OverviewOfIRB

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OSFI Basel II

An overview of the IRB Credit Risk

Approval Process and Using CreditData Reporting as an Approval Tool

Presentation to the CSRSA ConferenceJune 13, 2006

by

Peter Cheung, Manager

Basel Implementation Division, OSFI


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Contents

Overview of IRB Approval Process

Key Supervisory Considerations

Credit Data Reporting Overview

Questions


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Contents




Questions


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Basel II Implementation Milestones

Basel Committee released the Revised Framework in May 2004

Quantitative Impact Analysis(QIS) completed

IRB Gap analysis onsite reviews commenced in Jan 2004 on aquarterly basis

OSFI Consultative Paper on the New Basel Framework issued inJune 2004

OSFI Discussion papers on the following AIRB Guidelines were

issued in July 2004: Approval of AIRB approaches

Collateral Management Principles for AIRB Banks

Data Maintenance at AIRB Banks

The Use of Ratings and Estimates of Default and Loss at AIRB Banks

Validating Risk Rating Systems at AIRB Banks

Risk Quantification of IRB Systems at IRB Banks

Corporate Governance and Oversight at IRB Banks

AIRB Banks submitted draft Rollout plans in Dec 2004.

Formal Application date - Oct 31, 2005

Parallel run Nov 1, 2006

OSFI conditional approval of applications July 31, 2007

Accord Implementation - Nov 1, 2007


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Approval Review Phases

Phase 1- Monitoring of implementation efforts (Nov/04

to Jan/06)

Phase 2 - Formal application (Feb/06 to July/06)

Phase 3 OSFI approval reviews (Aug/06 to July/07)

Phase 4 Pillar 1 approval ( Aug/07 to Dec/07 or

Feb/08)

Phase 5 Ongoing monitoring (from Nov/07)

We are currently at Phase 3


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Key Approval Review Principles

IRB Approval Review principles are consistent with thekey principles of the OSFI Supervisory Framework:

Approval is risk based

Reliance based

Approval is a work-in-progress and will evolve No surprises

Reviews are tailored to the institution

The Basel II minimum requirements are the IRBentry requirement standard and OSFI Approval ofIRB Approaches Implementation Note

Capital impact assessment Effective cooperation with foreign-country

supervisors


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Credit Risk Approval Review Process(April/06 to Dec/07)

Approval reviews will consolidate the resultsfrom:

Reviews of application packages and Self-assessmentprocess

Supervisory Activities

Supervisory Activities: Gap Meetings and status updates ongoing activity,

focused on implementation progress against rollout plans,updates to extensions/waivers, changes to PMO &budgets

RRS Specific Reviews (Examinations) - verification of

self-assessments ( in coordination with IA work). Micro-level, specific sampling using criteria/standards focused onMinimum Requirements & Implementation Notes

Review & monitoring of data submissions for accuracy,timeliness & completeness


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Approval Review Structure

Integrated Review Decision

Self-Assessment

Process

PMO

Waivers and

Extensions

RRS Design

and Operations

Corporate Governance

And Oversight;

Internal AuditValidation, Risk

Quantification

Approval Review Structure

Capital Adequacy

Assessment

Data Management

Use Test


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Contents




Questions


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Use Test Considerations: Overview

Three key use test areas to consider in theassessment of use test performance:

Macro-use related to governance and oversight

Performance track record and demonstration

Micro-use related to internal loss estimates

Domestic Use Test expectations are set out in OSFIsIRB Implementation Note

Use Test is an entry condition for IRB approaches, viz. IRB processes should be integrated with overall risk

management

Banks should use the most appropriate measure for thepurpose at hand, however, banks must show animplementation consistent with IRB

Banks can use point-in-time measures for capital planningand through-the-cycle measures for IRB, but both measuresshould be consistent with a underlying common model


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Use Test Considerations: Individual

Elements

Use test is about understanding and demonstrating theinternal pressures that affect the development of IRBestimates

Systems and estimates should be developed for use outside ofregulatory reporting

There are a number of individual elements related to use

test that could potentially be considered: Pricing

The use and application of risk-based pricing

Conditional vs. unconditional PDs

Comparison (reconciliation?) of Economic and RegulatoryCapital

This is a key requirement for greater flexibility in strict use

Different estimates should be demonstrated as consistent

Banks are responsible for making the case

Performance Measurement

Contract definition and incentive-compatibility


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Use Test Considerations: Individual

