Essential Risk-Based Capital Concepts and
the (Not So New) Basel II Accord
FCA
FASTrack Capital Workshop
June 15, 2006
Bruce J. Sherrick
Section C2
iFAR
integrated Financial Analytics and Research, LLP
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Some Quotes…..

“The proposed new Basel II Accord is now described and
amended on over 750 pages of text, and the word ‘agriculture’
does not appear once.” (Peter Barry’s observation at the Capitalizing
for Risk in Agriculture Symposium, subsequently revised upward)

“The impact and consequences of Basel II will be immense for
financial institutions. New processes and procedures need to
be implemented, and there is a tremendous need for new data
management…. data issues are enormously complex requiring
(long histories) and external validation” (Susan Andre)
Some More Quotes…..

“Basel
I aged quickly and not gracefully”
John Hawke, Comptroller of the Currency, 2002

“… these proposals on Basel II and the amended Basel I
represent substantial revisions to the regulatory risk-based
capital rules applied to U.S. banking institutions, from the very
largest to the smallest” Governor Susan Schmidt Bies, 2006

“Far better an approximate answer to the right question than
an exact answer to the wrong one – the latter of which may be
made arbitrarily precise via a redefinition of the question”
(various attributions including Sherlock Holmes)
Does Basel II ask the right questions?
Introduction to Economic Capital
 Basel-II’s Role in encouraging the “right
amount” of economic (rather than
regulatory minimum) capital
 Basel II and the FCS
 Some Strategic Implications

Views of “Capital” differ:

Owners see as synonymous to wealth:




Financial Officers (CFO, Treasurer…):



Funding source and capacity for growth
Constraint
Regulators:


Growth in value
Current Return (income)
Riskiness of growth and return stream
Safety and soundness: Historic View that Too Much is
Never Enough
Basel II – Economic Capital Aligned for Efficiency
…Economic Capital
Risk Emphasis:
Hold Economic Capital to Cover

Future losses



Expected: loss allowance
Unexpected: equity
Arising from



Credit risk: borrower’s default
Market risk: effects of interest rate changes
on asset and liability values
Operational risk: failed human, performance,
processes and technology
…Economic Capital
Economic Capital Needs
Credit
Risk
Market
Risk
Operational
Risk
Economic
Capital
…Economic Capital
Loss Attributes
Frequency: Probability of default (PD)
 Severity: Loss given default (LGD)
 Amount: Exposure at default (EAD)

N.B.: Separation of PD from LGD is a KEY distinction
from typical risk-rating practices in current practice.
…Economic Capital
What is Economic Capital ?
Various views including:
Amount needed to “insure” against
undesirable outcome with given tolerance
 Guided by actuarial principles and market
pricing of ROE risk
 Backstop for risk and growth
 Includes equity capital and loss reserves

…Economic Capital
Who is this “Basel” anyhow..
Basel Committee on Bank Supervision
 Committee of central banks and regulators
from major industrialized countries
 Headquartered in Basel, Switzerland
 Hosted by the Bank for International
Settlements (www.bis.org)

What Does Basel Do?
Provides broad policy guidelines for each
country’s regulators to adopt or modify
 Forum for Industry interaction
 Extensive staff and research program
 Fosters international monetary and
financial cooperation and serves as a bank
for central banks.

1988 Basel Accord (Basel I)
Targeted at large, international banks
 Adopted by over 100 countries; applied to
all U.S. banks and other financial
institutions, including the FCS
 Slots loans and securities into four risk
classes (e.g. all commercial and
agricultural loans treated the same)
 The de facto standard. Period.

Basel I (1988 cited as 1st adoption)

Advantages




Simplicity
Uniformity
Capital refinement
New measures and
models

Disadvantages





Simplicity
Crude risk classes
Not responsive to
innovation
Ignores diversification
Largely ignores passage
of time and risk
mitigation
Background – Basel I to present



Basel Accord of 1988 aimed to homogenize (capital and other) practices of
internationally active banks, beginning with those in the G-10 countries.
Formally in place now in >100 countries, de facto standard for nearly all.
Represents a Minimum Hurdle view of capital



e.g., 8% with standard weights, non-responsive to changes in non-categoric risks
“The purpose of requiring banks to hold capital is to prevent 1-sided bets.”
– K. Rogoff, Journal of Economic Perspectives, 1999 special issue on
international bank regulation.
Viewed as deductible applied against implied public backstop for financial
institutions.
Background – continued
Asymmetry….

