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

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:

Growth in value Current Return (income) Riskiness of growth and return stream

Financial Officers (CFO, Treasurer…): Funding source and capacity for growth Constraint

Regulators: 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

MarketRisk

Operational Risk

Economic Capital

…Economic Capital

Loss Attributes

Frequency: Probability of default (PD) Severity: Loss given default (LGD) Amount: Exposure at default (EAD)

…Economic Capital

N.B.: Separation of PD from LGD is a KEY distinction from typical risk-rating practices in current practice.

What is Economic Capital ?

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

Various views including:

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.

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

Background – continued

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

adapted from PWC and BIS

OperationalEvaluation Mitigation Risk

SimpleStandardized externally supplied

SimpleBasic (30% Gross income)

IntermediateFoundation Internal Ratings Based (IRB)

ComprehensiveStandardized (beta/gamma)

Advanced Advanced IRB

Institution Calculated, Regulator approved

Internal Measurement based

---- Credit Risk ----

Credit Risk Options – the pecking order Standardized approach

Similar in concept to BASEL I with a few additional risk ranges and weights.

Foundation IRB Broad categorizations required (no choice); institution assigns ratings

linked to PD calculations. Other inputs set by supervisor/regulator

Advanced IRB 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

First draft - 1999 35 pages Too simple

Second draft - 2001 500 + pages Too complicated; trades off complexity and refinement

First “Final” version - 2003 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 Process

Basel II – Current Timeline

2003 2004 2005 20072009 – 95% floor

G-10 approvals

QIS 3 Calibration

Begin Parallelrunning

Begin phasein (e.o.y)

Phase inand beginenforcementvoluntarily

Beyond

Prep for Basel III….

2006

2007

2008

2009

20112010 – 90% floor2005 - prelim

2006 - final 2011 – 85% floor

Three Pillars1. Minimum capital requirements (our focus)2. Supervisory review

More intense as an institution uses itsinternal systems to measure risk

Goal attainment and management quality

3. Market discipline 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 Ratings1. Rating the Customer

• Risk classes• Probability of default by class

2. Rating the loan facility• Loan attributes

• Collateral quality• Seniority of claim• 3rd party guarantees

• Loss-given default by attribute

The Dual Rating Idea

ExpectedLoss

CustomerRelated

Probabilityof

Default= x

Loan Related

LossGiven

Default

Exposureat

Defaultx

LGDPD EAD= xEL

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.