The Basel II Accord: What Does It Mean for the North American Leasing Market?

Transcription

1 The Basel II Accord: What Does It Mean for the North American Leasin Market? 4301 N. Fairfax Drive, Suite 550, Arlinton, VA 22203; Lisa A. Levine, CAE, Executive Director Phone: Fax: Website:

2 The premier provider of industry research. The Equipment Leasin and Finance Foundation is the only non-profit oranization dedicated to providin future oriented research about the equipment lease and financin industry. The Foundation accomplishes its mission throuh development of studies and reports identifyin critical issues impactin the industry. All products developed by the Foundation are donor supported. Contributions to the Foundation are tax deductible. Corporate and individual contributions are encouraed. Equipment Leasin and Finance Foundation 4301 N. FAIRFAX DRIVE, SUITE 550 ARLINGTON, VA LISA A. LEVINE, EXECUTIVE DIRECTOR, CAE

3 TABLE OF CONTENTS I. EXECUTIVE SUMMARY... 4 A. Direct Impacts of Basel II... 5 B. Indirect Impacts of Basel II... 5 II. INTRODUCTION... 8 III. EVOLUTION OF BASEL II... 9 A. Basel Accord - Overview... 9 B. Basel II Accord- Overview Basel II Rationale and Objectives Key Chanes The Oriinal Basel Accord versus Basel II Who is Affected by Its Implementation? U.S. Participation Proposed Implementation Schedule IV. THE THREE PILLARS OF BASEL II A. Pillar I - Minimum Capital Requirements Credit Risk a) Standardized Approach b) Foundation IRB Approach c) Advanced IRB approach Operational Risk a) Basic Indicator Approach b) Standardized Approach c) Advanced Measurement Approach Market Risk B. Pillar II - Supervisory Review C. Pillar III - Market Discipline V. POTENTIAL IMPACTS OF BASEL II ON THE LEASING INDUSTRY A. Capital: Cost and Availability Capital Requirements for Lease Exposures Under the Standardized Approach Capital Requirements for Lease Exposures Under the IRB Foundation Approach Capital Requirements for Lease Exposures Under the IRB Advanced Approach Residual Value Risk for Leases Under the IRB Approach Effects on Bank Owned Leasin Companies Impact on Independent Leasin Companies B. Credit & Operational Risk C. Competitive Position D. Securitization of Portfolios E. Impact of Basel II on IT Systems VI. SUMMARY VII. APPENDIX - BASEL II STRUCTURE PAGE 2

4 ACRONYMS In support of this White Paper, the follow acronyms are supplied for reference. AMA EAD EL Advanced measurement approaches Exposure at default Expected loss FIN 46 FASB Interpretation No. 46 IRB Approach LGD LGE PE PD RAROC SME Internal ratins-based approach Loss iven default Loss iven event Probability of loss event Probability of default Risk Adjusted Return on Capital, also known as Return on Risk Adjusted Capital - RAROC Small to medium-sized enterprises PAGE 3

5 I. EXECUTIVE SUMMARY For most executives, the Basel Accord is a European bankin initiative that is a number of years away from completion. Coupled with North American implementation reluctance, Basel II has been a topic that could safely be inored. Well, not any more! Like an iceber, Basel has appeared on the horizon and has steadily and quietly moved closer to its taret of international financial institutions, brinin with it better credit risk measurement techniques. Like an iceber, there is much more to Basel than first meets the eye and leasin company CEO s must ensure that their firm is ready to take action. The Accord will affect leasin companies in North America either directly throuh participation, or indirectly, as the consequences of Basel II are felt lobally, once launched. Are you ready?? PAGE 4

6 A. DIRECT IMPACTS OF BASEL II Most literature on Basel II is focused on its affect on the bankin industry and its subsidiaries which includes leasin companies. This is understandable as the aim of Basel II is to strenthen the bankin credit risk framework. A key difference between Basel I and II is the increase in scope of parent and subsidiary companies that must adopt the Accord if a bank within the roup falls within the framework. This is illustrated in the Fiure 1. This leads to the conclusion that if an equipment leasin firm is a subsidiary of a bank that is adoptin Basel II then it will be directly affected by the Accord. However, the converse is not necessarily true. One key factor that is consistently bein overlooked is the decision by the European Commission of the European Union ( EU ) to adopt Basel II for all credit institutions and investment businesses operatin in the EU not just for internationally active banks. This will have a direct affect on the parents and subsidiaries of finance institutions operatin in the EU and sinificantly increase the number of companies affected by Basel II in North America. Moreover, it draws many more FIGURE 1. Scope of parent and subsidiary companies impacted by Basel II 1 Diversified Group finance companies into the Basel II spotliht. The question then becomes, which institutions will be affected? Fiure 2 illustrates the questions that need to be asked. If taken in isolation, a North American company s decision to adopt Basel II will be its own. At the moment it is unlikely that the adoption of the Accord will be a statutory requirement. In the EU, however, it is very likely that the requirements of Basel II will become part of the statute books of each member country, and adoption of Basel II will be a mandatory requirement for a financial institution to operate. Althouh a date for the chane in statutory reulations in each country has not been set, the intentions of the European Commission have been made very clear. 2 Holdin Company Internationally Active Bank Therefore, if a North American company has any parent or subsidiary company operatin within the EU they will be affected by Basel II. Accordinly, some lare non-reulated leasin companies with European operations will also find themselves directly impacted. B. INDIRECT IMPACTS OF BASEL II 3 Internationally 4 Active Bank Domestic Bank Equipment Leasin Company 1. Boundary of predominantly bankin roup. The Accord is applied at this level on a consolidated basis, i.e. up to holdin company level The Accord is also to be applied at lower levels to all internationally active banks on a consolidated basis. Internationally Active Bank The 10 larest internationally active U.S. banks as well as another 10 lare internationally active U.S financial institutions are expected to implement Basel II. The remainin banks in the United States will continue to operate under the current Accord. There will be, therefore, two types of bank owned leasin companies; we have named them Basel I leasecos and Basel II leasecos. Althouh the other 10 lare internationally active U.S. financial institutions may not be bank owned, references to Basel II leascos may include these companies PAGE 5

