1. The Basel Controversy!
Guilty or Not Guilty?
Prepared and Presented by: Mohammad I. Fheili
Organizational Planning & development Specialist
M I Fheili & Associates
mifheili@terra.net.lb & mifheili@gmail.com
Mobile: +961 3 337175 & +961 71585660
2. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Mohammad Fheili
“Over 30 years of Experience in Banking.
mifheili@gmail.com (961) 3 337175
Risk & Capacity Building Specialist.
Trainer in Risk, Compliance, and Capacity
Building.
University Lecturer: Economics, Risk, and
Banking Operations
Currently serves in the capacity of an
Executive (AGM) at JTB Bank in Lebanon.
Served as:
• Senior Manager & Chief Risk Officer at
Group Fransabank
• Senior Manager at BankMed
• Talent Development Advisor at ABL
• Economist at the Association of Banks
in Lebanon [ABL]
Mohammad received his college education
(undergraduate & graduate) at Louisiana
State University (LSU), and has been teaching
Economics and Finance for over 25
continuous years at reputable universities in
the USA (LSU) and Lebanon (LAU).
Finally, Mohammad published over 25
articles, of those many are in refereed
Journals (e.g., Journal of Money Laundering
& Control; Journal of Operational Risk;
Journal of Law & Economics; etc.) and
Bulletins.”
4. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Who is to Blame?
Lenders: for their predatory lending practices focused on sub-
Prime mortgage candidates
Rating Agencies: Overrate the MBS and other derivatives with
underlying securities of little value with full knowledge.
Mortgage brokers: for steering borrowers to unaffordable loans
Appraisers: for inflating housing values
Wall Street investors: for backing sub-Prime mortgage loans
without first verifying the security of the portfolio
Borrowers: for overstating income levels on loan applications
and entering into loan agreements they could not afford
Government: for lack of oversight
5. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Ongoing Effects:
Sub-Prime mortgage industry collapses, thousands of jobs
are lost
Surge of foreclosure activity
Housing prices and sales are both down
Interest rates rise across the board as the effects of the
collapse of the sub-Prime mortgage industry seep into the
near-prime and prime mortgage markets
Investors lost billions of dollars in securities tied to the sub-
Prime mortgage industry, resulting in upheavals throughout
the global financial market
6. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Measures Taken By . . .
United States:
$700BN BAIL OUT PLAN;
Fed cut key interest rate to 1%
United Kingdom:
Govt injected cash of £37bn into 3 major
banks
Bank of England cuts interest rate to 4.5%
Germany:
€500bn financial rescue
Japan:
Bank of Japan cuts interest rate to 0.3%
1.8trillion yen stimulus plan
Brazil:
Abandons its tax on foreign investment.
Plans to sell $50bn in dollar swap futures
contracts to defend currency.
Russia:
950bn Rouble long term funding to Banks
1.3trillion Rouble to State-run
Vnesheconombank to service Russian
Banks’ foreign loans
China
Abandons its tax on foreign investment
Plans to sell $50bn in dollar swap futures
contracts to defend currency
7. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Lessons in the process being learnt
Development of speculative real estate markets and lax standards
of credit appraisal are the surest routes to economic disaster
Rating instrumentality is no substitute to independent due
diligence
Higher capital allocation with or without Basel II or prospective
Basel III is no insurance for bank failures triggered by systemic,
people and process failures
Sophisticated mathematical models, notwithstanding back testing,
stress testing and the like hardly forebode collapses.
GAAP is not enough
Macro prudential analysis (MPA) requires revisit
High degree of flexibility is required in the choice of benchmarks
Appetite for mergers and acquisitions move in a new direction
Injecting liquidity through equity is a better route than a bail-out
package
Regulators to keep watch on leverage ratios more than the capital.
8. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
The Swiss-
Cheese Model
The Steel
Model
9. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Justifying Government Intervention
Sudden changes in asset quality and value can quickly
wipe out bank capital. Where short-term wholesale
liabilities fund longer-ion and investment term assets,
failure to roll over short-term financial paper, or ‘run’ on
deposits, can force de-leveraging and asset sales.
Banking crisis associated with such changes are often
systemic in nature, arising from the interconnectedness
of financial arrangements: banks between themselves,
with derivative counterparties and with direct links to
consumption and investment decisions.
It is for this reason that policy makers regulate the
amount of capital that banks are required to hold, and
require high standards of corporate governance,
including liquidity management, accounting, audit and
lending practices.
