Risk Management and
Regulatory Compliance
Yan Wang, Ph.D.
Senior Economist
The World Bank
ywang2@worldbank.org
1
Outline
• Focus on Regulatory capital and Compliance
– Objectives of banking regulation
– Overview of statutory prudential requirements:
• Basel I and calculations
• Credit risk charges for BS and OBS items
• Factor-in Capital charge in individual loan decisions
– Basel II, three pillars
– Pillar 1, credit, market and operational risk
– Pillar 2, and Pillar 3
– implications to Emerging Market Economies (EMEs)
• Link with accounting standards: Establishing
consistency with corporate and statutory risk
compliance and prudential standards
– Good accounting practices
• Summary
2
Integrated View of Risk Management System
Transactions Information
RAROEC Data
Mkt Pricing
Data
Loan Pricing Decision
ALM Data
Loan Approval
Loans Database
Current
Information
Historical
Information
Company Data Updates
Economic Data Updates
Risk Models
Regulatory
Capital
Sup & Reg
Reports
Economic
Capital
Annual
Reports
Investor/
Mkt
Reports
3
Objectives of
Banking regulations
•To protect banks’ depositors
•To ensure the reliability of public good, ie. Money;
•To avoid systemic risk arising from domino effects
•To maintain a high level of financial efficiency
Objectives
Tools
Systemic Risk
Consumer Protection
Capital Standards
Yes
yes
Disclosure standards
Yes
yes
Asset restrictions
Yes
Antitrust enforcement
yes
Conflict-of-Interest rules
yes
4
Source: Herring and Litan (1995)
A survey question
Which of the following capital adequacy
requirements have been implemented in your
country?
1. Risk-weighted capital adequacy ratio with only 4 risk
buckets
2. #1 and off-balance sheet capital charges
3. Simplified Standardized Approach (SSA) in Basel II
4. Use risk-weights under Standardized Approach
5. Internal Ratings-Based (IRB)
Do you agree with the assessment below?
5
Compliance with Basic Core Principles is still
Limited in Developing Countries: do you agree?
Source: Powell (2004)
6
Why should Loan Officers care
Capital adequacy requirements affect
• Pricing of capital, by the degree of riskiness of
your new loan/credit
• Selection of loan /credit products
(on-balance sheet or off-balance sheet?)
• Economic Value Added of an additional project as
EVA= profit – (capital x k)
CA requirements affect capital and k (discount rate or
cost factor)
• RAROC = EVA / capital
• Your bottom line
7
Risk Management Philosophy
Risk-Based
pricing
Optimized
Capital
Allocation
Continuos Improvement
Initiation / Maintenance
Collection tools
Encourage usage
of Credit Tools
Centralized
Strategy
Decentralized
Execution
Risk Management tools
Cost of loosing
business
Decision Making
Reducing Process Costs
Reducing Financial Costs
Sustainability
RM
Autonomy
Consistent portfolio growth, with quality, in a
controlled environment
8
General Supervisory Expectations
Supervisory expectations concerning sound credit risk assessment and valuation for loans
•
The bank's board of directors and senior management are responsible for ensuring that the banks
have appropriate credit risk assessment processes and effective internal controls commensurate
with the size, nature and complexity of the bank's lending operations to consistently determine
provisions for loan losses in accordance with the bank's stated policies and procedures, the
applicable accounting framework and supervisory guidance.
•
Banks should have a system in place to reliably classify loans on the basis of credit risk.
•
A bank's policies should appropriately address validation of any internal credit risk assessment
models.
•
A bank should adopt and document a sound loan loss methodology, which addresses
credit risk assessment policies, procedures and controls for assessing credit risk,
identifying problem loans and determining loan loss provisions in a timely manner.
•
A bank's aggregate amount of individual and collectively assessed loan loss provisions should be
adequate to absorb estimated credit losses in the loan portfolio.
•
A bank's use of experienced credit judgment and reasonable estimates are an essential part of the
recognition and measurement of loan losses.
•
A bank's credit risk assessment process for loans should provide the bank with the necessary
tools, procedures and observable data to use for assessing credit risk, accounting for impairment
of loans and for determining regulatory capital requirements.