7 FIGURE 2. Effected Institutions Am I part of a top 20 US financial institution? YES I may be impacted by Basel II Am I a parent of a European financial institution? YES NO Am I a subsidiary of a European financial institution? Basel I banks and Basel I leasecos may find pressure on them to adhere to Basel II requirements thereby drivin up costs Non-reulated leasin companies fundin costs may rise if they are bank borrowers Availability I am impacted by Basel II YES NO I am unlikely to be impacted by Basel II There may be more bank consolidations resultin in fewer lendin institutions as appropriate. Smaller non-reulated leasin companies may also feel the impact of Basel II indirectly in a number of ways. Some of the potential impacts of Basel II on the leasin industry are hihlihted below: For International Finance Institutions and U.S. Structure U.S. incorporation and compliance strateies Under Basel II, a non-reulated Financial Institution s incorporation stratey for capital adequacy efficiency will be different from the current incorporation strateies employed for tax efficiency. For example, U.S. non-reulated entities decisions to reister their corporate head offices in Delaware for tax advantaeous reasons, may need to review their current structures if the U.S. fully adopts Basel II compliance, as this may not be the most advantaeous place for a head office from a capital adequacy efficiency standpoint U.S. non-reulated Financial Institutions with reulated European subsidiaries may need to consider potential Basel II compliance U.S. non-reulated Financial Institutions that are considerin European expansion will need to assess compliance to Basel II practices in Europe or enter Europe as a Non-Reulated Financial Institution Capital/Fundin Cost Basel II banks will initially face hiher costs to participate in the new Accord includin the introduction of a risk weihtin for operational risk. However, capital requirements will be able to be manaed at a micro-economic level that may allow lower levels of retained capital in the balance sheet offerin improved return on equity ( ROE ). The impact of levels of required capital could be sinificant. See Fiure 3 for details Some banks and bank leasecos may decide to move out of certain sectors for a variety of reasons includin, the hiher capital requirements to support Residual Value based products. This may allow niche players to move in to those vacated sectors Hiher weihtins on some assets may also cause the market to reconfiure as players move in and out of industries Best Practices Risk Assessment and Mitiation Techniques Leasin companies may find themselves pressured to alin their models with Basel II compliant institutions Operations Operational procedures will need to be fully documented and internal audit functions within the bank and bank leasecos may require sinificant additional resources PAGE 6

8 FIGURE 3. Impact of Basel II - QIS 3 & Overview Global Results STANDARDIZED IRB FOUNDATION IRB ADVANCED AVERAGE MAX MIN AVERAGE MAX MIN AVERAGE MAX MIN G10 GROUP 1 11% 84% -15% 3% 55% -32% -2% 46% -36% G10 GROUP 2 3% 81% -23% -19% 41% -58% EU GROUP 1 6% 31% -7% -4% 55% -32% -6% 26% -31% EU GROUP 2 1% 81% -67% -20% 41% -58% OTHER GROUPS 1 AND 2 12% 103% -17% 4% 75% -33% 188 banks in 13 G10 countries Banks calculated capital requirements for consolidated roup exposures Group 1 banks: lare banks with reater than 3 billion Euros in Tier 1 capital Group 2 banks: smaller specialized banks Results show more substantial capital reductions for G10 and EU Group 2 banks (those more retail orientated). There is considerable variation to which capital requirements rise/fall in Basel II for different portfolios Greatest variation for G10 banks is within Foundation IRB - due in part to relative quality of exposures and scale of retail portfolio Test banks were iven 2 months to prepare data - not all banks could provide PD / LGD and EAD Systems Systems will need to be structured and riorously tested prior to implementation. Banks and bank leasecos initially adoptin the lowest level of Basel II compliance should implement systems that will allow transfer to more advanced measures of capital adequacy. In addition sinificant investment may be required for new / improved MIS operations Transparency Basel II requires new levels of disclosure that leasin companies may find become the norm. This may also affect a company s corporate overnance, as more openness and accountability become the standard Securitization Liquidity facilities will now have a risk weihtin applied to it thereby increasin costs Operational risk will also carry a risk weihtin and a capital chare Banks will need to hold additional capital aainst hiher risk tranches On the surface it would appear that Basel II may reduce securitization transaction levels as a way of controllin capital adequacy. After all, one of the main reasons for Basel II is the fact that banks are holdin too little capital to support total level of indebtedness. However, securitization continues to be a viable fundin option and some industry sources speculate that transaction levels may remain the same albeit usin slihtly different structures and with increased costs. It is safe to say that loan and lease pricin will be better matched to risk and there will be pressure on all companies to follow best practices in the future. In view of the foreoin, each leasin company should: 1) Determine if it will be required to comply with Basel II 2) If so, identify which reulator will monitor its business once the Accord is implemented and bein a dialoue 3) Bein reviewin its business practices to establish a plan to move towards Basel II best practice techniques 4) Review IT capabilities, identify areas where improvements are required and communicate budet considerations 5) Dependent on the Basel II approach adopted, review the levels of retained capital required in the Balance Sheet to support its current receivables by product lines. See Fiure 4 of an internationally active Tier 1 bank. PAGE 7

