MEMORANDUM SUBJECT : CAPITAL ADEQUACY FRAMEWORK AND EXPOSURE MANAGEMENT POLICY

Transcription

1 AFRICAN DEVELOPMENT BANK ADB/BD/WP/2009/10/Rev.1 AFRICAN DEVELOPMENT FUND ADF/BD/WP/2009/09/Rev.1 2 March 2009 Prepared by: FFMA/FFCO Original: English/French Probable Date of Board Presentation : 18 th March 2009 FOR CONSIDERATION MEMORANDUM TO : THE BOARDS OF DIRECTORS FROM : Kordjé BEDOUMRA Secretary General SUBJECT : CAPITAL ADEQUACY FRAMEWORK AND EXPOSURE MANAGEMENT POLICY REVISED VERSION * Please find attached, the revised version of the above mentioned document, following the joint AUFI/CODE meeting of January 29 th This version incorporates changes related to comments and feedback received from Board members as well as complementary information requested on the implementation cost and timeline of the capital adequacy framework. Attach. Cc : The President *Questions on this document should be referred to: Mrs. K. M. DIALLO Director FFMA Ext Mr. C. BOAMAH Director FFCO Ext Mr. P. VAN PETENGHEN Director FTRY Ext Mr. J. BILE Advisor FNVP Ext Mr. P.KEI BOGUINARD Manager FFMA.1 Ext Mr. M. KALIF Acting Manager FFMA.2 Ext Mr. T. DE KOCK Manager FFMA.3 Ext Mrs. C. AKINTOMIDE Manager GECL.1 Ext Mrs. M. AKIN OLUGBADE Manager FTRY4 Ext SCCD:N.A.

2 AFRICAN DEVELOPMENT BANK CAPITAL ADEQUACY FRAMEWORK AND EXPOSURE MANAGEMENT POLICY February 2009

3 TABLE OF CONTENTS ABBREVIATIONS...3 I. INTRODUCTORY BACKGROUND...5 II. RATIONALE FOR THE REVISION OF THE CAPITAL ADEQUACY FRAMEWORK RISK BASED CAPITAL ALLOCATION AND CAPITAL UTILIZATION LIMIT PRUDENTIAL EXPOSURE LIMITS OTHER RELATED POLICIES RELATED TO THE FRAMEWORK REVIEW PROCESS PHASED APPROACH, DYNAMIC AND CONTINUOUS REVIEW...11 III. THE PROPOSED REVISED FRAMEWORK KEY PILLARS OF THE POLICY FRAMEWORK METHODOLOGY FOR INTEGRATED CAPITAL ADEQUACY FRAMEWORK PRUDENTIAL EXPOSURE LIMITS IMPLICATIONS FOR OTHER RELATED FINANCIAL POLICIES...19 IV IMPLICATIONS OF THE PROPOSED ENHANCEMENTS IMPLICATION FOR THE RISK CAPITAL UTILIZATION RATE IMPLICATION FOR THE PRUDENTIAL LIMITS IMPLICATIONS FOR THE BANK S LONG TERM FINANCIAL CAPACITY...23 V IMPLEMENTATION IMPLICATIONS OF THE PROPOSED FRAMEWORK REVISION OF THE SOVEREIGN AND NON SOVEREIGN RISK MANAGEMENT GUIDELINES ESTABLISHMENT OF COLLATERAL MANAGEMENT FRAMEWORK ENHANCED EXPOSURE MONITORING DEVOLUTION OF EXPOSURE MANAGEMENT RESPONSIBILITY TO TASK MANAGERS RISK OVERSIGHT AND GOVERNANCE RESOURCE REQUIREMENTS AND TIMELINE TO IMPLEMENT THE PROPOSED CAPITAL ADEQUACY FRAMEWORK...25 VI CONCLUSION AND RECOMMENDATIONS...25 ANNEXES Page 2

4 ABBREVIATIONS 1. AfDB African Development Bank 2. ADB Asian Development Bank 3. IRB Internal Ratings Based Approach 4. ALCO Assets and Liabilities Committee 5. EBRD European Bank of Reconstruction and Development 6. IADB Inter American Development Bank 7. IBRD International Bank of Reconstruction and Development 8. IFC International Finance Corporation 9. MDB Multilateral Development Bank 10. MTS Medium Term Strategy 11. RMCs Regional Member Countries 12. OPSM Operations Private Sector Management 13. ORVP Operations Regional Vice Presidency 14. PD Probability of Default 15. LGD Loss Given Default 16. MSP Maximum Sustainable Limit 17. RCUR Risk Capital Utilization Rate 18. IFI International Financial Institution Page 3

5 EXECUTIVE SUMMARY Over the past decade, the African Development Bank ( the Bank ) through a combination of prudent lending policies, risk management practices, stringent expense controls and steady additions to reserves has consolidated its financial position. The consolidation of the Bank s financials has been accompanied by a steady decline in its development related exposures (loans and equity participations) primarily due to significant prepayments. The combination of these factors also resulted in a steady decline in the Risk Capital Utilization Rate (RCUR) 1. The relatively low level of RCUR has triggered a debate amongst key stakeholders of the Bank regarding the optimum use of its risk capital to fulfil its development mandate. Management therefore directed that a review of the Bank s Capital Adequacy Framework be undertaken. This proposal has been prepared in response to that request. The objective of this document is therefore to seek Board s approval for the proposed enhancement in the Bank s capital adequacy framework and its related policies, which have been discussed at the Joint AUFI/CODE meeting of January 29, Management s proposal derives from a series of independent reviews, technical notes, briefings and papers presented to the Board between March and November 2008 on potential revisions and enhancements to the Bank s methodologies for capital adequacy and other financial policies. It factors in comments and feedback received from some Board members during bilateral meetings and the joint AUFI/CODE meeting. The proposed risk management framework which uses Basel II Internal Rating Based (IRB) approach as a reference, is based on three key pillars, namely: (i) the development of a transparent and flexible methodology and the determination of minimum capital requirements for each risk asset in the Bank s portfolio; (ii) The establishment of prudential exposure limits for country, private sector operations and equity investments to minimize potential losses and ensure efficient monitoring of the risks assumed by the Bank; and (iii) The implementation of sound risk management governance to enhance transparency in the Bank s internal assessment process to comply with best banking practices. Overall it is proposed that the Bank adopts: (i) Basel II risk based methodology which differentiates risk charges between sovereign and non sovereign operations to better match the Bank s risk profile and covers all risks involved in the Bank s operations; (ii) the strategic prudential limits for non sovereignoperation and equity limit be adjusted to 40% and 15% of the total risk capital of the Bank, respectively to reflect the Medium Term Strategy and the global country concentration limits to be directly linked to the Bank s risk capital ; and (iii) the Bank maintain a single debt limit which caps the total outstanding debt to 100% of the usable capital. Management also recommends that the capital adequacy and related policies should be reviewed periodically in line with best practices and the review processes of other MDBs. It is important to note that all parties involved in the review of management proposal (risk advisory services, rating agencies, peer group reviewers) consider the proposed approach prudent given the migration in the medium term towards a riskier portfolio. An assessment of the implication of this enhanced capital adequacy framework indicates that the Bank currently has sufficient financial capacity for an upward adjustment of its prudential limits in order to play 1 Risk Capital Utilization Rate (RCUR) is the capital adequacy metric. It is calculated as the ratio of total risk capital used to back up risk assets and shareholders equity (reserves + paid in capital). RCUR was 75% in 2000 and declined to 45% in December 2007 Page 4

