City University of Hong Kong Professional Seminar on Latest Perspective on Basel II

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City University of Hong KongProfessional
Seminar onLatest Perspective on Basel II

• Simon Topping
• Hong Kong Monetary Authority
• 19 July 2004

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Outline

• Timetable for implementation in Hong Kong
• Range of approaches to be offered
• Transitioning from Basel I to Basel II
• Qualifying criteria for use of basic IRB
  approaches
• IRB validation qualitative quantitative
  aspects / use of benchmarking
• Determining minimum CARs under Basel II
• Changes to HKMAs supervisory approach

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Timetable for implementation in Hong Kong

• Implementation targeted for end-2006
• Following consultation with LegCo FA Panel,
  preparing draft Banking Amendment Bill 2005
  featuring rule-making power for HKMA in
  relation to capital adequacy financial
  disclosure
• Consultation on implementation approach,
  proposals for implementing IRB, draft Bill to
  commence shortly
• Basel II Consultation Group established

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Range of approaches to be offered

• Clearly desirable for all AIs to adopt Basel II,
  but some smaller AIs have concerns about
  cost/benefits
• Default option of standardised approach for
  credit risk ( operational risk, Pillar 2
  Pillar 3)
• AIs meeting qualifying criteria can apply for
  approval to use either basic approach or IRB
  approach
• Therefore for credit risk there will be 4
  options basic approach standardised foundation
  IRB advanced IRB
• While for operational risk there will be 2
  options basic indicator approach standardised
  approach (not AMA)

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Transitioning from Basel I to Basel II

• While the regulatory regime will be Basel
  II-ready by end-2006, some AIs, particularly
  those implementing the more advanced approaches,
  will require an extended period to make the
  necessary adjustments
• Therefore proposing a 3-year implementation
  period from end-2006 to end-2009 for IRB
• During this period transitional arrangements
  will apply
• Generally speaking, all AIs will adopt
  standardised approach at end-2006 unless they opt
  for basic approach or indicate their intention to
  adopt IRB
• Pillars 2 3 will apply to all AIs from end-2006

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Qualifying criteria for basic approach

• Comprises Basel I treatment of credit market
  risks plus operational risk plus Pillars 2 3
• Will be available to all AIs (primarily RLBs
  DTCs, also some smaller banks) which are small
  (total assets less than HK10bn) whose business
  is simple
• Not available for subsidiaries of larger banks
• Also available as an interim measure for AIs
  planning to adopt IRB within the transitional
  period

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Qualifying criteria for IRB

• Available to all AIs that can meet rigorous
  qualitative quantitative qualifying criteria
• AIs rating systems need to rank order quantify
  risk in a consistent, reliable valid manner
• Must provide for a meaningful differentiation of
  borrower transaction characteristics, a
  meaningful differentiation of credit risk,
  reasonably accurate consistent quantitative
  estimates of risk
• Must have been in use for 2 years minimum of 2
  years of data (within transitional period)
• Must cover all material exposures (phased rollout
  allowable, but IRB coverage must reach a target
  level before transition to IRB allowed)

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IRB validation (qualitative aspect)
Qualitative Aspect

• Scope
• Coverage of asset classes
• Appropriate rating system design for AIs
  exposures
• Credible rating operations and process
• Adequate corporate governance and audit
• Adequate use of the rating system

• HKMAs validation methodologies
• Questionnaire for AIs self-assessment
• Checklist for on-site examination

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IRB validation (quantitative aspect)
Quantitative Aspect

• I. Data quality
• Data maintenance
• Use of external data
• sample data checking
• data storage process

• II. AIs internal stress tests used in assessment
  of capital adequacy
• Benchmarking against HKMAs internal
  stress-testing parameters

III. AIs internal validation of PD/LGD estimates
internal statistical tests on discriminative
power of its credit scoring models
IV. HKMAs validation methodologies for PD/LGD
estimates
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IRB validation process

• A. HKMAs benchmarking models for identifying
  underestimated PD/LGD
• Listed companies (empirical testing a PD
  term-structure model)
• Private companies including SMEs (model based on
  financial statements)
• Retail exposures
• RML (empirical testing a model based on
  expected-loss measures)
• Credit cards, small SMEs, personal loans
  (scoring systems)
• Bank and sovereign exposures based on their
  external credit ratings
• Standard VaR validation for equities

IV. HKMAs validation metho-dologies for PD/LGD
estimates

• B. Benchmarking among AIs
• Comparing PD/LGD of same/similar exposures to
  identify outlier with underestimated PD/LGD
  measures
• Results depend on individual AIs rating
  approaches

• C. Back-testing
• Statistical tests (e.g. Gini coefficient)
• A sufficiently long period of actual default
  history is necessary for meaningful tests

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Validating PD estimates (corporates)

• Among IRB AIs, we could compare PD of
  same/similar exposures to identify outlier with
  underestimated PD measures
• However, it is possible that the use of
  benchmarking among AIs may be constrained by the
  widespread adoption of the same vendors, e.g.
  Moodys KMV
• AIs would not have enough actual default data for
  meaningful back-testing during the initial period
• We therefore need to develop some benchmarking
  models which can be used to identify
  underestimated PD measures (N.B. not developing
  super credit risk models)

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Benchmarking of PD estimation (listed company)
Mapping with SPs default rates Map model PD
term structure of company to SPs default-rate
term structures of different ratings (static
pools cumulative average default rates)
Input market parameter Listed companys leverage
ratio its volatility
Implied 1-year benchmarking PD of company Based
on actual 1-year average default rate of assigned
rating
Assigning model SPs rating Based on mapping
result, a rating is assigned to the company
Model Engine Generate PD term structure of
company
Compare 1-year benchmark PD with AIs 1-year PD
of company based on its IRB system. Based on
comparisons for a number of companies, the
results will indicate any inconsistencies /
systematic underestimation in the AIs PD
estimates.
Empirical tests PD term-structure model based on
133 listed companies with credit ratings (BBB
below) in US with 1,337 data samples at different
time
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Determining minimum CARs under Basel II

• Charge for credit risk under standardised
  approach is likely on average to be slightly
  lower than under Basel I
• However, this will be more than offset by the
  charge for operational risk
• Charge for credit risk under IRB less certain,
  but unlikely to be significantly lower
• Under Pillar 2, AIs will assess their target
  overall level of CAR by means of a capital
  adequacy assessment programme (CAAP) this will
  be subject to supervisory review
• Possible that less buffer or cushion above
  the regulatory CAR will be maintained so CARs
  may fall over time

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Changes to HKMAs supervisory approach

• For AIs on standardised approach, capital
  adequacy requirements o/a credit risk will
  continue to be set by the regulator
• For AIs on IRB approach, however, cap ad
  requirements o/a credit risk will be more
  internally set (N.B. closer to economic capital)
• For all AIs, setting the target CAR (under Pillar
  2) will in the first instance be the
  responsibility of the AI itself, rather than the
  regulator although the regulator will conduct
  its own assessment, at least initially (N.B. a
  development of the risk-based approach)
• Also for all AIs, market discipline (through
  Pillar 3 disclosures) will play an increasing
  role