Why Should Risk Managers adopt an IRB approach … · ¾Internal Ratings Based (IRB) Foundation:...

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Why Should Risk Managers adopt an IRB approach under

Basel II ?


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Please Note


We Will Try and Address the Following

1. What does Basel advise on Risk Management …

2. Why chose the Internal Risk Based (IRB) approach …

3. How do we measure Risk Ratings …4. Where do we go from here …

Topics


What is Basel II?

1. Refining the quality of risk exposure and allocating reserves more efficiently (allocating them on an economic basis)

2. Encouraging banks to start using improved techniques in risk measurement and control

3. Shifting the reliance to Risk Rating Facilities (vis obligors & types)

Risk Weights are in line with Risk Ratings not ResidencyIncreased number of mitigants as collateral (vis cash and gtors)

Anyone of three types of Methodologies can be Adopted.Adjustments made to accounting of Provisions

Was created in June 2004 and will help in:

Changes from Basel I

• Pillar 1: Banks’ allocation of economic capital.• Pillar 2: Regulators’ Powers (more discretion on complex issues+more bureaucracy).

• Pillar 3: Market Disclosure Standards (risks and capital allocation)

3 Pillars

Due 2005/6 for most banksWill be easier for more “sophisticated” international banksWill require many changes for more “traditional” banks

Implementation


Capital vis Assets

• The Ratio of Capital to Assets does not change at 8%• What changes is the way Assets are measured. • As such, the amount of capital to be allocated is also changed.

Capital vis Assets

1. Credit Risk: Changed substantially. Calculated using Risk Weights2. Market Risk: Remains unchanged. Calculated using Value at Risk.3. Operational Risk: A new category altogether. Calculated using either

15% of Gross Revenues or combines Businesses and related Risks

Ratio of Capital to Assets unchanged at 8% (Tier 1 min 4%)

Capital

Credit Risk + Market Risk + Operational Risk

Assets are now Broken into 3 parts:

= 8%

So if (CR+OR) increase, then Capital has to

increase to satisfy 8%New

CriteriaSame

Value at RiskNew Risk Weights


The Various Methodologies

Standardized: Risk Weights are based on External Agencies Internal Ratings Based (IRB) Foundation: LGD is fixed at 50% (75% for subordinated) and the bank has to calculate PD using empirical dataInternal Ratings Based (IRB) Advanced: Leaves it to the bank (in coordination with regulator) to calculate PD and LGD.

The more sophisticated, the lower the

capital allocation


5 Categories:Establish

Appropriate Risk

Environment

17 Risk Management Principles Identified by Basel


17 Risk Management Principles Identified by Basel

A. Establish an appropriate Credit Risk environment

B. Operate under a sound Credit Process

C. Maintain appropriate Credit Administration

D. Ensure adequate controls

E. Enhance Supervisory Role

Addressed in 5 Categories


A. Establish Appropriate Credit Risk Environment

1. Board of Directors to approve and review at least annual Credit Risk Strategy and Significant Credit Risk policies to reflect tolerance for risk and appropriate level of profitability

2. Senior management to implement the strategy and develop policies and procedures to identify, measure and control credit risk

3. Bank to identify and manage credit risks in all products and activities, to ensure that the new products or activities are subject to adequate risk management procedures and are approved by Board / Appropriate Committee

Involvement of Board of Directors, Senior Management

and General Management


B. Operate Under a Sound Credit Process

4. Bank to operate within sound, well-defined credit granting criteria, including a clear indication of Target Market, KYC, Purpose and Structure of Credit, and Source of repayment

5. Establish credit limits at obligor and Single Risk Name, and account for concentrations

6. Clearly-established process to approve new credits, amendments, renewals, and refinancing existing credits.

7. Extensions to be made on arm's length basis, particularly to affiliates.

Well-Defined


C. Maintain Appropriate Credit Administration8. Establish a system for ongoing administration of

credits9. System for monitoring the condition of obligors and

adequacy of provisions and reserves held.10. Develop and utilize internal risk rating system

consistent with size and complexity of bank11. MIS and analytical techniques to measure all credit

risk, and provide information on portfolios and concentrations.

12. System to monitor composition and quality of credit portfolio

13. Take into consideration future changes in economic conditions when assessing obligors and portfolios and conduct stress tests.

MIS


D. Ensure Adequate Controls

14. System of independent and ongoing assessment of the Credit Risk Management process, with results provided to Board of Directors and Senior Management

15. Credit function is properly managed and exposures are within prudent standards and limits. Exceptions to policies, procedures, and limits are reported in timely manner and at appropriate approval levels.

16. System for Early Remedial Action on deteriorating credit, problem management and workouts.

Approvals and Early Warning


E. Enhance Supervisory Role

17. To ensure that banks have systems in place, to conduct independent valuation, and set prudent limits for Single Risk Names

More Involvement


So Why IRB ?