•
Supervisory evaluation of credit risk assessment for loans, controls and capital adequacy
•
Banking supervisors should periodically evaluate the effectiveness of a bank's credit risk policies
and practices for assessing loan quality.
•
Banking supervisors should be satisfied that the methods employed by a bank to calculate loan
loss provisions produce a reasonable and prudent measurement of estimated credit losses in the
loan portfolio that are recognized in a timely manner.
•
Banking supervisors should consider credit risk assessment and valuation policies and practices
when assessing a bank's capital adequacy.
9
Incentives to undercount risk
Capital allocation affects measured profitability and creates
tensions within the bank
• Line managers have incentives to understate risk
• Managers may like to influence system design to lower hurdles
• Banks with a higher ratio of available capital to required capital can
expect lower funding costs
Compliance and risk management may have limited information
on what happens in line units
• Line unit personnel may have incentives not to be forthcoming
• If choices about internal risk measures influence the bank's IRB
measures, required capital measures might be distorted
Internal conflicts are important for several reasons
• If risk measurement is twisted, decisions may be poor
• Capital may be less than required for safety
10
II. International Regulatory
Standards (Basel I)
• The 1988 Basel I Accord came into effect in 1992
• Goal: to provide a set of minimum capital
requirements for commercial banks.
• Objective: promote the safety and soundness of
the global financial system, and to create a levelplaying field for internationally active banks.
• The Cooke ratio with only 4 risk buckets
Capital
CookeRatio 
 8%
Risk  weighted Assets
• The risk-based capital charges attempted to
create a greater penalty for riskier assets.
11
The 1996 Amendment
• Amendment separates the bank assets to
– Trading book: fin instruments for resale and
marked-to-market
– Banking book: loans valued at historical cost
basis
• The 1996 Amendment adds capital
charges for
– The market risk of trading book and
– The currency and commodity risk of banking
book
12
Risk Capital: definition
• Tier 1 capital or core capital
– Equity capital or shareholders funds
– Disclosed reserves: share premium, retained profits
and general reserves
• Tier 2 or supplementary capital
–
–
–
–
–
Undisclosed reserves
Asset revaluation reserves
Loan loss reserves
Hybrid debt capital instruments
Subordinated term debt (5 years and plus)
• Tier 3 for market risk only- ST subordinated
debt with a maturity of two years and plus
13
How to calculate Risk Capital
• Of the 8% capital charge for credit risk, at least
50% must be covered by tier 1 capital
• Eligible tier 1 capital for CR + allowed tier 2
capital >= Credit Risk Charge (CRC)
• For on-balance sheet risk charges:
CRC  8%  RWA  8%  (i RW i  Ni )
• Where N is the notional amount of asset i
• See table below
14
Risk capital weights by asset class
(on-balance sheet)
Weights (RW)
Asset Type
0%
Cash held
Claims on OECD central governments
Claims on central gov't in national currency
20%
Cash to be received
Claims on OECD banks and regulated securities firms
Claims on non-OECD banks below one year
Claims on Multilateral development banks
Claims on foreign OECD public-sector entities
50%
Residential mortgage loans
100%
Claims on the private sector (corporate debt, equity…)
Claims on non-OECD banks above one year
Real estate
Plant and equipment
15
Off-Balance Sheet Risk Charges
• Banks expose to credit risk from off-balance
sheet (OBS) items like Letters of credit (LC),
swaps
• The Basel Accord computes a “credit exposure”
through a credit conversion factors (CCFs).
Identified 5 categories and CCFs (see next
table)
• For the first four categories:
CreditExposure  CCF  Notional
16
Credit Risk Charge (CRC) for OBS
CRC (OBS )  8%  ( RWi  50%  Credit Exposure)
i
Example: CRC for letter of credit
Consider a letter of credit of $1.5 million with a domestic
export corporation. What is the credit risk charge (CRC) for
this letter of credit?
