Description
This is a presentation abput what is credit risk, components of credit risk, sources of credit risk, importance of credit risk. It also covers how credit risk is mitigated in under BASEL II.
Basel II: Credit Risk
Presented by:
Basel II : Major Paradigm Shift
The Existing Accord Focus on a single risk measure The New Accord More emphasis on banks’ internal methodologies, supervisory review & market discipline
One size fits all
Flexibility, menu of approaches, capital incentives for good risk management Increased risk sensitivity
Broad brush structure
BASEL II STRUCTURE
New Basel Capital Accord
Pillar 1 “Quantitative” Minimum Capital Requirements Pillar 2 “Qualitative” Supervisory Review Process Pillar 3 “Market Forces” Market Discipline
Calculation of capital requirements
Credit risk
Operational risk Advanced Approaches Trading book (market risk)
Process for assessing overall capital adequacy Banks are expected to operate above the minimum regulatory capital ratios Early intervention by supervisors
Disclosure requirements
Capital structure Risk exposures Capital adequacy
Risks in Banking
– Credit Risk • Default risk • Country Risk • Settlement risk – Market Risks – Liquidity Risk – Interest Rate Risk – Operational risk – Reputational Risk
CREDIT RISK? • RBI definition : Credit risk is defined as the
possibility of losses associated with diminution in the credit quality of borrowers or counterparties. • In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.
Components of credit risk
Size of Expected Loss “Expected Loss“ = EL = 1. What is the probability of a counterparty going into default?
“Probability of Default”
=
PD X
2. How much will that customer owe the bank in the case of default? (Expected Exposure)
“Loan Equivalency” (Exposure at Default)
=
EaD X
3. How much of that exposure is the bank going to lose?
“Severity” (Loss Given Default)
=
LGD
Sources of Credit Risk
a) • External factors changes in government policies - trade policy - fiscal policy - import-export policy slow down in economy changes in market variables Internal factors business failure risk Business management risk financial management risk settlement and pre-settlement risk on derivative products
• • b) • • • •
Sources of Credit Risk(contd…)
c) d) • • • • Willful default Portfolio risk adverse distribution adverse concentration large exposure correlation between industry sectors
Importance of Credit Risk
• Credit risk continues to be the primary source of problems at banks • Implying that most banks that have “gone under” were hit by credit risk • The effective management of credit risk is essential to the long-term success of any bank
Parties Involved
• Bank • Obligor – Sovereign – Public Sector Enterprises – Multilateral Development Banks – Securities Firms – Corporate – Retail/SME/Individuals • External Credit Assessment Institutions (ECAI) • Guarantors • Protection sellers • Regulator
Key Credit Risk Measures
• Determining credit risk requires the estimation of two variables: ? “Expected” credit loss ? The volatility in credit loss
• Losses in excess of the expected loss are commonly referred to as “unexpected loss”
• Expected loss is additive and can be estimated for subportfolios and aggregated. Volatility, however, is reduced by the diversification in a bank’s loan portfolio. Therefore a single bank-wide volatility is the key measure.
Credit Risk - Approaches
• Standardized approach
– Based on external assessments of risks – Simplified standardised approach (as extract) also available (Annex 9 of the Accord)
• Foundation Internal ratings-based approach
– Banks’ assessment of probability of default
• Advanced Internal ratings-based approach
– Banks’ assessment of all risk factors
STANDARDIZED APPROACH TO CREDIT RISK CAPITAL
Features of Standardized Approach
• Risk weights based on external credit assessments
• Unrated credits assigned to 100% risk bucket
• Two options for treating exposures to banks • Greater differentiation of corporate credits • Introduction of higher risk category (150%) • Option for higher risk weight on equities
New Standardized Approach
Sovereigns AAA/ A AA 0% 20% 50% 50% 50% BBB 50% 100% 50% 100% BB 100% 100% 100% 100% B 100% 100% 100% 150% C and below 150% 150% 150% 150% Unrated 100% 100% 50% 100%
Banks Option 1 20% Option 2 20% Corporates 20%
Notes: Under Option 1, risk weight depends on sovereign rating; under Option 2, depends on bank's own rating. Different rules apply for short term exposures.
