Everything you always wanted to know about Basel II in 15 minutes (a real estate perspective) Erik Kersten Senior Policy Advisor Supervisory Policy Quantitative Risk Management Views and opinions expressed in this presentation are those of the author and do not necessarily reflect the position of the Nederlandsche Bank.
Overview of Basel II Outline Real estate issues under Basel II
Capital requirements under Basel I Loans 100 (Risk weight 100%) 100 Owners equity 8 Deposits 92 100 Worst case Performing Loans 92 Loans losses (8) 92 Owners equity 0 Deposits 92 92 Required Capital = (Risk Weight * Exposure value)*8%
Capital requirements under Basel I Mortgage Loans 100 (Risk weight 50%) 100 Owners equity 4 Deposits 96 100 Worst case Performing Loans 96 Loan losses (4) 96 Owners equity 0 Deposits 96 96
Mortgage collateral under Basel I Residential mortgages: if LtV is lower then threshold: lower risk weight, less capital No recognition in capital of commercial real estate (with some exceptions) No realistic assumptions Capital treatment fuelled MBS-market
Purposes of the new capital accord a comprehensive approach to addressing risks Risk sensitive capital requirements Promote soundness and safety of the financial system Enhance competitive equality Accommodate industry best practice Result: Widen acceptance of collateral types used in practise and widen acceptance of internal models to Credit risk & Oprisk
Structure of Basel II
Menu of approaches (pillar 1) For measuring Credit Risk: Standardised Approach Foundation Internal Ratings-based Approach Advanced Internal Ratings-based Approach For measuring Operational Risk: Basic Indicator Approach Standardised Approach Advanced Measurements Approach For measuring Market Risk: Standardised Approach Internal Models Approach
Credit risk (Pillar I) The risk of loss due to the fact that an obligor will not meet its credit obligations in full Required Capital = (RW * Exposure value)*8% (no change!) Standardised approach RW Based on External ratings (Moody s, S&P, local rating agencies) Internal ratings based approach RW based on Internal ratings (banks own assessment)
Internal Ratings Based Approach Capital requirements for an exposure based on VaR and function of: PD, LGD, EAD and M These functions are given by Accord
IRB: the formulae look up PD 64748 Φ 1 ( PD) R 1 1 K = LGD ( Φ + Φ ( 0.999) { PD ) 1+ M 2.5 { b *1,06 1 R 1 R 1 1.5* b 1 44 243 4 14444 244443 look up 99.9% 144444424444443 account for correlation in the normal distributi on correct for maturity 14 44444444444 24444444444443 accountfor EL calculate PD stressed at 99.9% RW = K *12,50 1 50 1 50 Correlation ( ) 0.12 e PD 0.24 1 e PD R = + 1 50 1 50 e e For Corporates, Banks & Sovereigns SME correction : R ranging from 0.08 to 0.20 Retail : Mortgages : R = 0.15; credit cards : R = 0.04 and other retail : R ranging from 0.03 to 0.16 ( 0.11852 0.05478 ln( PD) ) Maturity adjustment( b ) = Only for Corporates,Banks&Sovereigns 2
internal refers to the inputs Foundation IRB Advanced IRB Probability of default Own estimates Loss Given Default Supervisory formula Own estimates Exposure at Default Supervisory formula Own estimates Maturity Bank s own estimates or 2.5 yrs Own estimates
RW vs PD RW-curves (PD tot 10%) (LGD=45%, Mortgages LGD= 10% M=2,5) 250,00% 200,00% RW 150,00% 100,00% Corporates Corporates(small) mortgages QRE Other Retail 50,00% 0,00% 0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% PD
Conclusion IRB is a more risk sensitive way of calculating capital requirements based on statistical properties of portfolio and enhances internal management of loans
Real estate in Basel II
Approaches in pillar 1 Measuring Credit Risk in mortgage lending Residential real estate: Standardised Approach RW down from 50% to 35% Monitoring LtV-ratio s (at least every 3 years) Advanced Internal Ratings-based Approach banks now have to estimate PD, LGD & EAD for their retail mortgages (NB collateral management conditions, e.g. LtV-monitoring process)
Approaches in pillar 1 Measuring Credit Risk in mortgage lending Commercial real estate: Standardised Approach RW based on external rating (non-rated => RW 100% Commercial real estate eligible as collateral (NB conditions: e.g. yearly LtV monitoring) Foundation Internal Ratings-based Approach RW based on internal estimates of PD Commercial real estate eligible as collateral (NB collateral management conditions, e.g. yearly LtV-monitoring process!) Advanced Internal Ratings-based Approach RW based on internal estimates of PD, LGD, EAD (&M) Commercial real estate eligible as collateral (NB same conditions, but more freedom in way of meeting those conditions)
Approach in Pillar 2 Banks are free to develop their own models Ensuring sound internal processes to assess risks and capital adequacy Active dialogue between banks and their supervisors, Identify deficiencies Take prompt and decisive action
Focus on IRB Most mortgages will probably be subject to IRBregime (Bigger banks use IRB)
What information do we need? How good is the obligor Probability of default; PD What determines a PD? Relation between PD and LtV (low LtV tend to have lower PD?)
What information do we need? How much will we recover after default Loss given default; LGD What determines a LGD? Relation between LGD and LtV LGD is more then Loans Current Market Value! economic loss: recovery value, time & costs, down turn effect (remember, we re talking UL)
What information do we need? How much money is the obligor likely to owe us when a default occurs Exposure at default; EAD (Credit Conversion Factor) What determines an EAD? All kind of options with mortgage-lending
LGD: strong effect on RW LGD = RW Mortgage RW vs PD, at different LGD levels 250,00% 200,00% 150,00% RW LGD = 45% LGD = 25% LGD = 10% 100,00% 50,00% 0,00% 0,00% 1,00% 2,00% 3,00% 4,00% 5,00% 6,00% 7,00% 8,00% 9,00% PD
Importance?
Importance? Overview of EU residential mortgage markets 2005 Netherlands Denmark Switzerland Iceland UK US Ireland Sweden Portugal Norway Spain Germany EU15 EU 25 Finland Luxembourg Malta Belgium France Greece Estonia Austria Latvia Italy Cyprus Croatia Lithuania Hungary Slovakia 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Mortgage Debt to GDP ratio Mortgage debt per capita right hand scale 50.000 45.000 40.000 35.000 30.000 25.000 20.000 15.000 10.000 5.000 0 Czech Republic Poland Slovenia Bulgaria Turkey Romania Serbia Russia Ukraine
Importance? in 1000 Gemiddelde koopsom en hypotheeksom (per kw) in % 290 14 Koopsom 270 Hypotheeksom 12 250 prijsmutatie j/j rechter as 10 230 8 210 6 190 4 ratio 116 114 112 110 108 106 104 Gemiddelde LTV (per kwartaal) 4e kw 2006 170 2 102 150 2000 2001 2002 2003 2004 2005 2006 Bron: Kadaster 0 100 2000 2001 2002 2003 2004 2005 2006 Bron: Kadaster
Mortgage lending important? Yes