Basel II AIRB Implementation

“Lessons in Progress”:
Commercial Credit Risk Data, Measurement and
Technology Challenges

Alok Sinha
Principal
Deloitte & Touche LLP
Agenda

Basel II – Overview and Current Status

AIRB Credit Risk – Key Requirements / Implications

Major Pain Points and Challenges

Industry Impact

Closing Remarks
Basel Overview & Current Status
Background on the Basel Accord

• The Basel Committee on Banking Supervision operates

under the Bank for International Settlements located in
Basel, Switzerland
– It was established by the central bank Governors of the G10
countries at the end of 1974 and meets four times a year
• In 1988 the Basel Committee issued the first Basel Accord
– It quickly became clear that this ‘one size fits all’ approach was
inappropriate given the wide variety of banking institutions
• Market Risk Amendment introduced in 1996
• Significant regulatory capital arbitrage opportunities exist in
Basel I
Basel II Timeline for US Implementation

Final NPR
Basel I-A released for
ANPR comment
Released
BIS-Final
rules issued
Basel II • Supervisory Guidance Expected
U.S. ANPR U.S. NPR
• Basel 1A NPR Expected
issued draft
released

1999 – 2003 2004 2005 2006 2007 2008 2009 2010 2011
Today

Preparation for implementation/Proposed Rulemaking Parallel

with
Basel I
Capital floor of:
95%
90%
80%
Basel II Introduces a Three Pillar Approach

Supervisory
Supervisory
Review
Review
Process
Process Market
Market
Minimum
Minimum
Capital Discipline
Discipline
Capital
Requirements
Requirements

Pillar 2

Pillar 1 • Supervisors to ensure sound Pillar 3

• Menu of measurement
approaches
• Increased reliance on internal
processes and data
• Subject to extensive qualification
requirements
internal processes and practices
• Thorough assessment of a • Extensive reporting
Bank’s risk profile and capital requirements
position
• Promote market discipline
• Define actions if risk and capital through transparency
assessment deemed
unsatisfactory
Economic Capital vs. Regulatory Capital
Economic Capital
Businesses are assigned capital in
proportion to economic risks they pose
Distinguishes risks for a counterparty,
relationship or transaction
Risk orientation: comprehensive
Distinguishes risk by credit quality (risk
ratings, EDFs and credit scores)
All risks are considered: credit, market,
operational, ALM, country, etc.
Explicitly accounts for diversification
Customized to institution’s risk
tolerance
Basel II is expected to lead to greater alignment between economic capital and regulatory
capital
Regulatory Capital (Basel
I)
Minimum capital requirements (Tier
I/Tier II) are based on broad system
risk levels
Very limited risk sensitivity; broad
brush structure
Asset orientation
No risk differentiation based on credit
quality
Considers credit and market risks
Does not account for diversification
By definition, comparable across
banks; limited value in the comparison
Regulatory Capital (Basel
II)
Capital definitions and minimum capital
levels largely unchanged
Significantly increased risk sensitivity
Exposure orientation
Credit risk quality differences captured
Considers credit, market and
operational risks
Accounts for average diversification
with broad exposure categories
Applies same capitalization standard to
all banks; hence comparable
AIRB Credit Risk – Key Requirements
Qualification Requirements - Overview
Overall - to Qualify for
IRB Approaches in
General
RATING SYSTEM
• Separate Borrower
Vs. Transaction
Ratings
• Minimum of 8 grades
• Less than 30% of
exposure in one
grade
• Separate rating for
legal entities
• Annual rating review
• Regulatory default
definition
• Stress testing
• ……………
MINIMUM
REQUIREMENTS
Banks are required to develop a one
year PD measure for each borrower
grade
3 Acceptable PD Calibration Approaches:
- Bank’s internal historical default
experience
- Mapping to external data (rating agency)
- Statistical default models (KMV EDFs /
RiskCalc)
Specific, Separate – for
LGD, EAD and Mitigants
Under Advanced IRB
LGD
• LGD Rating Dimension
• Validation / Stress testing
• Use in Pricing Models
• Relationship w/ collateral
• ……………
EAD
• Specified by Facility Type
• Forward looking
• Consistent with experience
• ………….
Risk Mitigation Options
• Collateral
– Financial Collateral (cash, securities, equity, etc.)
– Non-Financial Collateral (property, equipment, etc.)

• Guarantees and Credit Derivatives

– Standby L/Cs, financial guarantees, etc.
– Credit default swap (CDS), Nth to default CDS, etc.