6 the required catalytic role for private sector development and thereby be relevant to all RMCs through increasing its development credits. However, it must be underscore that potential sharp deterioration in the credit quality of the portfolio as result of aggressive lending above the lending scenario of the MTS will put pressure on the Bank s risk bearing capacity. In recognition of this fact an Institutional tolerance for risk is embodied in the proposed enhancement of the Bank s capital adequacy and related policies. This seeks to maintain a prudent risk profile consistent with the Bank s highest credit rating and adequate risk governance. I. INTRODUCTORY BACKGROUND From end March to early May 2008 the Board examined through a series of informal meetings the two independent reviews of the Bank s Capital Adequacy Framework and Management responses to these reviews. There was a broad consensus on the need for a revised capital adequacy policy based on the proposed two tier risk based methodology indicated in the document 2. This proposal is developed in response to the commitment made by Management. It follows the technical note 3 presented to the Board in September 2008 and the resulting questions and answers briefing note on potential revisions and enhancements to the Bank s methodologies for capital adequacy and other financial policies. The Board at its meeting of September 2008 requested Management to work with AUFI/CODE to develop a final enhanced framework for subsequent Board consideration. Due to the technical complexity of capital adequacy issues and the need to have an objective external assessment, Risk Analytics and Advisory services firms were engaged to review Management s proposal. The revised proposal was subsequently presented to AUFI/CODE and examined on January 29, This paper builds on these series of enhancement reviews as well as feed back from AUFI/CODE members. The proposal uses the Basel II IRB (Internal Ratings Based) approach as reference in line with current industry best practices and for the sake of transparency and simplicity. It advocates for a flexible, gradual and phased approach, avoiding the setting of hard rules that may be difficult to reverse in the future. The Bank s overall capital adequacy and exposure management policy proposal consists of: (i) a risk based methodology to determine risk capital charges to support the Bank s operations, (ii) a policy on capital adequacy that caps the total capital utilisation (iii) associated policies on prudential exposure limits, pricing and leverage, and (iv) risk governance and infrastructure to enhance transparency. This document consists of six sections focusing on the 3 pillars of the enhanced framework. After the introductory and background section, the second section reviews the Bank s Current Capital Adequacy Framework with focus on the limitations and rationale for changes. The third section presents Management s proposal for enhancement. The fourth section examines the Risk Management implications for other related financial policies. The fifth section focuses on key implementation pre requisites. Finally, the sixth section presents the conclusions and recommendations. A set of key annexes are also provided as references. 2 Management response to the Independent Review of the Bank s Capital Adequacy ADB/BD/IF/2008/86 3 Technical note on the Capital Adequacy Framework ADB/BD/IF/2008/196 Page 5

7 II. RATIONALE FOR THE REVISION OF THE CAPITAL ADEQUACY FRAMEWORK The current framework developed in has served the Bank well. While it has achieved the desired results in terms of providing an adequate risk and exposure management framework to the Bank changing operating environment and rapid developments in the financial markets, growing complexity of the Bank s development credit and treasury operations (introduction of new products, more complex financial transactions) have called for its enhancement. The enhancement review is grounded on the following factors: (i) the current framework is based on externally benchmarked and static risk parameters which do not fully reflect the Bank s current risk profile; (ii) there have been several developments in the Bank s operations recently with the approval of both the Private Sector Strategy and the Medium Term Strategy; (iii) stakeholders are calling for a better utilisation of the Bank s risk capital ; and (iv) the need for the Bank to be relevant to all RMCs as per its mandate viz. its current credit policy limiting access to its ordinary capital resources to only 13 countries. Moreover, in an environment of market turmoil, heightened uncertainty and increased volatility, the capital adequacy policy needs to be reinforced, henceforth the development of a more robust and resilient framework. 2.1 Risk Based Capital Allocation and Capital Utilization Limit The current methodological Framework The fundamental purpose of Bank s capital adequacy framework is to ensure a prudential balance between the risks assumed and its risk bearing capacity. The Bank s risk bearing capacity is judged in terms of the adequacy of its equity capital (i.e. available paid in capital plus reserves, also called risk capital) to absorb its balance sheet risks and continue to support normal lending operations. By enabling it to absorb risk out of its own resources, the Bank risk capital protects its shareholders by minimizing the probability of call on capital. In the current framework the risk capital utilisation rate (RCUR) is defined as the ratio of total used risk capital over total usable risk capital (RCUR). The capital adequacy policy limits the (RCUR) to 100% of risk bearing capacity with an alert which is triggered when the used risk capital level reaches 80% of the total risk bearing capacity. To determine the risks assumed, the Bank categorizes all its assets (loans, equity investments, guarantees, and treasury operations) into risk buckets/classes and assigns a risk capital charge to each asset based on the credit quality of the asset(i.e. its rating). The amount of risk capital required to support the overall portfolio of assets is estimated as the simple sum of the risk capital requirements of the individual assets. As illustrated by figure 1, the Bank s internal rating system classifies all Bank assets into five risk classes (Very Low Risk, Low Risk, Moderate Risk, High Risk and Very High Risk) which correspond approximately to the international rating system (AAA to BBB, BB+ to BB, B+ to B, CCC+ to CCC, below CC+) respectively. The risk capital requirement (kc) ranges from 25% 5 for assets in the very low risk class to 75% for assets in the very high risk category. The risk capital requirement for equity investment is 100% and 1% for Treasury assets. 4 Policy on Capital Adequacy and Exposure Management ADB/BD/WP/2000/29 5 A capital charge of 25% for very low class asset mean that the Bank sets aside 25 cent for 1 UA of credit committed in that rating class. Page 6

