Possible changes to the New Basel Capital Accord Basel II David Millar, COO, PRMIA Beijing, 3rd Apri

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Possible changes to the New Basel Capital Accord
(Basel II)David Millar, COO, PRMIABeijing,
3rd April 2009
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Basel II created by the Bank for International
Settlements

• Objective to strengthen the international
  financial system.
• Advisory, not regulatory, formulates supervisory
  standards and best practice,
• Has no supranational authority (with local
  supervisors), makes recommendations to the
  financial community
• Objective is to prevent national or systemic
  failure by ensuring banks are well capitalised
• Capital decided on risk-weighted assets
• Basel I was originally about capital, not risk
  management

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BASEL II overview
The Three Pillars

Disclosure Market Discipline
Supervisory Review Process
Regulatory CapitalRequirements
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2
3
Implications on, and requirements for, systems,
processes people
Calculated based on credit, market and
operational risk.
Operational control and compliance with Pillar 1
requirements.
Capital adequacy and risk control processes and
results will be disclosed.
Many options on approach to calculation of
capital requirements.
All must comply. Gives regulators opportunity to
vary the capital calculated in Pillar 1
Standards are common to all regulated firms.
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Why did the crisis happen?

• Change in the borrowing/lending model, and the
  move by bank revenues from commissions and
  interest to capital growth
• Easy credit, poor lending strategies and
  unmanaged securitisation
• Profit and bonus driven institutions short-term
  profit is the only goal, and there is no downside
• Governments encouraged growth, regulators were
  not in control.
• Liquidity was not understood or controlled and
  risk management was not carried out

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The result ..

• A financial system based on inter-bank liquidity
  and not on deposits
• An investment environment where it was easier to
  borrow than to save
• A culture where risk taking is rewarded with no
  penalty for failure
• A global economy where governments encouraged
  growth rather than savings and where regulators
  did not fully understand all the instruments.
• A risk management framework that was not up to
  the task.

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Why did Basel II not prevent it?
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Where was Basel II lacking?
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What is the BCBS doing about it?

• Various papers published in 2008
• Liquidity Risk Management and Supervisory
  Challenges
• Cross-sectoral review of group-wide
  identification and management of risk
  concentrations
• Guidelines for Computing Capital for Incremental
  Risk in the Trading Book
• Proposed revisions to the Basel II market risk
  framework
• Principles for Sound Liquidity Risk Management
  and Supervision
• Supervisory guidance for assessing banks'
  financial instrument fair value practices

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What is the BCBS doing about it?

• Four consultation papers published in January
  2009
• Principles for sound stress testing practices and
  supervision published 9th January for comment by
  March 13th.
• Revisions to the Basel II market risk framework
  published 17th January for comment by March 13th.
  Refers back to the 2008 paper.
• Guidelines for computing capital for incremental
  risk in the trading book published 17th January
  for comment by March 13th. Referes back to the
  2008 paper.
• Proposed enhancements to the Basel II framework
  published 17th January for comment by April17th.
• All four papers make specific recommendations for
  change, and, with the exception of the stress
  testing paper, put forward dates for
  implementation.

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Principles for sound stress testing practices and
supervision

• Stress testing to be part of governance and risk
  management culture with board and senior
  management involvement.
• Corporate wide, fully documented and regularly
  updated.
• Granular, inter-department and corporate testing.
• Forward looking scenarios risk management
  tested.
• Back-testing from catastrophic outcomes.
• Must cater for a full range of complex products,
  for all external market situations including
  major liquidity and reputational changes, and for
  high-risk counterparty failures.
• Pipeline and warehousing risk to be tested
  despite the underlying instruments being
  securitised.
• Supervisors to be closely involved and to take
  action on deficiencies. Scenarios to be
  challenged.
• Regulatory capital could be adjusted.