• Netting
– Master netting agreements (OTC derivatives, repos, etc.)
– On-balance sheet deposit netting

• Securitization*
– Traditional, synthetic
Portfolio Management – Regulatory Capital Relief via Credit
Derivative Hedging
• Types of eligible credit derivatives for capital relief
– Single name CDS
– Nth to default CDS
– Total Return Swaps (TRS)
• Credit Derivative eligibility requirements summary
– Legal enforceability in the relevant jurisdiction
– Explicit, irrevocable and unconditional contracts
– Full or pro-rata coverage of contractual payments
– Inclusion of relevant credit events (failure to pay, bankruptcy, etc.)
– Net income/credit losses accounting requirements for TRS
– Protection provider eligibility (e.g. highly rated financial firms for double
default treatment)
– Application of haircuts: currency, maturity, restructuring
– Monitoring of wrong way, concentration and liquidity risks
Portfolio Management – Regulatory Capital Relief via Credit
Derivative Hedging
• CDS Hedging Process and Data Implications
– Assignment of CDS eligibility flags
– Linkage to reference obligors and assets
– Determination of net positions at reference obligor level
– Identification and matching of internal and external hedges
– Determination of qualifying capital hedges (PD substitution, double default,
etc.)
– Maximization of capital relief through ‘optimal’ allocation of hedges
– Systematic identification and assessment of wrong-way, liquidity risks, etc.
– Lack of systematic access to legal agreement information (e.g. legal
enforceability flags, etc.)
Portfolio Management – Regulatory Capital Relief via Credit
Derivative Hedging
• CDS Hedging Example – Capital Calculations under Basel
II (double default approach)
Exposure Credit Derivative
PD 0.08% 0.02%
ELGD 45% 40%
Assumptions Instrument Type Term Loan CDS
Amount (USD) 1,500,000 1,500,000
Term (yrs) 4 3
Currency USD EUR
No restructuring
Contract Terms N/A
Immediate Pay-out

CDS Notional 1,500,000

Haircuts
Mat. Mism. Haircut 27%
Application
Restr. Haircut 40%
CCY Mism. Haircut 2%
Haircut Adj. Notional 646,800
Amount RWA
Exposure 1,500,000 596,368

Covered Portion 646,800 46,001

CDS Application Uncovered 853,200 339,214
Total 385,215
RWA Savings 211,153
RWA % Savings 35%
Synthetic Securitization / CLO considerations
• Basel II securitization framework:
– Identification of exposures that are not considered as
‘securitizations’ by the businesses but qualify per Basel II
– Determination of the appropriate treatment requires consideration
and understanding of several factors:

• Internal Assessment Approach (IAA) is only available for ABCP conduits

Product Type • RBA can be used for investment securities of ABS, MBS, CMO; however most
structured products are not rated therefore cannot use RBA.

• IAA requires the Bank’s internal rating methodologies to meet a number of

Eligibility criteria; some products (e.g. Tender Option Bonds, Structured Investment
Vehicles, etc.) can qualify as an ABCP program and can be eligible for IAA.

• If underlying loan level data is not available (or its quality is questionable), the
Data Availability
Supervisory Formula cannot be used

• The Bank can choose dollar-for-dollar deduction of unrated exposures that are
Materiality immaterial in size rather than sourcing and maintaining the required data for
SF approach.
Major Pain Points & Challenges
Complexity of Basel II Implementation is Compounded by a
Multiple Touchpoints and Dependencies
Risk Rating Risk Problem Collateral Economic CDS Hedging Country Risk
Systems Analytics Asset Mgt Mgt Capital Process Mgt

R Retail
Scoring
Retail
Segmentation
OTC
Derivatives
Structured
Products
Guarantees
Legal Netting
Rules
Deposit
Systems
E A
Q T
DA
Business Process Data Quality Credit to Finance Governance, Oversight Regulatory Fin.
Design & Integrity Reconciliations & Controls Accounting Acctg
U
I
Information Flows Data & Information Legal Entity Rules Supervisory Private Equity

R
& Controls Modeling
T A
Interpretation Processes Investments

DA
Credit MIS Reference Technology Multi-jurisdictional Regulatory Internal Reviews
E Design Data Mgt Program Mgt solution design Review and Audit

M Repo Style Collateral

E
Architecture
– Logical,
Transactions
Systems T A Mgt
Systems
Data
Maintenance
Data Privacy &
Secrecy Laws
Change Management,
Communication and

DA
and Mgt. Training
Physical and
N Application Regulatory Compliance Processes
T Structured
Operational Loss
Data, Measurement
Internal Audit,
Validation and
Reporting Systems: RWA Calculation
S Finance Financial, Risk Mgt. Engine Design & and Modeling Compliance Testing
Programs
Systems and Regulatory Implementation