17
Factor-in Credit Risk Charge in
loan decisions
• Compare the CRC for loan and LC or other
OBS item [two examples]
• Monitor/ control credit exposure
• Decision on granting or not granting loans
– Use EVA of a project as a benchmark where
EVA= profit- (capital x k)
– Subtract a risk-based capital charge from profits as
in a RAROC type system
Profit  (Capital  k)
RAROC 
Capital
If the addition credit capital charge is higher, then the loan /contract
is less worthwhile in term of RAROC.
18
Total Risk Charge
• Total risk charge is the sum of the credit risk
charges (CRC incl both on-balance sheet and offbalance sheet items) plus the market risk charge
(MRC).
TRC  CRC  MRC  8%  (Total risk  adjusted Assets)
19
III. Intro to Basel II
•
•
•
•
BCBS finalized Basel II in June 2004
Implementation started in 2007 to EU banks
Advanced IRB to be available end 2007
Simultaneous operation of Basel I and Basel II
until 2008
• United States pursuing a somewhat different
course
– Implementing only advanced Internal Rating-based
(IRB) approach
– Mandatory only for the most advanced / top banks
• Other authorities can proceed at their own pace
20
Basel II: Three Pillars
• Pillar 1
Capital
Requirements
• Pillar 2
Supervisory
Review
•Credit risk
•Market risk
•Operational risk
• Consistent review
process
• Intervene timely
• Risks not covered
in pillar 1
• External factor
• “Quantitative”
“Qualitative”
• Pillar 3
Disclosure
• Recommended
disclosure for
• Capital structure
• Risk exposure
• Capital adequacy
“Market Forces”
21
Pillar 1:
Minimum Capital Requirements
• Capital requirements will have greater flexibility
and reflect bank risk
– Some banks will be allowed to assess risk internally,
subject to approval
• There will be a (new) explicit capital charge for
“operational risk”
– Risk unassociated with intrinsic asset values
– Expected to comprise 20% of requirement
• Overall regulatory capital is not expected to
change, but may increase or decrease for
individual banks
22
A. Approaches for Assessing
Credit Risk
•
•
•
•
Simplified Standardized Approach (SSA)
Standardized Approach
Foundation Internal Ratings-Based (IRB)
Advanced IRB
23
1. Simplified Standardized
Approach (SSA)
• Closest to Basel I
• Some minor modifications
– Use Export Credit Agency ratings to calculate
required capital for sovereign risk exposure
– Available on OECD web site
• Corporate capital still at 8%
• Capital requirement for operational risk
– Uses Basic indicator approach
– 15% of gross annual operating income
• Other modest changes
– (lending to sovereign in own vs. foreign currency)
24
2.Standardized Approach for
Credit Risk Assessment
• Banks allocate their exposures to “risk buckets”
defined by regulators
• Risk weights depend on borrower identity
• Two methods of assigning risk weights
– One category below rating of headquarter country
– External risk weighting of institution
– For EME it is tricky as ratings for many firms are not
available –some tips here
• Risk mitigating factors also incorporated
25
Risk Weights Under Standardized
Approach
AAA to AA-
Claims on
Sovereigns
A+ to A-
BBB+ to BBB-
BB+ to B-
Below B-
Unrated
0%
20%
50%
100%
150%
100%
Claims on Banks
Option 1 (rating
refers to
sovereign)
20%
50%
100%
100%
150%
100%
Claims on Banks
Option 2 (rating
refers to bank)
20%
50%
50%
100%
150%
50%
26
What if ratings are not available?
• Tricks and tips
• Quality of the collateral
• Easiness in enforcing the collateral given default
–legal and liquidity issues
• Any guarantees /insurance?
• Export credit rating available?
• Enterprise credit registry / information available?