High Risk Categories
• Definition of 150% risk bucket
– Claims on sovereigns, PSEs, banks and securities firms rated below B– Claims on corporate below BB– Securitization tranches rated BB+ to BB– Unsecured portions of assets 90+ days past due
• National discretion permits application of higher RW for other high-risk assets, including venture capital and private equity
Multiple Ratings Scenario
• If two credit assessments are used, bank must apply higher (least favorable) risk weight • If more than two credit assessments are used:
– Use lowest (most favorable) risk weight, if two best ratings are identical – If not, use risk weight corresponding to second best credit rating
Issue versus Issuer Rating
• Issue ratings to be used where available • Rating of another issue may apply provided bank’s unrated claim ranks pari passu or senior • If not, then claim treated as unrated (100% RW) • Limited consideration given to issuer ratings
Short-term / Long-term Ratings
• Long-term ratings should generally be used to risk-weight both short-term and long-term claims • Short-term assessment can only be used on short-term claim when long-term rating not available • Short-term rating can never be used to assign preferential risk weight to long-term claims
Off-balance sheet items
• Off-balance-sheet items under the standardised approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF).
INTERNAL RATINGS BASED APPROACH TO CREDIT RISK CAPITAL
Internal Ratings Based Approach
Under the IRB approach, banks must categorize bankingbook exposures into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below.
• The classes of assets are (a)corporate, (b)sovereign, (c)bank, (d)retail, and (e) equity.
Corporate Exposure
• A corporate exposure is defined as a debt obligation of a corporation, partnership, or proprietorship. Within the corporate asset class, five sub-classes of specialized lending are separately identified.
1. 2. 3. 4.
project finance, object finance – ships, aircraft, satellites, commodities finance – crude oil, metals, crops income-producing real estate – residential buildings, ware houses 5. high-volatility commercial real estate.
Retail Asset Class
Within the retail asset class, three sub-classes are separately identified. A retail exposure is one where: Nature of borrower or low value of individual exposures • Exposures to individuals • Residential mortgage loans • Loans extended to small business, and managed as retain exposures provided the total exposure of the banking group to a small business borrower is (on consolidated basis, if applicable), is less than Euro 1 Million The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis.
Internal Ratings Based Approach: Foundation
• • Components provided by banks: internal ratings (probability of default requires sophisticated database) Components provided by Basel Accord loss given default ; exposure at default; maturity
Advanced Internal Ratings Based Approach
- Same principles as for Foundation Approach, but all items are provided by the bank, based on internally developed models
- Capital charge - subject to a floor at 90 % in 2008 and 80 % in 2009
Foundation and Advanced IRB Approach - A Comparison
Foundation IRB PD LGD EGD
Provided by banks, based on own estimates. Supervisory rules set by the committee Supervisory rules set by the committee
Advanced IRB
Provided by banks, based on own estimates. Provided by banks, based on own estimates. Provided by banks, based on own estimates.
M
Supervisory rules set by the committee or at National Discretion, by Banks’ own estimate
Provided by banks, based on own estimates.
Maintenance Of CRAR
• The initial Capital to Risk-weighted Ratio (CRAR) was initially set at 8 % • However, to meet the international standards, this has been raised to 9% with effect from March 31, 2000. • At the end of March 2002, there were 25 PSBs with a CRAR exceeding the stipulated 9% • The implementation of Basel New Accord has been estimated to be completed by end-2006
CREDIT RISK MITIGATION UNDER BASEL II
Credit Risk Mitigation (CRM)
• Banks use a number of techniques to mitigate the credit risks to which they are exposed. • Use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks). • Residual risks include legal, operational, liquidity, and market risks.