Methodologies Processes Technology Operations Reporting

BANK FUNCTIONS
Regulatory Operational Technology Corporate Derivatives
LOB Credit Policy
Reporting Risk Mgt & Operations Treasury Technology

Credit Risk Loan Portfolio Finance Corporate

Finance Internal Audit
Mgt Administration Management Operations Accounting
Basel II Enterprise Program Profile
• Basel II program characteristics at core US and large global banks
– Huge in scale, scope and complexity
– Multiple threads and workstreams
– Matrixed accountability structure
• Programs span diverse constituencies that do not often speak the same
“language”
– Challenging task to communicate the “implications” and “impacts” of
requirements
• While Basel II will end up as a regulatory directive, investments in
improved risk and business management are at the core of several
requirements
• Implementation activity is accelerating within significant technology,
change management involvement
– IA is keeping a close watch
Some Key Observations and Lessons to Date

• • Largest
Largestbanks
banks(and
(andexperts)
experts)under
under • • Project
Project Management
ManagementLessons
Lessons
estimated
estimated the complexity (andcosts)
the complexity (and costs) 1.1.Top
TopDown
Downwith
withan
anend
endtotoend
endview
view
• • Excessive
Excessivefocus
focuson
onsome
somenarrow
narrowareas
areas 2.2.Structured
StructuredApproach
Approach
• • 80/20 solutionsfor
80/20solutions forBasel
BaselIIIIwill
willnot
notwork –– Clear
work Cleardefinition
definitionofofownership
ownershipand
and
• • Current accountability
CurrentRisk
RisktotoFinance
Financereconciliation
reconciliation accountability
–– Balance
processes
processes untenable underBasel
untenable under BaselIIII Balance“Risk”
“Risk”vs.
vs.“Finance”
“Finance”roles
roles
–– Detailed
• • Limited
Limitedapplicability
applicabilityofofvendor
vendorsolutions
solutions Detailedproject
projectplanning
planning

• • Project 3.3.Coordination
Coordinationand
andCommunication
Communication
ProjectManagement
Management––Single SingleBiggest
Biggest
–– Front
Challenge
Challenge Frontoffice,
office,middle
middleoffice
officeand
andback
backoffice
office
–– Involvement
• • Linear
Linearapproach
approach Involvementofofappropriate
appropriateconstituents
constituents

• • Traditional • • Integrity
Integrityof
ofthe
theInformation
InformationArchitecture
Architecture
TraditionalPMO
PMOpoint
pointofofview
view oror
• • Excessive • • Credit
CreditMIS
MISDesign
Designand
andData
DataModel
Model
Excessivereliance
relianceononRisk
RiskAnalysts
Analyststoto
drive
drivePMO
PMO • • Qualification
Qualification“data”
“data”vs.
vs.computation
computation
• • Limited “data” attributes
“data” attributes
Limitedsuccess
successininleveraging
leveragingEconomic
Economic
Capital systems for operational
Capital systems for operational • • Operating
OperatingModel
Model- -regulatory
regulatoryprocess
process
implementation
implementation and governance
and governance
Surprise • • Revisit
Revisitshort
shortcuts
cutsfrom
fromprior
priormerger
merger
“integration” projects
“integration” projects
Exploring role of Economic Capital systems/processes in
Basel II Implementation
• Role and Contribution of Economic Capital Systems
– Drives consistency in risk definitions and risk measurement approaches
• Create a level playing field to assess businesses and activities affected by
different risk forms
– Incorporates Bank’s risk tolerance objectives in capital measure
– Brings focus and attention to “first order” data elements required for
quantification
– PD, LGD, EAD data histories and calibration
• Have proven very valuable starting point for Basel II
• Serves as the foundation for RAROC, value based performance
management and strategic decision support
– Primary role is management reporting
• The 80/20 rule works for economic capital
– Provides directionally correct and reasonably consistent results to support
key decision making
Limited success in leveraging economic capital systems for
Basel II “operational” implementation
• From a process and controls perspective, most bank economic capital systems
would be considered “immature” or ad hoc
– Systems were not designed and developed with a view to support external or
regulatory reporting
– Focus has been on methodology, analytics and assumptions, not so much on
controls, review, reconciliation and documentation
– “data” was considered good enough for risk modeling
• Minimum Basel II qualification criteria were never focus of economic capital
systems
– Risk ratings systems, corporate governance and oversight, credit process and
policies, etc.
• Basel II regulatory view of risk continues to differ from economic capital view in
several areas
– Securitizations, repo-style transactions, credit hedging, OTC derivatives
– In many aspects, regulatory model would be a simplification of EC model
• Pillar II (supervisory review) and Pillar III (reporting/disclosure)
Transition From Logical Model to Physical Model…..
securitizations
obligor PK,I1 securitizations_id
portfolio PK,I1 obligor_id
spe_id derivatives
credit_enhancement
PK portfolio_type obligor_name expected_maturity
provisions probability_default_obligor PK credit_enhancment_id currency_code PK derivative_id
int_portfolio asset_class early_amortization_flag
RWA_expected_loss int_asset_class FK1 securitizations_id early_am_controlled_flag FK2 securitizations_id
RWA_unexpected_loss SDBC_exemption_flag tranche_id early_am_uncommitted_flag spe_id
asset_class tier_2_Limit standalone_grade spe_id early_am_retail_flag derivative_counterparty_id
int_asset_class allowance_gen default_grade credit_enhancement_provider_id excess_spread_trapping_point derivative_counterparty_rating
allowance_spec_cha obligor_grade credit_enhancement_provider_rating early_amortization_trigger notional_amount
prov_portfolio borrower_group_size credit_enhancement_seniority 3_month_average_excess_spread e_swap_m2m
prov_def_surpl borrower_group_total_assets e_ccf_credit_enhancement clean_up_call_indicator add_on_factor
borrower_group_turnover credit_enhancement_maturity clean_up_call_exercise_point derivative_maturity
bank_chosen_formula
m
fmi_securitization
facility