9 FIGURE 4. Risk Weiht Impact Example Bankin Division Mortae Division Capital Division Business Bankin Private Bankin Credit Card International Division Global Investors Other operations and HQ Personal Financial Services RWA Basel I Capital Basel II Capital Excess Capital as % 60% 54% 37% -21% -40% -41% -144% -175% -187% or because they have operations in Europe. The Basel II Accord is a fundamental realinment of the way Banks will operate. Basel II builds on the first Accord and its oal is to improve the safety and soundness of the bankin system by placin more emphasis on a banks internal controls, the supervisory review process and market discipline. This will have broad implications on the equipment leasin industry. Total / Averae Basel II affects all leasin companies in some form. In conjunction with initiatives such as FASB Interpretation No. 46 ( FIN 46 ) and the use of Risk Adjusted Return On Capital models ( RAROC ), Basel II aims to improve the risk manaement practices of financial institutions. Adherence to these practices is simply ood business. II. INTRODUCTION 15.4 This white paper will provide insiht into potential impacts of Basel II on the Equipment Leasin Industry in North America. Within this context, this paper will examine the rationale behind both Basel Accords, hihliht the major differences between them and provide an overview of the rules framework. The Basel Accord has yet to be ratified and some areas discussed in the paper are subject to chane. Our research methodoloy included discussions with several industry members, analysis of the Basel II Accord and supportin articles published by the Basel Committee, and review of many other articles written on the subject. The result proves to be interestin; thouh there is no common consensus as to what the effects of Basel II will be on the leasin industry. Basel II is expected to uniquely impact each company. For example, Basel II is expected to be implemented in the United States by the 10 larest internationally active U.S. banks as well as a further 10 internationally active U.S. financial institutions. The remainin banks will continue to operate under the current Accord. In addition, there are many leasin companies that are nonreulated. These companies may also feel the impact Basel II by, amon other thins, increased costs of borrowin FIGURE 5. Three Pillars of Basel II Pillar I Minimum Capital Requirements Defines detailed proposals for the calculation of minimum capital requirements for credit, market and operational risks 26% The Three Pillars of Basel II Pillar II Supervisory Review Addressed to supervisory community; Ensures compliance with various operational and disclosure standards The Equipment Leasin and Finance Foundation and the ELA believe that the equipment leasin industry should have a better understandin of the Basel II Accord and it s influence and are responsible for the publishin of this white paper. The oriinal Accord and the Basel II Accord are the result of investiation and consultation of the Basel Committee with the bankin industry. The Basel Committee on Bankin Supervision, which meets at the Bank for International Settlements (BIS), was established in 1974 by the Central-Bank Governors of the Group of Ten countries ( One of their main objectives is to close the ap in current international supervisory coverae Pillar III Market Discipline Defines disclosure requirements an institution must meet under Basel II PAGE 8

10 to ensure that no forein bank escapes supervision and that the supervision is adequate. The first capital measurement system introduced, known as the Basel Accord, proposed a preliminary credit risk measurement framework. It has been adopted in over 100 countries. Due to the limitations of this credit risk manaement approach, coupled with industry feedback, the Basel Committee defined a New Capital Adequacy Framework to replace the oriinal Accord. In addition, Basel II oes one step further by attemptin to strenthen the tools used by reulators in different countries. Basel II is scheduled to take effect Q4 of Participatin banks must bein compliance efforts now if they are to strenthen their risk manaement capabilities and ather the extensive data necessary under the advanced credit risk measurement approach. Basel II will not only chane the way banks do business internationally, but also impact leasin companies operatin in North America. A uidin principle of the oriinal Accord is to create a level playin field by closin the reulatory aps with a common framework. Basel II moves away from the common framework concept and reconizes that the more sophisticated a bank is, the less capital is required for the same type of activity. At the heart of Basel II is the rationale that alinment of a bank s capital requirements with both existin and potential economic risks allows them to more effectively manae their business. Adoption and implementation of the oriinal Accord and the new Basel II Accord is up to each member country s reulators, which is expected to yield some reional differences For example, Europe will adopt them at an EU level in the form of a Directive while in the United States, only the larest, internationally active banks are expected to implement the Accord in Basel II is comprised of three mutually reinforcin pillars as shown in Fiure 5: the First Pillar sets capital requirements, the Second Pillar establishes a supervisory review process, and the Third Pillar focuses on market discipline. One of the main issues of the Basel II Accord is the array of credit risk measurement methods stemmin from Pillar 1 which may affect loan pricin to leasin companies. In fact, three options are bein proposed: Standardized approach Foundation Internal Ratins Based approach ( Foundation IRB ) Advanced Internal Ratins approach ( Advanced IRB ) The intent is to allow banks (with supervisory concurrence) to select the most appropriate level of risk sensitivity to coincide with their current level of operations and financial market infrastructure. III. EVOLUTION OF BASEL II A. BASEL ACCORD - OVERVIEW The interconnectedness of banks and the resultin shared risk were some of the drivers that led to the creation of the oriinal 1988 Basel Capital Accord, which focused on the overall amount of capital that a bank must hold. Sufficient capital is critical for limitin a bank s insolvency risk and potential costs for the depositors if the bank fails. This concern over capital stemmed from a number of key concerns, namely: Stability of the bankin system durin late 1970 s early 1980 s Decline in capital held by banks Increase of off-balance sheet activity. See Fiure 6 Why Move to Basel II. Financial institutions have typically souht short-term competitive advantae by maintainin low levels of capital, and thereby reducin costs or conversely increasin their leverae. Thouh bankin in eneral has been heavily reulated by overnment, the introduction of the oriinal Accord added capital requirements, which required internationally active banks to maintain 8% capital to risk weihted assets. However, the Accord has been limited in its effectiveness. An example of this is that the framework does not discern the economic essence of risk. Credit risk is classified in the followin ways and ranked accordinly - Lendin to OECD (Oranization for Economic Co-operation and Development) sovereins is deemed safest Followed by lendin to OECD banks Followed by mortaes Followed by everythin else. In such a framework, and under the Basel rules, a loan to a Fortune 500 company is considered just as risky as a loan to a local coffee shop, whether the coffee shop is located in San Dieo and borrowin in dollars, or in Japan borrowin in yen. Clearly, this crudeness in the approach produced unusual consequences, where the lack of distinction between economic reality and reulatory capital forced suboptimal behavior. By the late 1990s, lare sophisticated banks learned to benefit from portfolio diversification of risk, while the capital markets developed tools to easily buy and sell credit risk. Banks were dis- PAGE 9

