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Basel II – Standardised Approach for Credit Risk Damodaran Krishnamurti 17 Oct 2016
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Basel II – Standardised Approach

for Credit Risk

Damodaran Krishnamurti

17 Oct 2016

Changing Landscape

Pillar 1

Changes

Credit risk

InternalModels Standardized

FIRB

AIRBStandardized

Market risk

Operational risk

IMA Standardized

AMABIA

TSA / ASA

WB-IMF-FED Revised SA - Oct 17, 2016 2

Changing Landscape

Pillar 1

Changes

Credit risk

InternalModels Standardized

FIRB

AIRB

Cred.Standardized

Market risk

Operational risk

IMA Standardized

AMABIA

TSA / ASA

WB-IMF-FED Revised SA - Oct 17, 2016 3

Basel II – SA – Proposed Revisions

Objectives

• To make it more risk sensitive

• To reduce reliance on external ratings

• To increase comparability with IRB approach

• To increase comparability with SA in other jurisdictions – by reducing national discretion

Wider consultation

• Involved a few non-BCBS jurisdictions in the task force (Chile, UAE, Jersey, Philippines, Poland, Thailand,)

• First consultation issued in December 2014

• WBG Survey finding on First CD submitted to Basel Committee (available on BISwebsite at http://www.bis.org/bcbs/publ/comments/d307/wbsaor.pdf )

• Second consultation issued in December 2015

• Expected to be finalized around the new year (2017)WB-IMF-FED Revised SA - Oct 17, 2016 4

World Bank Survey

• Supported by the Basel Consultative Group

• Issued to over 100 jurisdictions

• Received completed responses from 53 jurisdictions

WB-IMF-FED Revised SA - Oct 17, 2016 5

Survey respondents’ operating capital

adequacy frameworks

WB-IMF-FED Revised SA - Oct 17, 2016 6

WB-IMF-FED Revised SA - Oct 17, 2016 7

1 Albania2 Argentina3 Armenia4 Bahamas5 Bolivia6 Bosnia & Herzegovina7 Brazil8 Cambodia9 Cayman Islands

10 China11 Colombia12 Costa Rica13 Croatia14 Czech15 Dominican Republic16 Dubai-DIFC17 Egypt18 Haiti19 Honduras20 India21 Indonesia22 Isle of Man23 Israel24 Jersey25 Jordan26 Kenya27 Lebanon

28 Lithuania29 Macedonia30 Madagascar31 Malaysia32 Mauritius33 Mexico34 Morocco35 Nicaragua36 Pakistan37 Palestinian Territories38 Panama39 Paraguay40 Peru41 Philippines42 Russia43 Rwanda44 Saudi Arabia45 Serbia46 South Africa47 Tajikistan48 Tanzania49 Thailand50 Trinidad & Tobago51 Tunisia52 Uruguay53 Vietnam

Exposure on MDBs

Current framework

Highly rated MDBs – zero RW; Other MDBs – as per external rating (see below)

Proposed framework

• Highly rated MDBs – zero RW (but ….);

• Other MDBs –

• as per external rating (same as above) or

• 50% if jurisdiction does not permit use of external

rating;WB-IMF-FED Revised SA - Oct 17, 2016 8

Exposure on banks

CD - 1

Current framework

WB-IMF-FED Revised SA - Oct 17, 2016 9

Sub debt & non-equity

capital instruments

Equity listed on recognized

stock exchanges

All other equity

250% 300% 400%

• Is Net NPA an effective measure of credit risk in banks

Exposure on banks: Survey feedback (1)

• CET1 Vs Tier 1 and Leverage ratio

• Alternative to CET 1 capital

10WB-IMF-FED Revised SA - Oct 17, 2016

Exposure on banks: Survey feedback (2)

• Can exposures to banks subject to higher minimum capital

requirements justify a lower risk weight?

• Is Pillar 3 disclosure by banks an acceptable source for a

counterparty creditor bank to verify the risk drivers?

11WB-IMF-FED Revised SA - Oct 17, 2016

Exposure on banks: Survey feedback (3)

• Breach of any prudential requirement – 300% RW

• Use of consolidated bank’s ratios when solo are not available

• Proposed need for alternate risk drivers for non-Basel III banks

12WB-IMF-FED Revised SA - Oct 17, 2016

Exposure on banks: CD 2ECRA

SCRA

Equity Sub-debt

250% 150%

13WB-IMF-FED Revised SA - Oct 17, 2016

Grade A Capacity to meet financial commitments; timely; over life of exposure; irrespective of economic cycles & business conditions; must exceed published minimum regulatory requirements & buffers established by the home supervisor

Grade B Substantial credit risk; capacity to repay in full dependent on stable or favourable economic or business conditions; must meet published minimum regulatory requirements

