Implications of Basel II for Agricultural Financial Analysis

1
Implications of Basel II for Agricultural
Financial Analysis

• Bruce J. Sherrick
• University of Illinois
• Center for Farm and Rural Business Finance
• January 28, 2003

2
Some Quotes..

• The proposed new Basel Accord is described on
  over 500 pages of text, and the word
  agriculture does not appear once. (Peter
  Barrys observation at the Capitalizing for Risk
  in Agriculture Symposium)
• 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)

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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.

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Background continued

• 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

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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.
• Outlines 3-pillar approach
• minimum capital calculations
• explicit and more homogenized role of supervisory
  review
• reliance on increased market discipline through
  increased disclosure requirements.

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Basel II - continued

• Early 2002 began development and distribution of
  QIS-3 materials intent to assess the
  implications for aggregate and specific capital
  under new guidelines. Deadline for response was
  Dec. 2002 no news yet from BIS. (see QIS3
  template)
• Some important release information
• post comment period new templates are likely
  being developed
• recognized need for alternatives for small and
  medium sized institutions
• referred to evolutionary implementation
• 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.

7
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.
• Requires formal evaluation of PD, EAD, LGD, and
  some measures of relatedness (correlation).

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Basel II Current Timeline
QIS 3 Calibration
Begin Parallel running
Phase in and begin enforcement voluntarily
Prep for Basel III.
G-10 approvals
Begin phase in (e.o.y)
2003
2004
2005
2006
2007
Beyond
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Basel II Major issues for Ag involve credit and
operational risk
adapted from PWC and BIS
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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.

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To Qualify an IRB system

• Portfolio broken into 6 groups Corp, Retail,
  Bank, Sovereign, Equity, Project not clear
  where ag fits
• Must demonstrate ability to estimate PD and
  backfit (out of sample validation) very tough
  for ag loans
• Collect, store, and update key borrower/loan
  characteristics very tough for ag loans
• Board and Management Qualifications
• Distinctions for credit risk that are
  meaningful
• (i.e., cannot use scale where all loans get same
  score)

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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.
• Successful more accurate risk pricing as well.
• RBCST parallels (tries to reflect Basel II ideas)

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Possible Translations

• Markets are brutally efficient in long run
  capital will seek its highest return.
• Operational risk much larger issue than in
  past.
• Regulator 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 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?).

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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.

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Top Ten Discussion Points contd

• 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.
  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.

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FFSC

• Huge benefits to standardized reporting, updating
  financials on current loans, and development of
  data warehousing.
• Chance to demand regulation (ala Stigler, ADM,.)
• Additional pressures for bank consolidation.
• New more complicated incentives and payoffs to
  capital arbitrage and new forms.
• BIS study of effect of Basel I found few cases of
  credit rationing, may be worse with Basel II.