11 To promote soundness and stability of the lobal bankin & financial system To enhance competitive equality To provide a more competitive approach to addressin risks and promote best practices in risk manaement the Oriinal accord failed to fully address Credit Risk the Oriinal accord failed to address Operational Risk To provide a more widely applicable approach to the capital assessment process. 2. Key Chanes The Oriinal Basel Accord versus Basel II insentivised to hold prime quality loans which led to a rise in securitization across the U.S. and Europe to reulate capital adequacy and ROE. This dichotomy is considered one of the major influences for the creation of Basel II. B. BASEL II ACCORD- OVERVIEW 1. Basel II Rationale and Objectives Since the introduction of the oriinal Accord, the business of bankin (risk manaement practices, supervisory approaches, and financial markets) has underone sinificant transformation. Consolidation has produced concentration in the bankin industry. Advanced risk manaement techniques have evolved resultin in more specific and detailed treatments of risk. A deficiency of the oriinal Accord is its relative inflexibility in addressin these new realities especially with respect to lare entities. In an attempt to address Basel I s limitations, the Basel Committee decided to draft a new version of the Accord in The Basel II Accord is expected to be finalized and published by the end of 2003, and implemented by year-end The Four principle objectives behind Basel II are: The Bank of International Settlements oal with the oriinal Accord was to level the playin field between banks of all sizes across different countries by reulatin capital requirements. Conversely, Basel II offers sinificantly more sophisticated approaches for capital allocation, and rewards oranizations that are capable of implementin such sophisticated methods. Basel II utilizes three mutually reinforcin pillars to support its approach to capital allocation: 1. Minimum Capital Requirements 2. Supervisory Review 3. Market Discipline. Capital is the most important element when discussin financial institutions, whether banks or leasin companies. The proposed chanes to the minimum capital requirements, the way a bank will interact with its reulators, the definition PAGE 10

12 of profitability for different business lines, and associated behavior are all reasons why the impact will be felt throuhout the financial services industry. Some of the effects of these chanes to the minimum capital requirements are: 1. It is expected that the amount of capital currently required to be held by banks will chane dramatically. Some lare sophisticated banks may find a sinificant surplus created by this chane. This could provide capital for repatriation as well as servin as an incentive for additional M&A activities. 2. The ap between the larest, most sophisticated banks and the rest will continue to row. As evidenced by previous industry consolidations, lobal super banks could start to dominate many business lines. This disparity may make it less attractive for institutions considerin an entrance into this market. 3. Basel II will challene conventional wisdom behind business lines, as the profitability of areas such as basic corporate bankin could be transformed. Banks will develop new strateies to address these new realities. 4. It is expected that there will be a reater alinment of economic and reulatory capital, encourain the industry to better price and manae risk. Many banks already employ economic capital models such as RAROC (Risk Adjusted Return on Capital) to price risk in transactions. Basel II attempts to brin these two numbers (economic and reulatory capital) closer toether. 5. Increased consolidation of Tier II financial institutions (i.e. smaller banks with assets less than 3 billion EUR or $2.7 billion USD), as these institutions typically hold the most secure retail receivables and therefore benefit most from the new capital requirements BIS results May In order to determine minimum capital requirements, Basel II introduces three approaches to the calculation of credit risk. These approaches are as follows: 1. Standardized 2. Foundation IRB 3. Advanced IRB The Basel Committee would like to see all internationally active banks use best practices when evaluatin risk and adopt modern risk manaement techniques. In order to achieve this, the Committee is promotin the more sophisticated of the two Internal Ratins Based approaches to measure risk that bein the Advanced IRB approach. The IRB approach is based on a eneric capital model and relies heavily on the bank s own information reardin the quality of its assets. The eneral consensus is that banks adoptin the IRB approach should, on averae, see a reduction in their capital requirements. U.S. Federal reulators have indicated that they expect U.S. institutions to adopt the Advanced IRB approach. The sinle most important consideration for the bankin industry is benefit versus cost. There are several key issues that could affect the industry s balance of benefit versus cost: 1. IRB Risk weihts, as proposed in the draft do not seem to provide a sinificant reduction in credit risk and by extension, capital. At the same time, the new proposed chare for Operation Risk will drive the total capital requirement to hiher levels than at present. 2. The new risk weihtin system is more complex than the current one and will require a sinificant increase in resources dedicated by both the banks and the reulators. The relative cost of this bureaucracy will be lower for lare financial institutions, as qualification, compliance, and disclosure are requirements that typically lend to companies of this scale. Nevertheless, the cost will be sinificant. 3. The Accord provides a capital incentive to banks pursuin the two more sophisticated approaches (Foundation and Advanced IRB), but many consider the declared capital concession to be too low. While adoptin the advanced IRB approach may result in the reduction of Risk Weihtins for Assets, the reulations state that the reduction must not fall below 90% of the Foundation IRB amount durin the first two years of usin the Advanced approach. 3. Who is Affected by Its Implementation? The Basel Committee intends Basel II to apply to internationally active banks in the G10 countries, includin Canada and the United States as well as their subsidiaries in non-g10 countries. However, the EU has decided to adopt Basel II for all credit institutions and investment businesses operatin in their jurisdiction. This will have far reachin effects on U.S. and other non-eu financial institutions (reulated or non-reulated) that do business in the EU as they may find themselves under the Basel umbrella. PAGE 11