Grade C Material default risks; limited margin of safety; adverse business, financial or economic conditions very likely to lead (or have led) to defaults; has breached published minimum regulatory requirements or adverse audit opinion,

Potential Implications for your jurisdiction

14WB-IMF-FED Revised SA - Oct 17, 2016

Exposure on Corporate

If Risk drivers not provided 300% RW

New corporate – first year 110% RW

Equity exposure 300% RW if listed on recognised stock exchanges; 400%, if not

CD - 1

Current framework

15WB-IMF-FED Revised SA - Oct 17, 2016

16WB-IMF-FED Revised SA - Oct 17, 2016

Exposure on corporates: Survey feedback

• Risk drivers

– 53% (27): Revenue either needs to be replaced by a more sensitive risk driver or

its computation needs to be clarified

– 31% (16): Leverage either needs to be replaced by a more sensitive risk driver or

its computation needs to be clarified

– 85% (45): risk sensitivity can be improved by including additional risk drivers

like industry sector and external ratings

• Availability of financial ratios

– 28% (14): Corporates do not provide data on revenue & leverage

– 49% (25): These data are provided at annual or longer intervals

Corporate: Specialised Lending

Current framework

• Currently no distinct treatment under SA; available under IRB approach

CD - 1

17WB-IMF-FED Revised SA - Oct 17, 2016

Specialised Lending – Survey feedback• Will introducing specialised lending categories enhance the

risk of sensitivity of the standardised approach?

• What percentage of total assets will constitute specialised

lending?

18WB-IMF-FED Revised SA - Oct 17, 2016

WB-IMF-FED Revised SA - Oct 17, 2016 19

Current framework

Equity exposures

• 400%, if not

300% if listed on recognised stock exchanges

CD - 1

Project finance exposures

Project financing: Survey feedback

• Likely influence on project financing models in EMDEs -

where banks may currently fund projects at the development

stage through equity finance

• Materially or significantly higher capital requirements in 56%

of RJs (24 out of 43) because of the revised treatment

20WB-IMF-FED Revised SA - Oct 17, 2016

Current framework

• Basel II SA refers to small businesses;

• Exposures on those that meet eligibility criteria is 75% (included in retail)

• Others – like corporate – 100% if unrated

CD - 1

• Exposures on those that meet eligibility criteria will be 75% (included in

retail)

• Others – included under corporate, can range from 100 to 130% depending

on leverage.

Exposures on SMEs

21WB-IMF-FED Revised SA - Oct 17, 2016

Non-retail SMEs : Survey feedback• Do leverage and revenue appropriately reflect the credit risk

of non-retail SMEs in your jurisdiction?

• The proposed risk weight bucketing for exposures to non-

retail SMEs will increase from 75% to at least 100%. Is the

proposal for this risk weight bucketing appropriate?

22WB-IMF-FED Revised SA - Oct 17, 2016

Exposure on Corporate – CD 2

• Jurisdictions that do not allow use of external ratings

• Flat 75% for investment grade assessments

• Flat 100% for the rest

• Equity exposures – 250%

• Subordinated debt – 150%

• Flat 85% for corporate SMEs; entities where the reported sales of the consolidated

group of which the firm is a part is less than €50 million

• Flat 50 RW add-on for unhedged fx exposures (denominated in a currency different

from the borrowers’ main source of income)

23WB-IMF-FED Revised SA - Oct 17, 2016

Project finance exposures – CD2

24WB-IMF-FED Revised SA - Oct 17, 2016

• As per issue specific external rating, if available

• Other debt exposures will be risk weighted as below:

– Project finance:

• Pre-operational phase 150%

• Operational phase 100%

• Operational phase: … the entity that was specifically created to finance the project has (i) a

positive net cash flow that is sufficient to cover any remaining contractual obligation, and (ii)

declining long term debt.

– Object finance & commodities finance 120%

– Land acquisition, development & construction exposures – moved under “real estate

exposure class” – 150%

• Equity exposures – 250%

• Subordinated debt – 150%

Potential Implications for your jurisdiction

25WB-IMF-FED Revised SA - Oct 17, 2016

Retail exposures

26WB-IMF-FED Revised SA - Oct 17, 2016

Criteria Current Framework Proposed FrameworkOrientation criterion The exposure is to an individual person or

persons or to a small business; excludes RRE

The exposure is to an individual

person or persons or to an SME

borrower; excludes RRE

Product criterion Revolving credits and lines of credit (including

credit cards and overdrafts), personal term

loans and leases (e.g. instalment loans, auto

loans and leases, student and educational

loans, personal finance) and small business

facilities and commitments

No change

Granularity criterion Regulatory retail portfolio should be sufficiently

diversified; may set a numerical limit that no

aggregate exposure to one counterparty can

exceed 0.2% of the overall

regulatory retail portfolio

No aggregate exposure to one

counterparty can exceed 0.2% of the

overall regulatory retail portfolio

Low value of individual

exposures

The maximum aggregated retail exposure to

one counterpart cannot exceed an absolute

threshold of €1 million

No change

Risk weight 75% No change

Unhedged fx exposure No risk weight Additional 50% RW (75% + 50%)

• Is there a need to increase the risk sensitivity of the regulatory retail

portfolio? 60% - No; 40% - Yes

• Is it appropriate to apply a flat risk weight add-on to retail exposures where the

currency of the loan is different from that of the borrower's income?

