BASEL II WHERE TO NOW?
Andrew Jennings
January 2009
Disclaimer
Opinions expressed in this presentation are those of the speaker
and do not necessarily reflect the views of Citigroup Inc or its
affiliates
1
BASEL II – Where we are now?
 10 years in its creation
 Banks have spent about £10bn - £20bn on its
implementation
 Many banks have started to report under Basel II
 Significant improvement over Basel I
 BUT …. Still needs improvement
 Greater importance of Pillar 2
 Basel Committee due to release a paper shortly
2
Basel II - Enhancements
 Trading book risk – inclusion of “Event Risk”
 Greater emphasis on Stress Testing
 Review of Off-Balance Sheet exposures
 Treatment of securitisations
 Counterparty risk – reducing credit default swap risk
 Liquidity
 External Audit Quality
 Fair value accounting
 Improved disclosure
 Others??
3
Tier 1 Capital and Stress Testing
Increased attention to Tier 1 ratios
Need to have sufficient Tier 1 capital after a severe
stress event.
Increased attention to severe stress results
Raises pro-cyclicality of Basel II
Consideration of provisioning policies
More emphasis on building up capital in ‘good times’
Implications for banking returns
4
IMPACT OF PROCYCLICALITY UNDER BASEL II
IMPACT OF A RECESSION ON BASEL II TIER 1 CAPITAL RATIO
UNDER A-IRB
20%
Impact of
increased RWA
and losses on
stress Tier 1 +17%
10%
0%
-10%
-20%
Change in Tier 1 Ratio
5
0%
QIS 4&5 Average
Results: Tier 1 -10%
Impact of
increased ECL post
stress: Tier 1 -5%
STRESS TESTING
 Increased importance
 Reverse stress test proposed
 Regulators setting stress testing assumptions
 Regulators set Basel II parameters if data is lacking
 Cover all risks
 Informs forward planning, capital requirements and
risk appetite.
 Contingency capital plans.
6
USE OF STRESS TESTING RESULTS
Severe but plausible stress test across whole bank.
Identify concentrations:
– Single large exposures
– Large losses as a result of large moves of a specific factor (eg
house prices)
– Consider secondary effects and changes in historic correlations.
Identify portfolios with ‘Fat Tails’ e.g.
– Secondary mortgages and some sub-prime mortgages
– Leveraged or Bridge Loans
– Originate to distribute portfolios awaiting sale
– Basis risk of ‘well hedged’ positions.
7
DATA QUALITY
Good quality risk data vital to optimise Basel II capital
requirement.
Poor quality leads to conservative capital estimates
and potentially excessive capital usage.
Credit and finance data need to be, as near as
possible, the same.
– Settlements outstanding,
– Deferred fees
– Impaired counterparties
– Correct mark to market
8
DATA QULAITY (continued)
Include non finance data
– Legal netting where available
– Full collateral data
– Risk ratings assigned
– Counterparty identified
– Comprehensive netting
– Legal vehicle used
– Identify defaults and recoveries promptly and comprehensively
9
Accurate Data for models
 Exposure at Default:
– Volume of data limited so changes can have a disproportionate
effect.
– Particularly noticeable for credit cards and un-drawn wholesale
commitments.
– High quality risk management of use of un-drawn commitments will
have a significant benefit in Basel II capital requirements.
Loss Given Default
– Evidence of downturn LGD and its variation across cycle.
– Management of defaults and recoveries.
– Sectoral and geographic analysis.
10
USE MODELS WHERE POSSIBLE
Operational Risk model – very different distribution
of operational risk.
Expected Positive Exposure (‘EPE’) for OTC
derivatives.
Model ALPHA (below defined regulatory level x1.4)
VaR or EPE for Secured Finance Transactions
(SFTs).
VaR for all aspects of Market Risk, but will include
event risk.
11
POTENTIAL TO OPTIMISE CAPITAL UNDER BASEL II
More difficult than Basel I
Explore those that make sense for your bank – e.g. in
Retail:
– Potential to sell defaulted credits which are difficult to collect
– Reduce undrawn commitments
Explore those that make sense for your bank – e.g. in
Wholesale:
–
–
–
–
–
–
12
Cancel swaps
Reduced intra group exposure
CDS hedging of higher risk exposures
Banking book/trading book split
Undrawn commitments – especially if under 1 year.
Collateralised or covered by parent guarantee.
RETURN ON BASEL II CAPITAL:
Given previous comments there is considerable
pressure on banks’ balance sheets
Most significant ratio to many banks is the Tier 1
regulatory ratio.
Need to optimise return on Tier 1 capital
Reduce assets utilisation
Risk has a vital role in helping identify opportunities.
13
14
Oh Man, I got the
BASEL II Blues !
15