8 Figure 1: Risk Capital Requirements Unused Risk Capital Total Used Risk Capital Total Usable Risk Capital Risk Capital Required 25% 28% 35% 50% 75% All Assets Very Low Risk Low Risk Moderate Risk High Risk Very High Risk Limitation of the current framework and Rationale for changes The risk capital charges indicated above are benchmarks that were developed mainly through comparative assessment with other International Financial Institutions (IFIs) at a time when the Bank had limited history on the default probabilities of its sovereign and non sovereign borrowers. In the absence of default probabilities, the risk capital charges were conservatively set to factor in the Bank s high risk operating environment. There are structural weaknesses and several operational constraints inherent in the current framework that are briefly summarised below: Limited coverage of risks The focus is primarily on credit risk related to the Bank s lending operations and treasury counterparties with minimum consideration for market related risks (i.e. risks arising from the balance sheet structure, equity and quasi equity investments, risk management products). Even for credit risk it has a broad brush approach that excludes the un drawn commitments (i.e. un disbursed loans balances). Operational risk is also not covered. Static risk parameters The risk capital charges indicated above are static benchmarks that do not factor risks related to longer tenors, general liquidity and credit squeezes in the market. They tend to result in mis pricing of credit risk over time. Lack of risk differentiation The risk charges do not make a differentiation between sovereign and nonsovereign operations, as well as between listed and unlisted equity investments. They imply that sovereign states and corporate borrowers have equal risk weight i.e. one size fits all. Also capital charges are set at the same level regardless of the maturity of the credit exposure, while in reality default risk is greater with a longer exposure. Furthermore, they do not provide built in flexibility to Management to support new products development based on their inherent risk profile as the portfolio grows. No scope for credit enhancements No recognition of credit risk mitigants, which encourage capital arbitration through structured transactions, is another inherent constraint. For private sector operations the current framework does not take into account the seniority of loans as well as the strength of the Page 7

9 collateral; in the same vein it does not factor the preferred creditor status in sovereign operations. Moreover, with the Bank s lending operations leaning more towards the emergence of new lending instruments (syndication, local currency lending, etc.) the current risk charges may no longer reflect the true risk profile of the portfolio. Conservative bias Finally, some stakeholders have expressed concerns that risk charges are too conservative, particularly for the lowest risk class 1 (sovereign investment grade borrowers) that historically have never defaulted on their payments to multilateral creditors. This view that: there has never been a default and/or practically a zero write off of sovereign loans on sovereigns rated investment grade (BBB and above) within five to seven year period of being rated at that level was confirmed by the independent reviews of the Bank s capital adequacy framework. In the light of the above limitations and given the general view that there is a conservative bias in the Bank s current methodology for determining risk capital charges for sovereign operations, a review of the current methodology was recommended. However, in refining the methodology and risk parameters, efforts are concentrated in areas where the incremental value is the highest and new measures are cost effective in terms of implementation. 2.2 Prudential exposure limits The Bank s exposure management strategy seeks to achieve adequate portfolio diversification by applying a framework of simple exposure limits. These exposure limits are linked to the Bank s risk bearing capacity and the pace at which the limits are consumed depends on the riskiness of the Bank s assets. There are divided into two broad categories: (i) strategic limits and (ii) operational or ancillary limits. The Bank s strategic exposure limits are described below: Equity Exposure Limit The aggregate risk capital required to support all equity investments combined must not exceed 10% of the Bank s total risk capital. This limit is in line with Article 15.4 (a) 6 Non Sovereign Exposure Limit The aggregate amount of risk capital required to support the Bank s non sovereign portfolio must not exceed 20% of the Bank s total risk capital. Global Country Exposure Limit The aggregate amount of the Bank s combined sovereign and nonsovereign exposure to any given country should not exceed 15% of the maximum sustainable portfolio. This maximum portfolio is the sustainable level of lending in terms of: (i) outstanding portfolio supported by used risk capital, plus (ii) the new commitments that could be generated by the unused risk capital. The operational limits are defined in terms of: Non Sovereign Single Country Exposure Limit The aggregate risk capital required to support all non sovereign operations in any single country must not exceed 20% of the non sovereign exposure limit. Non Sovereign Single Sector Exposure Limit The aggregate risk capital required to support all non sovereign operations in any single sector must not exceed 35% for the financial sector and 25% for other sectors of the non sovereign exposure limit. 6 Board Document ADB/BD/WP/99/46/Rev.4/Add.2 related to Article 15(4) of the Bank s agreement (limitations on Operations: Equity Investments). Resolution B/BG/2001/09. Page 8