Retail exposures: Survey feedback

27WB-IMF-FED Revised SA - Oct 17, 2016

Current framework

• Exposures that meet eligibility criteria is 35%

• Others:

– 75% if the exposure qualifies as retail exposure

– Else, like exposure on corporate – max 150%

CD – 1

• Exposures that meet eligibility criteria will be risk weighted as per their LTV and DSC ratios.

• Others: similar to current approach – will be treated as unsecured retail or corporate

exposure – 75% to 130%

• Flat add-on where loans denominated in currency other than the borrower’s main source of

income

Exposures secured by residential real estate

28WB-IMF-FED Revised SA - Oct 17, 2016

Exposures secured by RRE – Survey feedback• Do the chosen risk drivers (LTV and DSC ratios) have sufficient predictive power

of loan default and/or loss incurred for exposures secured by RRE?

• Should the DSC ratio and the value of the property be kept as constant as

measured at origination in the calculation of the LTV ratio?

• Where the counterparty is not an individual (a small business), is the LTV an

adequate risk driver or should it be supplemented by the DSC ratio or any other

risk driver?

29WB-IMF-FED Revised SA - Oct 17, 2016

Exposures secured by RRE – Survey feedback (2)

• Ability to compute LTV and DSC ratios

30WB-IMF-FED Revised SA - Oct 17, 2016

• 22 can compute DSC ratio

• 29 can compute LTV ratio

• 19 have requested additional specific guidance to ensure

consistent calculation of the ratios across banks and jurisdictions

• Is it appropriate to apply a flat risk weight add-on to exposures secured by RRE

where the currency of the loan is different from that of the borrower's income?

• Exposures on those that meet eligibility criteria will be risk weighted as per their LTVratios

• Flat 50 RW add-on for unhedged fx exposures (denominated in a currency different fromthe borrowers’ main source of income)

Ineligible exposures – higher of 100% or RW of Counterparty

Exposures secured by residential real estate – CD 2

Ineligible exposures – 150%

31WB-IMF-FED Revised SA - Oct 17, 2016

Exposures secured by commercial real estateCurrent framework

• 100% risk weight

• National discretion to reduce to 50% for well secured portion, in well developed & long established

markets

Proposed framework

• Exposure that is secured by immovable property that is not a residential property

• Exposures on those that meet eligibility criteria will be risk weighted as per their LTV ratios

• Flat 50 RW add-on for unhedged fx exposures (denominated in a currency different from the borrowers’

main source of income)

Ineligible exposures – higher of 100% or RW of Counterparty

32WB-IMF-FED Revised SA - Oct 17, 2016

Ineligible exposures – 150%

Potential Implications for your jurisdiction

33WB-IMF-FED Revised SA - Oct 17, 2016

Off-balance sheet exposures

CD - 1 CD - 2

For retail

only

34WB-IMF-FED Revised SA - Oct 17, 2016

Off-balance sheet exposures – Survey feedback• Do instruments allocated to each of the CCF categories share a similar

probability of being drawn? And are probabilities implied by the CCF's accurate?

• What is the likely impact on risk weighted assets in your jurisdiction because of

the higher CCF of 10 percent for commitments that are unconditionally

cancellable and 75 percent for commitments other than those that are

unconditionally cancellable?

35WB-IMF-FED Revised SA - Oct 17, 2016

Potential Implications for your jurisdiction

36WB-IMF-FED Revised SA - Oct 17, 2016

Credit Risk Mitigation (CRM)

Current framework

• Simple (substitution) and comprehensive (off-set) approaches for financial collateral;

• Substitution approach for guarantors who have a lower risk weight than the counterparty

Proposed framework

• Simple and comprehensive approaches remain, but proposal to introduce “investment grade” classification

instead of external rating.

– A security of which the issuer has an adequate capacity to meet its financial commitments under the security for the

projected life of the asset or exposure; meaning that: (i) the risk of default by the obligor is low and (ii) the full and timely

repayment of principal and interest is expected.