10. If you were to Summarize Risk Management
in Three Words, what would they be?
Identify
Assess
Mitigate
11. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
1
3
You were asked
by a Zoo Keeper
to pick One
animal to take
care of, for a day,
inside a 25m2
room; and alone?
Feel free:
To ask any
question. I’m
the Animal
Keeper!
To do what
you deem
necessary to
succeed.
2
4
12. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
It’s About Making Risk Choices
Identification Assessment Mitigation
Key
Risks
Identified
Risks
Non-
Identified Risks ? ?
Acceptable
Risks
Un-
Acceptable
Risks
?
Control
Transfer
Avoid!
Finance
RiskTakersinlinewithexistingpolicies
14. Is Risk Management a
Destination?
If your approach to risk
management is that it is a
destination by itself, . . .
. . . Then “Compliance” is your
“cup of tea”, and you have
effectively transferred the
burden of decision-making to
the hands of the supervisors
If your approach to risk
management is that it is a
process leading to . . . An
End
Then, you have taken
matters into your own
hands!
15. Bank’s Objective Function
MAXIMIZE PROFIT subject to:
RISK Constraints
RISK . . .
Default
Liquidity
Maturity
OtherTypes of Risks
Uses of
Funds
Sources of
Funds
Reserves
Loans
Securities
Other
Investments
Fixed Assets
. . .
AllTypes of
Deposits
Borrowings
Other Sources
Equity
Capital
. . .
. . . and Off-Balance Sheet . . .
16. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Nature of Risk Has Changed . . . !
Return
Risk
Return
Risk
Speculative Risk
Managing Revenue
Hazard + Others
Managing Costs
CreditRisk
MarketRisk
Reputation&
OtherRisks
Operational
Risk
Best Practices in Risk Management: Risk = Speculative + Hazards
Risk is Here to Stay . . .
18. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Increasing Understanding of Outcomes
IncreasingEvidenceonProbability
Risk
Uncertainty
Ambiguity
Ignorance
Consequences are increasingly uncertain
LikelihoodisIncreasinglyUncertain
But Managing RISK is not a guessing game, it is
a DATA-RICH Process
19. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Collect
them
all!
Data
Data
Data
Data
Data
Data
Data
Data
Data
Collect All The Data . . . To Improve Upon Your Ability To Make
Good Decisions
20. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
This is NOT Data Warehousing
21. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
How Do You Approach Data Collection? Look At
A Typical Banking Organization
LOGISTICS
Information
Technology
Human Resources
Administration
Others
RISK & CONTROL
Risk Management
Internal Audit
Internal Controls
Inspections
Others
BANKING
Retail Banking
Corporate Banking
Treasury
Private Banking
Others
Support Functions
(Cost Centers)
Business Generators
(Speculative Behavior)
Board of Directors
With well defined sets of duties &
responsibilities
With well defined sets of
duties & responsibilities
Typical Transaction: Start . . . . (goes through the entire banking organization) . . . End
Before . . .
During . . .
After . . .
22. How do you Identify, Measure, and Manage Risk in
a Typical Banking Transaction?
e.g., Banking Transaction: Credit
Facility Approval Process
23. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Dissect the Process, and Collect Data at Every
Step. E.g., Credit Approval Process
Acquisition/
Credit
Specific
Customer
Service
Collect And
Review
Data
Credit
Review
Assess
Collateral
And Risk
Document Approval
Sales: Bank-Client Interface Risk Analysis: Pricing the Facility Processing
Establishing
Contact
Evaluate first
customer
info
Customer
Meetings
Debriefing
Request
documents
Obtain data &
information
Completeness
/ plausibility
review
Follow up
Review
document
Follow up
with Loan
Officer /
Account
Manager
Standardized
Credit Rating
Document
on other
credit related
factors
Inspect
Object
Determine
Loan-to-
value
Evaluate
Exposure
Data is
Sufficient
Complete
Loan
Application
Prepare
Credit rate
Handover
Credit File
Follow Up
Data is
Complete
Approval by
Decision
Makers
Check
Compliance
with Authority
Structure
Prepare
Contracts
Get
Signatures
Provide
Security
Disbursement
Review
Disbursement
Plan Monitor &
Report
Resolution
Correlations & Loan Portfolio
Considerations
Loan/Asset Life Cycle
Credit Approval Process
Implement
On the
Credit
Decision
24. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Credit Committees. . . Decision-Making Process !
