Basel II and Good Risk Management Practices
The evolution of banking risk:
Why Basel I was deemed necessary
Case study: Bankers Trust
Why Basel II was deemed necessary to replace Basel I
The Evolution of Bank Risk Management
From a cost centre to a strategic competitive weapon
The Basel Accord II A Brief Overview
It is assumed that all delegates will have at least heard of the new Basel Accord. This section will summarise its implications for financial institutions, with particular attention to Pillars II and III.
Objectives of the new Accord
Application of the Accord
To whom does it apply?
Legal standing of the Accord and national discretions
Structure of the new Accord
Pillar I: Minimum Capital Requirement
-What constitutes bank capital?
- Expected and unexpected losses and the role of capital.
Pillar II: Supervisory Review Process its objectives
- Construction of an ICAAP - a brief outline
- Risk-Based supervision what is meant by this, and why are supervisors moving towards it?
Pillar III: Market Discipline what are the requirements and some issues
- Interaction with other regulatory requirements such as IFRS
- Will Pillar III remain?
What has resulted from the banking crisis in 2007-9
- Changes to the quantity and quality of capital
- Introduction of bail-in capital and PONV what happened in Cyprus
- A summary of other changes discussed in detail later in the programme
- Beyond Basel III do we see Basel IV emerging?
Delegates will be encouraged to discuss the current and planned progress of their institution towards the new Accord.
Good Risk Management Practices
Whilst each class of risk has developed its own methodologies, there are some overarching sound practices required to support the overall risk management framework
What is a risk framework?
The COSO framework how applicable to banks?
Developing an Appropriate Risk Management Environment
Typical organisational structure
Roles and responsibilities of each of the parties
Defining the risk appetite of the institution
- Factors that may influence a risk appetite
- Quantitative and qualitative approaches
Creation of risk management policies and procedures
Risk identification framework
Risk measurement methodologies
Management and control of risks
Reporting and monitoring of risks
Case study: the discussion will be with reference to a leading international bank. Delegates will be encouraged to discuss the progress of their institution towards good practices and highlight areas of priority.
Market risk has changed fundamentally over the past 15 years, with the introduction of Value-at-Risk. These sessions first discuss the main approaches used to control traders at the desk-top, and then the main approach banks use to calculate their regulatory VaR. Due to the recent banking crisis, there have been a number of substantive changes. The regulatory methods will be reviewed with example calculations and the implications of the changes discussed.
What are the main sources of market risk?
Interest rate, foreign exchange, equity and commodity risks
What are the main methodologies?
Case study: NatWest Bank
Traditional Desk-top Risk Measurement
Adopting a portfolio approach, interest rate risk will be discussed:
Construction of classic gridpoint sensitivity reports for a significant portfolio
Extension to incorporate curvature
Modern Risk Measures: Value-at-Risk
Introduction through a simple 1- factor example
Using historic simulation
- Extension to a 2-factor example
- Demonstration of more realistic examples
- What do banks do in practice?
- Practical difficulties of implementation: volatility and correlation, holding period
An outline of other methodologies
Regulatory Requirements of the Basel Accord
The Standardised Approach
- How to estimate the IR capital requirement using maturity bands example calculations
- How to estimate the IR capital requirement using duration bands example calculations
- How to estimate the FX, equity and commodity capital requirements
- How to incorporate options
Proposed new Standardised Approach
- How this will work, using the same above example
Specific risk: inclusion of credit risk from the trading book
Internal models using VaR
- Qualitative approval process
- Calculation of the regulatory capital for market and specific risk
- Introduction of Stressed VaR
- Back testing: what is it and how to apply it?
Extensions to market-risk framework likely introduction of Expected Shortfall
Definition of trading
Valuation of illiquid positions
Introduction of the Incremental Risk Charge what are its implications?
- Revisions to the IRC
Likely further developments
Measurement of Interest Rate and Liquidity Risk
The new Accord makes a distinction between traded and non-traded market risk. The latter often includes funding liquidity risk by extension. Banks apply different approaches to try to assess non-traded and liquidity risk and this section discusses them.