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Revisions to the market risk framework

• The trading book capital charge for a firm using
  the internal models approach for market risk
  would be subject to a general market risk capital
  charge, measured using a 10 day VaR at 99
  confidence level, as well as a stressed VaR
• Incremental regulatory capital (IRC) should
  capture not only default risk but also migration
  risk
• Modelling incremental risks for un-securitised
  products the IRC of the standardised
  measurement method would be applied to these
  products
• Justification required for any factors used in
  pricing which are omitted from the VaR
  calculation
• Use hypothetical back-testing, at least for
  validation. Update market data at least monthly,
  more frequently if necessary
• Scope of the prudent valuation is extended to all
  positions subject to fair value accounting

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Changes to risk in the trading book

• IRC captures default risk and credit migration
  risk, clustering, correlation and
  diversification any incremental charges for
  default and migration losses are added to the VaR
  capital charge for Market Risk model parameters
  to include - basis risk per product, Internal /
  external rating, seniority, maturity, payout
  triggers and procedures must pass the Use Test
  
• Consistency between trading and banking books
  99.9 confidence levels over a 1 year capital
  horizon and Capture the impact of rebalancing at
  the end of liquidity horizon
• Issuer and market concentrations (within and
  across product classes) will attract higher
  capital charges. No cross-netting of positions in
  different instruments
• Capital charges for securitisation (inc.
  re-securitisation) must reflect positions in the
  banking book trading book charges can not be
  less than the capital charges if it were in the
  banking book.

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Modifications to the framework

• Resecuritisations to carry a greater charge
• Banks may not use ratings for exposures based on
  guarantees provided by the bank itself
• Securitisations cannot rely on rating agency
  credit ratings alone - discount on short term
  weightings to be removed
• ICAAP to build excess capital over benign periods
  in the credit cycle in order to withstand a
  market downturn
• The originate to distribute business model,
  remuneration practices and risk concentrations to
  receive greater scrutiny by supervisors under
  Pillar 2.
• Firms to carry out their own internal rating
  process for securitised instruments as well as
  using credit rating agencies
• Reputational risk to be identified and
  quantified.
• Greater disclosure of securitised and
  resecuritised instruments under Pillar 3
  required.

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Implementation issues

• The following implementation plan is proposed
• Enhancements to Pillar II recommendations
  (Proposed enhancements to the Basel II
  framework and Principles for sound stress
  testing practices and supervision) - 1st July
  2009
• Enhancements to Pillar I III (Proposed
  enhancements to the Basel II framework) - end of
  2009
• Enhancements to trading book (Guidelines for
  computing capital for incremental risk in the
  trading book) and market risk changes
  (Revisions to the Basel II market risk
  framework) - end of 2010
• Implementation includes changes to systems and
  processes, management structures, capital
  allocations and the necessary regulatory
  approvals.

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PRMIAs response

• The time was too short to respond to the market
  risk and risk in the trading book papers (less
  than 2 months).
• PRMIA is in the process of responding to the
  changes in Proposed enhancements to the Basel II
  framework (not the Pillar 3 changes)
• Analyse the report
• Isolate major comments and questions
• Ask relevant members of PRMIAs C-Suite members
  (CROs, peers and direct reports) to review the
  questions
• Collate the responses (145 senior members)
• Review, summarise and comment
• Present findings to the BCBS by 16th April

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Key findings in PRMIAs response

• Securitisation is a rapidly shrinking market,
  those that stay inn it should not be allowed to
  pass on all the risk to others.
• Banks should not be outsourcing all their credit
  rating analysis.
• Both capital and liquidity buffer supported
• Strong wish for supervisor definition of many
  areas including reporting, handling of buffers
  and stress testing
• Greater formality of the role of risk management
  expected reporting to board, risk committees
  (as audit committees) and external risk reviews
  being some of the suggestions
• Control of remuneration risk wished for but
  little confidence that this could happen
• There is insufficient guidance or definition to
  hit the 2009 deadlines.
• The operational risk capital charge should have
  been reviewed and a leverage deposit ratio
  introduced in these changes.

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What else does PRMIA plan to do?

• To continue to influence through lobbying, press
  releases, production of white papers etc
• Create a foundation for new best practices to
  supplement the PRMIA standards
• Update the PRM exams based on the above also
  create new exams, i.e. Islamic risk management,
  Basel II/III, etc
• Expand PRMIA Case Studies and Ethics/Governance
  Standards
• Create board room training programs
• More events/forums for members to hear and speak
• Create/strengthen the member electronic debates
• Increase members services in making more
  materials available over the web site
• To create a profession to be seen to stand up
  and be heard

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• Thank you
• David Millar
• Chief Operating Officer
• david.millar_at_prmia.org