Credit Authority by Total Exposure
Small
Exposure
Medium
Exposure
Large
Exposure
Very Large
Exposure
Investment
Exposure
Sales
Risk
Analysis
Corporate
Board
Sales Locations
Sales Manager
Risk Analysis
Head of
Risk Analysis
Executives
Supervisory Board
Credit Committee
- Account Manager
- Group Leader
- Risk Analyst
- Group Leader
+ + + + +
+ +
First Vote Assessment Assessment Assessment Assessment
Opinion Opinion
First Vote
First Vote
Second Vote
Second Vote
Analysis Analysis Analysis Analysis
Second Vote Opinion Opinion
First Vote
Second Vote
First Vote
Second Vote
- - - -
-
- -
- - -
-
-
-
-
-
-
-
-
-
-
Second Vote
25. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
• INADEQUATE Risk Management
• Inadequate Supervision
• LAX Governance
• ABSENCE of Required Competencies
• Inadequate Enforcement of Internal Policies and Procedures
• LACK of Transparency
• Inadequate Disclosure
Why Banks
Fail?
Banking weaknesses in most failures were
unrecognized in due time because they were
CAMOUFLAGED with the hope that none shall
ever be discovered!
By the time “BANK
FAILURES” were discovered,
it was impossible to do away
with drastic measures to
resolve them!
If Bankers Have Been Doing Their Jobs Right, Bank Failures would
Not Reach A Catastrophic Proportions. . .
26. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Why not Blame Banking Innovations: Have Taken Place At A Rate
Faster than Employees Have Been Able to Digest . . . Risky
Business
New products
Product sophistications
New distribution channels
New markets
New technology
Complexity (IT-
Interdependencies, data
structures)
E-commerce
Processing speed
Business volume
Globalization
Shareholder and other
stakeholder pressure
Mergers & Acquisitions
Re-Organizations
Staff turnover
Cultural diversity of staff and
clients
Faster ageing of know-how
Rating Agencies
Insurance Companies
Capital Markets
Others . . . .
Trust between the Financial Supervisory Authorities and
Banks/Bankers have come under serious questions . . . !
27. History Testifies Against Basel . . .
. . . But, equally Important, it does not
free Bankers from potential guilt. . .
28. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
1
9
8
8
1
9
9
6
1
9
9
8
2
0
0
1
2
0
0
4
2
0
0
8
2
0
0
9
2
0
1
3
Market
Risk
Basel II
Consultation
Starts
Finalization of
Revised
Framework
Basel III
Proposals
Basel I Basel II Basel III
?
Jul. Jan. Jan.Dec.
__The Basel Committee of Banking Supervision was established in 1974 at the Bank for International Settlements (BIS)
> > > each member is represented by its Central Bank and the authority responsible for domestic banking supervision.
The Original Mandate was to deal with the regulatory challenge posed by the increasing internationalization of banking
in the 1970s.
__The collapse of the German Herstatt Bank and the New York-based Franklin National Bank in 1974 showed that
financial crises were no longer confined to one country, and that coordinated international action was needed to
prevent future crises from spilling over borders.
__The Committee’s first proposal, the 1975 Basel Concordat, established rules determining the responsibilities of
home and host country regulators vis-à-vis cross-border banks.
29. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
1
9
8
8
1
9
9
6
1
9
9
8
2
0
0
1
2
0
0
4
2
0
0
8
2
0
0
9
2
0
1
3
Market
Risk
Basel II
Consultation
Starts
Finalization of
Revised
Framework
Basel III
Proposals
Basel I Basel II Basel III
?
Jul. Jan. Jan.Dec.
__The Committee’s focus expanded in 1980s as American regulators looked for a way to share the regulatory burden
imposed on its banks after the Latin American Debt Crisis of 1982. In response, American regulators seized on the
Basel Committee to establish a common framework for the capital regulation of internationally active banks, the 1988
Accord on Capital Adequacy (Basel I).
__The 1988 Accord set minimum capital requirements based on a ratio of capital to risk-weighted assets of 8%. Assets
were risk-weighted according to the identity of the borrower.
__Whose job was to secure compliance with Basel I? The Financial Control Division of the banking organization (Not
Risk Management; most likely because risk management did not exist in the org structure of the bank then.
30. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
1
9
8
8
1
9
9
6
1
9
9
8
2
0
0
1
2
0
0
4
2
0
0
8
2
0
0
9
2
0
1
3
Market
Risk
Basel II
Consultation
Starts
Finalization of
Revised
Framework
Basel III
Proposals
Basel I Basel II Basel III
?