Cost of excess capital not borne by public regulator

Cost of too little capital is borne by taxpayer
Leads to…..
 Rational intent to set capital requirements with high likelihood
for adequacy = low tolerance for insolvency risk
Basel II – the main idea



Basel II consultative (early warning) document in 1999 with indications
that new proposal would represent a move toward “economic” capital and
more market pricing of risk.
January 2001 “package” reflecting comments on proposals and indicating
additional details on risk classes, rating and so forth. First attempt at
timeline for implementation – since delayed formally at least 5 times.
Outlines 3-pillar approach



minimum capital calculations
explicit and more homogenized role of supervisory review
reliance on increased market discipline through increased disclosure
requirements.
Basel II - continued


Early 2002 began development and distribution of QIS
materials – intent to assess the implications for aggregate and
specific capital under new guidelines. Current version is QIS5
template.
Some important information about use of QIS results:

calibration during phase-in



same total capital in system (more later about this point…)
incentive to use more risk-sensitive internal ratings systems
working example: loan asset with .7% probability of default and 50%
LGD and 3 year maturity would require 8% capital.
Basel II - continued

Interest rate risk moved toward “operational risk” and treated
in pillar 2.



Sophistication in funding can transform interest rate risk to counter
party credit risk (W. Staats).
Increased granularity – more finely disaggregated risk
categories in principle leads to better risk-pricing opportunities
– has been bane to FCS Banks – conflict with existing bond
rating categories and Rating Agency tables.
Requires formal evaluation of PD, EAD, LGD, and some
measures of “relatedness” (correlation).
Basel II – Major issues for Ag involve
credit and operational risk
---- Credit Risk ---Evaluation
Mitigation
Operational
Risk
Simple
Standardized
externally supplied
Basic (30%
Gross income)
Intermediate
Foundation Internal
Standardized
Ratings Based
Comprehensive
(beta/gamma)
(IRB)
Advanced
Advanced IRB
Simple
Institution
Calculated,
Regulator
approved
Internal
Measurement
based
adapted from PWC and BIS
Credit Risk Options – the pecking order

Standardized approach


Foundation IRB


Broad categorizations required (no choice); institution assigns ratings
linked to PD calculations. Other inputs set by supervisor/regulator
Advanced IRB


Similar in concept to BASEL I with a few additional risk ranges and
weights.
In addition to PD calculations, institution uses model-based estimates
of LGD and EAD, subject to regulatory approval.
FCS Institutions are planning to be FIRB and AIRB – some
are getting pretty good infrastructure…..
The Basel II Proposed Accord

Basel’s Role: To Standardize Economic
Capital and encourage Efficient Deployment
of Capital.

Allow Market Price of Risk to be determined

Respond to changes in risk through time

Simplify and Homogenize Safety and Soundness
practices
Basel-II’s Role..
Basel II

Basel II is both following and leading

Following “best practices” of the top tier of
banks world wide


Major developments in management, measurement,
and modeling
Leading/stimulating wider adoption and
tailoring to institutional size and
complexity
Basel II Process

First draft - 1999



Second draft - 2001



500 + pages
Too complicated; trades off complexity and refinement
First “Final” version - 2003



35 pages
Too simple
Scaled back with calibration for phase in
Implementation: end of 2006 or later
2nd through 5th Final Versions include QIS studies
and templates for “parallel” calculations and
“calibration” factors.
Basel II – Current Timeline
QIS 3
Calibration
2003
G-10
approvals
Begin Parallel
running
2004
2005 - prelim
2006 - final
Begin phase
in (e.o.y)
2005
2007
2006
2009
2007
2011
2008
Phase in
and begin
enforcement
voluntarily
Prep for
Basel III….
2009 – 95% floor
2010 – 90% floor
2011 – 85% floor
Beyond
Three Pillars
Minimum capital requirements (our focus)
Supervisory review
1.
2.


More intense as an institution uses its
internal systems to measure risk
Goal attainment and management quality
Market discipline
3.

Increased disclosure and market discipline
General Characteristics
Accord contains a spectrum of approaches
 Institutions can choose the appropriate
approach, subject to documentation
and approval
 Incentives (lower capital) are provided for
better risk management

Minimum Capital Requirements
for Credit Risk – 3 approaches
1. Standardized Approach




Similar to existing capital regulations
More risk weighting categories for commercial
loans (0%, 50%, 100%, 125%, 150%)
Mapped to external credit ratings or not
rated
Applicable to “community banks” or those
approved by regulator
2. Internal-Ratings Based Foundation
Approach:

Commercial loans





Institution estimates the probability of default
(PD) for at least eight risk classes and five years
of data
Retail loans: Estimate PD by customer segment
Regulator provides severity of default (LGD)
Regulator approves institutions methodology
Applicable to “regional banks” or those
approved by regulator
3.
Advanced IRB Approach





Commercial loans: Institution estimates PD,
LGD, and EAD
Retail loans: Same as Foundation approach
Adjustments for loan maturity,
concentration, and risk enhancements
More rigorous documentation
Applicable to “Large, Internationally active
banks”, or those approved by regulator
Operational Risks

Failed human practices, processes, and
technology: Enron, WorldCom, Tyco






Fraud
Employment practice and work place safety
Clients, products and business practices
Damage to physical assets
Execution, delivery and process management
Alternative approaches


Percent allocation: 20% - 12%
Build a database for adverse events (type, frequency,
severity)
Market Risk
Risk in trading book
 Addressed in several amendments to
Basel I, using VaR approaches
 Interest rate risk not yet included in
minimum capital requirement, yet explicit
in FAMC, OFHEO regulations
 Much Left to supervisory review