Elements (continued)

Individual elements related to use test Role of IRB information in capital decision-making

Information from IRB systems should play a key role

Granularity of use in decision-making

No prescribed approach

The bank will need to make the case that use is effective

Common data vs. common measures Common data is a start

Consistent vision of risk

Risk measures should be consistent but different

So-called capital optimization

Use expectation of individuals and groups should becommensurate with their respective role andresponsibility

Other perspectives of use test

Board and senior management oversight of IRB systems

History of using processes, models, parameters


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IRB Risk Quantification & Validation:

Background

Banks must meet the broad risk-quantification standardsfor own-estimates of PD, LGD and EAD PD estimates must be a long-run average of 1-yr default rates

LGD estimates must reflect economic downturn conditions

EAD estimates must be a long-run default weighted average

EAD Banks must have a robust system in place to validate theaccuracy and consistency of rating systems, processes,and the estimation of all relevant risk components Internal validation processes should be designed to provide

an EFFECTIVE CHALLENGE to the outputs of internal ratingsystems

Risk quantification and validation remains a keyimplementation focus for banks and supervisors The Accord Implementation Groups Validation Sub-Group

(AIGV) is a forum for supervisors to promote IRB validation(and implied risk quantification) discussion and informationexchange


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IRB Risk Quantification & Validation:

Downturn considerations

The Pillar 1 capital formula is driven by an assumption thatdefaults (and possibly severity of default) is driven by a (single)systematic factor

Whether or not a bank accepts the Pillar 1 capital formula, itmust develop a view on the influence of systematic factors

to show that long run averages really represent the long-run

to demonstrate conservatism, where historical data does notincorporate stress years

to demonstrate adherence of the capital planning process tothe requirements set out in paragraphs 434-437 (stresstesting used in the assessment of capital adequacy)

to identify stress years in order to produce a downturn LGD

to explain differences between realised outcomes and

estimates (validation requirements) Downturn LGD estimates some questions to consider:

Where is this applicable?

What are the drivers of downturn (where applicable)?

What are the plausible ranges of drivers that are applicableto downturn and why?


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Implementation Considerations:

Overarching Points

The completion of Basel II implementation is largely

within the grasp of banks. However, much work

remains before (and after!) the start date of Basel II

Basel II wont disappear as Y2K did

Greater comfort and use over time

Ongoing requirements after the start date of Basel II

What might success look like overall?

Pillar 1 processes (e.g., IRB) are seamlessly integrated with

overall risk management

A capital planning process that succeeds in

predicting Pillar 1 requirements (and dynamics)

understanding the interplay of Pillar 1 and Pillar 2 measures

explaining Pillar 1 outcomes to market participants (Pillar 3)

A flexible system that allows risk management to evolve and

permits banks to answer new questions with old data


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Some Issues

Technology is a necessary, but not a sufficient condition

Significant time and resources have been focused ontechnology and data maintenance solutions

While important, the fundamental requirements of riskmeasurement and risk management often remain

Risk Quantification and Validation (IRB) Risk measurement methodologies will need to be innovative

in order to appropriately develop IRB estimates

Long-run estimates (history, condition ranges, etc)

Downturn LGDs (drivers, condition ranges, etc)

Validation processes should create a mosaic of evidence

by combining information from various sources (bothquantitative and qualitative)

The effective challenge principle permits a range of possibleapproaches to structuring this work

Data limitations mean an increasing and necessary role forexpert judgment (credit experts and quants arecomplements not substitutes!)


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Some Issues (continued)

Demonstrating a clear understanding of credit RWAdynamics Acceptance of IRB approaches will mean that a bank has

adequately assessed the dynamic drivers of credit RWA How is regulatory capital expected to vary through the economic

cycle?

How does this dynamic process compare and contrast with thatof a banks internal, capital assessments? (Pillar 1/Pillar 2interplay)

How does stress testing help answer the above?

