Economic capital allocation with Basel II : cost, benefit and implementation procedures

428 Pages·2004·2.24 MB·English

by  Dimitris N Chorafas

Economic Capital Allocation
with Basel II
Cost, benefit and implementation procedures
Dimitris N. Chorafas
AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD
PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO
Elsevier Butterworth-Heinemann
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200 Wheeler Road, Burlington, MA 01803
First published 2004
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ISBN 0 7506 6182 8
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Contents
Foreword xi
Preface xiii
Warning: Basel II, the October 11, 2003, announcement and its aftermath xvii
1 Introduction xvii
2 Basel II implementation timetable xvii
3 Changes affecting IRB, EL and UL xviii
4 Bankers appreciate crisp definitions xx
5 Computation of unexpected losses xxi
6 The home-host issue xxiii
7 A preview of Basel III xxiv
Abbreviations xxvii
Part 1: Commercial banks and the new regulation 1
1 Basel II, impact studies and cost of implementation 3
1.1 Introduction 3
1.2 The three pillars of Basel II 4
1.3 A bird’s eye view of standardized, foundation IRB and advanced
IRB methods 9
1.4 Quantitative impact studies and capital adequacy 13
1.5 Examples of the potential sophistication of A-IRB method 18
1.6 The cost of Basel II 22
1.7 Business risk and cost control 25
1.8 Is Basel III coming at the heels of Basel II? 28
2 Benefits from risk-based pricing and rating targets 31
2.1 Introduction 31
2.2 Risk-based pricing: a major benefit from Basel II 32
2.3 Targeting an ‘AA’ and ‘AA+’ rating 35
2.4 How will Basel II affect credit institutions? 40
2.5 Benefits on the road from Basel I to Basel II 43
2.6 Basel II objectives and the effect of leverage 47
2.7 The need for a devil’s advocate in risk management 50
2.8 A-IRB, Basel II and the German Savings Banks: a case study 53
2.9 Looking at the Sparkasse Lu¨neburg project and its advantages 56
vi Contents
3 Regulatory capital defined 61
3.1 Introduction 61
3.2 The role of regulatory capital 63
3.3 Components of regulatory capital 66
3.4 Beyond Tier 1: the Tier 2 and Tier 3 regulatory capital 71
3.5 Pricing assets in Tier 1 and Tier 2 capital 74
3.6 Accounting for risks assumed with lending 79
3.7 Provisioning for bad loans under the new framework 81
4 Market discipline and its global impact 84
4.1 Introduction 84
4.2 Market discipline and enhanced financial disclosure 86
4.3 Qualitative and quantitative information in financial reporting 89
4.4 Credit ratings are a tool of market discipline 92
4.5 Important notions about risk grades and rating systems 96
4.6 Market discipline and management of default risk 99
4.7 Winners and losers with the new regime 102
Part 2: The allocation of economic capital to business units 105
5 Economic capital defined 107
5.1 Introduction 107
5.2 A close look at economic capital 108
5.3 Emphasizing total economic equity 112
5.4 Economic capital, contingent assets and contingent liabilities 115
5.5 Economic capital and management accounting 118
5.6 Synergy between economic capital and risk management 120
5.7 Economic capital and the impact of default models 123
6 Economic capital and solvency management 127
6.1 Introduction 127
6.2 Practical examples with Basel II implementation 129
6.3 Economic capital and an institution’s solvency 132
6.4 Solvency and the regulation of insurance companies 138
6.5 A practical look at position risk 141
6.6 Stress testing risk positions 144
7 Economic capital allocation: practical applications and theoretical
background 149
7.1 Introduction 149
7.2 Role of the corporate center in economic capital allocation 151
7.3 Top-down and bottom-up identification of economic capital
requirements 155
7.4 Economic capital allocation at Rabobank, Cre´dit Suisse,
Deutsche Bank and Citigroup 158
7.5 Citigroup’s adjustment factor: an example with operational risk 162
Contents vii
7.6 Developing a theoretical framework for capital allocation 165
7.7 An algorithmic solution for unexpected losses by the Deutsche
Bundesbank 168
8 Evolving rules and procedures for economic capital allocation 173
8.1 Introduction 173
8.2 Corporate focus on economic capital allocation 174
8.3 Real-life examples with economic capital allocation to business
units and channels 178
8.4 First-order and second-order risks 182
8.5 Learning a lesson from physical sciences 186
8.6 The issue of procyclicality and its impact on economic capital 189
8.7 Banco de Espan˜a: case study on an initiative against procyclicality 192
9 Strategies used by banks to increase their capital base 195
9.1 Introduction 195
9.2 The Modigliani-Miller hypothesis on equity vs debt 196
9.3 Leveraging increases significantly the probability of default 198
9.4 Economic capital increases should only be done in a responsible way 201
9.5 Diversification in the banking business is often wanting 203
9.6 Capital arbitrage through securitization 205
9.7 Statistics on securitized corporate debt and other instruments 208
Part 3: Defaults, internal ratings and technological solutions 213