Dual Ratings
Rating the Customer
1.
•
•
Risk classes
Probability of default by class
Rating the loan facility
2.
•
Loan attributes
•
•
•
•
Collateral quality
Seniority of claim
3rd party guarantees
Loss-given default by attribute
The Dual Rating Idea
Customer
Related
Expected
Loss
EL
=
=
Loan Related
Probability
of
Default
x
Loss
Given
Default
PD
x
LGD
x
Exposure
at
Default
EAD
Economic Capital includes UEL or the Unexpected Loss as well.
Risk Tolerance
___% capital should be adequate ___% of
the time
 How Safe – How many vote for:








50% of the time
95% of the time
99% of the time
99.97% of the time
100% of the time (don’t lend)
Now answer as a borrower…
Greater safety = more conservative =
more expensive
Basel’s Risk Rating Factors

At a minimum, methods and data should account
for:










Historical and projected cash flow repayment ability
Capital structure
Quality of earnings
Quality of information
Operating leverage
Financial efficiency
Financial flexibility: Liquidity
Management quality
Position in industry: Peer group standing
Country risk
Correlations and Concentrations

Very real effects





Correlations: How returns and losses move
together; lower the better
Concentrations: Dominating portfolio positions
by commodities and loan sizes
Measurement challenges
Basel adjusts for concentration and assumes
an average correlation
Ag Losses unlikely to satisfy best principles for
low correlation, low concentration, and easy
diversification
Basel II in Pricing…

Loan pricing



Expected loss: provision and allowance
Unexpected loss: risk premium covers the cost
of holding equity capital (see C8.xls)
Explicit cost of capital in loan pricing against
actual RBC requirement for that loan exposure
Stress Testing
Shocking the model with significant
downgrades of credit quality (increases
in PD and LGD) and assessing capital
adequacy
 Could be linked to changes in borrower
conditions, or macro conditions
 Stress testing is an inherent part of
enterprise-wide risk management
 Economic capital models and measures
should be designed to include stress
testing

To Qualify an IRB system…





Portfolio broken into 9 or more groups: Corp, Retail, Bank,
Sovereign, Equity, Project, etc., – not clear where ag fits
Must demonstrate ability to estimate PD and backfit (out of
sample validation) – very tough for small community banks,
small commercial banks with limited ag loans
Collect, store, and update key borrower/loan characteristics –
very tough for ag loans, esp. mortgages
Board and Management Qualifications
Distinctions for credit risk that are “meaningful”

(i.e., cannot use scale where all loans get same score)
Possible Translations…



Development of IRB Risk Rating systems involves tradeoff
between high fixed development cost and (potentially) lower
flow costs. Favors large lenders with good data (FCS, a few
large banks).
Increase pressure to consolidate.
Data becomes increasingly valuable.

Pay to play? Some may opt out, or contract for coordinated
services
Successful == more accurate risk pricing as well.

RBCST parallels (tries to reflect Basel II ideas)

Possible Translations…








Markets are brutally efficient in long run – capital will seek its
highest return.
Operational risk – much larger issue than in past.
Regulator are more “on the hook” in any case.
Basel and FFSC documents have some similar intent to
“promote the standardization in capitalizing, reporting, and
accounting…” (BIS).
Less data availability makes those that are available more
valuable, and increases potential for more “overfitting”.
Disclosure pillar reduces distance (insulation) between
management and boards.
Market discipline – embarrassment of non-compliance will be
critical.
Regulated vs. unregulated lenders (i.e., how will Deere react?).
Top Ten Discussion Points
Regulators much more involved.
 Incentive to avoid interest rate risk or convert to
credit risk.
 Pro-cyclicality (not good news for ag-lenders).
 Flow advantages to IRB methods.
 Fixed cost advantages of non-compliance and
standard approaches.


Ostrich strategies will fail.
Top Ten Discussion Points – cont’d





Different effects on different types of lenders (coops vs. mutual, vs. stock
vs. vendors) New opportunities for packaging/partnering with different
firms if easier to lend to vendor than to customer.
Calibration to current “total on average, but not individual lenders”
strongly favors IRB approaches, very scary for standard approaches.
Current QIS4 and QIS5 Calibration examples seem extreme for ag loans
with good collateral.
Catch-22 of establishing new compliant data systems with length of history
requirements.
Extremely data dependent/model driven – strong likelihood for overfitting
with existing ag data sets. Good potential for increased risk delineation.
“Lead or Follow” a meaningful strategic decision – especially for FCA
FCA Issues …

Huge benefits to standardized reporting, updating financials on
current loans, and development of data warehousing.

Chance for System to manifest “demand for regulation” (ala
Stigler, ADM,….) to suit comparative advantages

Additional pressures for historic data consolidation.

New more complicated incentives and payoffs to capital
arbitrage – and new forms (e.g., w/FAMC).

BIS studies of effects of Basel I found few cases of credit
rationing, likely to be worse with Basel II.