Basel II Creating Value for your Organization

1
Basel II Creating Value for your Organization

• A Post-Basel II/Economic Capital
• Audit Approach

Jacob Fleming Conferences, Barcelona Johan
Feijen, Rabobank Nederland 25/26th February,
2008
2
QUIZ
Based on your score just stay for the BIS II
Tour or have a break for coffee!
3
Program

• Risks Economic Capital
• Risk Economic Capital
• Integrated risk solvency management
• Regulatory Capital Approach under BIS II
• 2. A Post-Basel II/Economic Capital Audit
  Approach
• Basel II Building Blocks
• An integrated Internal Audit Approach

4
The risk landscape of banks

• How popular will my products be?
• How much will people be willing to pay for them?
  
• Will an internet bank target my customers?

• Will borrowers repay their debt?

Business/ Strategic Risk

• Will a foreign borrower be able to obtain the
  convertible currency required to repay his debt?

• Will I incur losses due to unfavourable market
  movements?

• Will my IT system fail ?
• Will someone rob the bank?
• Will I have employess as Nick Leeson or
  Jérôme Kerviel?

• Will interest rates change unfavourably?

Operational Risk

• Will I be able to meet short term obligations
  and will all transactions be settled on time?

4
5
Risk Economic Capital
Complex, integrated method All risksRisk
sensitiveAlligned to target credit rating Risk
diversification
Complex method Credit, Market and Operational
Risk Internal modelling allowedMore risk
sensitiveIRB/AMA approach
Simple methodCredit , Market risk Crude risk
weightingNot very risk sensitive
6
Risk Economic Capital

6 Economic Capital Analytics
7
Risks Economic Capital
Historical loss profile
Loss distribution
7
8
Risk Adjusted Return On Capital (RAROC)
RAROC Risk Adjusted Return (RAR)
100 Average Economic Capital (EC)

• Revenue s 1.000
• Minus Operating Expenses 350
• Gross operating result 650
• Adjustment for actual minus expected Losses
  (90)
• Adjustment for double counting Work-Out Costs in
  LGD and PL (10)
• Adjustment for interest costs due to under- or
  overcapitalization
• (actual capital minus normal economic
  capital) interest-free interest rate (50)
• Result after correction for normal
  capitalization 500
• Tax (e.g. 25) (125)
• Risk Adjusted Return (A) 375
• Economic Capital (derived from economic capital
  models) (RAR) 1.500
• Net Realized Risk Adjusted Return on Capital
  (RAROC) (A/B 100) 25

9
Risk Adjusted Return On Capital (RAROC)
Integrated Risk Solvency Management
10
The Basel II Accord
Pillar 1
Pillar 2
Pillar 3
Minimum solvency requirements
Market Discipline
Supervisory Review
Minimum solvency requirement for credit-, market
and operational risk approval of models by
supervisor
Qualitative review of risk management, internal
solvency management process and embedding in the
internal organisation
Disclosure of information on capital structure,
risk profile and risk management
Financial Institutions
Financial Market
Supervisors
11
Approaches under Pillar 1
12
Solvency requirement Credit Risk
Solvency requirements under the Standardized
Approach
Exposure
Risk-weight
8
Minimum solvency
x
x

Exposure at Default (EAD)
PD
LGD
EAD
M
8
Minimum solvency
x f
x

Solvency requirements under the Internal Rating
Based Approach
PD Probability of Default likelihood of
non-recourse of payments by counterpart () LGD
Loss Given Default loss on collateral in case
of default () EAD Exposure at Default the
amount of exposure including insolvency costs M
Maturity maturity of loan facilities (time)
13
Credit Risk Components
WorkoutCosts
Product
Collateral Value
Collateral Type
Limit
Utilisation
Rating
Customer Segment
Loss given default (LGD)
Exposure atDefault (EAD)
Probability ofDefault (PD)
Expected Loss
X
X
How much of this are we likely to lose?
What will be our exposure at this point in time?
What is the probability that a counterparty will
default?
CounterpartySpecific
TransactionSpecific
PD () LGD ( EAD () Expected Loss (EL)
14
Example Expected Loss

• Expected Default counterpart(PD) 0,5 (0,005)
• Outstanding amount EUR 450K
• Remaining loan facility EUR 25K
• Work Out Costs EUR 25K
• Collateral/risk mitigants none
• Loss expectation of collateral (Loss Given
  Default) 100
• Expected Loss
• PD EAD LGD 0,005 (450K 25K 25K)
  1,00 2500 (50 bpt.)

