2004 ELA Equipment Management Conference

Transcription

1 2004 ELA Equipment Management Conference February 23, 2004 The Basel II Accord and Risk-Based Pricing Impact on Leasing and Asset Management C O N F I D E N T I A L

2 Contents 1. Introduction 2. What Is the Basel II Capital Accord? 3. Risk Metrics: Direct Implications for Leasing Companies 4. Indirect Effects: Better Measurement and Management 5. Conclusions and Q&A Copyright 2003 Mercer Oliver Wyman 1

3 Mercer Oliver Wyman Is the Leader in Financial Services Strategy and Risk Management Consulting Formed in April 2003 from a merger of Oliver, Wyman & Company and the financial services strategy and actuarial consulting practices of Mercer Inc. Part of the Marsh & McLennan Companies 650 staff, including more than 500 consultants and directors Headquartered in New York City 26 offices in 11 countries throughout North America, Europe and Asia Key Global Offices: Atlanta Amsterdam Boston Chicago Columbus Detroit Frankfurt Lisbon London Madrid Milan Milwaukee Munich New York Paris Philadelphia Rotterdam San Francisco Singapore Toronto Zurich Copyright 2003 Mercer Oliver Wyman 2

4 Background and Overview of Today s Presentation Mercer Oliver Wyman worked with DLL on Basel II compliance as well as business applications of the risk metrics developed for Basel II The Basel Accord is a set of capital regulations The new accord, Basel II, requires amongst other things robust risk metrics Basel II was developed to better align regulatory requirements with current best practices for risk management Sophisticated risk metrics, whether required by Basel II or not, are an important development in financial services Allow more accurate measurement of the risk vs. return of investments Can be used in applications from performance measurement to pricing to strategic business management Asset Managers play an important role in risk measurement and, at least in Basel-bound firms, will be required to participate in this process Copyright 2003 Mercer Oliver Wyman 3

5 Contents 1. Introduction 2. What Is the Basel II Capital Accord? 3. Risk Metrics: Direct Implications for Leasing Companies 4. Indirect Effects: Better Measurement and Management 5. Conclusions and Q&A Copyright 2003 Mercer Oliver Wyman 4

6 The Basel II Accord Is Intended To Improve Upon the Regulations of the 1988 Basel Capital Accord The original Basel Accord provided consistent regulatory capital levels across the world s banking sectors Set of guidelines for holding capital, based on investment type and AuM Introduced in 1988 and adopted by the national regulators in over 100 countries The original Accord regulations had some unintended effects as well, such as: Encouraged higher-risk lending (e.g. low-quality corporate) Undifferentiated pricing for risk in corporate lending by many institutions Risk-free perception of asset management and deposit-taking businesses Widespread regulatory arbitrage (e.g 364-day revolving loans and CLOs) Recent advances in capital management practices have highlighted the need for an updated set of capital regulations More sophisticated risk measurement, e.g. Economic Capital Credit risk transfer technology via product innovation and sophisticated portfolio modelling Risk- and value-based management Copyright 2003 Mercer Oliver Wyman 5

7 The Basel II Accord Is Responding to Market Advances in Risk Measurement and Management Basel II is an updated set of regulations designed to bring banks up to speed with industry developments and redress the unintended effects of the original Accord More sophisticated internal risk measurement requirements designed to align regulatory capital more closely with Economic Capital Increased disclosure requirements to allow more transparency into an institution s risk and capital It is a consultative document, and therefore must be adopted by national regulators in order to take effect The EU will adopt these into regulation for all credit and investment institutions in their jurisdiction The US Federal Bank will most likely adopt only for internationally active banks The finalized Basel II Accord is expected to be published in June 2004 Regulations would take effect Dec 31, 2006 The regulations require 7 years of historical data in some cases; as a result, from 2007 to 2009 some data gathering requirements will be relaxed Copyright 2003 Mercer Oliver Wyman 6