Jul. Jan. Jan.Dec.
Basel I: Minimum Capital, Basic
Risk Weighting
Basel II: Changes to Risk Weights, Second and
Third Pillars not implemented in full (Practically)
Basel III: Changes to Risk Weights, Changes to
definition of Capital, New (experimental) measures,
Accounting Complications
31. Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
According to the Basel
Committee, the Accord have
the following objectives:
To promote safety and
soundness in the financial
system
To enhance competitive
equality
To constitute a more
comprehensive approach to
addressing risk.
Basel I Basel II Basel III
32. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
MAXIMIZE PROFIT subject to:
RISK, REGULATORY, Compliance, Reporting, Etc. Constraints
RISK . . .
Default
Liquidity
Maturity
Others ...
REGULATORY . . .
Basel I
Basel II
Basel III
Basel IV (In the making)
TLAC Requirements
Sanctions Rules
USA_FATCA Requirements
OECD_CRS (1st Reporting
2017)
IFRS9
AML, Etc. . . .
Uses of Funds Sources of Funds
Reserves
Loans
Securities
Other Investments
Fixed Assets
. . .
AllTypes of Deposits
Borrowings
Other Sources
Capital
. . .
Off-Balance Sheet
Legal Issues . . .
From Originate-
To-hold To
Originate-To-
Distribute
(Decompose &
Redistribute)
CRS: Common Reporting Standards, essentially inspired by FATCA, is a framework between governments to exchange information
obtained from local financial institutions to combat tax evasions.
TLAC: The Proposed Minimum Total Loss Absorbing capacity requirements for Globally Systemically Important Banks (G-Sibs). It aims to
boost G-Sibs’ capital and leverage ratios, ensuring these banks are equipped to continue critical functions without threatening financial
market stability or requiring taxpayer support.
Instead of to Off-
Balance Sheet;
now to Unregulated
Shadow Banking
with less concerns
over loan
monitoring &
Follow up.
Used as a Cushion
with loss-
absorbing capacity
or as a Source of
Funding!
The Banking Model… Complex
33. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
By the late 1990s, the
Accord had come to be
seen as a blunt instrument
that was “Useless for
Regulators and Costly for
Banks”.
. . . Banks succeeded in
exploiting the difference
between economic risk
and regulatory risk to
reduce capital levels
without reducing
exposure to risk.
Banks arbitraged Basel I’s
Capital requirements in two
ways:
They moved toward the riskier
assets within a given risk weight
category, which have a higher
yield.
They shifted assets off the
balance sheet, typically
securitizing them. These assets were
treated as true sales for regulatory
purposes, even though the bank often
retained much of the underlying risk
through credit enhancements.
Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
Basel I Basel II Basel III
34. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
The Revised Framework
begins with a core
concept: A Distinction
between “Expected” and
“Unexpected” losses.
Expected losses in any
given year can and should
be managed by “Pricing”
or through “provisioning”.
But Supervisors want a
buffer in the form of
Capital to be held for
Unexpected, or occasional
peak, losses.
This Capital Buffer will serve
to:
Limit Insolvencies
Absorb losses that could
activate explicit or implicit
government guarantees.
Ensure confidence in the
financial system.
. . . Need to establish balance
between the costs and benefits
of holding capital.
Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
Basel I Basel II Basel III
35. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
e.g., The Credit Risk Function
Quantitative
Evaluation
Qualitative
Evaluation
Internal
Rating
Financial Data Mitigation
Matrix
Probability of
Default - PD
Loss Given
Default - LGD
Exposure At
Default - EAD
Correlation
Risk
Components
Calculation
Of Credit
Risk
Amount
(Measurement
Model of
Credit Risk)
Stress Testing
Expected
Loss (EL)
Unexpected
Loss (UL)
(Single Asset
And
Portfolio)
< Internal Rating Systems >
< Quantification of Credit Risk >
Reporting to
The Board
Portfolio
Monitoring
Provisioning
Pricing
Profit
Management
Capital
Allocation
< Internal Use >
36. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Process of Internal Ratings
1
2
3
4
5
6
7
8
9
10
1
2
3
4
5
6
7
8
9
10
1
2
3
4
5
6
7
8
9
10
Borrower’s
Financial
Data
Quantitative
Rating
Model
Borrower’s
Qualitative
Information
Default
ProbabilityofDefaultPer
RatingGrade
Assessing Ratings Estimation of PD
Quantitative Evaluation Qualitative Evaluation
Initial Evaluation
(tentative)
Final
Rating
Rating Mitigation
(Later)
-------
Normal
Bankrupt
Needs attention
How to set the time horizon of
assessing the creditworthiness
of borrowers in assigning
ratings: Point-In-Time (PIT) and
Through-The-Cycle (TTC)
Two-Tier Rating System: Obligor
and Facility Ratings
37. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Pre-
Basel
Credit Risk Credit + Market Risks Credit + Market +
Operational Risks
(Pillars 1, 2, and 3)
Present
and
Beyond
1
9
8
8
1
9
9
6
1
9
9
8
2
0
0
1
2
0
0
4
2
0
0
8
2
0
0
9
2
0
1
3
Market
Risk
Basel II
Consultation
Starts
Finalization of
Revised
Framework
Basel III
Proposals
Basel I Basel II Basel III
?
