FROM BASEL 1 TO BASEL 3

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1 FROM BASEL 1 TO BASEL 3

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3 From Basel 1 to Basel 3: The Integration of State-of-the-Art Risk Modeling in Banking Regulation LAURENT BALTHAZAR

4 Laurent Balthazar 2006 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2006 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Balthazar, Laurent, 1976 From Basel 1 to Basel 3 : the integration of state of the art risk modeling in banking regulation / Laurent Balthazar. p. cm. (Finance and capital markets) Includes bibliographical references and index. 1. Asset-liability management Law and legislation. 2. Banks and banking Accounting Law and legislation. 3. Banks and banking, International Law and legislation. I. Title. II. Series. K1066.B dc

5 Contents List of Figures, Tables, and Boxes Acknowledgments List of Abbreviations Website ix xiv xv xix Introduction 1 Part I Current Banking Regulation 1 Basel 1 5 Banking regulations and bank failures: a historical survey 5 The Basel 1988 Capital Accord 16 2 The Regulation of Market Risk: The 1996 Amendment 23 Introduction 23 The historical context 24 Amendment to the Capital Accord to incorporate market risk 27 3 Critics of Basel 1 32 Positive impacts 32 Regulatory weaknesses and capital arbitrage 33 Part II Description of Basel 2 4 Overview of the New Accord 39 Introduction 39 Goals of the Accord 39 Open issues 40 Scope of application 41 v

6 vi CONTENTS Treatment of participations 42 Structure of the Accord 44 The timetable 47 Summary 47 5 Pillar 1: The Solvency Ratio 49 Introduction 49 Credit risk unstructured exposures standardized approach 50 Credit risk unstructured exposures IRB approaches 58 Credit risk: securitization 63 Operational risk 73 Appendix: Pillar 1 treatment of double default and trading activities 76 6 Pillar 2: The Supervisory Review Process 89 Introduction 89 Pillar 2: the supervisory review process in action 90 Industry misgivings 93 7 Pillar 3: Market Discipline 95 Introduction 95 Pillar 3 disclosures 95 Links with accounting disclosures 96 Conclusions 99 8 The Potential Impact of Basel Introduction 101 Results of QIS Comments 104 Conclusions 105 Part III Implementing Basel 2 9 Basel 2 and Information Technology Systems 109 Introduction 109 Systems architecture 109 Conclusions Scoring Systems: Theoretical Aspects 114 Introduction 114 The Basel 2 requirements 115 Current practices in the banking sector 117 Overview of historical research 119

7 CONTENTS vii The data 123 How many models to construct? 126 Modelization steps 127 Principles for ratio selection 130 The logistic regression 133 Performance measures 136 Point-in-time versus through-the-cycle ratings 142 Conclusions Scoring Systems: Case Study 145 Introduction 145 The data 145 Candidate explanatory variables 148 Sample selection 154 Univariate analysis 155 Model construction 171 Model validation 175 Model calibration 178 Qualitative assessment 179 Conclusions 181 Appendix 1: hypothesis Test for PD estimates 182 Appendix 2: comments on low-default portfolios Loss Given Default 188 Introduction 188 LGD measures 188 Definition of workout LGD 189 Practical computation of workout LGD 190 Public studies 194 Stressed LGD 198 Conclusions Implementation of the Accord 200 Introduction 200 Internal ratings systems 201 The quantification process 201 The data management system 202 Oversight and control mechanisms 203 Conclusions 204 Part IV Pillar 2: An Open Road to Basel 3 14 From Basel 1 to Basel Introduction 209 History 209

8 viii CONTENTS Pillar Basel Conclusions The Basel 2 Model 214 Introduction 214 A portfolio approach 214 The Merton model 217 The Basel 2 formula 219 Conclusions Extending the Model 237 Introduction 237 The effect of concentration 237 Extending the Basel 2 framework 238 Conclusions Integrating Other Kinds of Risk 248 Introduction 248 Identifying material risks 248 Quantification and aggregation 276 Typical capital composition 279 Conclusions 280 Conclusions 283 Overview of the book 283 The future 284 Bibliography 286 Index 291

9 List of Figures, Tables, and Boxes FIGURES 2.1 DJIA: yearly trading volume Securitization with recourse Remote-origination securitization Scope of application for a fictional banking group Treatment of participations in financial companies Treatment of participations in insurance companies Treatment of participations in commercial companies The three pillars Solvency ratio Capital using the SF Capital rate using the SF RWA for securitization and corporate exposures 73 5A.1 EE and EPE 77 5A.2 EPE, EE, and PFE 78 5A.3 EE, EPE, and effective EE and EPE Incremental IT architecture Integrated IT architecture Current bank practices: rating systems A decision tree A neural network A CAP curve 140 ix