8 Only a Subset of US Leasing Companies Will Be Required to Adhere to These Regulations US Leasing Companies Subsidiaries of European Banks Subsidiaries of Top 20 US Banks Basel II applies based on European adoption of regulations European Bank Basel II applies based on Fed adoption of regulations Internationally Active US Bank US Leasing Co. US Bank US Leasing Co. US Leasing Co. Copyright 2003 Mercer Oliver Wyman 7

9 Basel Will Affect Reporting and Regulatory Supervision, in Addition to Capital Requirements Proposed Basel II Capital Accord 1. Minimum Capital Requirements Supervisory Reviewof of Capital Adequacy 3. Market Discipline Credit Risk (Enhanced) Operational Risk (New) Market Risk (Unchanged) Pillar 1 sets guidelines for risk capital requirements Pillar 2 puts pressure on regulators to take a more active role in supervision of banks Pillar 3, Market Discipline, will transform financial reporting for banks and strengthen market discipline Copyright 2003 Mercer Oliver Wyman 8

10 Sophisticated Credit Risk Measurement Is a Major Component of the New Regulations For Credit Risk capitalization, banks will choose between three approaches: Standardized: the simplest approach, this relies on external ratings and regulatory benchmarks IRB Foundation: IRB Advanced: These more complex approaches rely heavily on internal data and ratings For each approach, the Accord requires that banks look at the drivers of credit losses: Probability of Default (PD) What is the likelihood of write-off for this creditor? Exposure at Default (EAD) How much exposure does the bank have to this creditor? Loss Given Default (LGD) X X = How much of the exposure will be lost if default occurs? Expected Loss (EL) Similar to Provisions Risk Capital Volatility of Losses The IRB approaches require internal historical data on these parameters, but benchmarks can be used under the Standarized Approach The Basel II Accord uses PD, EAD, LGD to predict a worst-case loss, and requires banks to capitalize against that loss These Metrics are Also the Basis of Best Practice Risk Measurement in Institutions Not Affected by Basel II Copyright 2003 Mercer Oliver Wyman 9

11 What Does This Mean for Leasing Companies, and Asset Managers in Particular? Leasing companies directly affected by Basel will be required to: Measure LGD, EAD, and PD for credit risk Measure operational and market risks Comply with disclosure and supervisory requirements Align processes and management with risk assessment For companies investing in the infrastructure necessary for compliance, a logical next step is leveraging the metrics in value-adding business applications Asset Managers in these companies will need to participate in LGD and residual risk quantification Providing historical data for quantifying LGD and residual risk Validating outputs Providing forward-looking perspective on collateral values Other leasing companies may be indirectly affected market pressure to imitate best practices will motivate some banks and finance companies to measure risk as robustly Basel will bring more visibility to both LGD and residual risks, making strong asset management performance even more important as a differentiating factor among lessors Copyright 2003 Mercer Oliver Wyman 10

12 Contents 1. Introduction 2. What Is the Basel II Capital Accord? 3. Risk Metrics: Direct Implications for Leasing Companies 4. Indirect Effects: Better Measurement and Management 5. Conclusions and Q&A Copyright 2003 Mercer Oliver Wyman 11

13 Improved Risk Metrics, Whether Required or Not, Can Have a Large Operational Impact Application A B C D Credit Rating Manual Automatic Decision Loss Quarter Application & Decisioning Portfolio Management IT and MIS Stricter credit rating guidelines Limit-setting based on additional risk information Risk based pricing capabilities may be leveraged Improvement in process efficiency Ongoing monitoring of credit risk parameters PD calibrations LGD calculations Managing for risk, e.g. securitization, hedging, etc. Data gathering modifications Providing credit analysts access to new credit risk information in real time Changes to reporting systems to ensure appropriate disclosure Copyright 2003 Mercer Oliver Wyman 12