Jul. Jan. Jan.Dec.
Basel II is no longer in
the embryonic tube
38. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Basel II: Born with Serious Defects
Pillar I: Minimum Capital Adequacy Ratios
Calculation
Of Exposure
Calculation
of PD/LGD
Calculation
of RWA
Adjustments for
Collateral Valuation
Adjustments for
Credit Mitigants
Netting Balance
Sheet Items
Calculations
Of Risk
Weights
Based on
PD/LGD
Supervisory Risk
Weights and LGD
Standardized Approach
IRB (Foundation)
IRB (Advance)
Value at
Risk
Standardized
Measurement
Methods
Interest Rate Risk
Equity Position Risk
Forex Risk
Commodities Risk
Treatment of Options
Support for all
Three Approaches
Basic Indicator Approach:
Capital is calculated as a
percentage of Gross Income
Standardized Approach: line
of Business Based Exposure
Indicators
Advanced Measurement
Approach: Capital
Computations as per LDA
Credit Risk Traded Market Risk Operational Risk
External/Internal
Rating
Systems
Pillar II: Supervisory Oversight Pillar III: Market Discipline
Usage of Metadata which
Enables transparency
Capital for other Risks
Rules-Based Engines Risk Assessment Reports
Capital Adequacy
Reporting
Flexible
Reporting
Quantitative
Reporting-IFRS 7
Qualitative
Reporting-IFRS 7
39. The Revised Framework: Basel II . . . Geared
toward strict compliance
The bulk of the revised framework is devoted to deriving
the various formulas and parameters needed to calculate
minimum capital requirements under Pillar 1. It:
Defines “total risk-weighted assets” on the basis of a
complex system of risk-weighting that applies to three
types of risks: Credit, Market, and Operational.
Defines “regulatory capital”
Requires that the ratio of regulatory capital to risk-
weighted assets be no lower than 8%.
. . . The risk-weights have been at the heart of the problem.
40. Risk Weights
Credit Risk Under Standardized Approach
Regulatory
Capital =
Risk
Exposure
Risk
Weights
8%X X
0% 20% 50% 100% 150%
Loans,
Bonds,
Etc.
Regulatory
Capital
Off-Balance
Sheet Items
Liabilities
Against
Customers
ASSETS LIABILITIES
Credit
Conversion
Factors
Type of ObligorGovernment
within OECD
Banks
within
OECD
e.g., mortgages
under certain
conditions
Corporates, Inc,
Insurance
Companies
42. Risk Weights . . .
Direct Claims on-balance
sheet
All Approaches to defining
risk-weights generate wide
variation in weights which
depend on the classification
of the credit. The large
differences in these risk
weights create strong
opportunities for a form of
regulatory arbitrage: Banks
can “free up capital” by
shifting portfolio exposure
from high risk-weighted
assets to lower risk-weighted
assets.
The shift from Basel I to Basel
II will “free up capital”,
notably as regards residential
mortgages and retail lending
since the risk-weights mostly
come down.
The IRB approach allows
greater sensitivity to the
probability of default (PD) for
any given type of loan but it
does not mitigate the wide
differences in risk-weights
across loan characteristics
observed with Basel I and
either version of the
standardized approach. . . IRB
provides great scope for using
lower risk weights.
43. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Risk Weights . . .
Off-balance sheet Items
Basel II aims to create
more neutral incentives
as regards off-balance
sheet exposures, which
are converted to balance
sheet equivalents by
“credit conversion
factors (CCFs)”.