10 x LIST OF FIGURES, TABLES, AND BOXES 10.5 A ROC curve Rating distribution Frequency of total assets Frequency of LN(Assets) ROA:rating dataset ROA:default dataset ROA before exceptional items and taxes:rating dataset ROA before exceptional items and taxes:default dataset ROE:rating dataset ROE:default dataset EBITDA/Assets:rating dataset EBITDA/Assets:default dataset A ROA:rating dataset Cash/ST debts:rating dataset Cash/ST debts:default dataset Cash and ST assets/st debts:rating dataset Cash and ST assets/st debts:default dataset Equity/Assets:rating dataset Equity/Assets:default dataset Equity (excl. goodwill)/assets:rating dataset Equity (excl. goodwill)/assets:default dataset Equity/LT fin. debts:rating dataset Equity/LT fin. debts:default dataset EBIT/Interest:rating dataset EBIT/Interest:default dataset EBITDA/Interest:rating dataset EBITDA/Interest:default dataset EBITDA/ST fin. debts:rating dataset EBITDA/ST fin. debts:default dataset LN(Assets):rating dataset LN(Assets):default dataset LN(Turnover):rating dataset LN(Turnover):default dataset Rating model implementation Simulated default rate S&P historical default rates, Distribution of asset values Loss distribution Cumulative bivariate normal distribution Asset correlation for corporate portfolios Maturity effect Loss distribution Potential asset return of a BBB counterparty A stylized bank economic capital split, percent 280

11 LIST OF FIGURES, TABLES, AND BOXES xi TABLES 1.1 A definition of capital Risk-weight of assets CCFs PFE The Basel 2 timetable Pillar 1 options RWA in the Standardized Approach RWA of past due loans CCF for the Standardized Approach RWA for short-term issues with external ratings Simple and comprehensive collateral approach Supervisory haircuts (ten-day holding period) Minimum holding period Criteria for internal haircut estimates Risk parameters Source of risk estimations RWA for Specialized Lending CRM in IRBF RWA for securitized exposures: Standardized Approach CCF for off-balance securitization exposures CCF for early amortization features Risk-weights for securitization exposures under the RBA The Standardized Approach to operational risk 74 5A.1 CCF for an underlying other than debt and forex instruments 79 5A.2 CCF for an underlying that consists of debt instruments 80 5A.3 Swap 1 and A.4 CCF multiplication 81 5A.5 Application of the double default effect 84 5A.6 Capital requirements for DVP transactions CEBS high-level principles for pillar Pillar 3 disclosures Results of QIS 3 for G10 banks Results of QIS 3 for G10 banks: maximum and minimum deviations Results of QIS 3 for G10 banks: individual portfolio results Summary of bankruptcy prediction techniques Key criteria for evaluating scoring techniques Bankruptcy models: main characteristics Accuracy ratios ROC and AR: indicative values Explanatory variables 150

12 xii LIST OF FIGURES, TABLES, AND BOXES 11.2 Ratio calculation Profitability ratios: performance measures Liquidity ratios: performance measures Leverage ratios: performance measures Coverage ratios: performance measures Size variables: performance measures Correlation matrix: rating dataset Correlation matrix: default dataset Performance of the Corporate model Performance of the Midcorp model Typical rating sheet Impact of qualitative score on the financial rating LGD public studies Simulated standard deviation of DR Estimated default correlation Implied asset correlation A non-granular portfolio The concentration effect The credit VAR-test An average one-year migration matrix Corporate spreads A stylized transition matrix Comparison between the Basel 2 formula and the credit VAR MTM results VAR comparison between various sector concentrations Benchmarking results: credit risk Benchmarking results: market risk Benchmarking results: operational risk Benchmarking results: strategic risk Benchmarking results: reputational risk Benchmarking results: business risk Benchmarking results: liquidity risk Benchmarking results: other risk Summary of benchmarking study Determination of the confidence interval Correlation matrix: ranges 279 BOXES 1.1 A chronology of banking regulation: A chronology of banking regulation: The regulation of market risk, Categories of RWA 51

13 LIST OF FIGURES, TABLES, AND BOXES xiii 5.2 Calculating a haircut for a three-year BBB bond Calculating adjusted exposure for netting agreements Classification of exposures Calculating LGD 62 5A.1 Calculating the final exposure The key requirements of Basel 2: rating systems Overview of scoring models Data used in bankruptcy prediction models Construction of the scoring model Five statistical tests Five measures of economic performance Steps in transforming ratios Estimating a PD Example of calculating workout LGD 190

14 Acknowledgments I would like to thank Palgrave Macmillan for giving me the opportunity to work on the challenging eighteen-month project that resulted in this book. Thanks are also due to Thomas Alderweireld for his comments on Parts I III of the book and to J. Biersen for allowing me to refer to his website. Thanks also to the people that had to put up with my intermittent availability during the writing period. Braine L Alleud, Belgium LAURENT BALTHAZAR xiv

