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Basel II – What does it mean for Canadian banks and investors?
Presented by:
Vivek Wadhwa, McKinsey & Company
January 25, 2008
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Basel II OverviewBackground and TimingNew Concepts
Impact on CapitalBuilding Blocks to Capital Calculations Supervisory Review and Sanity ChecksRegulatory Capital - Basel I vs. Basel IIFactors Contributing to Differences between FIs
Reporting and disclosuresPillar 3 – New Concepts and DisclosuresImplications for Investors and FIs
Agenda
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Basel II Overview
ScopeNew Basel Capital Framework (Basel II) applies to internationally active banks in the G10
Other countries can opt in ̶ a large number
have indicated they will do so
ObjectivesEstablish capital requirements that are more sensitive to a bank's risk profile
Confirm primary responsibility in determining the adequacy of a bank’s capital and its capital assessment process rests with banks
Require banks to provide greater disclosure to the public on their risk exposures (Pillar 3)
Timing in Canada Parallel run completed October 31‘07
Formal implementation as of November 1‘07
Capital floors apply for a two-year transition period to 2009 fiscal year
Market disclosure:̶ Phased in over 2008̶ Full disclosure by
end of fiscal 2008
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Basel II Overview
The Basel II Framework has three mutually reinforcing pillars
Minimum Capital Requirements
Credit RiskOperational RiskMarket Risk ‘98
Supervisory ReviewInternal Standards for Capital Assessment
Market DisclosureRisk AssessmentCapital Adequacy
Pillar 1 Pillar 2 Pillar 3
New Basel Capital Accord
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Basel II Overview
Basel II calculates minimum capital requirements based on exposure to different risks
Credit Risk Operational Risk Market Risk
Risk of losses in on-and off-balance sheet positions arising from movements in market
prices
Potential that a bank borrower or
counterparty will fail to meet its obligations in
accordance with agreed terms
Major changes
Risk of loss resulting from inadequate or
failed internal processes, people and
systems or from external events
New element Minimal change
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Basel II Overview
Credit Risk Operational Risk Market Risk
Internal Ratings Based (IRB) Approaches
Advanced IRB (AIRB)
Foundation IRB (FIRB)
Standardized Approach
Advanced Measurement Approach (AMA)
Standardized Approach
Basic Indicator Approach
Internal Model Approach (IMA)
Standardized Approach
Minimum Capital
Basel II offers a range of capital calculation approaches
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Basel II Overview
Basel II also offers a range of risk reducing treatmentsPrescribed eligible types of collateral Methods of reflecting credit risk mitigation (CRM) impact
Understanding implications of these different approaches to risk and risk mitigation is critical to any basis of comparability of FIs
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Basel II Overview
Impact on CapitalBuilding Blocks to Capital Calculations
Credit Risk including Securitization and Equity HoldingsOperational RiskMarket Risk
Supervisory Review and Sanity ChecksRegulatory Capital - Basel I vs. Basel IIFactors Contributing to Differences Between FIs
Reporting and Disclosures
Agenda
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Building Blocks to Capital CalculationsCredit Risk
OSFI Expectation that:
Banks meeting the following criteria must use AIRB approach for Credit and at a minimum Standardized approach for Operational Risk:
Regulatory capital in excess of $5 billion, or
> 10% of assets or liabilities that are international
Each FI must meet all minimum requirements and obtain approval for AIRB
To adopt an alternate approach for specific credit portfolios orsubsidiaries requires OSFI approval
All other FIs can opt for approach of their choice, subject to OSFI approval
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Building Blocks to Capital CalculationsCredit Risk – OSFI Guidance
OSFI permits:
A phased in adoption of the AIRB approach for material credit portfolios, if an FI requests a “Waiver” of same
Permanent exemption for non material portfolios if requested, subject to approval
A 3 year conversion to AIRB for material portfolios outside Canada, subject to granting an extension to the FI with clear roll out plan
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Building Blocks to Capital Calculations Credit Risk – New Concepts and Definitions
Basel II Credit Risk language
Takes into account outstanding exposures andpotential exposure risks in the event of default
EADExposure at DefaultCan use contractual maturity or effective maturityMMaturity
Driven by the Facility Risk Rating (FRR)May reflect guarantees and/or collateral
LGDLoss Given Default
