Basel 2: Current Status

1. Basel 2: Current Status Phil Rogers, HSBC Bank Credit and Risk 25 July 2006

2. What is Basel 2? • A more risk sensitive, method of assessing the capital adequacy of financial institutions…….. • which encourages banks to develop more sophisticated credit and operational risk management techniques…… • whilst preserving the overall level of capital in the banking system

3. 3 Pillars • Pillar One: Minimum Capital Requirements. (Bottom up) • Pillar Two: Supervisory Review Process. (Top down) • Pillar Three: Market Discipline (Public Disclosure)

4. 3 Types of Risk will Require Capital • Credit Risk. Far more sophisticated approach than current Basel 1 Accord • Operational Risk. New capital charge • Market Risk. Modified version of current rules. Defined by the Trading Book Review, 2005

5. Legal Framework • The BIS Framework Document, published July 2005, known as “Basel 2”, is an agreement of Central Bankers only. It has no legal status • In the EU the legal authority derives from the Capital Requirements Directive (CRD), September 2005 - not identical with Basel 2 • In the UK the Rules are implemented by the FSA Prudential Source Book (BIPRU) - not identical with CRD

6. 3 Approaches to Credit Risk • Standardised Approach (SA), a modified version of Basel 1. Generally regarded as suitable only for smaller banks • Foundation Internal Ratings Based Approach (FIRBA) • Advanced Internal Ratings Based Approach (AIRBA)

7. 3 Approaches to Operational Risk • Basic Indicator (capital based on 15% of income). Suitable only for smaller banks • Standardised (capital based on 12% to 18% of income depending on risk of individual business lines) • Advanced Measurement (capital assessed using the Bank’s operational risk models)

8. Timings for Credit Approaches • Standardised Approach and Foundation IRB Approach: From 1 January 2007. Must be in place by 1 January 2008 • Advanced IRB Approach: From 1 January 2008 • IRB Approaches have experience requirements for the use of ratings and a 1 year parallel run • US has delayed until 2009 at the earliest, but delay in the EU considered unlikely

9. Basel 2 Credit Parameters • Probability of Default (PD) • How likely is it that the customer will default in a 12 month period? • Exposure at Default (EAD) • What will exposure to the customer be at default? • Loss Given Default (LGD) • How much of the exposure at default will be lost?

10. IRB: Foundation re Advanced • For Foundation IRB banks estimate only PD for non-retail exposures. EAD and LGD are set by the regulators. For retail exposures banks estimate all 3 parameters • For Advanced IRB banks estimate PD, LGD and EAD • Advanced is, therefore, more costly, more complex and subject to higher quality standards but • It is intended that there should be capital incentives for banks to adopt more comprehensive and accurate measures of risk

11. Credit Risk associated with an exposure is a function of the characteristics of both borrower and facility Credit Risk of Transaction Borrower characteristics Facility characteristics How much exposure do you have to this facility? What would you expect to lose on this facility if the customer defaults? Who are you lending to? Probability of Default (PD - %) Exposure at Default (EAD - £) Loss Given Default (LGD - %)

12. Expected Loss • Long run average of losses in a portfolio • Analysis should be based on at least one full economic cycle (but most UK banks do not have the data) • Is not part of capital calculation, but is a cost to the business. • Is expected by Basel 2 to be covered by provisions. Any difference between EL and provisions must be explained and a capital adjustment may be necessary

13. Components of Expected Loss • 12 month Probability of Default (PD) % • Loss Given Default (LGD) % • Exposure at Default (EAD) £ • PD x LGD x EAD = Expected Loss

14. Examples of Expected Loss Probability of Default (%) Loss Given Default (%) Exposure at Default (£) Expected Loss (£) / (%) x x = PD - 0.07% LGD - 39.5% EAD - £2.8m £784 0.028% x x = LGD - 24% £470 0.017% x = x LGD - 11% £216 0.01% x x =

15. Unexpected Loss • Part of Regulatory and Economic Capital Calculation • Is a function of PD, LGD, EAD plus Loss Volatility • Level is determined by complex algorithms • For Regulatory Capital algorithms are set by the regulator

16. Expected Loss is the average loss Unexpected Loss measures the variability around the Expected Loss (one standard deviation) Expected & Unexpected Loss Portfolio 1 Portfolio 2 Source: Moody’s KMV

17. Examples of Basel 2 RWA and Capital Calculations PD (%) EAD (£) LGD (%) Maturity Credit Risk Basel II Formula Maturity EAD PD LGD EL RWA Capital* 2.5 Years £2.8m 7bp 39.5% £784 £599,977 £47,998 24% £470 £359,986 £28,799 11% £216 £164,994 £13,199 1.2% 39.5% £13,440 £2,451,210 £196,097 24% £8,064 £1,470,726 £117,658 11% £3,696 £674,083 £53,927 Total Capital = RWA*8%

18. Outstanding Issues • Downturn LGD/EAD. The Rules require estimates to be based on downturn experience. UK data not available for many portfolios. Uncertainty re what will be acceptable • Governance. Draft FSA Rules require material aspects of credit rating systems to be signed off by a main Board member. Practicality under discussion • Stress Testing. Draft FSA Rules require banks to stress ratings for a 1 in 25 year event. Practicality for large banking groups under discussion with the FSA

19. Outstanding Issues (2) • Use Test. Banks are required to use Basel 2 risk measures in their day to day business but the level of conservatism required by the Regulators creates challenges in some areas • Home/Host. Balance of responsibility between “home” and “host” regulators not always clear, especially outside EU. Implications of the US delay not fully defined • Pillar 2. Practicalities of the Internal Capital Adequacy Assessment Process (ICAAP) unclear

20. Summary • Banks and other financial institutions must move to Basel 2 by 1 January 2008. Some will already be parallel running • Higher quality business will attract more capital than at present and vice versa • Many financial institutions are upgrading risk management processes to meet the new demands • Some uncertainties but, in the EU at least, it will happen