Reasons for an IRB Approach

1. Saves on Capital, balancing the new cost of Operational Risks

2. It optimizes Risk Management Processes and Control

Reduces Credit Costs

3. Improves Pricing decision making4. Improves Credit decision making5. Improves Portfolio Management

Improves Decision Making

6. Helps create a credit culture7. Standardizes common approach to credit throughout

the organization

Enhances Overall Credit


1. Saves on Capital - simple example of Reduced Capital Allocation

CoFac il i ty

No Type Limit Loan Eq. Risk Adj. RRLoss Norms

(bpts)Weighted Average

A 1 OD 2,178 100% 2,178 AA 0 02 OD 250 100% 250 AA 0 03 FX 2,550 50% 1,275 AA 0 04 FX 500 50% 250 AA 0 0

B 1 OD 817 100% 817 A 0.4 3272 LCR 2,000 100% 2,000 A 0.4 8003 LG 1,089 50% 545 A 0.4 218

C 1 LC 1,361 20% 272 Baa 7 1,9052 LG 2,450 50% 1,225 Baa 7 8,575

D 1 OD 2,178 100% 2,178 Ba 56 121,9682 LC 100 20% 20 Ba 56 1,1203 LG 2,178 50% 1,089 Ba 56 60,984

E 1 TL 1651 100% 1,651 B 291 480,4412 FX 550 50% 275 B 291 80,025

Total 19,852 14,025 54 756,363

Capital 8% 1,122 56

Exposure Converted into Loan

Equivalent Amounts

Total Reserves calculated using

Loss Norms

Old Capital 1,122New Capital 56


2. Optimizes Risk Management Processes and Control

By competency, experience, specialization etcIncreased number of views with increasing riskPre-defined involvement of Board of Directors

Appropriate Management Involvement

Manages Concentration RisksAutomatically confines risks to pre-allocated levelsStandardizes the process of allocating exposureControls product risks and management

Management of Risk

Mechanisms applicable in all divisions, across all geographiesStandardizes approving authority mandates

Process Control


3. Improves Pricing Decisions - New Banking Business Model

Revenues (net of funding costs) ie Marketing / Selling Business Margin

(2:1)less Expenses (Wages, Rent, etc) from Rev/Exp ratio

Loss Norm =EAD*PD*LGD

(EL) 3%

3%

6%

less Cost of Credit / Operation / Market

Net Profits before Taxes and Other Reserves (UL) ROEC target

Based on the adopted Risk Rating System and verified by empirical evidence for measuring PD and LGD

Cost of Credit


4. Improves Credit Decision Making

The higher then risk factor, the more structured the facilityHelps outline rationale for granting, extensions and renewals of credits.Helps set elevator management in administration of credits Allows for MIS and close monitoring of obligorsHelp manage Early Problem Recognition and Remedial Management program

Has the Ability to Quantify Risks and

therefore set appropriate

action/mitigants


5. Improves Portfolio Management

CoFac il i ty

No Type LimitLoan Eq.

Risk Adj. RR

Loss Norm

Weighted Average

A 1 OD 2,178 100% 2,178 Baa 7 15,246

2 OD 250 100% 250 Baa 7 1,750

3 FX 2,550 50% 1,275 Baa 7 8,925

4 FX 500 50% 250 Baa 7 1,750

B 1 OD 817 100% 817 B 291 237,7472 LCR 2,000 100% 2,000 B 291 582,0003 LG 1,089 50% 545 B 291 158,450

C 1 LC 1,361 20% 272 Ba 56 15,2432 LG 2,450 50% 1,225 Ba 56 68,600

D 1 OD 2,178 100% 2,178 B 291 633,7982 LC 100 20% 20 B 291 5,8203 LG 2,178 50% 1,089 B 291 316,899

E 1 TL 1651 100% 1,651 Baa 7 11,5572 FX 550 50% 275 Baa 7 1,925

Total 19,852 14,025 Ba 147 2,059,710

Same methodology, but summations are

done collectively rather than by

group/borrower.


Assume

Perform the following changes and note the PRR:

1. Client B requested an increase in its OD facility to 4,400

2. Due to a problematic year, the risk rating of A reduced by two notches

3. During the year, clients B and D’s facilities 3 and 2 respectively were switched to Short Term Loans

Note the changes to PRR


Portfolio Risk Rating (PRR)

CoFacil i ty

No Type LimitLoan Eq.

Risk Adj. RR

Loss Norm

Weighted Average

A 1 OD 2,178 100% 2,178 Baa 7 15,246

2 OD 250 100% 250 Baa 7 1,750

3 FX 2,550 50% 1,275 Baa 7 8,925

4 FX 500 50% 250 Baa 7 1,750

B 1 OD 4,400 100% 4,400 B 291 1,280,4002 LCR 2,000 100% 2,000 B 291 582,0003 LG 1,089 50% 545 B 291 158,450

C 1 LC 1,361 20% 272 Ba 56 15,2432 LG 2,450 50% 1,225 Ba 56 68,600

D 1 OD 2,178 100% 2,178 B 291 633,7982 LC 100 20% 20 B 291 5,8203 LG 2,178 50% 1,089 B 291 316,899

E 1 TL 1651 100% 1,651 Baa 7 11,5572 FX 550 50% 275 Baa 7 1,925

Total 23,435 17,608 B 176 3,102,363

Change in B’s Borrowings



CoFac il i ty

No Type Limit Loan Eq.Risk Adj. RR

Loss Norm

Weighted Average

A 1 OD 2,178 100% 2,178 B 291 633,7982 OD 250 100% 250 B 291 72,7503 FX 2,550 50% 1,275 B 291 371,0254 FX 500 50% 250 B 291 72,750

