurem ent fram ew ork for internationally active banks that becam e a globally accepted standard

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Basel I I Evolution

History of the BI S

I n June 1 9 9 9 , the Com m ittee released a proposal to replace the 1 9 8 8 accord w ith Basel I I , w hich captures operational risk and relates the allocation of capital to actual risk Basel I I addresses not only capital regulation but also encom passes supervisory review and m arket discipline ( the Three Pillars)

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Basel I I Evolution

History of the BI S

Som e exam ples of destabilizing events: Several Bank failures Barings Bank in Far East Recent exam ple of Hedge Fund w hich lost significant portion of value in less than 1 w eek Mexican crisis in 1 9 9 4 -9 5 Thailand & Korea in 1 9 9 7 Russian debt default Turkish & Argentine crises

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Basel I I Evolution

W hat has changed over tim e?

More com plex econom ies Econom ies m ore intertw ined, events in one econom y m ay have w orldw ide im plications 1 . Financial institutions over reach m any geographies 2 . Revenue drivers in an econom y m ay be dependent on outside interests ( e.g. tourism ) 3 . Reliance on external com m odities ( e.g. oil)

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Basel I I Evolution

W hat has changed over tim e?

Financial institutions have changed too 1 . Far larger array of products 2 . More different lines of business 3 . Larger institutions active in m any countries, difficulties/ m istakes in

• ne country can destabilize bank

across entire operations ( Barings Bank) 4 . More com plex products, som e of w hich are off balance sheet ( interest rate sw aps, foreign exchange forw ards/ futures etc)

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Basel I I Evolution

W hat has changed over tim e?

Financial institutions Risk & Return perspective, all risks are not equal 1 . A residential m ortgage vs. a credit card 2 . Structured finance, bigger spreads, bigger fees and also bigger risks 3 . Lending w ith lim ited regard for TDS in consum er portfolio, higher rates how ever, especially in a dow n turn, greater chance of default 4 . LTV m ultiples on residential m ortgages

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Basel I I Evolution

W hat has changed over tim e?

As capital is the “cushion” for the financial institution, as products and business practices becom e m ore com plex, then capital calculations too have grow n in com plexity Also review / oversight of these institutions continues to grow in com plexity I nvestor inform ation and transparency for stakeholders in these institutions also needs to expand The above are the 3 Pillars of Basel I I

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Highlights - Basel I I

Three Pillars

1 . Minim um Capital Requirem ents 2 . Supervisory Review of institutions capital adequacy and internal assessm ent process 3 . Market Discipline w hich addresses institutions disclosure practices

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Highlights - Basel I I

Minim um Capital Requirem ents

• Credit Risk

Three key approaches to m easure Credit Risk 1 . Standardised Approach 2 . Foundation I nternal Rating Based ( “I RB”) 3 . Advanced I RB

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Highlights - Basel I I

Minim um Capital Requirem ents

• Credit Risk

Standardised Approach Based on external ratings, m ay be credit rating agencies or risk w eights dictated by accord &/ or local regulator Different asset types w ill have different risk w eightings e.g. Corporate 1 0 0 % , Retail 7 5 % , Residential Mortgages 3 5 %

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Highlights - Basel I I

Minim um Capital Requirem ents

• Credit Risk

Standardised Approach

• Off Balance sheet item s w ill be converted

into credit exposure equivalents utilising credit conversion factors Exam ple w ould be Com m itm ents w here over 1 year attracts 5 0 % CCF, under 1 year 2 0 % & fully cancellable 0 %

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Highlights - Basel I I

Minim um Capital Requirem ents

• Credit Risk

I RB Approaches For calculation of Risk W eighted Assets reliant on 4 quantitative inputs 1 . Probability of Default 2 . Loss given Default 3 . Exposure at default 4 . Maturity

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Highlights - Basel I I

Minim um Capital Requirem ents

• Credit Risk

I RB Approaches Difference betw een Foundation I RB & Advanced I RB is that w ith Advanced, quantitative inputs provided by bank based

• n ow n estim ates, w hereas w ith Foundation

w ith exception of Probability of Default Supervisors provide values

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Highlights - Basel I I

Minim um Capital Requirem ents

• Credit Risk

I RB Approaches

• Assets divided into classes w ith 3 key elem ents:

1 . Risk Com ponents – estim ates of risk param eters provided by Banks/ Regulators 2 . Risk W eight functions – how risk com ponents are transferred into risk w eighted assets 3 . Minim um Requirem ents – requirem ents that m ust be m et for bank to use I RB approach for given asset class

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Highlights - Basel I I

Minim um Capital Requirem ents

• Operational Risk

The risk of loss resulting from inadequate or failed internal processes, people and system s or from external events, includes legal risk.

