Basel Ⅱ Implementation in Korea
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1 Basel Ⅱ Implementation in Korea Mun ChongChin Director New Basel Accord Office Financial Supervisory Service Seoul, 7 July 2006
2 Agenda Ⅰ. Features of Basel Ⅱ Ⅱ. Implementation Efforts in Korea Ⅲ. Implementation Issues in Korea Ⅳ. Future Work -1-
3 Ⅰ. Features of Basel Ⅱ 1. Reasons for developing Basel Ⅱ 2. Major Features of Basel Ⅱ -2-
4 1. Reasons for Developing Basel Ⅱ 1) Increased sophistication of risk management practices 2) Increased complexity of banking venturing into new area, especially at larger banks OTC derivatives, structured finance, etc. 3) Developing a new forward-looking approach which is more sensitive to the actual risk 4) Ensuring a level playing field 5) Encouraging future improvements in the measurement and management of risk 6) New approach well-anchored on a solid corporate governance and sound risk culture BCBS(Basel Committee on Banking Supervision) decided to develop a new capital framework -3-
5 2. Major Features of Basel Ⅱ 1) Applicable to a wider scope of banking groups 2) Encompassing additional risk such as operational risks 3) Expanding the recognition of credit risk mitigation techniques 4) Based on three re-enforcing Pillars 5) Providing incentives to encourage improvements in banks internal risk management processes 6) Forcing the market place to exert external discipline on banks 7) The necessary greater co-operation among supervisors across jurisdictions -4-
6 Ⅱ. Implementation Efforts in Korea 1. Summary 2. Announcement of the Local Proposal 3. Implementation Date, Scope and Methodology 4. Approval Process and Use-test 5. Detailed Guidelines 6. Review of Banks Preparation -5-
7 1. Summary(1) Basel II Implementation Plan (Mar 2002) Specialized Units for Implementing Basel II New Basel Accord Steering Committee (Jan 2004) New Basel Accord Office in the FSS (Apr 2004) Local Proposal of Basel II (Oct 2004) Task force consisting of the FSS & Bank staffs contributed to the proposal Implementation Date, Scope and Methodology (Dec 2004) Implementation date : 1 Jan 2008 Scope of application : All domestic and foreign banks operating in Korea Methodology : Bank s own selection -6-
8 1. Summary(2) Detailed Guidelines Detailed guidelines for the IRB and AMA which require supervisory approval before usage Review of Banks Preparation (Jun, Dec 2005) On-site review of IRB/AMA banks preparation - IRB : 10 banks -AMA: 7 banks -7-
9 2. Announcement of the Local Proposal Announcement of the Local Proposal The Financial Supervisory Service(FSS) announced the local Proposal of Basel Ⅱ on 26 Oct 2004, which is based on the final version of Basel Ⅱ released by Basel Committee on end of June 2004 Task Force consisting of the FSS and bank staffs contributed to the proposal and reflected the market opinion National Discretion The FSS utilized some of the national discretions in order to reflect the Korean financial market <Example> 1. Under SA approach, <option 1> is applied to bank exposure In order to sustain the stability of financial and settlement system, the FSS selected the option 1 for bank exposure which applies the country credit rating instead of bank s own rating 2. Under F-IRB, the requirements to PD estimation is adjusted(5 years 2 years) Considering the domestic banks practice and preparation, the FSS eased the burden to implement F-IRB and gave the incentives to the domestic banks -8-
10 3. Implementation Date, Scope, Methodology Target Date for Implementation The FSS set 1Jan 2008 as the target date for the implementation of Basel Ⅱ All approaches for credit and operational risk will be implemented in Korea at the same time Scope of Application All domestic and foreign banks operating in Korea are subject to Basel Ⅱ Foreign banks branches will be excluded from Basel Ⅱ as in other countries Selection of the methodologies The selection of the methodologies is up to each bank Considering the level of risk management technology, banks can select the methodology for credit and operational risk measurement -9-
11 4. Approval Process and Use-test(1) Approval Process for IRB and AMA Banks targeting IRB or AMA must apply for qualification at least 6 months before implementation From year 2008, the application process will have the 6-month cycle (two cycles per year) end of Mar end of Jun Common Process Dialogue and Preview Application Review and Decision Implementation Retail F-IRB Use-test of Credit Rating System (2 years before application) A-IRB Use-test of Credit Rating System(3 years before implementation) AMA Initial Monitoring(2 years before implementation) -10-
12 4. Approval Process and Use-test(2) IRB Use-test Banks targeting to implement IRB must run the internal credit rating system which satisfies broadly the IRB minimum requirements for 2 years before application (Retail F-IRB) or 3 years before Implementation (A-IRB) Development and Validation of credit rating system Utilization of Credit rating system Understanding of Top Management And Reporting Development of credit rating system, estimation of risk parameters (PD, LGD, EAD) Validation of credit rating system and risk parameters In addition to the calculation of the regulatory capital, banks must utilize the internal credit rating system to other business processes Loan Approval, Pricing, Provisioning etc The main issues relating to credit rating and risk parameter estimation should be approved by the board of directors and top management Top management should fully understand the development and operation of credit rating system and check whether the system is operated in a proper way -11-
13 5. Detailed Guidelines Issuance of detailed guidelines for IRB and AMA The FSS issued detailed guidelines for IRB and AMA which require supervisory approval before usage IRB - Guideline for credit risk of corporate exposure (Aug 2005) - Guideline for credit risk of securitization exposure (Feb 2006) AMA - Guideline for AMA (May 2005) Cf. (Pillar2) - Guideline for Internal Capital Adequacy Assessment Process (July 2005) -12-
