2006 Bank Indonesia Seminar on Financial Stability. Bali, September 2006

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1 Economic Capital 2006 Bank Indonesia Seminar on Financial Stability Bali, September 2006 Charles Freeland Deputy Secretary General

2 IRB approaches - Historical Default Rates High correlation between ratings and default rates S&Ps PD over 5-year horizon Default 0 AAA AA A+ A- BBB BB+ BB- B CCC 2

3 Risk weights under Basel I and Basel II 200% 180% 160% 140% Risk weight 120% 100% 80% 60% 40% 20% 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Probability of default defailt Corporates SME 5mn Retail Basel I Basel II Standardised 3

4 Frequency distribution of credit losses Loss Rate Unexpected Loss (UL) Expected Loss (EL) Time Frequency 4

5 Modeling the tail Frequency of loss Expected loss Unexpected loss Stress loss Amount of loss 5

6 Economic capital (EC) Defined as the amount of capital that a bank or business unit requires in order to support the economic risk it incurs EC is calculated by the institution itself Value-at-risk (VaR) as EC measure: for given confidence level α, EC is the α quantile of the loss distribution of a portfolio minus EL of that portfolio ECα = qα ELPF qα = inf { q > 0 P( LPF q) α} Differences between regulatory and economic capital may lead to capital arbitrage 6

7 Regulatory and economic capital (I) There are differences in the amount of capital available for allocation: The definition of capital available for its internal allocation process is at the bank s discretion In a Bundesbank survey most banks said they used core capital only So the amount of capital used for internal capital allocation can be much lower than Basel capital 7

8 Regulatory and economic capital (II) There are different measures of exposure to credit risk: current Basel I regime Basel II standardised approach IRB approaches full-blown credit risk models (not permitted in Basel II) Differences in risk factors modelled: There are no operational risk requirements under Basel I regime, but a important factor in current internal economic capital calculations 8

9 Regulatory and economic capital (III) Different parameters in calculation confidence level: dependent on the rating the bank aims to achieve 99.9% / 99% for regulatory purposes The difference in level may have a large impact on capital requirements especially for fat-tailed return distributions Multiplier: Scaling factor of 3 (4 for exceptions) in the calculation of market risk requirements only for regulatory purposes 9

10 Convergence (I) Reconciliation of capital calculations difficult due to different demands of bank management and regulators regulatory rules must be objective corroboration of calculations for regulatory purposes must be possible regulatory rules must be suitable for a wide spectrum of banks differing in size specialisation sophistication Regulatory constraints only apply at the bank level 10

11 Convergence (II) In contrast, banks economic capital calculations can be subjective can be tailored to the needs of a bank s specific scope of business business policy risk propensity size EC limits are usually binding at the level of single (sub-)portfolios 11

12 Convergence (III) Gap between regulatory and economic capital requirements narrows with Basel II rules regulatory capital requirements seem to move in line with banks economic capital through economic cycle absolute levels of regulatory and economic capital requirements differ differences only problematic if regulatory capital constraint binding at the bank level 12

13 Credit Risk Mitigation Eligible collateral: restricted in Basel 1 to: Cash on deposit at the lending bank OECD sovereign and PSE securities Some Multilateral Development Banks securities Eligible guarantors: restricted in Basel 1 to OECD sovereigns, PSEs, banks and securities firms Some Multilateral Development Banks Non-OECD sovereigns if local currency and non- OECD banks for short-term guarantees 13

14 Aim of new proposals Improve incentives for banks to manage credit risk in a prudent and effective manner Relate capital treatments to the economic effects of different CRM techniques, delivering greater consistency and flexibility Continue to offer a prudent and simple approach that can be adopted by a wide range of banks Key changes: Expanded range of eligible collateral and guarantors Recognition of more on-balance sheet netting 14

15 Structure of treatment for collateral More recognition of collateral SIMPLE APPROAC H COMPREHENSIV E APPROACH Supervisory haircuts COMPREHENSIV E APPROACH Own-estimated haircuts OWN ESTIMATION OF LGD STANDARDISED APPROACH FOUNDATION IRB ADVANCED IRB More stringent risk management standards 15

16 Eligible collateral Eligible physical collateral: outside the scope of the simple and comprehensive approaches, as collateralisation is incorporated in the LGD measure (Foundation and advanced IRB) Eligible financial collateral: a wider range of eligible financial collateral is taken into account, through the simple and comprehensive approaches. 16

17 Eligible financial collateral In Standardised and F-IRB: With respect to the simple approach: Cash Gold Debt securities with, at least, a BB- rating (for sovereign and PSEs) and a BBB- rating (for other issuers) Unrated debt securities if they are (i) issued by banks, (ii) listed and (iii) senior Equities included in a main index UCITS if (i) they are quoted daily and (ii) the underlying are only instruments listed above With respect to the comprehensive approach: All instruments listed above are eligible But also equities listed and UCITS In A-IRB: no limit 17

18 Haircuts The comprehensive approach : Key risks of collateral Value of collateral can fluctuate over time Market value of the collateral Haircut Adjusted value of collateral Frequency of marking to market Time Banks may not be able to effectively seize and liquidate the collateral (eg documentation or legal risk) To deal with these key risks, the comprehensive approach is built on a system of haircuts 18

19 Basic idea of the comprehensive approach The amount of a collateralised exposure can be reduced by the value of collateral (subject to a given haircut according to the nature of the collateral) The adjusted amount of exposure is multiplied by the risk weight of the counterparty Example Loan of 100 to a 50% risk-weighted counterparty, collateralised by bonds with a present value of 80 that are subject to haircut of 10% Adjusted exposure: (ie 80 less 10%) = 28 Risk weighted loan: 28 x 50% = 14 19

20 Supervisory Haircuts Issue rating for debt securities Residual Maturity Sovereigns Other issuers 1 year 0.5% 1% AAA-AA to /A1 >1 year, 5 years 2% 4% > 5 years 4% 8% A+ to BBB-/A2/A3 and unrated bank securities per para 108d) 1 year 1% 2% >1 year, 5 years 3% 6% > 5 years 6% 12% BB+ to BB- All 15% Main index equities and Gold 15% Other equities listed on a recognised exchange (including convertible bonds) UCITS/Mutual funds 25% Highest haircut applicable to any security in which the fund can invest Cash in the same currency 0% 20

21 Guarantees Eligible guarantors: Sovereigns, PSEs, banks and securities firms attracting a lower risk-weighting than the obligor Other entities rated A- or more Eligible guarantees: Guarantees that provide a direct and unconditional claim on the guarantor The bank must have the legal right to pursue the guarantor for monies outstanding Explicitly documented obligation 21

22 Treatment of guarantees Under the standardised approach: substitution of risk-weightings Example : a loan to a Czech bank, guaranteed by the Czech government would receive a 20% risk weighting, instead of 50% Under the F-IRB: substitution of PDs Example: the same loan would be assigned, for instance, a 0.01 PD, corresponding to a 7.82 RW, instead of 0.05, corresponding to a RW Under A-IRB: reflect the guarantee in PD or LGD 22

23 Keep an eye on BCBS website 23