10 Default defined 215
10.1 Introduction 215
10.2 Default milestones 217
10.3 Definition of default point 221
10.4 Contribution of default point to credit risk strategy 226
10.5 Credit risk information can be painful news 230
10.6 Expected default frequency and the database 234
11 IRB, technological infrastructure, models and correlations 237
11.1 Introduction 237
11.2 IRB and the technology needed by credit institutions 239
11.3 Twenty-first century real-time and real-space in the banking industry 243
11.4 Requirements for efficient IRB modeling 248
11.5 Management must be careful with models and statistics 251
11.6 The calculation and evaluation of correlation coefficients 254
11.7 Are correlation coefficients reliable and well understood? 256
11.8 Beware of magnitude of risk with correlated exposures 258
12 Internal ratings, supervisory weights and collateral 263
12.1 Introduction 263
12.2 The volatility of capital reserves and Basel II 264
12.3 Meeting the prerequisites of layers of supervision 269
viii Contents
12.4 Problems and opportunities associated with risk weights 272
12.5 A case study with small and medium enterprises 275
12.6 Risk weights with standardized and IRB methods 279
12.7 The handling of collateral 282
12.8 Remargining of collateral, credit derivatives and special vehicles 285
13 Software which can help in IRB implementation 290
13.1 Introduction 290
13.2 Mapping the analysis of bankruptcy patterns 291
13.3 Marking-to-model the loans portfolio: RAROC and LAS 294
13.4 Moody’s KMV family of models 298
13.5 Economic capital allocation by Moody’s KMV portfolio manager 303
13.6 Sharpe ratio: its usage and misusage 304
13.7 Implementing the Best Capital Adequacy Ratio 307
13.8 Using BCAR as a step towards a comprehensive solution 309
14 How to be in charge of IRB 314
14.1 Introduction 314
14.2 The risk of misinterpretation of financial information 316
14.3 Management quality rating system by Goldman Sachs 319
14.4 Management’s appreciation of unexpected losses 322
14.5 Legal risk in a global economy and bankruptcy laws 326
14.6 Longer-term liability and legal risk 329
14.7 Rating agencies, legal risk and other risks 332
Part 4: Regulatory and political issues tend to be indivisible 337
15 Supervisory authorities and their regulatory policies 339
15.1 Introduction 339
15.2 Broader context of Basel II and its implementation 341
15.3 The need to expand the supervisors’ power of action 345
15.4 Core Principles, the Financial Stability Forum and the Committee
on the Global Financial System 347
15.5 Group of Seven, Group of Ten and Group of Twenty 350
15.6 Memoranda of Understanding concerning the offshores and
bankruptcies 353
15.7 Globalization, the wealth of nations and the finance industry 355
16 Contrarians to Basel II, CAD 3 and 2010 challenges 361
16.1 Introduction 361
16.2 Dissent is an integral part of sound governance: the good news 362
16.3 Reservations about Basel II expressed by professional bodies 366
16.4 The Shadow Financial Regulatory Committee and its ‘debt is king’
proposal 369
16.5 The 27 February 2003 testimony to the US Congress Subcommittee 371
16.6 The eleventh hour is no time for constructive criticisms 374
Contents ix
16.7 If one does not want to be taken for fool, one should not say
foolish things 377
16.8 Basel II and the EU’s third Capital Adequacy Directive 380
16.9 The challenge of regulating globalized markets 383
Appendix: the Basel Committee on Banking Supervision and Basel II 387
Acknowledgments 389
Index 403
Foreword
In early 2003, Dr Dimitris N. Chorafas was chairing a Capital Allocation conference
in London, where I was presenting a case study on how to create an integrated capital
management methodology. At this stage the banking industry was awaiting the third
consultative paper to be released by the Basel Committee of Banking Supervision and
Basel II/Economic Capital master-classes, workshops, lectures and panel discussions
were on the agendas of quite a number of conferences to address and discuss the latest
techniques in regulatory and economic capital allocation.
During the conference and in the ensuing discussion it quickly became clear to me
that Dimitris Chorafas, based on his fundamental understanding of financial markets
and more than forty years’ experience in advising financial institutions, combines a
holistic view on the impact of Basel II on the financial industry with a pragmatic sense
of its implications for individual banks and their strategy.
Being responsible as a senior program manager for implementing a Basel II
compliant economic capital framework at a major European bank, I have come across
a number of publications and books related to Basel II and economic capital
allocation. However, there are actually not that many books around which, from a
practitioner’s perspective, address the subject in a comprehensive and easy-to-
understand manner. To that end, I was more than happy to participate in Dimitris
Chorafas’s research, which led to this book: Economic Capital Allocation with Basel
II: Cost, Benefit and Implementation Procedures.