10 Non Sovereign Single Obligor Exposure Limit The aggregate risk capital required to support all non sovereign operations with any single obligor or group of related obligors must not exceed 4% of the non sovereign exposure limit. The major issue associated with these limits is that they have been instituted at time when the Bank s portfolio was marked with a steady growth profile dominated by sovereign operations, and with a limited experience in private sectors operations and complex treasury activities. Since then the Bank portfolio risk profile has shown a significant shift in line with a current economic environment which is quite different from what was prevailing in the early 2000s. Furthermore, with the current financial crisis an increasing number of MICs realized the importance of having access to a stable long term funding source to finance their social and economic development. The international capital market can no longer provide such funds at cheap cost. This results in more pressure from stakeholders to increase lending to creditworthy borrowers. Responding to this business imperative within the framework of the current limits becomes challenging. More importantly, the current limits are no longer consistent with the Bank s Medium Term Strategy and shareholders expectations. Notwithstanding the above, the concentration and exposure limits review should factor in the need for a capital buffer to support a sustained growth without jeopardizing the Bank s triple AAA rating. 2.3 Other Related Policies related to the framework In addition to the Risk Capital Utilization Rate, the Bank uses other policy metrics to monitor its capital adequacy. These include leverage and gearing ratios all linked to the Bank s risk bearing capacity Leverage policy The leverage policy governs the total volume of borrowed funds that can be mobilized by limiting the Bank s debt to its risk bearing capital and callable capital. By doing so it establishes the maximum size of the total liabilities for a given level of risk bearing capacity. The Bank manages its leverage through three key debt ratios presented below. By linking the debt level to Capital, these ratios provide comfort to bondholders and recognize callable capital as the last resort resource for debt repayment in the unlikely event of the Bank s being unable to face its financial obligations. These ratios have been the subject of extensive internal review by ALCO sub committees, and external review by risk advisory services and rating agencies and were endorsed by ALCO with the following conclusions: Leverage Ratio 1 which specifies that total debt shall not exceed 80% of Total Callable Capital introduces an arbitrary haircut of 20% on callable capital which has no justification. Leverage Ratio 2 which requires that total senior debt, shall not exceed 80% of the callable capital of non borrowing member countries. This ratio is no longer relevant because the Bank no longer issues subordinated debt. Leverage Ratio 3 which stipulates that total debt, shall not exceed 100% of Usable capital. Also, further to the independent reviews of the Bank s capitalization level, ALCO requested an investigation of whether the total debt to usable capital ratio (Ratio 3) should not introduce the concept of Net Debt. Page 9

11 The Net Debt concept takes into account debt raised to finance Development Related Exposures, while debt raised to fund liquid investment securities (rated above AA ) is excluded. Net Debt = DEBT LIQUID INVESTMENT (for securities rated above AA ) Usable Capital (for shareholders rated at or above AA) < 100% Preliminary consultations with rating agencies indicate that most of the agencies do not have any objection with the implementation of the net debt to usable capital ratio as the Bank s key borrowing limit. However, there were differing views amongst sister institutions and risk advisory services on the proposal, articulated around its strengths and weaknesses, more importantly, this ratio can result in an increase in the Bank s debt level with no policy limit when the additional debt contracted is invested in liquid assets. In a volatile market environment, the assumption of liquidity of highly rated assets is questionable. Reducing the Bank debt ratio to a net debt ratio will not resolve the leverage constraint linked to its medium term business strategy. It might only provide some headroom which will not postpone the leverage constraint problem and thereby the ability of the Bank to response to clients demands as result of the financial crisis Gearing Policy Unlike the risk capital utilization rate, the Bank s gearing policy links its outstanding commitments to the total capital and reserves (including the callable capital) as stipulated in article 15.(1) of the Agreement Establishing the Bank. In other words, loan amounts committed plus equity investments and guarantees should not exceed the unimpaired subscribed capital plus surplus and reserves. The gearing policy is less restrictive and the ratio stood at 38.1% as at end of December The projections based on the MTS lending growth scenario and the average portfolio risk profile indicate that the limit will be reached around year Loan Loss Reserve and Pricing Policies Like all other financial institutions, extending credits carries some degree of losses that are an inevitable part of the business: expected losses. There is also a non negligible probability of large losses well beyond the expected losses, although the probability is very low: unexpected losses. It is for these large but lowprobability unexpected losses that financial institutions hold risk capital. Expected loss risk of doing business is covered by provisioning and pricing (i.e. the minimum lending margin required to break even). Prior to the revision of the relevant International Accounting Standards in 2005, the Bank made both specific and general provisions on its loans. Loan loss provisions were then based on expected losses and restricted to only loan principal. Income was also not accrued on non performing loans. With effect from 2005, and in response to the revisions of IAS 39, the Bank now determines impairment on loans using the incurred loss approach. The amount of impairment determined on the basis of such approach is charged against the income statement. Cumulative amounts of impairment are deducted from the loan balances on the balance sheet. Under Basel II, loans are considered to be impaired when 90 days past due. The new capital adequacy framework will adopt and apply the IFRS impairment principles in line with the Bank s financial regulations and accounting policies. 7 Based on the 2008 un audited financial statements. Page 10

12 With respect to pricing, within the 2000 capital adequacy framework, the Bank approved a flexible, costrecovery pricing policy based on a sister institution s framework for private sector operations dating back to As the Bank s portfolio risk profile, instruments and operating markets are quite different from the one experienced at that time the pricing framework is due for revision. 2.4 Review Process The Bank has followed a thorough and rigorous five step process to develop the proposed new capital adequacy framework. The first step involved consultations with the Multilateral Development Banks to complete a peer review and benchmarking exercise. The second step consisted of an independent review of the Bank s Capital Adequacy Framework by two reputable international financial institutions. These two institutions were asked to provide an independent assessment of the appropriate level of the Bank s capital, taking into account its anticipated operations expansion, in particular the non sovereign lending. The independent assessment of the capital adequacy framework has culminated in a recommendation for a revised capital adequacy framework. The third step involved discussions of Management proposals with rating agencies. In this respect, the proposed methodology and resulting risk capital charges were discussed with international rating agencies to ensure that the changes do not jeopardize the Bank s financial soundness and integrity as measured by its Triple A rating. They have also provided feedback on the revision of prudential limits as summarised in Annex 2. The fourth step involved consultations with the Asset and Liability Committee ALCO working groups that have specialized expertise across the Bank s complexes. The resulting technical note was discussed by the Boards and supplemented by a questions and answers document. This was followed by an independent and comprehensive review of Management proposal by two risk advisory services. Final review was made subsequent to the discussion of the proposal by the Joint AUFI/CODE committee to factor Board members comments. This document completes the final step of the five step review process and is submitted to the Board of Directors for approval. 2.5 Phased approach, dynamic and continuous review From external benchmarking to Basel II and Economic Capital Allocation The initial capital adequacy framework was based on benchmarking and peer group review. For the revised framework, a phased and gradual approach is proposed, focusing at the first stage on Basel II regulatory capital approach (Internal Rating Based approach Advanced) combined with stress testing. At a later stage, this approach will be complemented by an economic capital method. In this respect, it is worth indicating that our benchmarking review indicates that there are several approaches that offer conceptually sound solutions but they are difficult and costly to implement. Therefore a simple and technically more sound risk based approach using Basel as reference is more prudent at this stage. Periodic review for further enhancement The proposed framework represents work in progress with respect to the phased approach. It will need to be continuously reviewed during the coming years as the Bank builds up its database of risk parameters related to the methodology. The proposed approach will be more dynamic as risk capital charges will be reviewed annually based on the characteristics of the Bank s evolving portfolio. During the implementation of the framework, enhanced reporting systems will allow the Board and Management to track the impact of these changes. There is also a proposal to enhance the risk oversight function and to make this review process more flexible in the future. Page 11