• Eligible Guarantors: Credit protection given by the following entities can be recognised when they have a lower

risk weight than the counterparty:

– a. Sovereign entities, public sector enterprises (PSEs), MDBs, banks, securities firms, and prudentially regulated financial

institutions;

– b. Parent companies, subsidiaries, and affiliate companies of the counterparty – where the credit worthiness is not

positively correlated with the borrower’s credit risk;

– c. other entities identified as “investment grade” that meet all of the following conditions provided that the credit

protection is not provided to a securitisation:

• For corporate entities, must have securities outstanding on a recognised security exchange;\

• where their credit worthiness is not positively correlated with the borrower’s credit risk;

37WB-IMF-FED Revised SA - Oct 17, 2016

Past Due Loans (Defaulted exposures)

Proposed framework

• IRB definition of defaulted exposure adopted (90 dpd + qualitative)

• Defaulted RREs (net of specific provisions & partial write-offs)– General RREs – 100%

– Income producing RREs – 150%

• Other defaulted exposures (net of specific provisions & partial write-offs)– Unsecured or unguaranteed portion – 150%

– Secured/ guaranteed portion as per CRM framework

38WB-IMF-FED Revised SA - Oct 17, 2016

Current frameworkSpecific provisions as %

of outstanding amount of

the loan

Applicable risk weight on unsecured portion net of specific provisions

Past due loans secured by

collateral other than those

recognised for CRM

All other

past due

loans

<15 100 150 150

15 to < 20 100

20 to < 50 50 100

50 and above 100 - 50 100 - 50

Past Due Loans: Survey feedback• Is it appropriate to re-define this asset class to include all past due assets (not

just past due loans)?

• Is it appropriate to assign a flat risk weight for all past-due assets?

39WB-IMF-FED Revised SA - Oct 17, 2016

Past Due Loans: Survey feedback (2)

• Is it appropriate to include an add-on to the applicable risk weight - which may

vary as a proportion of the amount of provisions? Would holding of higher level

of provisions for past due asset warrant a lower risk weight than for a

performing asset?

40WB-IMF-FED Revised SA - Oct 17, 2016

Current and Proposed Framework: Summary

41WB-IMF-FED Revised SA - Oct 17, 2016

ASSET CLASS CURRENT PROPOSED

Min Max Min Max

Sovereign 0 150 0 150

PSEs 20 150 20 150

MDBs 0 150 0 150

Banks 20 150 30 250

Corporates 20 150 20 250

Retail 75 100 75 100

RRE 35 100 25 150

CRE 50 100 60 150

OBS Items CCF CCF

Commitments

- Unconditionally

cancellable

0 10

- others <= 1 year 20 50 to 75

- others > 1 year 50 50 to 75

NIFs & RUFs 50 50 to 75

Whether the proposed changes will make the

revised framework simpler than the current

framework?

42WB-IMF-FED Revised SA - Oct 17, 2016

Whether the proposed changes will make the

revised framework simpler than the current

framework? Survey feedback

43WB-IMF-FED Revised SA - Oct 17, 2016

Likely overall impact (CD – 1) Survey feedback

44WB-IMF-FED Revised SA - Oct 17, 2016

• Materially or significantly higher capital requirements in 74% of RJs

(32 out of 43). Sources of additional capital requirement are:

– Higher credit conversion factors for off-balance sheet items: about

(32 out of 44)

– Exposure to banks: about 65% of RJs (29 out of 45)

– Project finance exposures: about 56% of RJs (24 out of 43)

– Exposures to non-retail SMEs: about 56% of RJs (25 out of 45)

73% of RJs

– Exposures secured by residential real estate: about 47% of RJs (21 out of 45)

Overall survey feedback

Makes the framework less simple (39 RJs) – without adequately compensating with a more consistent or comparable outcome

Leads to :

- Higher capital requirements (32 RJs);

- Higher cost of borrowing (34 RJs);

- Higher cost of computing and disclosing risk drivers (RDs) (15 RJs)

Likely unintended consequences:

- Pressure to implement Basel III (37 RJs);

- Adverse impact on project financing (38 RJs);

- Adverse impact on lending to SMEs (12 RJs)

45WB-IMF-FED Revised SA - Oct 17, 2016

Survey feedback: Main areas for reconsideration

Risk drivers

• Alternate RD for non-Basel III banks (CET1 Ratio)

• Alternate RD for corporates (Revenue)

• Alternate RD for exposures secured by RRE (DSC ratio)

• Additional guidance for computation of risk drivers to promote consistency and comparability

Treatment of

• Conversion factors for off-balance sheet items

• Non-retail SME exposures

• Equity exposure to corporates

• Specialized lending

Scope for greater role for national discretion and Pillar II

46WB-IMF-FED Revised SA - Oct 17, 2016

QUESTIONS

Thank You

[email protected]

World Bank Group

1818 H Street

Washington, DC 20433


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