15 List of Abbreviations ABA American Bankers Association ABCP Asset Backed Commercial Paper ABS Asset Backed Securities ADB Asian Development Bank AI Artificial Intelligence ALM Assets and Liabilities Management AMA Advanced Measurement Approach ANL Available Net Liquidity AR Accuracy Ratio BBA British Bankers Association BCBS Basel Committee on Banking Supervision BIA Basic Indicator Approach BIS Bank for International Settlements BoJ Bank of Japan bp Basis Points CAD Capital Adequacy Directive CAP Cumulative Accuracy Profile CCF Credit Conversion Factor CD Certificate of Deposit CDO Collateralized Debt Obligation CDS Credit Default Swap CEBS Committee of European Banking Supervisors CEM Current Exposure Method (Basel 1988) CI Confidence Interval CND Cumulative Notch Difference xv

16 xvi LIST OF ABBREVIATIONS CP Consultative Paper CRE Commercial Real Estate CRM Credit Risk Mitigation CSFB Credit Suisse First Boston DD Distance to Default df Degrees of Freedom DJIA Dow Jones Industrial Average DR Default Rate DVP Delivery Versus Payment EAD Exposure at Default EBIT Earnings Before Interest and Taxes EBITDA Earnings Before Interest, Taxes, Depreciations, and Amortizations EBRD European Bank for Reconstruction and Development EC Economic Capital ECA Export Credit Agencies ECAI External Credit Assessment Institution ECB European Central Bank ECBS European Committee of Banking Supervisors EE Expected Exposure EL Expected Loss EPE Expected Positive Exposure ERC Economic Risk Capital ETL Extracting and Transformation Layer FDIC Federal Deposit Insurance Corporation FED Federal Reserve (US) FSA Financial Services Act (UK) FSA Financial Services Authority (UK) GAAP Generally Accepted Accounting Principles (US) HVCRE High Volatility Commercial Real Estate IAA Internal Assessment Approach IAS International Accounting Standards ICAAP Internal Capital Adequacy Assessment Process ICCMCS International Convergence of Capital Measurements and Capital Standards IFRS International Financial Reporting Standards ILSA International Lending and Supervisory Act (US) IMF International Monetary Fund IMM Internal Model Method (Basel 1988) IOSCO International Organization of Securities Commissions IRBA Internal Rating-Based Advanced (Approach) IRBF Internal Rating-Based Foundation (Approach) IRRBB Interest Rate Risk in the Banking Book IT Information Technology JDP Joint Default Probability

17 LIST OF ABBREVIATIONS xvii KRI LED LGD LOLR LT LTCB M M&A MDA MTM MVA NBFI NIB NIF NYSE OCC OECD OLS ORM ORX OTC P&L PD PFE PIT PSE PV QIS RAROC RAS RBA RCSA RIFLE ROA ROC ROE RRE RUF RW RWA S&L S&P SA SEC Key Risk Indicator Loss Event Database Loss Given Default Lender of Last Resort Long Term Long Term Credit Bank (Japan) Maturity Mergers and Acquisitions Multivariate Discriminant Analysis Marked-to-Market Market Value Accounting Non-Bank Financial Institution Nordic Investment Bank Note Issuance Facilities New York Stock Exchange Office of the Comptroller of the Currency (US) Organisation for Economic Co-operation and Development Ordinary Least Squares Operational Risk Management Operational Riskdata exchange Over the Counter Profit and Loss Account Probability of Default Potential Future Exposure Point-in-Time Public Sector Entities Present Value Quantitative Impact Studies Risk Adjusted Return on Capital Risk Assessment System Rating-Based Approach Risk and Control Self-Assessment Risk Identification for Large Exposures Return on Assets Receiver Operating Characteristic Return on Equities Residential Real Estate Revolving Underwriting Facilities Risk Weighting Risk Weighted Assets Savings and Loan (US) Standard and Poors Standardized Approach Securities and Exchange Commission (US)

18 xviii LIST OF ABBREVIATIONS SF Supervisory Formula SFBC Swiss Federal Banking Commission SFT Securities Financing Transaction SIPC Securities Investor Protection Corporation SL Specialized Lending SM Standardized Method (Basel 1988) SME Small and Medium Sized Enterprises SPV Special Purpose Vehicle SRP Supervisory Review Process ST Short Term TTC Through-the-Cycle UCITS Undertakings for Collective Investments in Transferable Securities UNCR Uniform Net Capital Rule USD US Dollar VAR Value at Risk VBA Visual Basic Application VIF Variance Inflation Factor

19 Website If you would like to be informed about the author s latest papers, receive free comments on Basel 2 developments, new software, updates on the book, or even to ask questions directly of the author, register freely on his website: All the workbook files that illustrate examples in this book can be freely downloaded from the website. xix