PK facility_id

facility_maturity_date
facility_start_date
facility_term_out_date

securitization_tranche

PK,I4 tranche_id
outstanding
cashflow
FK1,I1,I3 securitizations_id
PK,FK6 obligor_id
PK,I1 cashflow_id e_tranche
PK,I2 outstanding_id
bank_interest_in_tranche
FK1,I3,I2 outstanding_id exposure_seniority
FK1,I3,I1 outstanding_haircuts_id
fees_cashflow individual_tranche_rating
FK4 netting_id
interest_cashflow tranche_of_interest
FK5 facility_id
principal_cashflow nominal_exposure
cashflow_period notional_principal_amount
FK1 obligor_id add_on_derivative_type
exposure_repo liquidity_facility
replacement_cost PK liquidity_facility_id
exposure_abs_net_position
exposure_abs_net_fx program_wide_flag
outstanding_currency FK2 securitizations_id
reporting_date FK1 tranche_id
valuation_type spe_id
oustanding haircuts short_term_exposure_type liquidity_provider_id
residual_value_risk_flag liquidity_facility_rating
PK,I1 outstanding_haircuts_id residual_lease_value eligible_liquidity_facility
LPperiod-t eligible_liquidity_facility_md_flag
internal_haircut_flag
Dfactor-t liquidity_facility_seniority
internal_exposure_haircut fair_value_lease
internal_currency_haircut liquidity_facility_line_amount
effective_maturity e_ccf_liquidity_facility
issue_rating_of_debt_security_outstanding t_derivative
rating_agency_outstanding liquidity_facility_maturity
loss_given_default
instrument_type_outstanding LGD_Business_type
issuer_type_outstanding EAD
c_percent_pool
rwa_outstanding
crm_haircuts FK3,I6 securitizations_id
FK2,I7 tranche_id
PK,I1 crm_haircuts_id netting
partial_write_off
PK netting_id specific_provision
days_between_remargining
defaulted_assets_flag
rating_agency_collateral
netting_enforceable specialised_lending_eligibility_flag
issue_rating_of_debt_security_collateral
netting_contract VaR backtest_exception
instrument_type_collateral
net_exposure VaR flag
issuer_type_collateral
securitization_purchase_discount
transaction_type
bank_holding_period
internal_collateral_haircut
bank_holding_period_haircut deposit
PK,I5 deposit_id

FK2,I2,I3 exposure_id
deposit
net_ag_flag_d
deposit_maturity_date
FK1,I1,I4 crm_haircuts_id
deposit_currency
crm FK2 obligor_id
I2 crm_id

FK2,I4,I6 outstanding_id
FK1,I3,I1 crm_haircuts_id
FK3,I5,I8 protection_provider_id
loss_given_default
probability_default
rwa_crm_portion
crm_currency
collateral_type
crm_term_out_date
allocated_exposure
cash_flag
gold_flag
senior_debt_flag
liquidity_approved
I7 index_id
ucits_flag
mutual_funds_flag protection_provider
Basel II Credit Risk Logical Data Model
daily_price_flag PK,I1 protection_provider_id
CRM_type
credit_derivative_type protection_provider_name
collateral_amount
credit_protection_value
supervisory_input_OC
guarantor_type
standalone_grade_protection_provider Last Update: 02 October 2003
rating_protection_provider
exchange_id default_grade_protection_provider
FK4 tranche_id
FK2 obligor_id
collateral_fair_value
Outstandings Data Asset Securitization
Obligor Provisions
Credit Risk Mitigation

