TheRiskBasedApproachandHowitFitsintotheBasel2Framework

1、The Risk Based Approach and How it Fits into the Basel 2 FrameworkWhat is the Risk Based Approach?If you surveyed regulators as to what the risk-based approach means you would get many different answersThe most widely accepted proposition about the approach would probably be the following:Identify r

2、isks and apply scarce risk management resources where the risks are the greatestIn other words - the risk based approach is all about managing risk. Importantly, it is about applying scarce risk management resources efficiently.I will look briefly at how that principle should apply to banks themselv

3、es and then turn to its application to regulatorsHow does the Risk Based Concept Apply to Banking?Major sources of banking risk:Credit - The risk of loss arising from the possibility that customers or counterparties will default on their obligationsMarket - The risk of loss arising from the impact o

4、f movements in market prices on the value of assets and liabilities Liquidity - The risk of loss arising from the inability to meet cash outflow demands from available sources of liquidityOperational - The risk of loss arising from poor governance, inadequate controls over operating procedures, fail

5、ure of systems, and so on (catch all)Question: Which is the greatest risk?Universally agreed that credit risk is dominant - experience in the 80s/90s was a good reminderDeveloped markets suffered their worst loan losses for 50 yearsCommon characteristics:excessive exposures to individual borrowersex

6、cessive exposures to sectorsexcessive reliance on collateralpoor credit evaluationAll arose primarily from credit riskThe Asian markets followed the same path but with a 5 10 year lagMain advances since thenData - Most banks now track historical data to develop model parameters such as credit grade

7、migration, default statistics and estimates of losses. Credit Grading - pre-1990 banks typically used only 4 or 5 credit grades and they were one-dimensional - a borrower was a 1, 2 etc. Post 1990s credits are graded separately the basis of both probability of default and loss given default. Granula

8、rity up also.Portfolio approach to measuring risk - big philosophical change to thinking in terms of risks of groups of borrower or facility types. Old idea but took years to permeate banking.Credit risk modelling - is all about putting a statistical framework around risk measurement. Again a big st

9、ep forward in quantification of risk.Risk-based pricing etc - using the measurement of risk to manage risk. Applies to capital allocation as well - this is the key to risk-based banking - use it in all aspects of the business.Integrated risk management - still fairly new - looks at combining types o

10、f risk into single measures of exposure.Risk based capital allocation allocating capital to business lines within the bank according to where the risks are greatest.Motivation for the changes from the 1980s/early 1990sBankers remember the pain - In 3 years in the early 1990s US banks wrote off $26 B

11、ill in commercial and industrial loans, and another $24 in commercial real estate loansShareholders react quickly to differential losses - The downturn was quick and those banks with the worst credit losses experienced and average share price decline of 75% compared with 33% for banks with lower cre

12、dit losses recovery for the poor credit managers was also slower and lowerCompetition is increasing - Competition is coming from globalization, internet and marketsThe supporting tools are available - Big advances in past 5 years with VaR and credit risk modellingThere is more to lose - The total ca

13、pitalization of US banks is now more than ten times what it was in 1997 plus many CEOs are paper rich.Risk Based RegulationThe central Pillar of banking regulation is capital adequacyStarting with the first Capital Accord in 1988 banking regulators began imposing risk-weighted capital adequacy requi

14、rementThe philosophy is straightforward - greater risk requires greater capitalThe Capital Accord had a long and contentious history. Started with a general concern among supervisors about the need for international co-operation following bank crashes in the 1970s. By the late 1970s capital adequacy

15、 arrangements were in place in many banking systems. But there were big differences.In some countries (e.g. US, Canada, Japan, Italy and Australia), capital adequacy was measured as a simple leverage ratio (the ratio of capital to total assets). In others, (e.g. France, Germany, Switzerland, the Net

16、herlands and the UK), on a risk-weighted basis, with higher levels for higher-risk assets.Key breakthrough was in 1986 when the US accepted the risk-based approach. In late 1986, US, UK and Germany reached broad agreement. This led to the 8% 1988 Capital Accord - Basel I. Even though the framework i

17、s now generally agreed to be outdated, it is widely agreed by bankers around the world that the 1988 Capital Accord played a critical role in getting banks to focus on the many aspects of capital management including the importance of risk allocation. So it has a special place in history.The Challen

18、ge for Basel IINeed for greater risk sensitivity than Basel 1 and its “one size fits all” ApproachNeed for a framework that is credible, sound and reflective of industry practicesNeed to be more incentive compatible with desire of regulators to promote and enhance good credit risk managementProblem

19、- there is no standardized approach agreed by industry for the measurement and management of credit risk (unlike market risk) - Market risk has developed more quickly to a statistical basis of calculating risk because there is common agreement on the appropriate modelling framework:Not so with credi