How does non-traded market risk arise
-IRR exposure: earnings and economic value approaches
- Gap analysis contractual and behavioural
- Static and dynamic simulation
- Assessment of IR risk an approach with a worked example
Funding liquidity risk
- How does it arise, and how should it be managed
-The new regulatory constraints:
- The details of Liquidity Coverage Ratio and its business implications
- The likely details of the Net Stable Funding Ratio
- Impact on banking, such as the long-term funding of infrastructure projects
What does the Accord require?
Delegates will be encouraged to discuss the organisation of the market risk function within their institution and the main management reports used.
Banks are traditional credit risk-taking institutions. Hence, through experience, presumably they have developed well-founded mechanisms for managing credit risk? If that is the case, why have the leading international banks fundamentally changed the way in which they view credit risk over the past twenty years? And does the Basel Accord support or hinder this new paradigm?
Overview the Traditional View of Credit Risk Management (CRM)
Banks as traditional credit taking institutions
The typical credit control process
Traditional credit risk mitigation
The effectiveness of the process: does it work?
Level I CRM
Case studies: Bankgesellschaft Berlin, Continental Illinois and Credit Lyonnais
Modern Credit Risk Management
Portfolio Credit Risk Management
Why is it the new paradigm?
What are the fundamental concepts?
Basic data requirements: Exposure At Default, Probabilities of Defaults, Loss Given Defaults and correlations
How to Estimate EADs
Traditional loan exposures
Provision of guarantees such as standby letters of credit or trade finance
Settlement, pre-settlement and derivative risks
Introducing Expected Positive Exposure how to calculate for a derivative
The concept of credit conversion factors
How to Estimate PDs
Cohort methodologies how they work in practice
- Use of historic data from external parties
- Shortcomings of these approaches and how to overcome them
- Various approaches: OCC, Fed Reserve, DB, FSA, etc.
Introduction of Statistical factor models (also known as scoring models)
- Examples of statistical models
- Introducing subjective data
- Corporate and retail modelling what is the difference?
- Practical implementation of scoring models
- Using Logistic regression to estimate PDs
Traditional credit analysis
- What are the main components of a traditional rating methodology
Credit analysis vs. statistical model? What is the verdict?
- The credit market
- The debt market
- The equity market and Mertons model
- Hybrid models
Each approach will be briefly but critically discussed
How to estimate LGDs:
Is estimating LGDs hard?
How to implement a Distressed Cashflow model
Discussion of some estimation projects
Seven Levels of Credit Risk Management Where is your Institution?
Active credit portfolio management
Delegates will be encouraged to discuss the organisation of the credit risk function within their institution and the main management reports used.
Estimation of Regulatory Capital for Credit Risk
The Standardised Approach
The who and the what of the Accord
The role of external rating agencies
- International or domestic thats the question?
- How has the US removed ECRAs from its regulations
Credit conversion factors
Permitted risk mitigation
Overview of the Internal Rating Based Approaches
Foundation and advanced approaches
- What you supply, what the Accord supplies, and what the national supervisor supplies
- What is likely to change in the future?
- How to apply to different client sectors
- Example calculations
- What is the regulatory credit model?
- The underlying theoretical assumptions
Minimum organisational and technical requirements to implement these approaches
Permitted risk mitigation
Results of the BIS QIS5, June 2006
Introduction of a Leverage Constraint
What is a Leverage ratio, and how does it compare to the Basel II ratio?
How does the US ratio work
The new proposed Basel III ratio
- How it will work, and the timetable
- Likely business implications, especially on off-BS activities such as Letters of Credit
Will it be changed the views of some banking supervisors
A brief outline of portfolio credit modelling
Note: this section will only be covered if there is sufficient interest in the technical details by the delegates. If not, it may be very briefly discussed and demonstrated.
Analytically modelling portfolio default assuming independence
Simulating portfolio default
Estimation of correlations
Modelling a realistic portfolio
Construction of a loss distribution
Calculating credit VaR
Implementing such a model in practice
Extension of the default model to a migration model as required by IRC
Extension of the default model to a copula model
Delegates will be given a computer-based example of a portfolio model, to investigate the impact of changing a range of input parameters. If there is time and desire, the events underlying the credit crisis will be discussed from a technical perspective.