Exposure at Default EUR 500K

• Expected Default counterpart (PD) 0,5 (0,05)
• Outstanding amount EUR 450K
• Remaining loan facility EUR 25K
• Work Out Costs EUR 25K
• Collateral pledge of receveivables EUR 500K
• Loss expectation of collateral (Loss Given
  Default) 40
• Expected Loss
• PD EAD LGD 0,005 (450K 50K) 0,40
  1000 (10 bpt.)

Exposure at Default EUR 500K
Conclusion creating a win-win situation with the
counterpart is achievable!
14
15
Steering Regulatory Economic Capital

• Impact of better rated client on EL and EC big
• In this example 30 reduction on EL and 38 on EC

16
Steering Regulatory Economic Capital

• Impact of collateral on EL and EC
• In this example double coverage reduction both
  on EL and on EC of 18.

17
Risk Economic Capital - summary

• Economic Capital is a managerial tool for
• Capital measurement
• Capital allocation (source asset!)
• Capital Planning
• Limit Setting
• Risk Adjusted Return on Capital (RAROC) serves
• To measure performance in a risk-based and
  uniform manner
• Risk based pricing
• Support in credit acceptance process
• Capital Portfolio Management

Economic Capital/RAROC is alligned to Value
Management
18
Program

• Risks Economic Capital
• Risk Economic Capital
• Regulatory Capital Approach under BIS II
• 2. A Post-BIS II/Economic Capital Audit Approach
  
• BIS II building blocks
• An integrated Internal Audit Approach
• BIS II risk assessement

19
Basel II Building Blocks
Risk Capital Strategy
BIS (Project) Governance Framework
Implementation
Data quality Management
Risk Models Methods
Systems
Solvency Reporting
Internal Data
Credit Risk
BU IT systems Central IT systems Interfacing
Solvency Management
Market Risk
Internal Reporting
External Data
Operational Risk
External Reporting
Business Integration
20
Basel II Project Goverance Implementation

• Project governance
• Buy-in senior management
• Sound project structure
• Clear roles responsibilities

• Project Management Implementation
• Sound analysis of BIS II requirements gaps
• Clear action plans
• Reporting on progress, milestones and actions
• Adequate hand-over procedures from project to
  regular operations
• Clear and timely communication to stakeholders
  (Project Board/ Steering Committee, Supervisor,
  Local Management, etc.)

21
Data quality management

• General IT controls

22
Data quality management
Key objectives Completeness Consist
ency Accuracy Correct model use Timeliness
Continuity Reliable risk solvency
reporting Adequate risk solvency management

• General IT controls

23
The model lifecycle
(Re)development
1
Review
Validation
5
Model Governance
2
4
3
Approval
Implementation
24
The model audit approach
(Re)development - Business Units
Documentation
Documentation
Validation - Validation team
Model governance
Policies for model development -validation
Segregation of responsibilities Model coverage
Monitoring Business Unit Validation team
Documentation
Documentation
Approval (Committee)
Implementation - Business Unit IT
25
Basel II System Audits

• Exposures derived from risk systems, not from
  financial systems
• Exposure reconciliations are key
• Exposures according to Portfolios - Models
  Solvency Reporting
• Exposures according to financial systems and risk
  systems
• Adequacy/robustness
• data base structure
• Automated data quality
• integrity controls
• Interface controls
• Continuity change
• management

Reference source COBIT and COSO/Basel II IT
controls
26
Solvency Management Process (ICAAP)

• Capital management plan capital target
• Senior management involvement
• Risk based and comprehensive all material risk
  categories covered
• Forward looking aspects
• Impact of stress-testing
• Contigency planning
• Periodical review of ICAAP including risks and
  capital

27
Basel II internal audit planning
28
Summary

• The financial sector is in a new era of
  Integrated Risk Management and solvency
  management
• Embedding sound risk management techniques in the
  business processes and performance measurement
  are key elements
• A Building Blocks approach for the internal audit
  can add assurance value to your organization

29
Questions?

• j.h.s.feijen_at_rn.rabobank.nl