Definition of CRM Techniques
• Techniques used to reduce credit risk, encompassing:
– Collateral (cash or securities) – Third party guarantees – Credit derivatives – On-balance sheet netting
Credit Risk Mitigation
• Basel II allows banks to accept a wider range of collateral than under Basel I • Subject to legal certainty test • Eligible Financial Collateral • Eligible IRB Collateral – Receivables and Real Estate (conditions apply) • Two approaches – Simple Approach and Comprehensive Approach
Eligible Financial Collateral
• Under the simple approach:
– Cash – Gold – Debt securities with, at least, a BB- rating (for sovereign and PSEs), a BBB- rating (for other issuers) or A3P3 (for short-term securities) – Unrated debt securities if they are (i) issued by banks, (ii) listed and (iii) senior – Equities included in a main index
• Under the comprehensive approach:
– All instruments listed above – Equities not included in a main index but listed on a recognized exchange
Collateral - Simple Approach
• Similar to Current Accord – substitution approach • Collateral must be revalued at least every six months • No maturity mismatch • Floor at 20%, except for cash and government securities • Approach designed for banks that engage only to a limited extent in collateralized transactions
Collateral - Comprehensive Approach
• Adjust the exposure amount and value of collateral using haircuts to account for fluctuations in the future market value of each • 2 different methods are available to determine the appropriate haircuts
Haircuts
• Using haircuts, banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either. • banks have two ways of calculating the haircuts: (i) standard supervisory haircuts, using parameters set by the Committee, and (ii) own-estimate haircuts, using banks’ own internal estimates of market price volatility.
Comprehensive Haircuts
• • • • • • • •
In a collateralised transaction, the exposure amount after risk mitigation is calculated as follows: E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx)]} where: E*= the exposure value after risk mitigation E = current value of the exposure He= haircut appropriate to the exposure C= the current value of the collateral received Hc= haircut appropriate to the collateral Hfx= haircut appropriate for currency mismatch between the collateral and exposure
Comprehensive Haircuts
EXAMPLE
1. Loan of INR 100 to counter party having risk weight of 100% 2.Collateral security value is INR 80
3.Haircut percentage is 10% (presumed)
Calculate the Risk Weight after adjustment
Comprehensive Haircuts
Example:
Loan of INR 100 to counter party having risk weight of 100% Collateral security value is INR 80 Haircut percentage is 10% (presumed)
Step 1: Calculate amount of adjusted exposure E* E* = (100 x (1+.1) ) – (80 x (1-.1)) = 110- 72 = 38 Step 2: Multiply the adjusted exposure E* with risk weight 38 x 100% = 38 Hfx= haircut appropriate for currency mismatch between the collateral and exposure is not applied in this case.
Standard Supervisory Haircuts
Thank you
doc_586941236.ppt
This is a presentation abput what is credit risk, components of credit risk, sources of credit risk, importance of credit risk. It also covers how credit risk is mitigated in under BASEL II.
Basel II: Credit Risk
Presented by:
Basel II : Major Paradigm Shift
The Existing Accord Focus on a single risk measure The New Accord More emphasis on banks’ internal methodologies, supervisory review & market discipline
One size fits all
Flexibility, menu of approaches, capital incentives for good risk management Increased risk sensitivity
Broad brush structure
BASEL II STRUCTURE
New Basel Capital Accord
Pillar 1 “Quantitative” Minimum Capital Requirements Pillar 2 “Qualitative” Supervisory Review Process Pillar 3 “Market Forces” Market Discipline
Calculation of capital requirements
Credit risk
Operational risk Advanced Approaches Trading book (market risk)
Process for assessing overall capital adequacy Banks are expected to operate above the minimum regulatory capital ratios Early intervention by supervisors
Disclosure requirements
Capital structure Risk exposures Capital adequacy
Risks in Banking
– Credit Risk • Default risk • Country Risk • Settlement risk – Market Risks – Liquidity Risk – Interest Rate Risk – Operational risk – Reputational Risk
CREDIT RISK? • RBI definition : Credit risk is defined as the
possibility of losses associated with diminution in the credit quality of borrowers or counterparties. • In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.
Components of credit risk
Size of Expected Loss “Expected Loss“ = EL = 1. What is the probability of a counterparty going into default?
“Probability of Default”
=
PD X
2. How much will that customer owe the bank in the case of default? (Expected Exposure)
“Loan Equivalency” (Exposure at Default)