This diagram illustrates attribute groupings and high-level relationships. These will be fully
defined in the Analyse Phase.
…is Uncovering Significant Credit Data Issues

• Linkage of Facilities to Borrowers

• Multi Borrower Facilities
• Multiple Ratings for Same Borrower
• Borrower Legal Hierarchies
• Credit Product to Account Mappings
• Consistent Product Hierarchies
• Legal Hierarchies vs. LOB Hierarchies
• Collateral, Guarantees and Hedges
• Identification of Structured Finance Facilities
• ABCP Conduits
• Credit Support
• Standby Letter of Credit
• Tax driven securitization structures etc
• Risk Mapping of the Balance Sheet
Some sample implementation pain points
¾ Internal Historical Data, especially LGD and EAD

¾ CDS Hedging Process for Qualification and Application of Rules

¾ Structured Finance / Securitization Products

‰ Securitization Data Infrastructure

¾ Banking Book vs. Trading Book (overlaps)

¾ Collateral data capture and reporting

¾ Repo-Style Transaction Data Capture / Netting Rules etc.

¾ Transitioning information from front office to risk data repositories

¾ Credit MIS to General Ledger Reconciliations

¾ Legal Entity Reporting in different jurisdictions

¾ Future state operating model for regulatory reporting

¾ Data Quality (in risk MIS and Finance)

¾ End to end testing

Basel II driven transformation can lead to long term benefits
• Governance and controls Efficient Credit
Qualification • Process and policy T Process:
C • Historical data A Underwriting
R
Approvals
U • Calibration techniques G
Methodology & Risk Rating
• Treatment choices and options Reconcilable
Analytics
R • Risk modeling Views E
Administration
T
Credit Review
R • Data attributes
Calculation • Data quality Common
O Active Portfolio
E Requirements • Data model
Transformational
Data &
Definitions Management:
• Data definitions P
Limit Monitoring
N • Required and optional process
Initiatives E
Process changes R Risk Reporting
T Requirements • Recognition of credit risk CREDIT
A Problem Asset Mgt
mitigants FINANCE
T Hedging Strategy
TECHNOLOGY
• Data flows and control processes I Tactical
Implementation of OPERATIONS
S RWA Requirements
• Calculation engine Consistent N
Rebalancing
• Roles and responsibilities Hierarchies
G Value Realizatio
T
• Integration with current regulatory
Pricing
Integration with reporting
A Regulatory • Local legal entity requirements High Quality M Business Unit
Reporting • Parallel run of Basel I and Basel Data O Profitability
T II
D Relationship
Profitability
• Specific disclosure reports E
E Pillar 3 Reporting
• Additional data requirements
Targeting
Requirements L Strategic Positioning
Industry Impact
Basel II vs. Basel I – Winners and Losers
Lower Capital Charges
Retail banking, and secured residential real
estate lending, esp. residential mortgages
Investment-grade corporate lending
Lending against financial assets and
collateralized lending
Short-term lending – i.e. trade finance
Hedged (CDS) or guaranteed credit
exposures
Higher Capital Charges
Non-investment grade corporate lending,
sub-prime retail lending, project finance and
lease finance
Lending to emerging markets (perhaps
excluding “advanced” ones)
Significant equity investments; equity
investments to hedge funds
Operationally intensive businesses – asset
management, clearing, trust and custody
Prime brokerage (business with hedge
funds)
Credit card ABS programs or conduit
facilities
Potential trends
• Greater alignment between EC and Regulatory capital
– Some unintended consequences are possible
– Possible integration for management reporting
– Fewer opportunities for capital arbitrage
• Data Quality improvement
– Reduced noise in credit data
– Consistency
– Greater objectivity in credit assessment
• Improved AQ and Concentration reporting
• Streamlined regulatory reporting process
Competitive Landscape
• A-IRB banks vs. Basel 1A banks
• Banks vs. unregulated finance companies
• US vs. European banks
– Leverage ratio requirement
– Adoption timing differences
• Impact on average capital levels for banks
– 1. Markets
– 2. Markets
– 3. Markets
– 4. Rating agencies
– 5. Regulatory minimum requirements
©2006 Deloitte Development LLC All rights reserved.