Driven by borrower characteristics, including Borrower’s Risk Rating (BRR)May reflect guarantees
PDProbability of DefaultDescriptionAbbr.Risk Parameter
Risk parameters are assigned based on the obligor’s and facility’s risk profile
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Building Blocks to Capital Calculations Credit Risk – Example
RWA calculation for a $100 Exposure in a selection of Basel Asset Classes, no collateral impact
2.32.1Maturity in year (M)
$100$100Exposure at Default (EAD)
0.440.38Loss Given Default (LGD)
0.00480.0024Probability of Default (PD)
Borrower 2Borrower 1Risk Parameters
9.404.70Qualifying Revolving Retail32.9517.45Residential Secured54.3531.99Corporate SME
RWA ImpactBasel Asset Class
RWA generally higher on Corporate exposures than Retail
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Building Blocks to Capital Calculations Securitization
Basel II addresses two key areas of securitization
Holdings of securities issued by securitization vehicles
Provision of credit enhancements (mainly liquidity facilities) to securitization vehicles
Basel II treatment very different from Basel I Risk weights are mapped from internal ratings (under Internal Assessment Approach)
Range from 7% to 650% with a 100% Credit Conversion Factor on everythingCan result in dollar-for-dollar capital deduction for facilities with an equivalent rating level below BB-
Basel II treatment is similar to revised Basel I Risk weights are associated with ratings levels
The Basel II risk weights are generally favourable compared with the Basel I risk weightsUnrated positions and those with low agency ratings are deducted from capital in both frameworks
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Building Blocks to Capital Calculations Equities in the Banking Book
Only allowed for:non-tier 1 perpetual pref. shares without redeemable feature perpetual pref. shares with redeemable feature at the issuer’s option
PD’s must satisfy same requirements as bank’s PD estimate Minimum 90% LGD5 year maturity adjustment
Standardized Approach
Prescribed risk weights:
100% in most cases
Internal Ratings Based
Market Based Approach PD/LGD Method
Simple Risk WeightNon material - similar to Standardized Material - risk weighted at 300% (publicly traded), 400% (other equities)
Internal ModelsCapital – same as Internal VaR model Subject to floors equivalent to: 200% (publicly traded), 300% (all other)
IRB also allows for Grandfathering – up to 10 years under Basel I for equity positions as at July 2004
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Building Blocks to Capital Calculations Operational Risk
Standardized Approach Advanced Management Approach
Based on risk measure generated by internal operational risk measurement systemMust reasonably estimate expected and unexpected losses based on:
internal and external loss datascenario analysisbank-specific business environment internal control factors
Requires credible, documented and verifiable approachRequired capital driven by analysis of expected and unexpected losses
Based on Gross income which: Acts as a proxy for the size of the business Serves as an indicator of the operational risk
Grouped into eight regulatory business lines
Each line charged a rate prescribed by the FrameworkAverage over 3 years for each business line X business line’s rate
Required capital driven by the type and size of business lines
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Building Blocks to Capital Calculations Market Risk
Market Risk capital calculations remain largely unchanged from Basel I
Standardized Internal Model
Use requires OSFI approval
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Basel II Overview
Impact on CapitalBuilding Blocks to Capital Calculations
Credit Risk including Securitization and Equity HoldingsOperational RiskMarket Risk
Supervisory Review and Sanity ChecksRegulatory Capital - Basel I vs. Basel IIFactors Contributing to Differences Between FIs
Reporting and Disclosures
Agenda
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Framework for banks to assess their own capital adequacy and processes, including:
Assessment of regulatory capital in conjunction with economic capitalStress testing regulatory capital calculated under Pillar 1Internal capital adequacy assessment processCapital plan
Framework for supervisors to review banks’ capital adequacy and processes, including:
Evaluation of bank’s internal capital adequacy, assessment and strategies, as well as bank’s ability to monitor and ensure compliance with regulatory capital ratio and relevant standardsEarly intervention if a bank’s risks are deemed to be out of proportion with its capitalResolution strategiesFramework to address all other risks not captured in Pillar 1
Supervisory Review and Sanity Checks
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Regulatory CapitalKey Changes from Basel I
50/50 Deductions from Capital
General Allowances