14 6. Review of Banks Preparation Banks Implementation Plan The FSS required banks to submit their implementation plan (Apr 2005) The FSS carried out off-site review based on the implementation plan On-site Review of Banks Preparation For the banks targeting IRB or AMA, the FSS also carries out on-site review semi-annually from June 2005 IRB : 10 banks ( F-IRB : 6 banks ) ( A-IRB : 4 banks ) AMA : 7 banks -13-
15 Ⅲ. Implementation Issues in Korea 1. Independent Validation 2. Unused Portion of Commitments 3. Economic Downturn LGD 4. BCP (Business Continuity Plan) -14-
16 1. Independent Validation Early Stage of Validation Function Korean banks are now trying to carry out independent validation to assure the credibility of their rating systems Different View at the Different validation function -15-
17 2. Unused Portion of Commitments Change of CCF in Basel Ⅱ Basel Ⅰ SA Basel Ⅱ F-IRB A-IRB Commitments with a maturity of up to 1 year Commitments with a maturity of over 1 year 0% 50% 20% 50% 75% Own estimation Significant Impact on RWA So far, Korean banks have lenient lending practice with regard to the commitments even if customers don t actually need the given limit According to the QIS results, the unused portion of commitments is one of the important factors that affect the RWA -16-
18 3. Economic Downturn LGD(1) Rationale The estimated LGD should be conservative reflecting the situation in economic downturn when default rate is relatively high Banks should put rigorous process in place for assessing the impact of economic downturn on recovery rate and estimation of downturn LGD <Common rules for LGD> LGD estimates should be based on data reflecting the following: Comparison of LGD for bank exposure with industry average LGD Economic and market situation Changes in the bank s lending practices -17-
19 3. Economic Downturn LGD(2) Definition of default used in estimating LGD should be consistent with that used for PD and EAD estimation LGD estimates should be experience-based and reflect the concept of economic loss LGD estimates of defaulted assets should reflect appropriate conservative estimates considering potential changes during recovery period Three-stage approach 1 Define adequate economic downturn situation for each segment 2 Identify whether default rate and recovery rate have adverse relation 3 Calculate downturn LGD estimate by reflecting adverse relations between default rate and recovery rate -18-
20 4. BCP (Business Continuity Plan) Sound Practice for managing Operational risk Banks should have in place contingency and business continuity plans to ensure their ability to Operate an ongoing basis and limit losses in the event of severe business disruption -Sound Practices for the Management and Supervision of Operational Risk (BCBS, Feb 2003)- After the September 11 terror attack, regulators must pay more attention on BCP IT Back-up Center V.S. Alternative Business Center Korean banks already set up IT back-up centers according to the guidance by FSS However, most Korean banks don t have alternative business center where they can operate business in case of disaster -19-
21 Ⅳ. Future Work 1. Eligible ECAI Recognition 2. Quantitative Impact Study 3. Enhanced Review of Bank s Preparation 4. Reflection of Market Opinion -20-
22 1. Eligible ECAI Recognition Eligibility Criteria of an External Credit Assessment Institution (ECAI) In order to implement the Standardized Approach (credit risk), eligible ECAIs should be determined in advance The FSS prepared eligible ECAI recognition criteria(*) and gathered market opinion through a workshop (June 2006) (*) objectiveness, independence, consistency, transparency, credibility Next Step ECAI application by the rating agencies (July 2006) Review the eligibility of applicants and recognize eligible ECAI (3Q 2006) Mapping ECAI s rating grades to the risk weights provided by BCBS (4Q 2006) -21-
23 2. Quantitative Impact Study Need to Carry Out QIS The FSS carried out QIS 3 to evaluate the impact of Basel Ⅱ on domestic banks With the final version of Basel Ⅱ announced, many countries carried out QIS 4 or QIS 5 to analyze the impact more precisely In order to evaluate and analyze the impact of Basel Ⅱ implementation more precisely and reflect the results to the adjustment of proposals (e.g. national discretion), the regular QIS need to be carried out QIS in Korea The FSS will carry out overall QIS and narrowly focused QIS as well to evaluate the impact on certain business line (e.g. SME, credit card) more thoroughly The FSS will adjust QIS criteria given by BCBS in order to reflect national discretion -22-
24 3. Enhanced Review of Banks Preparation Preliminary Review in 2006 In order to carry out the official review in 2007 more effectively, the FSS will enhance the quality of preliminary review in 2006 The FSS internally set up cooperative review unit comprised of risk specialists and RMs (relationship manager) It will carry out the review work which is divided by quantitative and qualitative parts Dealing with Regional Banks The FSS annually visits and trains the regional banks which lag behind the large banks and are relatively disadvantageous to prepare implementing Basel Ⅱ the FSS will have a chance to hear the difficulty in preparing Basel Ⅱand make communication channel for further exchange of local banks opinion -23-
25 4. Reflection of Market Opinion Various Channels to reflect Market Opinion The FSS hosts public hearing, workshop and seminar frequently in order to gather the interested parties (banks, rating agencies and research institutes etc) opinion and adjust the proposal to the Korean financial market condition Through the Task Force consisting of the FSS and banks, the FSS will carry out several empirical analyses and reflect the results to the proposal and the determination of the national discretion Other communication channels including interview are always welcome Interested parties(banks, rating agencies, research institutes etc) Public Hearing, Workshop/Seminar Task Force Interview etc FSS -24-
26 Thank you for your attention -25-
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