13 III. THE PROPOSED REVISED FRAMEWORK The Bank s stakeholders have several expectations that Management s proposal relating to capital adequacy should be addressed diligently and prudently. However, this necessitates a flexible, gradual and phased approach as indicated above. 3.1 Key Pillars of the Policy Framework The three essential pillars that will ensure an effective capital adequacy framework are the following: 1. A comprehensive methodology for integrated capital adequacy framework covering all institutional risks with their commensurate risk capital charges. 2. The establishment of prudential exposure limits for country, private sector operations and equity investments for an efficient management of the risks assumed by the Bank; and 3. The implementation of a sound risk management framework that integrates capital adequacy with other related financial policies in line with best banking and risk management practices. 3.2 Methodology for integrated capital adequacy framework An important component of a sound capital adequacy framework is a transparent methodology that measures risks accurately and allocates adequate capital to the risks assumed. However, it is important to note that there is no single standardised or universal methodology for determining the MDBs capital adequacy. Management is proposing a two tier risk based methodology: Tier 1 Setting of risk capital charges the methodology would be an enhancement of the existing model based on Basel II regulatory framework to ensure that risk capital charge allocation is transparent, simple to understand and implement. Tier 2 Integrated risk adjusted system to support all segments of the business portfolio and all risks faced by the Bank (credit, market and operational risks) Methodology underlying minimum capital requirements Key risk drivers The Bank s risk capital is available for supporting additional loan growth, transfers to development initiatives and waivers for adjusting public loan pricing. In such context, the Bank needs to monitor carefully the key risk drivers of capital utilization and ensure that capital charges reflect the evolving risk profile of the portfolios. In this respect, the new framework ought to be dynamic in order to tailor risk charges to the changing business risk profile for an optimal redeployment of risk capital. The new framework for risk capital allocation seeks to address these concerns of optimal redeployment of capital and those mentioned in the previous section. Instead of using static benchmarked risk capital charges, this methodology maps risk capital charges to the Bank s portfolio risk profile based on: (i) historical Probability of Default (PD), (ii) Loss Given Default (LGD) and (iii) effective maturity (M) for each asset in the Bank s portfolio. These are detailed out in Annex 1. Parameters Risk Metrics Probability of Default Loss Given Default Exposure at Default Risk Charges Risk Capital Utilization Rate PD LGD EAD K RCUR Page 12

14 The risk capital charges are determined using the probability of default and loss given default that are directly derived from the IRB methodology. They are applied to the exposure at default to determine the total risk assumed and consequently the amount of risk capital used by the Bank Risk Differentiation One of the key features of the new capital adequacy approach is the ability to generate capital charge by type of portfolio, type of product lines and investments factoring credit enhancements. The current approach applies uniform capital charges to private sector and public sector loans, listed and unlisted equity investments. In the new methodology, the structure of the minimum capital requirements provides flexibility to accommodate products of different risks. This enhances the internal risk management and decision process with respect to the marginal contribution of new transactions to portfolio risk and alternative usage of risk capital. The differentiated charges by portfolio type are summarized below. Sovereign Risk Capital Charges The sovereign risk capital requirements (ks) for assets in each risk rating category were determined using the Bank s specific historical information on three key risk parameters: PD, LGD and M. Details on the methodology used to determine the PDs and LGDs for the sovereign sector, as well as the benchmarking results with other institutions is presented in Annex 1. Table 1 below summarizes the current and the revised risk capital charges for the sovereign sector, and shows higher risk capital charges as the credit quality deteriorates. The decrease in risk charges for countries rated between 1 and 4 as compared to the current charges is in line with the observations of stakeholders and independent reviewers about the fact that sovereign borrowers with investment grade ratings have historically rarely defaulted on their payments to multilateral creditors. On the other hand, countries rated between 5 and 10 recorded higher risk charges than in the current framework, primarily reflecting the historically observed long time duration during which these countries remain in default (usually between 10 to 20 years) once they fail to meet their obligations to the Bank. The revised capital charges are considered prudent considering the historical and peer experience. Given the current economic climate, these capital charges will be reviewed periodically with particular attention to regional (not country only) impact, which could trigger a wave of simultaneous defaults. Table 01: Sovereign risk capital charges under various approaches ADB Risk Classes ADB Internal Rating 1 10 Credit Quality Current Risk Charge (kc) Revised Sovereign Risk Charges (ks) Very Low Risk 1 Excellent 25% 3% Low Risk 2 Strong 28% 7% Moderate Risk 3 Good 35% 15% 4 Fair 35% 35% High Risk 5 Acceptable 50% 57% 6 Marginal 50% 89% Very High Risk 7 Special Attention 75% 98% 8 Substandard 75% 100% 9 Doubtful 75% 100% 10 Known loss 75% 100% Page 13