13 FIGURE 7. Basel II Timetable for Implementation ACTION CP1 Issued Q1 Q2 Q3 Q4 Draft directive issued by BIS CP2 Issued QIS 3 Impact Analysis QIS 3 (Basel) Revisions Public Comment Accord finalized and published EC wide / Local leislation to adopt Basel II BIS plan and implement Accord Institutions plan and implement Accord Collect data Parallel run data in adopted approach Basel II live TASK COMPLETED BIS STANDARD IRB / AMA 4. U.S. Participation After five years of discussion and revision, Basel II is oin throuh the final rounds of comments. While the Basel II Committee is expected to approve the packae by the end of 2003, the correspondin U.S. rulemakin process is expected to be completed year-end 2004, with implementation to bein towards the end of The U.S. supervisory authorities expect that 20 lare internationally active U.S. banks and financial institutions will apply the Advanced Internal Ratins Based (A- IRB) version of Basel II. All other banks in the U.S. will be expected to remain on the current Accord capital standard. However some of these institutions, as well as some non reulated leasin companies doin business in Europe, may find that they will be required to participate in Basel II. Althouh seen by many as a European initiative, American bankers and reulators have been at the forefront of the Basel II Accord dialoue, thouh participation has not been as widespread as by their European counterparts. Note thouh, that Bill McDonouh, Head of the Federal Reserve Bank of New York has served as the Chairman of the Basel Committee. 5. Proposed Implementation Schedule The first draft Consultative Paper ( CP1 ) of the Basel II Accord was issued in June 1999, with the intent that the Basel Committee would work with and solicit feedback from the industry aimin to finalize the Accord in 2003, with implementation in The latest draft, CP3, was issued in April 2003 with industry comments requested by July 31, Fiure 7 illustrates some of the key dates in the lifeline of the Basel II Accord. The present status of the Basel II Accord process is perhaps best described as continuin intense neotiations between the bankin community and the reulators. Both sides are eaer to replace the existin Accord and the bankin industry has had sinificant weiht with the reulators. In turn, the reulators have actively involved the financial institutions throuhout the consultation phase. Thouh there have been some delays, the process is movin forward and the Accord is expected to be implemented on schedule. The Basel Committee continues to review the results of two previous quantitative impact studies, whereby banks conducted PAGE 12

14 FIGURE 8. Basel II Pillar Overview FEATURE DESCRIPTION IMPACT PILLAR 1 Minimum Capital Requirements New methodoloies for credit risk weihts Reconition of Credit Risk Mitiants Replacement for the current crude system of risk weihts Basel II weihts are based on either external credit ratins (Standardized Approach) or Bank's own internal credit risk information (IRB approach), dependent on the Bank's level of MIS sophistication Current Rules reconize only the hihest quality collateral (i.e. cash) & uarantees (i.e. from OECD incorporated banks) Basel II will reconize a wide rane of mitiants the benefits increasin with the bank's sophistication Reulatory Capital will become much closer alined to economic capital. There will be a chane in the attractiveness to enae in certain business lines Sophisticated banks likely to see reduction in required capital Less sophisticated banks likely to see increase in required capital Barriers to entry will increase Sophisticated banks able to tactically alin capital to support business oals Introduction of specific Operational Risk PILLAR 2 - Supervisory Review Current Rules required banks to hold capital aainst credit risk and market risk Basel II most likely to require a separate capital chare for Operational Risk (OR) Standard rules and powers for the reulators for policin the new, more complex, framework Standardization across countries for set of minimum requirements Bank sophistication and size will be a differentiatin factor Revolvin-credit business within banks likely to see disproportionate OR capital chare More bureaucracy for the industry to deal with PILLAR 3 - Market Discipline Standardized requirements for the banks to disclose allocation and risk information to the markets beyond current accountin uidelines Investors will be better informed about banks' risk and capital allocation Shareholders may demand more information from non compliant Basel II institutions simulations based on the new rules. The findins of these studies have been made public May 2003 see bcds/qis/qis3results.pdf. As such, the Basel II Accord continues to be a movin taret. IV. THE THREE PILLARS OF BASEL II As mentioned earlier, the major enhancement within Basel II is the introduction of the Three Pillars for assessment of levels of retained capital required in the Balance Sheet to support the receivable base. Fiure 8 provides an overview of each Pillar, includin a brief description as well as major impacts of each. PAGE 13