Securitizations rated below BB-A3/P3Any shortfall in GA (above)“Non Delivery vs. Payment” (Non-DvP) failed transactions (where second contractual payment late by ≥5 daysExpected Loss for equity exposures under PD/LGD approachMinority Interest to be deducted
Deductions either didn’t exist or were deducted from Total Capital
Only net residual of Total GA + Specific Allowances less Expected Losses can be included
Included in eligible capital, to a maximum amount
Basel IIBasel I
These factors can represent significant deductions from capital
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Regulatory CapitalTransition Period
Individual FI’s regulatory capital requirement is subject to:
Capital Floors during Transition (if approved by OSFI)FYE 2008: Capital floor is 90% of Basel I calculationFYE 2009: Capital floor is 80% of Basel I calculation
Full benefits of Basel II may not accrue to FI’s during the Transition Period as a result of floors or choices made by the banks
OSFI has the right to increase and/or maintain the floor at their discretion including post Transition Period
OSFI approval required on the methodologies, models, and related estimates for banks implementing AIRB
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Factors Contributing to Differences Among FIs
Various factors will contribute to differences in capital requirements including:1. The risk profile of exposures combined with the calculation approach can
produce significantly different capital requirements2. The composition of a bank’s portfolio – Corporate and Retail formulas
differ3. Coverage of credit portfolios under AIRB and Standardized4. Collateral can favourably impact risk parameters producing lower RWA5. Foreign jurisdiction discretionary rules treatment for foreign portfolios
Basel II is a multi-faceted approach to capital calculations
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Factors Contributing to Differences Between FIs
1. The risk profile of exposures combined with the calculation approach can produce significantly different capital requirements:
Higher risk profile = higher RWA
Under AIRB approach
A bank’s own risk parameters are assigned to each individual exposure based on risk profile (PD, LGD)
Maturity date
EAD factors on undrawn commitments
Under Standardized approachRange of risk weights (0% up to 150%) prescribed by the Framework - linked to external credit ratings, LTVs (mortgages), and/or other risk characteristics
Longer maturities = higher RWA
Higher factors = higher RWA
Higher risk = higher RWA
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Factors Contributing to Differences Between FIs
2. Composition of portfolioCorporate AIRB capital calculation formula different than Retail IRBRetail has no Maturity factorSMEs can be treated as Corporate or Retail, SME adjustment to formula reduces capitalAll things being equal, Corporate formula will produce higher RWA than Retail
3. Coverage of credit portfolios under AIRB and StandardizedStandardized approach typically produces higher RWA
If Bank A has 20% of its portfolios under the Standardized approach and Bank B has 50%, it is reasonable to expect higher RWA for Bank B, all things being equal
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Factors Contributing to Differences Between FIs
4. Credit Risk Mitigation approaches can favourably impact risk parameters producing lower RWA
GuaranteesExample (IRB approach – PD substitution):
Assume a mortgagor is assigned a PD of 20% prior to taking collateral into accountIf the exposure is an NHA insured mortgage, the exposure is treated as ‘Sovereign’ with associated risk parameters (as low as 0% PD)RWA will be reduced significantly
CollateralExample (IRB approach – LGD substitution):
Assume a Corporate loan is secured by US T-BillsThe collateralized loan’s RWA is calculated using secured LGD, which will be much lower than the unsecured LGDRWA will be reduced significantly
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Factors Contributing to Differences Between FIs
5. Foreign jurisdiction discretionary rules for foreign portfolios OSFI typically allows use of foreign national supervisor’s treatment for discretionary items – if treatment is not too dissimilar to Canadian treatmentExample:
If exposure to a foreign Public Sector Entity (PSE) is allowed to be treated as ‘Sovereign’ by the foreign national supervisor, OSFI will allow this exposure to be treated as ‘Sovereign’
OSFI allows preferential treatment to local currency exposures to foreign governments or central banks, provided the respective national supervisors give similar treatmentExample:
If foreign supervisor allows local banks to assign 0% risk weight for their local dollar sovereign debt, OSFI will allow similar treatment
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Basel II Overview
Impact on Capital
Reporting and DisclosuresPillar 3 – New Concepts and DisclosuresImplications for Investors and FIs
Agenda
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Reporting and DisclosuresPillar 3 - Market Discipline
What is Pillar 3?