14 A Substantial Responsibility for Asset Management Is Loss Given Default (LGD) Conceptually, LGD represents the exposure, net of recoveries, lost in a default In practice, the calculation must be based on historical data* Internal records on both cash and asset recovery are the foundation Both direct (legal, repossession) and indirect (collections dept) costs are included Asset Managers will be integral in the measurement of this component LGD should be differentiated by major drivers 8 Asset type 8 Age at default In depth knowledge of asset management policies and exposures is key Value $1,200 $1,000 $800 $600 $400 $200 $0 Conceptual LGD for Leasing Exposure: $ Hypothetical default occurring at 12 mo. Probable Loss Amt: $450 LGD = = 47% $450 $950 Age of Lease (Months) Amortization Depreciation * or benchmarks if the Standarized Approach is adopted Copyright 2003 Mercer Oliver Wyman 13

15 Conservatism in LGD Will Require Asset Managers To Provide Forward-Looking Input Historical write-off data is required by Basel II for IRB Approaches The danger with using solely historical data is that market trends will be ignored e.g. when an asset becomes outmoded, historical averages will overestimate FMV As a result, Asset Managers must provide conservative, forward-looking review on historical LGD experience Value $10,000 $8,000 $6,000 $4,000 $2,000 $0 Hypothetical Depreciation History of Asset Booked in 2002 When Upgrade Appears on the Market in 2003 Amortization of Contract Historical Avg FMV at Given Age 2003 FMV at Given Age $6,000 $2,000 $ E.g. if default occurs at 15 months, EAD = $6,000 LGD Historical Only = 1 - $2,000 $6,000 = 67% LGD Using 2003 Data = 1 - $200 $6,000 = 97% Copyright 2003 Mercer Oliver Wyman 14 Age of Asset

16 Additionally, Residual Risk Quantification Will Also Require the Involvement of Asset Managers The regulations regarding market risk have not changed However, an economic risk assessment for residuals is necessary for management applications Economic Capital associated with residual risk is applied based on the expected FMV The volatility of residual return helps define the Economic Capital Complicating factors, such as equipment renewal, require additional input from asset managers Example: Low Residual Risk Asset Example: High Residual Risk Asset Value Value $6,000 $4,000 Historical Depreciation Experienced Residual at Termination $6,000 $4,000 Historical Depreciation Experienced Residual at Termination $2,000 $2,000 $0 $ Age of Asset Age of Asset Copyright 2003 Mercer Oliver Wyman 15 The average of the experienced residual corresponds to the Expected FMV, but risk comes from the volatility around that average

17 Contents 1. Introduction 2. What Is the Basel II Capital Accord? 3. Risk Metrics: Direct Implications for Leasing Companies 4. Indirect Effects: Better Measurement and Management 5. Conclusions and Q&A Copyright 2003 Mercer Oliver Wyman 16

18 Improved Risk Measurement, Whether Required by Basel II or Implemented Voluntarily, Paves the Way for Valuable Applications Such as Risk Based Pricing Economic Capital allows for economic measurement of risk, independent of regulatory capital RAROC, Risk Adjusted Return on (Economic) Capital control for the risk/return trade-off when evaluating investments with different risk profiles Risk-Based Pricing provides the price that should be required of a loan/lease, based on its risk profile Value-Based Management combines the above concepts to evaluate tactical business decisions against one another Copyright 2003 Mercer Oliver Wyman 17

19 Business Applications, Such as RAROC and Risk Based Pricing, Turn Information into Tangible Benefits Regulatory or Voluntary Information Analytics: Risk Metrics and Economic Capital Performance Measurement: RAROC (Risk Adjusted Return on Economic Capital) Business Applications: Risk Based Pricing and Value Based Management Marginal Infrastructure Business Benefit This section will discuss these applications in general, and will give specific examples from DLL s portfolio Mercer Oliver Wyman and DLL partnered to implement each of these applications Business applications in the forthcoming examples are specific to DLL s US portfolio: 8 Mostly small ticket, though some >$250,000 ticket sizes 8 Intermediated market where dealer is the true client 8 Rate cards in use for all small ticket transactions; this interferes with traditional risk based pricing, but value based management is still viable Copyright 2003 Mercer Oliver Wyman 18