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Highlights - Basel I I

Minim um Capital Requirem ents

• Operational Risk

Capital Calculation Options

1 . Basic I ndicator Approach – 1 5 % of 3 year average of gross incom e 2 . Standardised Approach – Divides bank into 8 business lines and in each takes gross incom e tim es a predeterm ined beta ( Retail banking 1 2 % ) 3 . Advanced Measurem ent Approaches – Regulatory Capital w ill equal risk m easure provided by Bank’s internal m easurem ent system utilising specified quantitative and qualitative criteria

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Highlights - Basel I I

Minim um Capital Requirem ents

• Market Risk
• Defined as the risk of losses in on and off balance

sheet positions arising from m ovem ent in m arket

• prices. Risks subject to this provision are:

1 . Risks pertaining to interest rate related instrum ents & equities in the trading book 2 . Foreign exchange risk and com m odities risk throughout the Bank

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Highlights - Basel I I

Minim um Capital Requirem ents

• Market Risk

Direction provided on how to calculate risk w eighting of various elem ents of m arket risk

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Highlights - Basel I I

Pillar 1 – Other Guidelines

Also addresses treatm ent of investm ents in

• ther financial institutions, financial

subsidiaries, insurance com panies and other com m ercial entities. Tightens up allow able am ounts of these investm ents before deductions have to be m ade to a Bank’s capital Principal here is that capital has to be available for use and em ployed w ithin financial institution

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Highlights - Basel I I

Supervisory Review

Supervisory review process not only ensures Banks have adequate capital but to encourage banks to develop & use better risk m anagem ent techniques in m onitoring and m anaging their risks

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Highlights - Basel I I

Supervisory Review

4 Key Principles

1 . Banks should have a process for assessing their

• verall capital adequacy in relation to their risk

profile and a strategy for m aintaining their capital levels 2 . Supervisors should review and evaluate Banks’ internal capital adequacy assessm ents and strategies, as w ell as their ability to m onitor and ensure their com pliance w ith regulatory ratios. Supervisors should take appropriate supervisory action if they are not satisfied w ith the results of the process

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Highlights - Basel I I

Supervisory Review

4 Key Principles

3 . Supervisors should expect Banks to operate above the m inim um regulatory capital ratios and should have the ability to require Banks to hold capital in excess of the m inim um 4 . Supervisors should seek to intervene at an early stage to prevent capital from falling below the m inim um levels required to support the risk characteristics of a particular bank and should require rapid rem edial action if capital is not m aintained or restored

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Highlights - Basel I I

Supervisory Review

Com m ittee of European Bank Supervisors issued a list of the follow ing Risk Factors:

• Credit Risk – Obligor’s failure to m eet term s of contract or

failure to perform as agreed. I ncludes concentration risk, residual risk, credit risk in securitization, and cross boarder risk

• Market Risk – Addressed earlier in presentation
• I nterest Rate Risk – Adverse m ovem ents in interest

rates in the banking book

• Liquidity Risk – I nability to m eet its liabilities w hen they

com e due w ithout incurring unacceptable losses

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Highlights - Basel I I

Supervisory Review

Com m ittee of European Bank Supervisors issued a list of the follow ing Risk Factors ( cont.) :

• Capital Risk – I nadequate com position of ow n funds for

the scale and business of the institution or difficulties in raising additional capital, especially if this needs to be done quickly or at a tim e w hen m arket conditions are unfavorable

• Earnings Risk – I nadequate diversification of earnings or

the inability to provide sustained profitability due for exam ple to an inadequate cost to incom e ratio

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Highlights - Basel I I

Supervisory Review

Com m ittee of European Bank Supervisors issued a list of the follow ing Risk Factors ( cont.) :