In my view the book is spot on in its content, timeliness and coverage, linking the new
Basel II regulation with practical and theoretical guidance on economic capital
allocation strategies. A comprehensive discussion of the political aspects of supervisory
regulation and the challenges ahead concludes the book. It provides the reader with a
fascinating blend of theory, case studies and views from bank experts, rating agencies
and banking regulators. Dimitris Chorafas’s book has all the hallmarks of becoming a
reference for Basel II and economic capital allocation and I am enthusiastic about
recommending it to banking practitioners and academics alike.
Eugen Buck
Managing Director
Senior Project Manager Economic Capital
Rabobank Nederland
Preface
The new capital adequacy rules by the Basel Committee on Banking Supervision,
widely known as Basel II, is a set of regulatory standards targeting not only a sound
capital ratio for credit risk, market risk and operational risk, but also a host of
subjects relating to good governance. As is the case in engineering and in the physical
sciences, the setting of standards is most important because it brings both:
(cid:2) A reduction in the variability of results, and
(cid:2) The localization of reasons of existing variations.
These two aftermaths see to it that standardization and regulation lead to an
enlargement of the field of activity, rather than to a constrained perspective as it is
often intuitively felt. They also bring to attention the need for a sound foundation for
economic capital allocation. Apart from the capital requirements, which must be met,
an able solution rests on three pillars:
1 Corporate strategy. Capital allocation should not be done on general income basis.
It should follow strategic decisions, prognosticate business opportunities and
promote chosen lines of activity, using income from channels with less future (cash
flows).
2 Risk management. The amount of current and future exposure is vital input to all
strategic decisions – and therefore to capital allocation. Regulatory and economic
capital must assure financial staying power.
3 Advanced information technology. Top-tier information technology (IT) provides
the infrastructure which would allow factual allocation of financial resources.
Experimentation, simulation and reliable documentation are ‘musts’.
A similar statement is valid about testing strategic plans, risk control policies and
procedures, as well as technology and models used to help senior management to do
a better job. Basel II brings into perspective the critical question of what should be
settled and what should be tested in the process of regulation, standardization, and
management control.
A pragmatic answer to the testing question is that new methods of risk control
closely associated to the dynamic definition of regulatory capital, as well as the use of
modern technology, permit us to assess a credit institutions’ exposure with a higher
degree of accuracy than ever before. This is fulfilling an essential condition for
sound management. Risk analysis requires a lot of skill, time and data. Here, too,
standardization helps.
xiv Preface
Basel II sets standards and guidelines which reflect an increasingly sophisticated
banking practice, and have to be integrated into the regular day-to-day business of
credit institutions. The challenges this process poses, including its opportunities and
problems, are the issues this book mainly addresses. This has been a deliberate choice,
rather than focusing on the fine print of Basel II, which is anyway published by the
Basel Committee on Banking Supervision.
One of the challenges, perhaps the most important, is the attention to be paid by
senior management, loans officers, traders and investment experts to unexpected
losses. Expected losses should be covered through regulatory capital, while the role of
economic capital is to address unexpected losses and extreme events. How to allocate
economic capital to the bank’s business units is one of the contributions this book
makes to the banking industry.
Based on an extensive research, the book is written for senior bankers in
commercial and investment banking, as well as for officials of regulatory authorities,
responsible for supervising regulatory capital calculations, risk management projects
and economic capital allocation. The text consists of sixteen chapters which are
divided among four parts.
Part 1 gives an overview of Basel II and its pillars, presents the results of
quantitative impact studies (QIS) in which 350 banks in forty different countries
participated, discusses the cost of Basel II implementation, outlines the benefits to be
derived from such investment, including risk-based pricing and rating targets, defines
the component parts of regulatory capital and outlines the global impact of market
discipline.
Credit rating now plays a critical role in the definition of regulatory capital –
whether done by independent rating agencies, under the standard method of Basel II,
or by the bank itself under the Foundation internal ratings-based (IRB) approach and
the Advanced IRB approach. Eigenmodels associated to Basel II and the need for on-
line interactive datamining, add to the sophistication of required solutions.
The theme of Part 2 is allocation of economic capital to business units and activity
channels. After defining the sense of economic capital and the role it plays in the
management of a credit institution, the text documents how and why economic
capital serves to sustain the bank’s solvency, outlines the mathematical background of
economic capital allocation and presents a wealth of practical applications realized by
some of the best known institutions.
Entities which participated in the research which led to this book include regulatory
authorities like the Basel Committee on Banking Supervision, Bank of England,
Deutsche Bundesbank and Swiss National Bank, as well as commercial banks which
have been active in the refinement of some of the Basel II characteristics and in
economic capital allocation. In alphabetic order these banks are Barclays Bank,
Citigroup, Cre´dit Suisse, Deutsche Bank, First Austrian Bank, Merrill Lynch,
Rabobank, United Bank of Switzerland and other credit institutions.
Other major contributors to the research whose outcome has been distilled in this
book have been the foremost independent ratings agencies: Standard & Poor’s,
Moody’s Investors Service, Fitch Ratings and A.M. Best. Based on all of these research
findings, the book brings to the reader’s attention the evolving rules in capital
allocation. It also explains, and critically analyses, strategies used by banks to increase
their capital base.