• Develop your own risk weights tables to be
reviewed by regulators
27
3. IRB Approaches to Credit
Risk Assessment
• Foundation-based approach
– Banks can use their own estimates of loan default
probabilities
– Probabilities are combined with standard estimated of
losses given default to determine value-at-risk
• Advanced approach
– Banks estimate value-at-risk as well
– Limited to most sophisticated banks
28
Regulatory Impact
• Overall capital requirements expected to be
unchanged on average
– Calibrated to “Standard loan”
• 1% default probability, 2.5 years maturity, 45% loss given default
• 8% capital requirement
• Capital requirements will be increasing in credit
risk assessments
• Capital Requirements will also be adjusted for
credit risk concentration
– Excessive exposure to a single borrower subject to additional
capital requirement
– Exceptionally low exposure can lead to reduction at discretion
of domestic regulator
29
Numerical Example
• $10 billion loan
• Basel I: Capital Requirement $800 million
• Basel II:
– If the loan is healthy:
Capital Requirement $100 million
– If Bad loan:
Capital Requirement $4.5 billion
• Bottom Line: Extensive sensitivity to credit risk
under the new program
30
B. Operational Risk
• Basel II also includes a capital requirement for
operational risk
– On average, will offset reduced requirement on rated loans under
standardized approach
– But may not be offset for EMEs with many unrated firms
• Operational Risk also has three alternative methods
/approaches
– Basic Indicator
– Standardized
– Advanced Measurement
• Basel II Accord Total Risk Charge is
TRC  CRC  MRC  ORC
31
Pillar 2:
Supervisory Review
• Committee confirmed the need for
supervisory review in addition to
minimum capital requirements
• Supervisors will determine soundness of
internal processes used to assess capital
adequacy and bank risk
• Intervention under conditions where
violations are found
32
Four key principles
• Banks are responsible for assessing
capital adequacy
• Supervisors role in assessing internal
monitoring of bank
• Banks are normally expected to operate
with capital above regulatory minimum
• Supervisors should intervene into problem
banks at an “early stage”
33
Pillar 3:
Market Discipline
• Disclosure is necessary for market
participants to assess the risk profile
and capital adequacy of banks
• Proposals provide guidance on disclosure
• Capital structure
• Risk Exposure
• Control Environment
• Self-discipline
• “Bailing in” of private sector
34
Pros and Cons of Basel II
• Creates more risk-sensitive capital charges for
credit risk and incl operational risk – benefits
banks with large portfolios and high grade
corporate credits.
• Criticisms of Basel II:
–
–
–
–
–
Growing gap between best practice and pillar 1
Banks operate in diverse environment cannot benefit
Capability to provide fair regulation that is not uniform
Differences btw regulatory constraint and RM
The coherence btw new regulation and new
accounting rules
35
Implementation of Basel
• To implement Basel II the banks require
expensive projects with long lead times
•
•
•
•
•
•
Train staff
Gather historical loss data
Build risk models
Improve IT systems
Implement policies and procedures
One of their first steps is to ask “what will the
supervisors accept?” So, it is country specific
36
Implementation Challenges
• Systems Changes: Many banks have recently revamped their
rating systems to be two-dimensional; others are preparing for this
fundamental change. Most have little experience with this approach.
• Experts Versus Models: Commonly used expert-judgment based
systems may be used, but may face a challenging hurdle in meeting
supervisory standards.
• Rating Philosophy: Banks must more fully articulate their rating
approach (not just “point-in-time” or “through-the-cycle”) and reflect
that choice in other aspects of the rating system.
• Accuracy and Validation: Banks must work to develop appropriate
tests of ratings accuracy; the exact nature will depend on details of
each bank’s rating philosophy.
37
IV. Link with Accting Standards
•Safety and Quality of Loans depends on sound
generally accepted accounting practices consistently
applied. Basle Committee has prepared a lit of sound
practices. (Next Slide)
•Int’l Accting Standard Committee (IASC)/ IASB has
been revising principles
Questions:
•How many of these are applied in your country, in your
institution, in your bank and by you?
•Has the accounting association in your country issued
guidance? Are all IASC standards applied or only some?
•What are the risks of not having good accounting practices?
38
Good Accounting Practices
Foundations for Sound Accounting
1. A bank should adopt a sound system for
managing credit risk.
2. Judgments by management relating to the
recognition and measurement of impairment
should be made in accordance with documented
policies and procedures that reflect such
principles as consistency and prudence.
3. The selection and application of accounting
policies and procedures should conform with
fundamental accounting concepts.
39
Good Accounting Practices (Cont’d)
ACCOUNTING FOR LOANS
Recognition, discontinuing recognition and measurement
4) A bank should recognize a loan, whether originated or purchased, in its
balance sheet when the bank becomes a party to the contractual provisions
that comprise the loan.