• Operational Risk – Covered earlier
• Strategic Risk – Changes in the business environm ent

and from adverse business decisions, im proper im plem entation of decisions or lack of responsiveness to changes in the business environm ent

• Reputation Risk – Adverse perception of the im age by

custom ers, counterparties, shareholders/ investors, or regulators

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Highlights - Basel I I

Market Discipline

• Com plim ents Pillars 1 & 2
• Com m ittee to develop a set of disclosure

requirem ents w hich w ill allow m arket participants to assess key pieces of inform ation on the scope of application, capital, risk exposures, risk assessm ent processes and hence the capital adequacy of the institution

• Providing disclosures that are based on a com m on

fram ew ork is an effective w ay of inform ing the m arket and provides a consistent & understandable disclosure w hich allow s for com parability

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Highlights - Basel I I

Market Discipline

Possible Disclosure I tem s

1 . financial position 2 . financial perform ance 3 . risk exposures 4 . risk m anagem ent processes and strategies 5 . accounting policies 6 . business, m anagem ent & governance inform ation

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• RBC Group adopting AI RB approach and to be fully
• perational by early 2 0 0 7
• Approach and tim e fram es influenced by host

regulator

• W ithin AI RB protocol, for operations of financial

institutions w ithin sm aller m arkets and of a lesser scale, can adopt Standardized Approach as long as the aggregate of these adoptions are not m aterial

• RBC after careful study has elected to go w ith

Standardized Sim ple for the Caribbean

• I t is likely other m ajor Canadian banks and their

subsidiaries are follow ing sim ilar approach RBC Approach

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RBC Approach

CARI BBEAN APPROACH

• Support groups assessed/ gained know ledge of local
• perations
• Looked at products offered, accounting system s,

data bases and I T system s capabilities

• Determ ined w hat w ould be entailed to qualify for

AI RB vs. Standardized approach

• W eighed m erits of both approaches ( cost/ benefit &
• ther considerations) Decision m ade to proceed w ith

Standardized

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CARI BBEAN APPROACH

• Determ ined then w hat options available w ithin

Standardized and preferred courses

• Established data requirem ents necessary, w here

housed, and taking confidentiality regulations into account

• Undertook one tim e clean up of data
• Built interfaces, m apped data, transm itted
• Developed test cases to test data for integrity
• Final clean up of data and m apping

RBC Approach

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RBC Approach

EXAMPLE OF DECI SI ONI NG Do m ortgages qualify for 3 5 % risk w eighting? Considerations:

• Mortgage indem nity kicks in at 8 0 % vs. 7 5 % in Canada
• I ndem nity in Canada provided by Governm ent entity vs.

com m ercial insurer here

• Do exceptions to TDS etc. occur m ore often here w hile not

prevalent in Canada as portfolio has to m eet securitization standards?

• W hat are m inim um data fields required, is that inform ation

currently captured/ available?

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RBC Approach

CHALLENGES OF BASEL I I

• Significant $ cost on institution in funding necessary

technology and increased hum an resources.

• Resources ( I T, Risk Managem ent) preoccupied w ith

Basel at expense of neglecting business im peratives.

• Availability of resources
• Com pressed tim elines
• I nternal interdependencies
• Varying im plem entation tim es of regulators
• Aligned regulators

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Myths & Misconceptions

1 . W e can just take GL balances for each product and based on total, capital w ill be calculated. Does not m eet granular reporting requirem ents. 2 . Clarity w ill exist at outset. Approaches have to be discussed/ w orked out w ith the host regulator. 3 . Once w e “go live” w ith capital calculations, w ork w ill be over. Data integrity has to be m aintained and w e have the other 2 Pillars to w orry about.

RBC Approach

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RBC Approach

Myths & Misconceptions

4 . Only requests for data w ill be driven from Basel reporting needs. Other functions/ interests saw opportunity to expand their data bases. 5 . Let’s slow it up, Basel 2 w ill blow over. The Bank understandably w ants to be fully com pliant w ith our host regulator so that is not an option.