15 FIGURE 9. Calculatin Capital Ratios UNCHANGED CHANGED CAPITAL A. PILLAR I - MINIMUM CAPITAL REQUIREMENTS NEW The proposed chanes to the minimal capital requirements under Basel II are relatively straihtforward. Under the oriinal Accord, banks are required to hold at least 8% of total capital aainst their risks, of which 50% must be Tier 1 capital (shareholder equity/retained earnins). The oriinal Basel Accord identifies two types of risk when calculatin Minimum Capital Requirements: Credit Risk, calculated as risk-weihted assets ( RWA s ), and Market Risk, introduced by way of a 1996 amendment. Market Risk is usually calculated usin value-at-risk statistical models and expressed as RWAequivalent. UNCHANGED CREDIT RISK + OPERATIONAL RISK + MARKET RISK FIGURE 10. Pillar 1 - Credit Risk Calculation = CAPITAL RISK UNCHANGED Basel II impacts the minimum capital requirements throuh extensive chanes to the assessment of Credit Risk, with the addition of Operational Risk and the continued used of Market Risk. As in Fiure 9, the definition of capital and market risk is unchaned from the oriinal Accord. As a result the chanes to Credit Risk and the addition of Operational Risk are the two measures that ultimately matter when calculatin capital ratios. The central issue of Basel II is that if a chane in Credit Risk and Operational Risk toether increase or decrease the denominator, then the numerator (Capital) has to be increased or decreased in the same proportion to keep the Capital Ratio unchaned. Choice of three levels of calculation - increasin in detail, complexity and sophistication Increasin sophistication, with more advanced qualitative criteria STANDARDIZED APPROACH Similar to Basel 1 Accord but with some additional risk sensitivity throuh use of wider rane of risk weihts linked to external ratins. FOUNDATION INTERNAL RATINGS APPROACH Increasin sophistication, means reater disclosure Institution's portfolio is split by broad cateory of exposure. Institutions assin ratins linked to probability of default. Other inputs set by supervisor. ADVANCED INTERNAL RATINGS APPROACH Similar to Foundation Approach but institutions use their own estimates of loss iven default and of exposure at default in addition to calculation probability of default. 1. Credit Risk Credit Risk requires the most capital, and hence is considered the most important from a bank and leasin company standpoint. One of the most important principles behind Basel II is closin the ap between the reulations imposed by the oriinal Accord and economic norm. As such, the new framework was created to discern the economic risk across various credit exposures. Basel II abandons the one size fits all approach and introduces a rane of approaches to accommodate the differences in sophistication amon banks. Whichever approach is selected, it is important to note that a bank must adopt the same approach on a consistent lobal basis for all business lines. The three approaches to Credit Risk in Basel II are as follows: a) Standardized Approach The Standardized Approach is the most basic and is therefore the least sensitive. It is used by banks that either opt for this approach or are not in a position to implement the IRB approaches. The risk weihts are set based on credit ratins established by reconized credit aencies such as S&P, Moody s, or any other aency meetin specific requirements laid out in the Accord. This approach is conceptually the same as the present Accord, but more risk sensitive as it allows a bank to allocate a supervisory risk-weiht to each of its credit exposures, after sub-dividin them into several cateories, includin corporate and retail portfolios. The distinction between counter parties (banks versus corporate entities) remains, but the distinction between OECD (Oranization for Economic Co-operation PAGE 14

16 and Development) members versus other countries, is removed. Since the focus is equally on the credit ratin as on the type, the risk sensitivity of weihts under the standardized approach is better than the current rules of the first Basel Accord. Corporate exposures are assined a risk weiht accordin to their external credit ratin: risk weihts of rated corporate claims lie at 20% for AAA to AA, at 50% for claims rated A+ to A-, at 100% for claims rated BBB+ to BB-, at 150% for claims rated below BB-, and at 100% for unrated claims. Retail exposures are risk-weihted at 75%, but in order to qualify must satisfy the followin criteria: 1. Exposure is to an individual person or persons or small business where maximum areated retail exposure to one sinle borrower cannot exceed an absolute threshold of Euro1 million or US $900,000 (Exchane Rate Sept. 9/03: 1Euro=.90USD) 2. Exposure takes the form of revolvin credits and lines of credit, personal loans or leases, or business facilities and commitments No areate exposure to one sinle borrower can exceed 0.2% of the overall reulatory retail portfolio Most physical collateral is not eliible for reconition under the standardized approach. The absence of reconition of the mitiatin effect of collateral clearly penalizes leasin companies, since leasin is characterized by marketable physical collateral, which larely contributes to the reduction of risk in the event of default. Of note, however, FIGURE 11. Pillar 1 - Operational Risk Calculation Choice of three levels of calculation - increasin in detail, complexity and sophistication Increasin sophistication, with more advanced qualitative criteria BASIC INDICATOR APPROACH Capital is calculated based on 15% of averae ross income over the previous 3 years. is the fact that vehicles, which were not included in the oriinal discussions, have now been accepted as collateral. This is certainly ood news for the auto leasin industry. b) Foundation IRB Approach The IRB approach is built to take advantae of two main principals. First, it is desined to take advantae of the bank s own information about the quality of its assets. Second, it is desined to promote and take advantae of best practices in risk manaement. There is relative unanimity in the industry that IRB is a major step towards alinin capital with true economic rounds. Banks usin the Foundation IRB will estimate the Probability of Default, ( PD ) relatin to each borrower, while the bank supervisors will supply the other inputs, i.e. Loss iven Default ( LGD ) and Exposure at Default ( EAD ) as primary inputs into the capital requirement calculation. Two aspects of the IRB qualification requirements worth mentionin are: STANDARDIZED APPROACH Increasin sophistication, means reater disclosure Institution is split by business lines. Institution measures volumes of exposure indicator (EI) set for each business line by reulator. ADVANCED MEASUREMENT APPROACH Institutions will measure exposure indicators, which include the probability of loss event (PE) and the loss iven event (LGE) for each business line based on internal data. 1. External data sources are allowed, which could include data poolin amon banks and adoptin data from credit ratin aencies 2. In order to use IRB, banks must have five years of historical PD data. At the time of the implementation of Basel II, the requirement would be only two years, which will row to five within the first three years. c) Advanced IRB approach Under the Advanced IRB approach, banks will supply all three inputs into the assessment of credit risk, i.e. PD, LGD and EAD. The difficulty with the IRB approaches, accordin to the Committee s own research, will be the lack of banks own estimates of Loss Given Default for non-retail exposures. While monitorin of PD is a standard industry practice, the research suests that few banks have robust data on which to base LGD. To qualify for the Advanced IRB approach, Banks require LGD data spannin a PAGE 15