20、t - where there are many competing modelling paradigms.This has made it very difficult for the Basel Committee and, however we may feel about the outcome, - and it has had its share of criticism - it is important to recognize that the task was by no means straightforward.The OutcomeThe outcome has n

21、ot been entirely satisfactory.While there should be no fundamental disagreement with the philosophy of having alternative approaches, logic tends to favour a two-option approach with:One very simple approach for those banks that cannot justify the cost of developing an expensive, sophisticated risk

22、model, andAnother that allows banks to develop their own best-practice risk model and to use it for regulatory as well as internal purposes.The trouble is that we ended up with neither of these:First there are 3 alternatives (or 4 if you count the recent Simplified Standardised approach as a separat

23、e approach) not 2;Second, even the simple model is extremely complex in some of its parts; andThird, the model-based approach stops short of relying fully on the banks own model.Rather than be overly critical I prefer to think of Basel II as just another step along the evolutionary path to a framewo

24、rk that will eventually fit the philosophy I just outlined. .Risk Based SupervisionSo much for risk-based banking and regulation - what about risk-based supervision? That is, how does the risk-base approach alter the way in which regulators should go about implementing and monitoring banking regulat

25、ions?In a nutshell, a risk-based supervisor should attempt to:Identify the riskiest banks;Identify the greatest risks within those banks; andUse its limited resources so as to minimize the overall regulatory riskWhat do I mean by “Regulatory Risk”? Taking a selfish perspective, this is the risk that

26、 the supervisor will be criticised or punished by the political system for failing to meet its expectations (however unrealistic these might be).This risk is greatest when a systemically significant bank fails - thus regulatory and systemic risk are largely co-incident.Risk Rating BanksThe first ste

27、p in this process of risk-based supervision involves identifying the riskiest banks - this requires the supervisor to have a risk grading system.Interestingly, we have seen an evolution in supervision over the past decade or so that is parallel to that in banking.Many supervisors have moved from the

28、 old one-dimensional grading system such as the CAMEL system, with its 4 or 5 grades, to a two-dimensional system with much greater granularity - parallel to the developments in the banking approach to credit grading.The two dimensions of regulatory risk are:Probability of failure (PF); andConsequen

29、ces given failure (CGF)A small bank with a high probability of failure may be no more of a risk to a supervisor than a big bank with a low probability of failure - it may even be less of a risk.Let me illustrate this approach using the model we developed in AustraliaAPRA Reviewed developments in US,

30、 UK and CanadaDeveloped PAIRS system (Probability and Impact Rating System)As in banking - risk grading system should not eliminate subjectivity but the discipline imposed by a structured approach should increase objectivityBack up with peer review and quality controlConceptual FrameworkThe basic co

31、nceptual framework for assessing likely bank failures requires the supervisor to assess three elements for each bank:Their inherent risk based on factors such as:Asset qualityBalance sheet riskLiquidity riskOperational riskLegal riskStrategic risk and contagion riskThe quality of management and cont

32、rol, based on:The Board & senior managementOperational managementRisk, Management systemsInformation systemsCompliance and applicationCapitalCurrent excess/ Earnings/ Access to additionalThese are combined to create and index of risk of failure. The index starts with inherent risk, then looks at the

33、 extent of risk mitigation from:Management and control; andCapitalTo arrive at a risk of failure (PD equivalent)This is then combined with a measure of impact (LGD equivalent) based largely on size and complexityThe result is an exponential index of supervisory oversight - based on the product of th

34、e two graded indexes. This measure is then used to prioritise the allocation of supervisory resources within APRA.Beyond Risk GradingRisk-based supervision requires better risk grading to identify the institutions posing the greatest risksIt also requires targeted inspections and investigationsIt re

35、quires judgement and graduated supervisory responsesThis is where Basel II has focused its attention through Pillar 2Pillar 2 supervisory frameworkPhilosophy: Pillar 1 Capital Framework is only an approximation - it is not entirely comprehensiveCapital is critical in mitigating risk but it is not th

36、e only relevant factor - a bank should have sound processes and procedures for measuring, monitoring and managing riskSupervisory Review:The idea behind the Pillar 2 supervisory review process is for the supervisor to use all the tools available - including on-site inspections, off-site monitoring,

37、meetings with management and auditors and so on - to assess how well the Pillar 1 Minimum Capital Adequacy matches with the risk profile of each bank.Fundamental to this assessment is the regulators understanding of how the bank itself goes about measuring and monitoring its risks and assessing its

38、own capital needs.The final link in the chain is that supervisors are encouraged to use their judgement to impose additional capital or supervisory sanctions where residual risks are assessed to be excessive.This is extremely demanding on supervisors - especially those in some countries that have not been used t