=
EaD X
3. How much of that exposure is the bank going to lose?
“Severity” (Loss Given Default)
=
LGD
Sources of Credit Risk
a) • External factors changes in government policies - trade policy - fiscal policy - import-export policy slow down in economy changes in market variables Internal factors business failure risk Business management risk financial management risk settlement and pre-settlement risk on derivative products
• • b) • • • •
Sources of Credit Risk(contd…)
c) d) • • • • Willful default Portfolio risk adverse distribution adverse concentration large exposure correlation between industry sectors
Importance of Credit Risk
• Credit risk continues to be the primary source of problems at banks • Implying that most banks that have “gone under” were hit by credit risk • The effective management of credit risk is essential to the long-term success of any bank
Parties Involved
• Bank • Obligor – Sovereign – Public Sector Enterprises – Multilateral Development Banks – Securities Firms – Corporate – Retail/SME/Individuals • External Credit Assessment Institutions (ECAI) • Guarantors • Protection sellers • Regulator
Key Credit Risk Measures
• Determining credit risk requires the estimation of two variables: ? “Expected” credit loss ? The volatility in credit loss
• Losses in excess of the expected loss are commonly referred to as “unexpected loss”
• Expected loss is additive and can be estimated for subportfolios and aggregated. Volatility, however, is reduced by the diversification in a bank’s loan portfolio. Therefore a single bank-wide volatility is the key measure.
Credit Risk - Approaches
• Standardized approach
– Based on external assessments of risks – Simplified standardised approach (as extract) also available (Annex 9 of the Accord)
• Foundation Internal ratings-based approach
– Banks’ assessment of probability of default
• Advanced Internal ratings-based approach
– Banks’ assessment of all risk factors
STANDARDIZED APPROACH TO CREDIT RISK CAPITAL
Features of Standardized Approach
• Risk weights based on external credit assessments
• Unrated credits assigned to 100% risk bucket
• Two options for treating exposures to banks • Greater differentiation of corporate credits • Introduction of higher risk category (150%) • Option for higher risk weight on equities
New Standardized Approach
Sovereigns AAA/ A AA 0% 20% 50% 50% 50% BBB 50% 100% 50% 100% BB 100% 100% 100% 100% B 100% 100% 100% 150% C and below 150% 150% 150% 150% Unrated 100% 100% 50% 100%
Banks Option 1 20% Option 2 20% Corporates 20%
Notes: Under Option 1, risk weight depends on sovereign rating; under Option 2, depends on bank's own rating. Different rules apply for short term exposures.
High Risk Categories
• Definition of 150% risk bucket
– Claims on sovereigns, PSEs, banks and securities firms rated below B– Claims on corporate below BB– Securitization tranches rated BB+ to BB– Unsecured portions of assets 90+ days past due
• National discretion permits application of higher RW for other high-risk assets, including venture capital and private equity
Multiple Ratings Scenario
• If two credit assessments are used, bank must apply higher (least favorable) risk weight • If more than two credit assessments are used:
– Use lowest (most favorable) risk weight, if two best ratings are identical – If not, use risk weight corresponding to second best credit rating
Issue versus Issuer Rating
• Issue ratings to be used where available • Rating of another issue may apply provided bank’s unrated claim ranks pari passu or senior • If not, then claim treated as unrated (100% RW) • Limited consideration given to issuer ratings
Short-term / Long-term Ratings
• Long-term ratings should generally be used to risk-weight both short-term and long-term claims • Short-term assessment can only be used on short-term claim when long-term rating not available • Short-term rating can never be used to assign preferential risk weight to long-term claims
Off-balance sheet items
• Off-balance-sheet items under the standardised approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF).
INTERNAL RATINGS BASED APPROACH TO CREDIT RISK CAPITAL
Internal Ratings Based Approach
Under the IRB approach, banks must categorize bankingbook exposures into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below.
• The classes of assets are (a)corporate, (b)sovereign, (c)bank, (d)retail, and (e) equity.
Corporate Exposure
• A corporate exposure is defined as a debt obligation of a corporation, partnership, or proprietorship. Within the corporate asset class, five sub-classes of specialized lending are separately identified.
1. 2. 3. 4.
project finance, object finance – ships, aircraft, satellites, commodities finance – crude oil, metals, crops income-producing real estate – residential buildings, ware houses 5. high-volatility commercial real estate.
Retail Asset Class
Within the retail asset class, three sub-classes are separately identified. A retail exposure is one where: Nature of borrower or low value of individual exposures • Exposures to individuals • Residential mortgage loans • Loans extended to small business, and managed as retain exposures provided the total exposure of the banking group to a small business borrower is (on consolidated basis, if applicable), is less than Euro 1 Million The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis.