The Basel Accord has introduced a capital requirement for operational Risk for the first time. But what is operational risk? Can it be realistically measured as the Accord requires? Or is the whole topic the triumph of optimism over reality? These are some of the basic questions to be debated in the section, along with a detailed coverage of the approaches banks are employing.
What is operational risk: alternative definitions?
What is the regulatory charge supposed to cover?
The Basel categories and definitions
The results of the latest loss data collection exercise
Why has operational risk been included in the new Accord?
The early view of operational risk, and the current view
Case study: Royal Bank of Canada
Developing an Operational Risk Methodology
Developing suitable objectives and policies
Typical operational risk organisational structures
Relationship with other functions, especially internal audit
Top down or bottom up a major decision?
Creating a risk framework
Build or buy an operational risk database
Aside: Process analysis which are the key processes?
Process mapping what are the major risks in any given process?
Key risk indicators what can be used as a risk metric?
The KRI project
Regulatory indicator approaches what is permitted?
Bottom-up Risk Measurement Models
Loss Distribution Analysis: statistical modelling using historic data
- Using external data good or bad?
- Fitting severity and frequency distributions
- Modelling a LD, and estimating the 99.9% VaR
Computer-Based Demonstration using Real Data
Control self assessment: score-card or self-assessment approaches
- Example of assessment questionnaire
- Training of people to conduct self-assessment
- Examples of professional software used to support this methodology
- Results from an actual CSA
- Estimation of VaR using simulation
Exceptional and unexceptional events
Will the normal modelling capture exceptional events?
If not, what can be done?
Case studies: Barings and Allied Irish Bank
Exposure management internal mitigation and insurance
Where is current best practice, and what are the leading institutions doing?
Results of QIS3 (2004) and QIS5 (June 2006)
Summary: will it work?
Various case studies, including BCCI, Daiwa and First National Bank of Keystone
Should time permit and the delegates desire it, the following topics may also be discussed.
Reputational risk is regarded by many banks to be the most important risk of all, ranking above even credit risk. Yet, because it is soft and very difficult to measure, reputational risk management is often down-played. This session discusses how reputational risk may be assessed and managed in practice, using a number of banks as examplars.
Legal risk is deemed to be an integral part of operational risk and is yet often managed completely separately. This session debates the different forms of legal risks, and asks how the operational capital may be assessed.
Accounting and Tax Risk
Traditionally, these risks have remained the remit of the financial function, away from the prying eyes of risk management. Should that remain, or should accounting and tax risks simply form another component of operational risks.
It is a regulatory requirement that banks have to submit an Internal Capital Adequacy Assessment report to their supervisor each year. However, the Accord is very low on precise details as to what should go into this report. This session will go through the production of an ICAAP in detail, with some real examples.
Objective of the ICAAP with the concept of proportionality
Where to start?
- Linking the ICAAP to the long-term strategic plans of the bank
Identifying all material risks
Assessing all material risks
- How to handle soft risks such as reputational, liquidity or fraud risks
Discussing risk mitigation
Other components of an ICAAP
Things to do, and things to avoid!!
Beyond the Accord: Risk and Return
The objective of this session is to explore how modern risk management may contribute to the overall strategic development of the institution. In particular, what is the acceptable trade-off between the return on a transaction and the risk it incurs for the bank? A number of different aspects will be reviewed, and current global best practice will be discussed.
RAROC: Risk-Adjusted Return on Risk-Adjusted Capital
What is RAROC? How is it defined?
Variants such as EVA
Determining the cost of capital using the capital asset pricing model
The use of RAROC:
Ex ante: allocating economic capital to business units
Ex post: performance measurement
How correlations and marginal risk contribution can be integrated into RAROC
Implementing RAROC: what are the practical problems?
How can risk management add value to the organisation?
Risk management of the future
Course Summary and Close