5) A bank should remove a loan (or a portion of a loan) from its balance sheet
when the bank realizes the rights to benefits specified in the contract, the
rights expire or the bank surrenders or otherwise loses control of the
contractual rights that comprise the loan (or a portion of the loan).
6) A bank should measure a loan, initially, at cost, which is the fair value of the
consideration given for it.
Impairment - recognition and measurement
7) A bank should identify and recognize impairment in a loan or a collectively
assessed group of loans when it is probable that the bank will not be able to
collect, or there is no longer reasonable assurance that the bank will collect,
all amounts due according to the contractual terms of the loan agreement.
The impairment should be recognized by reducing the carrying amount of
the loan(s) through an allowance or charge-off and charging the income
statement in the period in which the impairment occurs.
8)A bank should measure an impaired loan at its estimated realizable value
40
Good Accounting Practices (Cont’d)
Restructured troubled loans
9) A bank should recognize a loan as a restructured troubled loan when the lender, for
economic or legal reasons related to the borrower’s financial difficulties, grants a
concession to the borrower that it would not otherwise consider.
10) A bank should measure a restructured troubled loan by reducing its recorded
investment to net realizable value, taking into account the cost of all concessions at
the date of restructuring. The reduction in the recorded investment should be
recorded as a charge to the income statement in the period in which the loan is
restructured.
Adequacy of the overall allowance
11) The aggregate amount of specific and general allowances should be adequate to
absorb estimated credit losses associated with the loan portfolio.
Income recognition
12-13) A bank should recognize interest income on an unimpaired loan on an accrual
basis. [Shortened]
PUBLIC DISCLOSURE
14-23) A bank should disclose information about the accounting policies and methods
followed to account for loans and the allowance for impairment. (shortened)
41
Accounting Standards: IAS 39
• IAS 39 establishes principles for
recognizing, measuring, and disclosing
information about financial assets and
financial liabilities.
• A good understanding of this standard is
absolutely necessary for any loan officer.
– If you know IAS 39 then you can ask the right
risk questions
42
V. Best practices going beyond II
24 sound RM practices: G-30 report in 1993
• Role of senior management
• Marking derivatives to market on a daily basis
• Measuring market risk
• Performing stress simulations
• Investing and funding forecast
• Independent market risk mgmt
• Measuring credit exposure
• Independent credit risk mgmt function
43
Risk Management and Compliance
Key Operational Questions
•
•
•
•
•
•
•
•
•
Who has the ownership of credit risk function and framework.?
What are the responsibilities for the management of credit-related work
groups?
Is there a credit portfolio group, credit modeling team, credit risk policy and
reporting teams?
The credit portfolio group --- Does it support the credit officer by
complementing a typically rather transaction-focused view with monitoring
expected and unexpected losses of the credit book, reviewing provisions,
etc?
Who is responsible for compilation and risk reporting, including information
on limit excesses, counterparty ratings, exposures, concentrations, etc.
Who oversees supervision of credit data quality, process and delivery of all
critical credit risk information to various stakeholders and the board?
Who deals with external credit bodies such as rating agencies and
regulators.
Who has ownership of credit processes, including limit setting, provisioning,
credit stress and scenario testing and calculating capital requirements.
Is there benchmarking of performance of credit risk functions between
business units?
44
Summary
• Financial regulations are crucial to reduce systemic risk and
protect consumers. Recent examples during the financial
market turmoil
• CRC affect your loan/pricing decision and your bottom-line
• Compliance with Basel I as well as SSA approach
• Implications for individual loans / credit products/contracts
• The principles of Basel II should be considered by EME:
three pillars. Most country uses SSA approach
• Pros and cons of Basel II are discussed
• Challenges of implementation are discussed
• Established the Link between compliance with accounting
standards
• A list of good accounting practices are provided
• Countrywide Financial: what has failed? discussion
45
Countrywide Financial (CFC)
• Over-exposure to sub-prime mortgage
instruments. Bought by BoA in Jan08 at $4bn
46