15 Non Sovereign Risk Capital Charges For the private sector portfolio the determination of the risk parameters (PD, LGD) is less straightforward due to lack of depth in the historical database which dated back less than a decade and consists of only 45 operations. Given the paucity of observable data for the period a number of possible scenarios might arise. The Bank should select the approach that is best calibrated to the credit risk profile of its private sector portfolio. Such approaches shall be periodically revisited to factor experience gained by the Bank over time in private sector operations. Probability of Default (PD) Based on the finest evaluation of the private sector transactions default and further measurement guidance provided by external risk advisory services and rating agencies, four options have been considered hereafter: (1) Option 1 cohort analysis of ADB Historical Data calibrated; (2) Option 2 Implied PD (Private Sector PD anchored to Sovereign PD) This approach is based on developing structural relationship between the sovereign and non sovereign PD. (3) Option 3 Proxy relationship with MDBs having similar portfolio risk characteristics; and (4) Option 4 Generic Market consisting of implied default from external data providers. Annex 1 summarizes the various options and their implications for risk capital charges. Management recommends option 2 (i.e. implied PD) as a transient measure until the build up of consistent default history for private sector operations. It is worth noting that the notch difference between sovereign and non sovereign may exceed the 1 2 level suggested by the policy (3 notches for some obligors as per the assessment of advisory services). Loss Given Default (LGD) LGDs estimate depends on several factors such as the seniority of loans and the strength of the collateral. Under the Basel II approach senior claims on corporates and banks not secured by recognized collateral are assigned a 45% LGD, while subordinated claims are assigned a 75% LGD. LGD experience of comparable sister institutions for private sector operations indicate 40% LGD for senior secured loans and 55% for subordinated loans. Also, from the analysis of the Bank s database, while LGD are not necessarily correlated to ratings, it was observed that for very weak credits, rated below 7, a 100% LGD is observed. Moreover, the historical recovery rate of the Bank s private sector portfolio was very low. Based on these assessments and given the more risky operating environment of the Bank s private sector operations and in order to remain in line with best practice and Basel standards, the following LGD matrix is proposed for the Bank. The matrix was endorsed by ALCO. For the outstanding portfolio, applying this matrix, the LGD obtained for each entity of the Bank s portfolio will be reviewed on a case by case basis by the Non Sovereign Credit Working Group of the ALCO, in charge of monitoring private sector entities ratings and LGDs will be adjusted on a yearly basis. Senior Strong security Moderate security Weak security Unsecured Subordinated LGD 8 35% 45% 50% 50% 75% Using this matrix and applying the structurally determined PDs, the risk charges for the private sector are summarized in Table 02 below. The non sovereign risk charges will be continuously monitored. Over time, the need to change the levels of risk charges as additional data and methodological improvements are taken into account, will be communicated to the Board for decision. 8 For all exposure rated between 8 and 10, LGD is 100% Page 14

16 Table 02: Non Sovereign risk capital charges under various approaches ADB Risk Classes ADB Internal Rating 1 10 Current Risk Charge (kc) Senior Secured (kns1)* LGD = 43% Proposed Senior unsecured (Kns2) LGD = 50% Subordinate (kns3) LGD = 75% Very Low Risk 1 25% 24% 27% 41% Low Risk 2 28% 27% 31% 46% Moderate Risk 3 35% 38% 44% 65% 4 35% 44% 50% 75% High Risk 5 50% 47% 55% 82% 6 50% 47% 55% 82% Very High Risk 7 75% 49% 60% 87% 8 75% 100% 100% 100% 9 75% 100% 100% 100% 10 75% 100% 100% 100% * Average of the three types of security (strong, moderate, weak) It is important to note that this differentiation in private sector risk charges, by adding more risk categories for use of credit risk mitigants, requires active collateral management that is currently not in place. Under the above methodology the risk charge is specific to a given transaction as it is based on its risk characteristics. This implies that for a strongly secured highly risky transaction the risk charge will be relatively lower than a low risk unsecured transaction. Comparative Analysis with IFIs operating in similar business environment The benchmarking with peer group IFIs summarized in Table 3 indicates that the risk capital charges of the Bank are in line with market standards. It is also important to note that the risk charges do not curtail private sector business growth or prevent the institution to make commitments in high risk countries. The main issue in benchmarking the Bank s private sector capital charges with other Private sector oriented IFIs remains the extent to which charges are determined within the context of specific risk appetite of an institution. Also using a specific allocation process can be replicated to another institution. These benchmarks may provide a valuable comparative basis, but it is evident that they are not yet a potential replacement for the risk charges of the Banks non sovereign portfolio. Furthermore, there are issues of risk/reward and profitability concerns that vary as per the mandate and the geographic diversification of the business of each institution. Table 03: Indicative risk capital charges using peer group IFIs risk parameters ADB Risk ADB Internal Current Comparable IFI (1)* Comparable IFI (2)* Classes Rating 1 10 LGD (40%) Risk Charge Senior (40%) Subordinated (55%) Very Low Risk 1 25% 19% 27% 37% Low Risk 2 28% 23% 30% 41% Moderate Risk 3 35% 24% 34% 46% High Risk % 50% 29% 32% 36% 38% 49% 52% 6 50% 35% 40% 55% Very High Risk 7 75% 36% 41% 56% 8 75% 100% 100% 100% 9 75% 100% 100% 100% 10 75% 100% 100% 100% Page 15

17 3.2.3 Comprehensive approach to risks Aggregated Weighed Average Risk Profile The Bank like any financial institution is exposed to three broads types of risks for which risk capital has to be allocated in order to protect it from financial losses: (i) credit risk; (ii) market risk; and (iii) operational risk. The proposed methodology will encompass this whole risk universe by addressing all these risks which are either not fully captured or not captured at all under the current framework and assign appropriate amounts of capital charge commensurate with their risk profile. However, the biggest emphasis still will remain on the development related credit risk (sovereign and non sovereign) which is the largest source of risk for the Bank. Table 04 summarizes the coverage of risk and aggregate exposure used to determine the Bank s total risk capital utilization. Table 04: Risks covered in the revised Capital Adequacy Framework Business Activities Type of Risk Methodology for Risk Capital Charge Allocation Disbursed Loan Portfolio Based on proposed Risk Capital charges for both the Sovereign and Non Sovereign Portfolio. Development Related exposures (primarily credit risk; market risk on equity investments) Undisbursed Loan Portfolio Equity Participation Direct Credit Substitute (Guarantees) New products (Unhedged local currencies, Portfolio Management) Same as for the disbursed loan portfolio but with a 75% Credit Conversion Factor. 50% 75% for Listed Equities 76% 100% for Unlisted Equities Loan Equivalent value of the Guarantee to which risk capital charges are applied. Capital charges will be determined on a case by case basis if the estimated potential loss is estimated to be material. Treasury Operations (Credit & Market risks) Credit Risk on Treasury Assets Credit Risk on Swaps and other Derivatives Market risk on Treasury portfolios Based on credit rating of the counterparty: 0% for Cash, and sovereign rated AA+ and above ; 1.6% to 4% for all other Treasury exposure depending on the type of instrument & maturity. Replacement cost of the derivatives (market value) adjusted for collateral to which a capital charge of 1.6% is applied. Mitigated by the Bank ALM policy and matching principle for interest rate and currency risks. Additional risk charges will be applied to the residual exposure if this exposure is material. Value at Risk will be used as metrics in tandem with stress testing. All Bank activities (Operational Risk) Operational Risk 15% of the average Operating Income for the preceding 3 years. No provision for Legal or reputation Risk In managing the overall risk profile of the portfolio, Management will target an average weighted rating of the portfolio between 3 and 4 based on the above coverage. Page 16