20 Economic Capital Forms the Basis of Risk Adjusted Business Management Tools Regulatory Capital Agency Driven Capital Economic Capital Actual Capital Definition Amount of capital required to protect the Group against statutory insolvency over a one-year time-frame Amount of capital the rating agencies expect in order to feel comfortable giving Fortis a AA rating Amount of capital required to protect the Group against economic insolvency over a one-year time-frame Amount of equity capital or Embedded Value actually held to protect the Group against economic and statutory insolvency over a one-year time-frame Purpose Designed to protect policy holders and creditors Acts as a floor, which triggers takeover by the regulators Designed to test and communicate capital adequacy warranting the target debt rating based on the rating agency metrics and models Designed to be a tool for management Designed to communicate accounting solvency and profitability to outside constituents Measurement Basel II: Based on simplified statistical rules Uses LGD, EAD, and PD for largest banks Does not accurately reflect the real economic risks of the business Based on relatively undifferentiated rules of thumb and/or simple models Not formulaic other factors such as quality of management and likelihood of government bail-out are also considered Reflects real risks taken in the sense of unexpected movements in the value of assets and liabilities Uses LGD, EAD, and PD as well as other risks such as residual in statistically robust equations Accounting result; expanded definition includes hidden reserves Bare Minimum Capital You Must Have Capital You Are Expected to Have Capital You Ought to Have Capital You Actually Have Copyright 2003 Mercer Oliver Wyman 19

21 RAROC Is a Measure of Risk vs. Return That Uses Economic Capital as the Risk Component Regulatory capital does not fully reflect the true economic risks of the business This can distort the performance measurement of the businesses Business Unit A (High Risk) Business Unit B (Low Risk) Income Costs Identical income and costs Return Equity Equity is insensitive to risks Economic Capital True economic risks differ Return on Equity 10% 10% RAROC 8.9% 11.4% Both BUs appear to be equally profitable But Measured on a risk adjusted basis, B is a better investment Copyright 2003 Mercer Oliver Wyman 20

22 Risk Based Pricing Backs-Out the Minimum Price To Achieve a Return that Balances the Risk Sample Contract Cash Flows (Expected) Cash Flow % of Original $ Contract 10% 9% Residual Gain Operating Expenses 8% 7% 6% 5% 4% 3% NIM at Min. Price Fee Income Residual Costs Risk Costs (including expected loss) Minimum price to cover net expenses and risk costs 2% 1% 0% Marginal NIM for Market Price Additional Income due to Market Price > Minimum Price Interest Revenues Other Revenues Operational Costs Risk Adjustment Net Income and Revenue Types Risk Based Pricing provides the link between credit risk and market pricing Some high risk leases are unattractive at market prices Low risk leases may have room for reduced prices, giving the business line an edge in the market Each piece of the transaction cash flow is included in the pricing model Termination/residual income is an integral part of the model Each component of the cash flow model affects the minimum price Copyright 2003 Mercer Oliver Wyman 21

23 Robust Risk-Based Pricing Can Provide Significant Improvement Over Current Practice Average NIM 6.0% Case Study: Client s Current Pricing vs. Hurdle-Return Pricing (By %EL)* 5.0% 4.0% 3.0% Price charged is above minimum rate to achieve hurdle return Hurdle-return price Price charged to client is below minimum rate to achieve hurdle return 2.0% 1.0% Average price charged 0.0% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8% 2.0% Low Risk Expected Loss % High Risk * Because DLL deals with end-users via dealers, this type of risk based pricing was not viable. Source: MOW confidential client analysis Copyright 2003 Mercer Oliver Wyman 22