B 1 OD 817 100% 817 B 291 237,7472 LCR 2,000 100% 2,000 B 291 582,0003 LG 1,089 50% 545 B 291 158,450

C 1 LC 1,361 20% 272 Ba 56 15,2432 LG 2,450 50% 1,225 Ba 56 68,600

D 1 OD 2,178 100% 2,178 B 291 633,7982 LC 100 20% 20 B 291 5,8203 LG 2,178 50% 1,089 B 291 316,899

E 1 TL 1651 100% 1,651 Baa 7 11,5572 FX 550 50% 275 Baa 7 1,925

Total 19,852 14,025 B 227 3,182,362

Change in A’s Risk Rating



CoFac il i ty

No Type Limit Loan Eq.Risk Adj. RR

Loss Norm

Weighted Average

A 1 OD 2,178 100% 2,178 Baa 7 15,246

2 OD 250 100% 250 Baa 7 1,750

3 FX 2,550 50% 1,275 Baa 7 8,925

4 FX 500 50% 250 Baa 7 1,750

B 1 OD 817 100% 817 B 291 237,7472 LCR 2,000 100% 2,000 B 291 582,0003 OD 1,089 100% 1,089 B 291 316,899

C 1 LC 1,361 20% 272 Ba 56 15,2432 LG 2,450 50% 1,225 Ba 56 68,600

D 1 OD 2,178 100% 2,178 B 291 633,7982 OD 100 100% 100 B 291 29,1003 LG 2,178 50% 1,089 B 291 316,899

E 1 TL 1651 100% 1,651 Baa 7 11,5572 FX 550 50% 275 Baa 7 1,925

Total 19,852 14,649 Ba 153 2,241,439

Change in Facility Types


6. & 7 Enhances Overall Credit Culture

Increases the Credit Awareness and StandardsUse of the same language throughout the organizationUse of the same methodologies in managing risk

Enhances the Overall Credit Environment


OK, what do we need to consider?


Issues Relating to Cost of Credit

PD =

Risk Rating

Is dependent on various factors including financials, management, industry, environment etcIts value is verified using empirical evidenceShould be controlled and managed over time

Process to be managed to ensure maximum recoveriesCan be reduced using specific methodologiesEffectiveness of control is assessed using empirical evidence

LGD


Common Reasons for Corporate Failures

Too much debt 28%Inadequate leadership 17%Poor planning 14%Failure to change 11%Inexperienced management 9%Not enough revenue 8%Other 13%(source ibisassoc.co.uk) 100%

Total Management

51%

Inexperience includes: 1.too much credit to

clients2.inadequate

inventory levels3.inadequate

borrowing practices

Dun and Bradstreet rates it higher at 87% covering:• Incompetence 46%• Lack of Management Experience 30%• Lack of Product and Service Experience 11%


How to apply PD - Pillars of a Risk Rating System

ManagementFinancial Strength

Industry Environment

Risk Rating

30% 50%

10% 10%

1 10

Character, Depth, MISRisk Mgt, Experience

Story, Projections,Sensitivity

Trends, Market Share,Technology, Talent

Economy, Politics,Contagion, Trends

1-10 1-10

1-10 1-10

1. Used to show degree of riskiness

2. Includes both financial and non financial elements – each rated on a scale of 1 to 10 (1 lowest risk)


How to Reduce Probability of Default

Identify and Stick to a Target Market and Risk Acceptance Criteria (TM & RACs)

Chose Your Clients Carefully

Use appropriate analytical techniques to assess financials, identify associated risks, and measure them

Assess Financial Performance

Assess non-Financial Attributes

Assess Management, and other non-financial risks

Amount, Duration, Covenants, CollateralDoes the client need it, can it repay on time etc…

Structure Facilities

Appropriately


How to Reduce Loss Given Default

Quality Relationship

ManagersHire effective and experienced relationship managers

Understand and React to Early Warning SignalsEarly Problem

Recognition

Manage Internal Information and Approval Processes Efficiently

Classification System & Control

Manage Negotiations EffectivelyIncrease CollateralTighten Structuring

Effective Negotiation Skills


What is Risk Management?

Our job is to:

1. Identify Risks2. Assess their

impact on the client’s future ability to repay

3. Structure our lending to minimise losses in case of default

Do not Know Client

Fully Control Client

Risk Scale

5% 20% 60% 15%

Nam

e Le

ndin

g

His

tory

Projections and Calculation of Future

NOCF

Unexpected events

Base Case Sensitivity

Management / Other Structuring


Where to Go From Here?

Quantitative Analysis of Default Predictions is here to stay.The “one-size-fits-all” approach is very expensive, very uncompetitive, and belongs in a museum.Banks need quantitative expertise not only for building the methodology, but also for selecting the right approach.Change your Credit Culture and start TrainingChange your Processes and ProceduresThis is NOT a software problem ala Y2K.

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