18 3.2.4 Capital Utilization limit (RCUR) The degree of risk the Bank is willing to assume in achieving its development mandate and its overall risk tolerance, are limited by its risk bearing capacity. In weighing the trade offs it faces in its normal business, the Bank seeks to eliminate any material risk of either unacceptable financial consequences (such as a call on shareholder capital) or unacceptable non financial consequences (such as severe damage to the Bank s reputation). RCUR provides a long term view on the parameters of such trade offs. In the new capital adequacy framework, RCUR will be maintained as metrics as it provides a forward looking tool to measure the risk assumed through the Bank business. When combined with the other related financial policies, it would protect the Bank from the potential losses associated with development related exposures and treasury operations. The trigger of 80% on RCUR for increasing the Bank s capital base will also be maintained. However this ratio will be monitored in tandem with minimum level of equity to risk assets determined through nonaccrual shock stress testing and market risk stop loss. 3.3 Prudential Exposure limits Having prudently built its reserves and minimized market and credit risks in its portfolio, the Bank has some flexibility to leverage its risk capital. This provides some scope to take additional risks in pursing its development mandate through: (i) extending credit to high risk private sector transactions with commensurate development impact; (ii) participating in investment funds in countries rated below the average risk to attract private investors; and (iii) committing larger amounts in the form of direct or syndicated loans to single obligors (borrower, country). Such increase in limits would factor in the possibility for the Bank to sell exposure. With respect to operational ancillary limits, the Bank s exposure management strategy will continue to seek to achieve adequate diversification across portfolios. Accordingly, the guiding principles used to determine the proposed prudential limits are: (i) efficient deployment of the Bank s risk capital to respond to the call of shareholders, (ii) institutional business strategy marked by significant growth of the private sector exposure, and (iii) maintaining the triple A rating by ensuring that the Bank maintains sufficient capital buffer to sustain risks assumed through its business and being able to respond to shocks. Management s proposal which factors the above considerations is summarized in Table 05. Table 05: Proposed Prudential Exposure Limits Prudential limits Current Proposed Share of Global Country Limit 15% Maximum Sustainable Portfolio 15% Total Risk Capital Private Sector Limit 20% 40% Total Risk Capital Equity limit 10% 15% Total Risk Capital Single Country Non Sovereign exposure 20% 25% Non sovereign Risk Capital Single Sector Limit Financial Services 35% 35% Non sovereign Risk Capital Single Sector Limit Other sectors 25% 25% Non sovereign Risk Capital Single Obligor limit 4% 7% Non sovereign Risk Capital Page 17

19 3.3.1 Ceiling on the Bank s Private Sector Operations The proposed level of 40% is based on the current size of the Bank s private sector operations and their projected annual growth over the MTS period. It drives the maximum sustainable volume of operations that would not jeopardise the Bank s key financial ratios. This ceiling has been determined by stress testing the relationship between new non sovereign operations and risk capital utilization and key solvability ratios. The key assumptions include: (i) Growth of the Bank s risk capital; (ii) volume of new non sovereign approvals; (iii) mix of instruments (loans versus equity); (iv) disbursement profiles; (v) repayment profiles; and (vi) risk profiles of new approvals as well as rating migration patterns of outstanding exposures. If the credit risk profile of the private sector portfolio deteriorates, this level will not be sufficient to sustain long term private sector growth. To ensure that in a worse than expected scenario the limit will not be a binding constraint, there is a need to pay more attention to risk sharing instruments to transfer risks from the Bank to third parties able and willing to take such risk. Adequate exist mechanisms in entering into funds and venture capital businesses need to ensure that the Bank s role remains catalytic Limit on the Bank s Equity Participation Management proposes that, the aggregate risk capital required to support all equity investments combined must not exceed 15% of the Bank s total risk capital, an increase from the current 10%. This decision may need to be endorsed by the Board of Governors. However, given that the equity investments entail higher risk coupled with the inadequate exit mechanism due to limited capital market activity in RMCs, Management is of the view that the increase in the limit should be gradual. In proposing an increase in the limits, Management is cognisant of the higher risk nature of equity investment but also the necessity to respond to the increasing call from its stakeholders to: (i) play a catalytic role in development of the capital markets and provide seed capital in equity investment funds to attract private investors; and (ii) contribute to the development of SMEs and microfinance through equity participation in local and regional development Banks. Also, the increase in the equity limit will be accompanied by several initiatives to ensure that the risks inherent in this instrument are properly and actively managed. These measures include but are not limited to: (i) presentation of the equity investment strategy to the Board by the Private Sector Department (OPSM); (ii) enhanced equity portfolio monitoring to ensure new high risk equity transactions are limited as they have significant impact on the weighted average risk rating and net income through provisioning; (iii) disinvestment, exist strategy or sell down of shares to maintain exposure within prudential limits and (iv) annual equity portfolio performance review Global Country Exposure Limit The fundamental change in the global country limit relates to its direct linkage to risk capital. In the current framework the global limit was based on the maximum sustainable lending portfolio. The 15% rate remains but is now proposed to be anchored to the Bank s total risk capital. For comparison purposes the 15% share of risk capital corresponds to around 18% to 20% of the maximum sustainable lending portfolio depending on the product mix and the asset quality composition of the portfolio. Business decisions will continue to be driven by strategic fit, development impact and client needs. Page 18