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I m plications

TI MI NG

• I nternational Banks are being driven by hom e

regulators and, in som e cases, w ill be Basel I I com pliant before host ( local) regulator addresses Basel I I im plem entation

• Decisions are m ade on assum ption of cooperation

betw een regulators and a sim ilar interpretation of accord

• W ould be unfortunate and costly if a local regulator

w ere to insist on differing approaches w hich necessitated an unw inding ( AI RB im plem entation, capital engine locally)

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I m plications

COOPERATI ON BETW EEN REGULATORS

• Difficult environm ent for international banks if

regulators not aligned w ith interpretation/ application

• Through cooperation/ com m unication, likely can learn

from each other to avoid each regulator “reinventing the w heel”

• Can reliance be placed on hom e regulators to m onitor
• verall risk profiles of international banks, w ith hom e

regulator and bank agreeing to sum m ary com m unication to host to provide info for com fort levels

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I m plications

I NDI GI NOUS & REGI ONAL BANKS

• W hile im plem entation likely 3 to 4 years off, they are

probably becom ing fam iliar w ith accord and likely im plications

• Discussions w ill soon take place w ith regulators ( if

they have not already occurred) on an approach and alignm ent w ith regulator view

• Likely approach w ould be the Standardized
• Even w ith Standardized, m ay need to revisit risk

policies/ principles/ processes ensuring adequate docum entation and acceptable underw riting standards

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I m plications

ALL BANKS

I ncreased regulator oversight w ill lead to

• ngoing analysis around underw riting

criteria From an RBC perspective, on a consum er book underw riting factors w e w restle w ith include

1 . W hat is right m ax TDS ( tax free environm ent but no credit bureaus) 2 . How religiously do w e apply it 3 . Should security ( m ortgage, w age assignm ent) override TDS 4 . W hat is the right LTV or Loan to Cost?

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I m plications

ALL BANKS

5 . Should different assets & Borrow ers be treated differently? Raw Land vs. residential hom es

• vs. loans to non residents to buy

second hom es 5 . W ithin certain products, do w e not have a social responsibility such as lot loans for first tim e hom ebuyers, relaxation of financial reporting and sim plified loan structure for sm all business

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I m plications

ALL BANKS

7 . How m any w aived paym ents are allow ed in a year 8 . W hat is the criteria for restructuring a loan and how

• ften should w e restructure over

the life of a loan I f m ore liberal criteria is adopted, should this not be reflected in increased capital requirem ents for the financial institution?

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I m plications

I NDI GI NOUS & REGI ONAL BANKS

• Risks other than credit risk, Banks w ill need to

address

• Focus w ill likely not only be quantitative to

calculate required capital but qualitative as w ell

• Risks m ay vary over tim e and by geography,

how ever strategic, liquidity, capital etc. could be real in the Baham as

• Focus should not only be looking back at past

difficulties but forw ard looking, stress testing processes, trying to anticipate future risks

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I m plications

SUPERVI SORY REVI EW

• As contem plated in the protocol, regulator roll w ill

likely be m ore expanded

• I ntent w ould be to w ork w ith banks to ensure

appropriate capital levels are m aintained, w ith these capital requirem ents conceivably adjusted in different econom ic environm ents

• Also to encourage banks to develop & use better risk

m anagem ent techniques in m onitoring & m anaging their risk

• Regulator can be of assistance to banks as they

benefit from experience/ learnings

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I m plications

SUPERVI SORY REVI EW

Regulator w ill need to ensure appropriate law s/ legislation in place to provide regulator w ith authority contem plated and force disclosure Likely w ill need increased staff w ith ability to carry out m andate Training of staff could be prevalent

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I m plications

CLOSI NG COMMENTS

I n Risk Managem ent success is not having a portfolio w here there is no delinquency and no loan grow th Nor is success having high loan grow th w ith lots of delinquency I t is to assist the business in grow ing revenues w hile m aintaining the portfolio w ithin an acceptable risk profile

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I m plications

CLOSI NG COMMENTS

• To m e, in the sam e vein, success w ith Basel I I w ould

be im plem entation of the accord w ith im proved capital guidelines & calculation, better risk m anagem ent processes and techniques as evidenced by supervisory verification, and im proved disclosure levels. How ever this should be accom plished in an environm ent allow ing for continuing business m om entum and Basel associated costs w hich are reasonable for the scale and com plexity of the

• peration.