24 Value Based Management Goes a Step Beyond Risk Based Pricing to Include Other Value Levers Value-driving factors beyond price are included in modeling Which customer characteristics are correlated to value-adding behavior? What are the effects of different structuring possibilities at the necessary customer rate? Results can be segmented to compare: Customers Business Units Products Salespeople, etc. Business tactics can be tested Simple: how much value will be created if we increase prices on these types of deals More complex: what is the trade-off between fee income and conversion rate? Example: Distribution of Lease Value Frequency Value at Booking Value including origination costs Lease Value -1, ,000 1,500 2,000 Example: Impact of Strategic Initiatives Changing Acceptance Policy Terminating Relationship with Value Destroying Clients Raising Prices on Unprofitable Segments given Resulting Decline in Bookings Charging a Fee for Certain Termination Behaviors given Resulting Decline in Bookings -2% 0% 2% 4% 6% Copyright 2003 Mercer Oliver Wyman Profit Improvement over Portfolio Base Case 23

25 For Example, Intermediaries Can Be Compared at a Detailed Level to Unveil the Drivers of Under- Performance Comparison of Value at Intermediary* Level Dealer A: High Conversion, High Value *Can be compared at contract, BU, salesperson level, etc. Please note that values are rounded Dealer B: Low Conversion, Low Credit Quality Booked Volume $1,590,000 $1,460,000 # Leases Avg Lease Volume $13,900 $13,800 Avg Term (Months) Approval Rate 93% 61% Conversion Rate 91% 65% Dealer Cost to Serve $65,000 $127,000 Average Interest Rate 9.7% 10.7% Average Spread 6.4% 6.1% Net Interest Margin $182,000 $175,000 Lifetime Default Rate 11% 15% Expected Loss -$39,000 -$48,000 Termination Value $10,000 $19,000 Non Interest Revenue $35,000 $39,000 Non Interest Expense -$40,000 -$39,000 Dealer Value Total $82,000 $19,000 Dealer Value/Volume 5.2% 1.3% Similar general characteristics Much lower approval and conversion rate Slightly higher volume for Dealer B means higher NIM Lower credit quality deals are pulling through Total value is well below required return. Value suffers due to high cost-to-serve and low credit quality Copyright 2003 Mercer Oliver Wyman 24

26 Sophisticated Value Based Management Means Improved Prediction of Termination Results Trade Up With Return Probability 6% 5% 4% 3% 2% 1% Trade Up With Return by Dealer Size Trade up with return probability Length of Time in Automatic Lease Extension (ALE) Months in Extension Digital Copiers Telecom Other Asset Types 0% $0-100K $100K to 500K $500K to 1MM $1MM to $5MM > $5MM 0 <2 Year Short Term 2-3 Years Medium Term >3 Years Long Term Dealer Volume 2001 Contract Term While credit rating indicates the lessee s default behavior, other lessee characteristics can predict likelihood of other termination types This improved prediction may be passed through to pricing or residual setting Copyright 2003 Mercer Oliver Wyman 25

27 Contents 1. Introduction 2. What Is the Basel II Capital Accord? 3. Risk Metrics: Direct Implications for Leasing Companies 4. Indirect Effects: Better Measurement and Management 5. Conclusions and Q&A Copyright 2003 Mercer Oliver Wyman 26

28 Conclusions Basel II will mean more detailed risk quantification in those leasing companies affected by the new regulations Asset managers in particular will need to contribute perspective, if not resources, to LGD calibrations Residual risk treatment will not change but more sophisticated quantification is desirable for applications like RAROC and Risk-Based Pricing Some institutions are not affected by Basel, but will still choose to quantify risk in a similar manner Improved risk metrics can lead to better pricing and strategic decision-making Economic Capital uses the same metrics as Basel II, and provides an economic rather than regulatory measure of risk capital RAROC and Risk-Based Pricing provide the fundamental measures of return 8 Return against target at given price level 8 Or conversely, price necessary to achieve target return The concepts used in Value-Based Management provide a more advanced level of strategic decision-making Copyright 2003 Mercer Oliver Wyman 27

29 Please See the Handout for More Detail The Basel II Accord: What Does it Mean for the North American Leasing Market? 2003 by the Equipment Leasing and Finance Foundation Lisa Levine, CAE, Executive Director Copyright 2003 Mercer Oliver Wyman 28