Welcome to the April 2009 edition of the BCPA Newsletter.
It is good to know ...
The 4 Most Important Differences Between the USA and the European Union in the implementation of the Basel ii framework
1. Scope of application
Only a few financial institutions have to implement Basel II in the Unites States. Only core banks ($250 billion or more consolidated total assets, or $10 billion or more total on-balance sheet foreign exposure) have to implement Basel ii. These banks will implement the advanced approaches only.
All financial institutions have to implement Basel ii in the European Economic Area. These banks do not have to implement the advanced approaches only. They may implement simpler approaches, especially for a part of their portfolio.
2. Pillar 2
Financial institutions in the European Economic Area have to implement the detailed guidelines of the Committee of European Banking Supervisors (CEBS) for the application of the Supervisory Review Process.
The rules in the United States are more general. There are fewer guidelines or details.
3. Definition of Default
In the United States, for wholesale exposures, default is triggered by the non-accrual status, i.e. it includes well-secured past due amounts. For retail exposures, there are two benchmarks at 180 days and 120 days respectively.
In the European Economic Area they follow the general 90 days definition of the Basel ii Accord.
4. The Expected Loss Given Default (ELGD)
In the US, for each wholesale exposure and each segment of retail exposures, banks must directly estimate the parameters for the calculation of the:
A. Loss Given Default (LGD)
B. Expected Loss Given Default (ELGD)
In the Basel papers (and the European implementation) there is nothing about the ELGD.
LGD is defined as our best guess of the economic loss that would be incurred if the exposure were to default within one-year during economic downturn conditions.
ELGD is defined as our best guess of a bank's empirically based best estimate of the default-weighted average economic loss per dollar of EAD, which the bank expects to incur in the event that the obligor of the wholesale exposure defaults; or the loss the bank would expect to incur on a segment of retail exposures that defaults within a one-year horizon.
The ELGD estimates must incorporate a mix of economic conditions.
Outside the United States, supervisory authorities usually require all banks to comply with the New Basel ii Accord, but have provided banks the option of choosing among the different approaches for calculating credit and operational risk capital requirements.
For banks in the United States,
only the largest and most internationally active banks have to comply with Basel ii, but they have to follow only the advanced approaches for the calculation of credit and operational risk capital requirements (the IRB and the AMA approaches only).
In the USA there are 4 agencies involved in Basel ii interpretations and implementation:
The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS).
These 4 agencies have identified 3 groups of banks (this is unique in the United States; there is no grouping like that in the Basel ii papers):
1. CORE BANKS
(The term "banks" covers banks, savings associations, and BHCs - bank holding companies).
These are large internationally active banks. They are required to adopt only the advanced approaches. These advanced approaches provide more incentives for banks to improve their risk management practices.
Core banks must meet either of the following two independent threshold criteria:
A. $250 billion or more consolidated total assets.
B. $10 billion or more total on-balance sheet foreign exposure.
2. OPT-IN BANKS
These are banks that volunteer to adopt the advanced approaches.
3. GENERAL BANKS
The remaining banks that do not adopt the advanced approaches
It is good to know...
Reverse Stress Tests - The New Rules For Stress Testing After the Financial Crisis
Stress tests should be geared towards the events capable of generating most damage whether through size of loss or through loss of reputation.
A stress testing programme should determine what scenarios could challenge the viability of the bank and thereby uncover hidden risks and interactions among risks.
Commensurate with the principle of proportionality, stress tests should be geared towards the most material business areas and towards events that might be particularly damaging for the firm.
This could include not only events that inflict large losses but which subsequently cause damage to the bank's reputation.
Reverse stress tests start from a known stress test outcome (such as breaching regulatory capital ratios, illiquidity or insolvency) and then asking what events could lead to such an outcome for the bank. As part of the overall stress testing programme, it is important to include some extreme scenarios which would cause the firm to be insolvent (ie stress events which threaten the
viability of the whole firm).
For a large complex firm, this is a challenging exercise requiring involvement of senior management and all material risk areas across the firm.
A reverse stress test induces firms to consider scenarios beyond normal business settings and leads to events with contagion and systemic implications. For example, a bank with a large exposure to complex structured credit products could have asked what kind of scenario would have led to widespread losses such as those observed in the financial crisis.
Given this scenario, the bank would have then analysed its hedging strategy and assessed whether this strategy would be robust in the stressed market environment characterised by a lack of market liquidity and increased counterparty credit risk.