17 minimum of 7 years, and ideally coverin a complete economic cycle 1. In addition, the institution needs to demonstrate that it is fully competent with the inputs into the risk function, and must disclose more information on an onoin basis. The more sophisticated the approach, the more risk-sensitive it is thereby increasin the likelihood of a better evaluation of credit risk. It is enerally believed that the Committee s intention is to allow lower capital under the more sophisticated approaches. Initial estimates are that the difference in capital between the Foundation IRB and Advanced IRB approaches may be in the reion of 10-20% in favour of the Advanced IRB approach. However, the more risk sensitive the approach, the hiher the cost to implement due to the increased sophistication required in the bank s capital manaement system. Once implemented, all participatin banks will have to adopt the Standard approach, at a minimum. As noted above, U.S. reulators have indicated they expect banks in their jurisdiction to adopt the Advanced IRB approach. It is widely believed that most sophisticated banks will adopt the IRB approach, whether Foundation or Advanced. 2. Operational Risk An explicit chare for Operational Risk ( OR ) is one of the new measurement criteria in Basel II, and is one of the most contentious. Basel II defines OR as Risk of direct or indirect loss resultin from inadequate or failed internal processes, people, system or from external events. The source of the controversy is that the only numbers suested in the draft, at FIGURE 12. Pillar 1 - Market Risk Calculation Choice of two levels of calculation - increasin in detail, complexity and sophistication STANDARDIZED MEASUREMENT APPROACH Increasin sophistication means reater disclosure The standardized measurement introduces capital chares to be applied to 1) Current market value of open positions in interest related instruments and equities in institutions' tradin books 2) Institutions' total currency and commodities positions in respect of forein exchane and commodities risk 20% of total risk capital or 30% of annual ross revenue, may be too hih and that the OR chare is likely to be sinificantly hiher for non-credit bankin businesses. The committee has acknowleded openly that the 20% benchmark is too hih, and it is expected to be reduced to probably 15% of averae ross income over the previous three years. As with credit risk, there are three approaches to calculatin OR capital, dependin on the individual bank s sophistication. The approaches are: Basic Indicator approach Standardized approach Advanced Measurement approach IN-HOUSE MODEL APPROACH The In-House Approach allows institutions to use in-house measurements subject to a number of quantitative and qualitative criteria, these include 1) "Value at risk" computed daily 2) Minimum price shock to ten days tradin 3) Model to incorporate one years tradin data Unlike the credit risk framework, where all three approaches are likely to be used by the industry, only the Standardized approach seems likely to be used by nearly everyone outside the United States. The Basic approach appears rudimentary The capital chare for the institution will be the reater of: 1) The previous day's value at risk 2) Three times the averae of the daily value at risk of the precedin 60 business days while the Advanced Measurement approach may be too complex. Unlike the credit risk framework, different business lines may operate different approaches, but the approaches must be consistent within business lines and across eoraphic boundaries. U.S. supervisors will propose that banks that are required to, or choose to adopt the Advanced IRB approach will also be required to hold capital for OR usin the Advanced Measurement approach (AMA). Under AMA, Advanced IRB banks will have the primary responsibility for assessin their own OR capital requirement. The supervisor will require that the procedure be comprehensive, systematic, and consistent with certain uidelines. The OR risk capital chare is expected to reflect banks own environmental and control mechanisms and can be reduced by insurance and other risk mitiants. Several U.S. banks that are developin an 1 The new Basel Capital Accord, Consultative Document, para 342, Basel Committee, January PAGE 16