Review and explanation of capital reporting requirements iskey to managing expectations of different stakeholders

Parallel reporting is the first real opportunity for a meaningfuldress-rehearsal of systems and processes that support capital

computation Analysis of results is essential to promoting greater comfort with

the outputs of Pillar 1 approaches

recognizing and relating changes/differences to risk

comparing capital drivers over time (and to QIS)

continued track record, post-implementation

On going demonstration of compliance


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Supervisory Activities: Self-Assessment and

Approval Recommendation

Review of Self-AssessmentPackages

Self-Assessment

Process Review

Technical/ RRS Specific

Exam Reviews

Conclusion on Self-Assessment

Basel Readiness AssessmentStatus/ Gap

Meetings

Data SubmissionData Submission

QualityQuality

AssessmentAssessment

Approval Recommendation


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Contents




Questions


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Background

OSFI presently collects supervisory data from banks for thefollowing:

Financial Statements

Credit Risk

Market Risk

Liquidity

Capital Securitization

Basel II requirements for approval and ongoing on-site work and

monitoring, resulted in revising the capital and credit risk data

requirements.

Allowed flexibility in the data requirements during the parallel runperiod

Also provided flexibility in reporting requirements for domestic and

international subsidiaries for capital and credit risk data.


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Scope of Credit Risk Data Analytics

Tool to compliment the established Approval process in

IRB risk rating performance

To assess the Financial Institutions credit risk profile

To determine the need for specific reviews

To enable peer comparison and relative benchmarking

On-going monitoring to support credit risk assessment

Use of early warning capabilities


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Work to date - Credit risk data

Developed the list of data requirements within OSFI

Presented the data tables for Wholesale and Retail metrics to CBA

and obtained agreement for the data call during 2005

Final data requirements for both wholesale and retail were

substantially reduced from initial data ask based on industry

comments

Provided data definitions, taxonomies and technical specifications

to the CBA in October 2005.

Set up a OSFI support model to answer questions on the above.

Developed a modified credit risk data call for Standardized banks

Internal work efforts underway to develop analytic reporting

capabilities using a business intelligence tool (COGNOS).


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Portfolios that intend to report on the IRB Approach,

begin reporting Oct 31st 2006

Credit DataReporting

No impact on Capital AdequacyReport requirements

Financial Institutions are

expected to submit internal

management reporting that is

sufficient to characterize therisk associated with these

portfolios

Reports should generally reflectthe types and dimensions of

data presented in the data calldocuments

Submission of the electronic

data call is expected as soon asthe systems are in place, even

if this is before the ultimateapproval date

Internal Ratings BasedTransitional and To Be

Approved

Begin reporting Oct 31, 2006for 4 quarters (i.e., Q1, Q2, Q3

and Q4 of 2007) of meaningfuldress rehearsal

Internal Ratings BasedReady and Approved

Nothing submitted to OSFIbeyond the requirements of the

Capital Adequacy Report

Financial Institutions are

expected to submit

management reporting that issufficient to characterize the

risk associated with these

portfolios

Standardized / Immaterial

Portfolio Approach

Expected by Nov 1, 2010Expected by Nov 1, 2007

Not Necessarily InternalRatings Based


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Details of the credit risk data call

Credit risk data is to be submitted via either of two means:

Electronic flat file structure to be submitted via Automated

Data Transmission facility

A standardized Excel template has been created for some

Economic Capital, Back testing and Transition Matrices.

These to be provided via CD or other electronic medium.

Initial focus is on the Deposit Taking Institutions adopting

the Advanced Internal Ratings Based Approach although

similar deliverables have been created for those that have

adopted the Standardized Approach.

CBA has received business and data definitions fromOSFI. These documents are also available on the OSFI

website.


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Basel II Credit Data Support:Submission of Inquiries

Please submit all inquiries regarding credit data to this

address using the proposed structure (see appendix):

[email protected]

OSFI Website:

www.osfi-bsif.gc.ca


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Appendix:

Basel II Credit Data Support - Proposed

Structure for Inquiries

To expedite inquiries, please ensure that the following items are coveredin each question submitted:

Inquiry References:

For any Business or Technical inquiry, please provide: Full DocumentTitle Document Page Number and Section number (if applicable)Document Schedule Number/Reference (if applicable)

Inquiry:

A concise summary of the question.

Background:

Sufficient background information that supports the inquiry.

Proposal:

A suggested or proposed response or solution that the institution hasconsidered in relation to the inquiry submitted.


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QUESTIONS?

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OverviewOfIRB