20 It is important to note that the global limit applies to both ADB and ADF countries. However, in the case of ADF countries, the limit is meant for private sector operations and enclave projects and sets an overall ceiling on such operations. Global limit changes are within the realm of Board of Directors oversight responsibilities Ancillary Operational Limits To build a portfolio that is adequately diversified, the Bank put in place ancillary operational limits. These limits are aimed at reducing concentration exposure across risk segments and essentially related to sector, single country and single obligor limits within the ceiling of private sector operations. For exposure management purposes, 8 broad industry sectors are defined. The total risk capital used for any single industry sector should not exceed 25% of the total risk capital available for non sovereign operations. However, because of their diversified nature and fact that financial institutions are regulated by national central banks, the limit for this sector is 35%. The country and single obligor limits increase by 5% and 3% respectively in the revised framework. The single obligor limit is also a consolidated limit across all business lines (development credit and treasury operations). The single sector limits for financial institutions and other sectors remained unchanged. 3.4 Implications for Other Related Financial Policies Pricing of non sovereign operations The Bank utilizes a flexible cost recovery pricing framework as defined in the non sovereign operation guidelines. In this framework, the Bank s cost of extending its risk bearing capacity (in the form of lending to clients) provides a risk based benchmark for determining the lending spread for the facility. The Bank s lending rate to a client is composed of a Base Rate and a Lending Margin: Pricing Components Base rate Lending Margin Libor Operating Cost Economic Contribution Risk Premium Of which: Charges for Expected Losses Charges for Unexpected Losses As indicated in section 2. The risk premium component is based on a sister institution framework and its risk parameters dated back The Bank has now gained experienced in pricing private sector transactions. The flexible cost recovery policy is still relevant but the risk premium would have to be adjusted to reflect the PDs and LGDs derived from the enhanced framework. The capital charges applicable for pricing will also factor tenor risk to reflect the relatively long tenor of the Bank loans as compared to the market. A more granular internal rating scale based on the 10 grade function (i.e. expansion of the current grading into sub grades) will be used to ensure better differentiation of the transactions and reflect the reality of individual businesses rather treating all businesses within certain country equality Provisioning Policy There will be no change in the Bank s provisioning policy. However, under Basel II, loans are considered to be impaired when 90 days past due. However, IFRS principles based incurred loss method will be applied Page 19

21 to impaired loans, treasury investments and equity participations in line with the Bank s financial regulations and accounting policies Leverage Policy The rationale for changing the Bank s leverage indicators and limits is grounded on the following pillars: (i) adopting ratios closely monitored by rating agencies in order to ensure that the Bank maintains high standards of transparency thereby supporting its high credit rating in international capital markets; and (ii) maintaining a simplified framework that minimizes probability of call on capital. Ensuring that these fundamentals are embedded in the overall assets and liabilities management framework through pertinent operational limits is the key objective. It is proposed that the Bank maintain a single debt ratio, the debt to usable capital ratio in its current format, a policy similar to other MDBs and providing sufficient limitation to leverage. IV IMPLICATIONS OF THE PROPOSED ENHANCEMENTS 4.1 Implication for the Risk Capital Utilization Rate The MTS baseline lending growth marked by private sector expansion entails an increase in exposure over the period and increased capital requirement commensurate with that growth. Using the proposed new methodology this increase in risk capital utilization does not constitute a constraint as shown in Table 06. However stress testing of risk profile associated with such growth (i.e. WARR of above 4) indicates that the increased exposure could utilize more than 96% of the risk capital of the Bank by Therefore, a significant deterioration in portfolio quality could challenge the triple A rating if not managed prudently. The growth in exposure should be accompanied by prudent and active portfolio management. Table 06: Impact of the proposed Framework in the Risk Capital Utilization Rate* ( UA million and %) Total Risk Capital 4,708 4,623 4,705 4,802 4,882 4,999 5,124 5,236 5, Current RCUR (1) 49% 52% 54% 62% 75% 85% 94% 105% 116% Current Coverage: Sovereign 41% 39% 36% 37% 43% 45% 48% 52% 56% Non sovereign 5% 10% 15% 22% 30% 37% 44% 51% 57% Treasury 2% 3% 3% 3% 3% 3% 3% 3% 3% 2.Proposed RCUR (2) 39% 44% 48% 56% 67% 77% 88% 99% 110% Proposed Coverage: Sovereign 32% 27% 24% 24% 27% 29% 30% 33% 36% Non sovereign 5% 10% 16% 24% 33% 40% 48% 56% 63% Treasury 2% 3% 3% 3% 3% 3% 3% 3% 3% Operational 1% 1% 1% 1% 1% 1% 1% 1% Undisb. 3% 4% 5% 4% 5% 6% 7% 8% 3. Variance in RCUR RCUR (2) (1) 10% 8% 6% 6% 8% 7% 6% 6% 6% *The projected risk capital utilization rate is subject to changes linked to the continuous updating of the portfolio, the financials and the assumptions. Page 20

22 In the proposed framework risk capital limit will reach its trigger level around 2014 assuming steady growth in reserves. The portfolio impact is a reduced consumption of risk capital in the sovereign portfolio and higher increase in risk capital utilization by the non sovereign portfolio. Other risks not covered in the old framework such as operational and un disbursed commitments will utilize 5% to 9% from 2009 to the end of the MTS planning horizon. Figure 2 illustrates the growth profile of the risk capital utilization. Figure 2: Risk Capital Utilization 4.2 Implication for the prudential limits Implications for Global Country Limit Portfolio diversification is a key risk mitigation rule. For this purpose most of the MDBs manage credit risk and concentration through country limits, although they follow different approaches which reflect the specificity of their credit policy and the nature of financial operations. The risk based limit approach proposed in the enhanced capital adequacy framework limits the risk that the Bank takes in the most creditworthy country with the highest debt absorptive capacity to 15% of the total risk capital. The risk based limit approach also requires that the more risky the country, the lower the country limit (i.e. more risk capital is required to back up commitments when the Bank takes on more risk). Accordingly, individual countries limits are differentiated by relative risk position vis à vis the best rated country using a two dimension matrix: (i) risk rating; and (ii) country economic potential. The matrix is illustrated by Table 07. In risk dimension the high credit worthy country (risk class 1) will receive 15% (corresponding to 100% of the limit) of the global limit and the very low credit worthy country will have 2%. In the absorptive capacity dimension, countries are classified in five classes based on economic potential, ranging from Very Small Economy to Very Large Economy using IMF quota and GDP. The country limits for the non sovereign portfolio varying, for the same risk class (e.g. very low risk) from 15% for very large economy to 3% for the Very Small economy. It is important to note that the global country limit is an aggregate limit that integrates all exposures to counterparties and borrowing entities domiciled in the country for sovereign and son sovereign lending as well as treasury activities with entities in that country. The matrix is expected to be further refined to reflect the increased granularity of the rating master scale and absorptive capacity. Page 21