Given the appropriate judgments, this type of stress test can reveal hidden vulnerabilities and inconsistencies in hedging strategies or other behavioural reactions.
Before the financial market turmoil, such an analysis was considered of little value by most senior management since the event had only a remote chance of happening. However, banks now express the need for examining tail events and assessing the actions to deal with them.
Some banks have expressed successes in using this kind of stress test to identify risk concentrations and vulnerabilities.
A good reverse stress test also includes enough diagnostic support to investigate the reasons for potential failure.
Areas which benefit in particular from the use of reverse stress testing are business lines where traditional risk management models indicate an exceptionally good risk / return tradeoff; new products and new markets which have not experienced severe strains; and exposures where there are no liquid two-way markets.
It is good to know that the Bank of International Settlements (BIS)believes that...
Basel II and the Financial Crisis - Stress Testing is the Answer
Stress testing is a tool that supplements other risk management approaches and measures. It plays a particularly important role in:
1. Providing forward-looking assessments of risk;
2. Overcoming limitations of models and historical data;
3. Supporting internal and external communication;
4. Feeding into capital and liquidity planning procedures;
5. Informing the setting of a banks' risk tolerance; and
6. Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions
Stress testing is especially important after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the underpricing of risk. It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no loss data is available.
Pillar 1 (minimum capital requirements) of the Basel II framework requires banks using the Internal Models Approach to determine market risk capital to have in place a rigorous programme of testing.
Similarly, banks using the advanced and foundation internal ratings-based (IRB) approaches for credit risk are required to conduct credit risk tests to assess the robustness of their internal capital assessments and the capital cushions above the regulatory minimum.
Basel II also requires that, at a minimum, banks subject their credit portfolios in the banking book to stress tests. Recent analysis has concluded that implementation of this requirement would not have produced large loss numbers in relation to banks' capital buffers going into the crisis or their actual loss experience.
Further, the general tests banks are required to conduct as part of Pillar 2 (SRP - supervisory review process) might have included more severe scenarios than the ones currently used and produced results more in line with the actual stresses that were observed.
By itself, it cannot address all risk management weaknesses, but as part of a comprehensive approach, it has a leading role to play in strengthening bank corporate governance and the resilience of individual banks and the financial system.
A stress test is commonly described as the evaluation of the financial position of a bank under a severe but plausible scenario to assist in decision making within the bank. The term is also used to refer not only to the mechanics of applying specific individual tests, but also to the wider environment within which the tests are developed, evaluated and used within the decision-making process.
It is good to know...
How Many Countries Comply With Basel II? - How Many Countries Adopt Basel II's Advanced Approaches?
More than 100 countries are already implementing to some extend the Basel II framework.
It is interesting that only 13 countries have the obligation to do it (the 13 Basel Committee of Banking Supervision member countries).
Credit Risk, Standardised Approach: This is by far the most widely used credit risk methodology, adopted by almost 90% of the countries.
The Foundation Internal Ratings Based Approach and the Advanced Internal Ratings Based Approach will be used by 60-65% of the countries.
Operational Risk, Basic Indicator Approach: This is the most widely used operational risk methodology, , adopted by almost 85% of the countries.
The Standardised Approach is not far behind, as almost 75% of the countries will accept it. Half of the countries have the intention to use the the Advanced Measurement Approaches (AMA).
More than 75% of the countries will implement Pillars 2 and 3 by 2015. These Pillars appear to be much more challenging than it was originally anticipated.
It is interesting to mention that the International Monetary Fund (IMF) is supporting the Basel II framework, but believes that partial, or selective implementation will be athreat to international stability.
Countries are able to cherry-pick parts or the framework and to adopt options and national discretions that may lead to a false sense of security.
For the International Monetary Fund (IMF), it is important to assess the effectiveness of the various Basel II implementations
around the world.
According to the IMF, the Basel Committee is reviewing the framework after the current marker crisis to strengthen the treatment of complex products (like securitization exposures and off-balance-sheet products that return to the balance sheet of the financial organizations) and stress testing methodologies.
Dear members,
- Visit the website of our association.
- Write in your CV, resume, websites etc. that you are members of the Basel ii Compliance Professionals Association (BCPA)
- Take advantage of the distance learning and online certification program of our Association - at a cost that is unheard of.