Internal Ratings Based Approach: Foundation
• • Components provided by banks: internal ratings (probability of default requires sophisticated database) Components provided by Basel Accord loss given default ; exposure at default; maturity
Advanced Internal Ratings Based Approach
- Same principles as for Foundation Approach, but all items are provided by the bank, based on internally developed models
- Capital charge - subject to a floor at 90 % in 2008 and 80 % in 2009
Foundation and Advanced IRB Approach - A Comparison
Foundation IRB PD LGD EGD
Provided by banks, based on own estimates. Supervisory rules set by the committee Supervisory rules set by the committee
Advanced IRB
Provided by banks, based on own estimates. Provided by banks, based on own estimates. Provided by banks, based on own estimates.
M
Supervisory rules set by the committee or at National Discretion, by Banks’ own estimate
Provided by banks, based on own estimates.
Maintenance Of CRAR
• The initial Capital to Risk-weighted Ratio (CRAR) was initially set at 8 % • However, to meet the international standards, this has been raised to 9% with effect from March 31, 2000. • At the end of March 2002, there were 25 PSBs with a CRAR exceeding the stipulated 9% • The implementation of Basel New Accord has been estimated to be completed by end-2006
CREDIT RISK MITIGATION UNDER BASEL II
Credit Risk Mitigation (CRM)
• Banks use a number of techniques to mitigate the credit risks to which they are exposed. • Use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks). • Residual risks include legal, operational, liquidity, and market risks.
Definition of CRM Techniques
• Techniques used to reduce credit risk, encompassing:
– Collateral (cash or securities) – Third party guarantees – Credit derivatives – On-balance sheet netting
Credit Risk Mitigation
• Basel II allows banks to accept a wider range of collateral than under Basel I • Subject to legal certainty test • Eligible Financial Collateral • Eligible IRB Collateral – Receivables and Real Estate (conditions apply) • Two approaches – Simple Approach and Comprehensive Approach
Eligible Financial Collateral
• Under the simple approach:
– Cash – Gold – Debt securities with, at least, a BB- rating (for sovereign and PSEs), a BBB- rating (for other issuers) or A3P3 (for short-term securities) – Unrated debt securities if they are (i) issued by banks, (ii) listed and (iii) senior – Equities included in a main index
• Under the comprehensive approach:
– All instruments listed above – Equities not included in a main index but listed on a recognized exchange
Collateral - Simple Approach
• Similar to Current Accord – substitution approach • Collateral must be revalued at least every six months • No maturity mismatch • Floor at 20%, except for cash and government securities • Approach designed for banks that engage only to a limited extent in collateralized transactions
Collateral - Comprehensive Approach
• Adjust the exposure amount and value of collateral using haircuts to account for fluctuations in the future market value of each • 2 different methods are available to determine the appropriate haircuts
Haircuts
• Using haircuts, banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either. • banks have two ways of calculating the haircuts: (i) standard supervisory haircuts, using parameters set by the Committee, and (ii) own-estimate haircuts, using banks’ own internal estimates of market price volatility.
Comprehensive Haircuts
• • • • • • • •
In a collateralised transaction, the exposure amount after risk mitigation is calculated as follows: E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx)]} where: E*= the exposure value after risk mitigation E = current value of the exposure He= haircut appropriate to the exposure C= the current value of the collateral received Hc= haircut appropriate to the collateral Hfx= haircut appropriate for currency mismatch between the collateral and exposure
Comprehensive Haircuts
EXAMPLE
1. Loan of INR 100 to counter party having risk weight of 100% 2.Collateral security value is INR 80
3.Haircut percentage is 10% (presumed)
Calculate the Risk Weight after adjustment
Comprehensive Haircuts
Example:
Loan of INR 100 to counter party having risk weight of 100% Collateral security value is INR 80 Haircut percentage is 10% (presumed)
Step 1: Calculate amount of adjusted exposure E* E* = (100 x (1+.1) ) – (80 x (1-.1)) = 110- 72 = 38 Step 2: Multiply the adjusted exposure E* with risk weight 38 x 100% = 38 Hfx= haircut appropriate for currency mismatch between the collateral and exposure is not applied in this case.
Standard Supervisory Haircuts
Thank you
doc_586941236.ppt