18 OR capital requirement under the AMA have indicated their confidence with preliminary results. The three approaches to Operational Risk in Basel II are as follows: a) Basic Indicator Approach As the default approach for assessin OR, the Basic Indicator approach is very simple the required capital is calculated as 15% of the bank s ross income over the previous 3 years. Unfortunately, this approach is considered too crude since OR varies considerable between bankin businesses, different banks, and different countries. b) Standardized Approach The Standardized approach is similar to the Basic Indicator approach, except it attempts to correct for differences between business lines. For each of the proposed business lines, there is a standard exposure indicator and a standard factor (beta), the product of which is required capital. It appears that more work is required on the Standardized approach, as the startin values for beta and proposed business lines both need to be expanded. c) Advanced Measurement Approach As the most complex of the three OR approaches, the Advanced Measurement approach still remains relatively straihtforward. The product of expected losses ( EL ) and amma (a standard factor supplied by the reulator for this risk in the business line) yields Required Capital for a particular risk within a particular business line. The challene with this framework is that banks would be required to accumulate and maintain Probability of Loss Event ( PE ) and Loss Given Event ( LGE ) data for several dozen risk/business line pairs. Given the inherent complexity, many banks will not choose to adopt this approach. That bein said, however, the participatin banks in the United States are all movin to this approach to measure their operational risk. 3. Market Risk Market Risk remains unchaned from the oriinal Basel I Accord. This assessment is based larely on the bank s own measure of value-at-risk or the standardized approach for market risk. Emphasis should be focused on evaluatin the adequacy of capital to support the tradin function. B. PILLAR II - SUPERVISORY REVIEW Accordin to the Basel Committee, the supervisory review process of Basel II is intended not only to ensure that banks have adequate capital to support all the risks in their business, but to encourae banks to develop and use better risk manaement techniques in monitorin and manain their risks. 2 With Pillar II, the concept of economic capital is introduced into the reulatory capital equation, thus enablin the determination of capital adequacy based on the level of risk posed by a transaction. The Four Principals of Pillar II are: Principle 1: Banks should have a process for assessin their overall capital adequacy in relation to their risk profile and a stratey for maintainin their capital levels. 3 Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strateies, as well as their ability to monitor and ensure their compliance with reulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. 4 Principle 3: Supervisors should expect banks to operate above the minimum reulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. 5 Principle 4: Supervisors should seek to intervene at an early stae to prevent capital from fallin below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. 6 Basel II reconizes the responsibility of bank manaement in developin an internal capital assessment process 2 Basel Committee on Bankin Supervision. Consultative Document, The New Basel Capital Accord, April 2003, p138 3 Basel Committee on Bankin Supervision. Consultative Document, The New Basel Capital Accord, April 2003, p139 4 Basel Committee on Bankin Supervision. Consultative Document, The New Basel Capital Accord, April 2003, p142 5 Basel Committee on Bankin Supervision. Consultative Document, The New Basel Capital Accord, April 2003, p144 6 Basel Committee on Bankin Supervision. Consultative Document, The New Basel Capital Accord, April 2003, p144 PAGE 17

19 and settin capital tarets that are commensurate with the bank s risk profile. It is manaement s responsibility to ensure that there is adequate capital to support risks beyond the core minimum requirements. Conversely, supervisors are expected to evaluate how well banks are assessin their capital needs relative to their risks and to intervene when appropriate. There are three main areas that are particularly suited to treatment under Pillar 2: Risks considered under Pillar I that are not fully captured by the Pillar I process (e.. credit concentration risk) Factors not taken into account by the Pillar I process (e.. interest rate risk in the bankin book, business and strateic risk); Factors external to the bank (e.. business cycle effects) Pillar II does have two important implications that favour the larer, more sophisticated banks. First, it will contribute to increased bureaucracy costs, thouh the lare, sophisticated banks will bear a proportionately lihter load for this compared to smaller banks. Secondly, implicit support of the banks by reulators will increase, with benefits larely available to the more sophisticated banks. C. PILLAR III - MARKET DISCIPLINE The Basel Committee believes that the information currently provided by banks needs to o much further for the markets to adequately assess the risks of individual banks. Pillar III requires banks to disclose essential information reardin their capital allocation and the risks they take beyond current financial reportin uidelines. Markets would then be in a position to help police the new rules by requirin hiher or lower costs of capital based on the individual bank s level of risk. Examples of proposed level of disclosure are: Data included in disclosure information must be traceable to its oriinal source A clear audit trail Systems and processes required to verify data must be of a hih standard Credit exposures before and after credit mitiation Credit risk manaement framework Details of scorecards front office or behavioral Defaults by portfolio - eoraphic and industry exposures Capital chare by business line (could be eoraphic reion) Operational risk manaement framework Operation losses by business line Capital requirement by risk type Back testin results In the move from minimum disclosure to maximum transparency, some within the bankin industry feel the Committee may have one too far compromisin sensitive and possibly competitive data. This is important to note, as the level of disclosure that is finally areed upon within Basel II may also become the standard within the leasin industry over the next several years. Accordinly, leasin companies should review their existin disclosure practices in preparation of the need to provide additional market disclosure. The level of disclosure is the only element of the three-pillar approach that may see revision of the Accord by yearend V. POTENTIAL IMPACTS OF BASEL II ON THE LEASING INDUSTRY The proposals within Basel II are aimed at internationally active banks within the G10. As such, the impact of Basel II on the leasin industry is expected to come via 1. Reulated bank ownership (those bein reulated to comply with Basel II) 2. Market pressures, driven by the reulatory requirements imposed on those reulated financial institutions and shareholder / market requirements for compliance 3. Need for U.S. leasin companies doin business in the EU to conform to Basel, i.e. lare independents The final details of how Basel II will be implemented in North America are not finalized, but it is fair to expect that most reional and super-reional banks as well as lare international non-reulated leasin companies will move in this direction, and see increased investment in: Data collection for credit risk time series Sinificant MIS investment especially for those internationally active finance institutions Additional dianostics to determine current status and deficiencies Credit risk modelin and wider diversity of resultant credit pricin Mark-to-market valuation of credit risk Industry pools of credit risk data, especially for small and medium enterprises (SME) More penetration and interation of current and future risk manaement technoloy into banks operations and policies there will be an incentive for the advanced IRB approach Definin and measurin operational risk and implementin procedures to reduce those risks PAGE 18