Practical and Business Implications of Basel 2 for UK Mortgage Lenders'

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Practical and Business Implications of Basel 2
for UK Mortgage Lenders.

• Bruce T Porteous
• 29 April 2004

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Important, but Exciting?
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Basel Overview.

• Basel 1 Objectives
• Consistent minimum capital adequacy standard for
  banks worldwide.
• Basel 2 Objectives
• Better align capital with risk.
• Regulatory capital arbitrage is harder.
• Promote best risk management practice.
• Timetable for Basel II
• Basel Committee publishes final accord Summer
  2004.
• EU Capital Adequacy Directive adopted by end of
  2005.
• Transposition into national laws for
  implementation at 31/12/2006.
• In practice, kicks in from 31/12/2008.

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Basel II Overview.

• Key proposals
• 3 Pillar approach.
• New capital charge for operational risk.
• Market risk essentially unaltered.
• Choice of basic versus advanced approaches.
• Advanced approaches allow firms to hold less
  capital per unit of risk, versus basic
  approaches.
• Waiver from basic methods requires a
  demonstration of threshold competency levels of
• Data volumes.
• Quantitative risk management.
• Systems and controls.

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Pillar 1.

• Minimum capital requirements.
• Credit, Market, Operational.
• Basic and advanced approaches.
• Formulaic.

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Pillar 1. Credit Risk Capital Requirements for
Residential Mortgages.
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Pillar 1. Practical Implications.

• Clear capital incentive to get onto advanced
  credit approaches.
• Operational risk still generally unclear.
• FSA waiver requirements (CP189) look onerous,
  bureaucratic and unclear.
• Need to be compliant by 31/12/2004 (advanced
  retail credit).
• Big bank advantage (more resources and data).
• But capital win is mainly retail.
• Banks with clean data, good MIS, integrated IT
  systems should also be well placed.

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Pillar 1.Practical Implications.

• Can the FSA cope with all of the firms who want
  on the advanced train?
• Can the big banks book their tickets in advance?

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Pillar 2. Supervisory Review.

• Qualitative requirements.
• Basel 2 embedded in business as usual risk
  management processes (e.g. underwriting
  decision). The use test.
• Appropriate systems in place to
• Measure risk.
• Monitor risk.
• Manage risk.
• Report risk.
• Consistency of approach across supervisory
  regimes?

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Pillar 2. Supervisory Review.

• Quantitative requirements.
• ICA process in place and business as usual.
• ICA economic capital, but loosely defined.
• Risk targets set (consistent with controls and
  risk profile).
• ICA covers
• Risks not captured by Pillar 1.
• Internal risks not covered (banking book market
  risk).
• External risks not covered (business cycle).
• Consistency of approach across supervisory
  regimes?

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Pillar 2.Retail Mortgage Bank Example.
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Pillar 3.

• Risk exposures, risk assessment processes will be
  comparable across firms.
• Market discipline will drive good practice.
• Increased amount and frequency of disclosure.
• Web based disclosure etc.

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Securitisation.

• Basel 2 securitisation rules are still unclear
  and evolving.
• Under Basel 1, securitised mortgages require less
  capital than on balance sheet mortgages.
• Arbitrage possibility (plus additional funding
  source, of course).
• Some current business models securitise heavily.

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Securitisation.

• Basel 2 gt
• on balance sheet capital securitised capital.
• Securitisation allows Basel 2 benefits now.
• Capital/funding management in the run up to Basel
  2?
• Long term future of RMB securities market?

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Business Environment Impact.

• Advanced approach banks will have a competitive
  advantage
• Higher ROC?
• Cheaper mortgages?
• Loan books of standardised firms may have more
  value to advanced banks (consolidation?).
• Retail business may become strategically more
  attractive (versus more risky types of banking
  activity).
• Harder for new entrants, less innovation?

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Demands on Lenders.

• Increased workload
• Corporate governance, risk framework, internal
  reporting.
• Data cleaning and analysis. IS impact.
• Business as usual processes.
• Interactions with FSA (waiver application).
• The market will expect the big banks to be on the
  advanced approaches.
• Most pressure on smaller firms. Can a
  standardised firm compete?

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Costs and Benefits.

• Costs.
• Group/Firm specific.
• Upgrade governance processes.
• Upgrade business processes.
• Data cleaning, consolidation and analysis.
• IS costs.
• Staff costs (numbers and skills).
• Benefits.
• Best risk management practice.
• Probable capital reduction benefit for retail
  lending.
• Cost Benefit Analysis.
• Likely to be favourable for mortgage lending.

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Clear?
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Conclusions.

• Substantial and ongoing work by/from 31/12/2004
  (for advanced credit risk approach).
• Risk management should improve across the board.
• More sophisticated (big?) lenders favoured.
• Increasing pressure on margins and smaller
  lenders.
• Consolidation?
• Future of securitisation markets?
• End customers should win.

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Questions?