A set of disclosure requirements to increase transparency and enable market participants to assess important information about a bank’s:
Risk profileRisk management processes Level of capitalization
Particularly important due to reliance on internal methodologies in Advanced Approaches
Use and acceptance of internal methodologies by the Regulator is contingent on a number of criteria including appropriate disclosure
The Framework imposes minimum disclosure requirements on banks, which include 14 tables covering qualitative and quantitative disclosures
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Reporting and DisclosuresPillar 3 Deliverables / Timing
Deliverable Description DisclosureFrequency
ImplementationTiming
Qualitative Disclosures
Information on risk management objectives and processes
Annually Required by year-end 2008
Quantitative Disclosures
Tables detailing risk exposures and capital requirements
Quarterly Canadian banks phasing in over 2008
All disclosures required by year-end 2008
Location of disclosures is at the discretion of the institution, but FIs are encouraged to provide related information in one
location, to the extent possible
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Reporting and DisclosuresOverview of Pillar 3 Disclosures
1: Scope of Application
2: Capital Structure
3: Capital Adequacy
Tables 1, 2, 3: Capital
4: General Disclosures (all Banks)
5: Portfolios s/t Standardized Supervisory Risk-weight in the IRB approaches
6: Portfolios s/t IRB approaches
7: Credit Risk Mitigation
8: Exposures related to Counterparty Risk
Tables 4, 5, 6, 7, 8:Credit Risk
9: For Banks using Standardized and IRB approaches
Table 9: Securitization
10: For Banks using Standardized Approach
11: For Banks using Internal Models Approach (IMA)
Tables 10, 11: Market Risk
12: (Qualitative only)
Table 12: Operational Risk
13: Disclosures for banking book positions
Table 13: Equities
14: Interest rate risk in the banking book
Table 14: Interest Rate Risk
Table format is at the discretion of the institution
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Reporting and DisclosuresNew Concepts and Definitions
Basel Counterparty Types under the IRB ApproachMultiple new classifications which provide added granularity of reporting:
CorporateSovereignBankRetail
Residential SecuredQualifying Revolving Retail (e.g. credit cards and unsecured lines of credit)All Other Retail
Basel classifications will likely not align directly with existing reporting practices
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Reporting and DisclosuresNew Concepts and Definitions
Credit Risk Exposure Types Additional granularity of reporting with exposures categorized as:
Drawn, Undrawn, Repo style transactions, OTC Derivatives, Other Off-Balance Sheet exposures
Sample Table (Credit Risk Exposures):
XXXXXXXXXXXXXXXXXXTotal Gross Credit Risk Exposures
XXXXXXXXXXXXXXXXXXBank
XXXXXXXXXXXXXXXXXXSovereign
XXXXXXXXXXXXXXXXXXCorporate
XXXXXXXXXXXXXXXXXXOther Retail
XXXXXXXXXXXXXXXXXXQualifying revolving retail
XXXXXXXXXXXXXXXXXXResidential secured
TotalOtherOTC
derivativesRepo style
transactionsUndrawnDrawn
Period 1
(millions of Canadian dollars)
Total Gross Credit Risk Exposures By Counterparty Type
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Reporting and DisclosuresImplications for Investors and FI’s
Enhanced granularity of data will allow for more in-depth analysis and improved understanding of underlying risks
However, disclosures will be based on new and/or modified concepts and definitions, making historical comparisons more challengingBanks may select different levels of granularity for their disclosures (e.g. number of Probability of Default (PD) bands)
It will be difficult to compare banks relative to their Basel IIdisclosures, especially in the initial stages of implementation
Calculation approach(es) taken by one bank will likely differ from othersLinks to Basel I and financial statement disclosures are likely to differ at the outset and may become more comparable over timeFI’s have the choice of location of disclosures - MD&A, financial statements, web site - expect refinements over time
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Reporting and DisclosuresImplications for Investors and FI’s
The implementation of Basel II will be an evolution Aggregate amount of capital in the banking system is not expected to change significantly. However, shifts will occur over time as
AIRB coverage of portfolios including international and US subsidiaries increases and other risk parameters evolveRisk management processes become richer and data, testing and models are enhanced
The alignment of risk, capital requirements and business strategy will continue
FIs will continue to more closely align pricing, portfolio composition and risk-adjusted performance with risk and capital
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Investor Relations
BMO Financial Group: Steven [email protected] : (416) 867-5452
Scotiabank: Mahendra [email protected] : (416) 866-7579
TD Bank Financial Group: Kelly [email protected] : (416) 944-5422
National Bank of Canada: Helene [email protected] : (514) 394-5000 ext 0296
CIBC: John [email protected] : (416) 980-2088
RBC: William (Bill) Anderson [email protected] : (416) 955-7804
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Media Relations
BMO Financial Group: Ralph [email protected] : (416) 867-3996
Scotiabank: Ann [email protected] : (416) 933-1344
TD Bank Financial Group: Simon Townsend [email protected] : (416) 944-7161
National Bank of Canada: Denis Dubé[email protected] : (514) 394-8644
CIBC: Rob [email protected] : (416) 980-3714
RBC: Beja [email protected] : (416) 974-5506