The CCFs are very varied,
depending on the type of
exposure, and create
arbitrage opportunities.
Structured Products
Treatment depends on a number of
parameters:
Where banks use IRB approach for the
type of underlying exposures being
securitized, risk weights depend on
external ratings where these are available
(7% - 100%)
Standardized approach, exposures B+ and
below must be deducted totally from
capital
Originating banks may exclude securitized
exposures where the risk is fully
transferred.
Exposures which are in effect off-balance
sheet require a CCF . . .
44. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
ORM Under Pillar I
Basic Approaches
Advanced Approaches
CRUDE
generating
high capital
charge
SOPHISTICATED
generating
low capital charge
Standardised ApproachesPillar1-incentives
Subject to
qualitative
entry criteria
Pillar2-soundpractices
Subject to
qualitative
entry criteria
45. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Capital Charge for Operational Risk
Gross Income is defined
as the sum of net interest
income and net non-
interest income
BIA: When the gross
income is negative in any
of the three years it is
excluded from the
calculations
Income from loans and other interest bearing
assets
Less: cost of deposits and other interest
bearing liabilities
Plus: Fees & commissions
Plus: Net income from other trading activities
Basic Indicator
Approach
The Entire
Business
Organization
Financial Indicator is
a Proxy for
Operational Risk
Scaling
factor
Total Capital
Charge
3-year Avg.
Gross income
* 15% =
* =
46. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Standardised Approach
Corporate Finance
Trading & Sales
Retail Banking
Commercial Banking
Payment Settlements
Asset Management
Agency Services
Retail Brokerage
1
2
3
4
5
6
7
8
BL1 Gross income
BL2 Gross income
BL3 Gross income
BL4 Gross income
BL5 Gross income
BL6 Gross income
BL7 Gross income
BL8 Gross income
* 18% =
* 18% =
* 12% =
* 15% =
* 18% =
* 12% =
* 15% =
* 12% =
Financial Indicator is
a Proxy for
Operational Risk
Scaling
factor
Total Capital
Charge
* =
Capital Charge for Operational Risk
Gross Income (same as in BIA)
represents the income from
“normal” banking activities & should
not include:
Any provision
Any operating expenses
Profits/losses from the sale of
securities in the banking book
Extraordinary or irregular items
SA: It is always a 3-year average gross
income (negative values for aggregate Gross
Income are replaced with zero)
SA and BIA assume that the level of
operational risk a bank runs is directly
proportional to the size of its gross income
The use of gross income as risk exposure
indicator is far simple than the use of risk-
weighted assets
47. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
ORM Advanced Measurement Approach - AMA
Operational Risk [Reporting] is broken down into event types as they cut across business lines
Internal
fraud
External
fraud
Employment
Practices
and
Workplace
Safety
Clients,
Products &
Business
Practices
Damage to
Physical
Assets
Business
Disruption
and systems
failures
Execution,
Delivery &
Process
Management
Corporate
Finance
Trading &
Sales
Retail
Banking
Commercial
Banking
Payment
and
Settlements
Agency
Services
Asset
Management
Retail
Brokerage
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
loss data loss data loss data loss data loss data loss data loss data
QIS: Quantitative Impact Study
48. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Total capital
Credit risk + MARKET RISK + Operational risk
= CAR ≥ 8%
Market risk element of
the denominator is the
market risk
requirement relating to
Trading Book and Part
of Banking Book.
Rules were introduced
in the 1996 Market Risk
amendment to Basel I
and largely unchanged
under Basel II
Credit risk Market Risk Operational risk
Minimum Capital Requirements for
Market Risk
49. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Market Risk
Interest Rate Risk
(Trading)
Equity Position Risk
FX Risk
Commodity Risk
Specific Risk
Interest Rate Risk (Banking)
Liquidity Risk
Market Risk
Traded
Market
Risk
Treasury
Risk
On and Off-Balance Sheet
positions arising from movement
in market prices
Loss of value of the
investments (Continually
buying and selling financial
instruments)
The business the bank
conducts with its customers
(Lending and Deposit Taking
activities)
50. The Role Played By Basel II In The Financial
Crisis
The average level of capital required by the new
discipline is inadequate and this is one of the
reasons of the recent collapse of many banks.
The new Capital Accord, interacting with fair-value
accounting, has caused remarkable losses in the
portfolios of intermediaries.
Capital requirements based on the Basel II
regulations are cyclical and therefore tend to
reinforce business cycle fluctuations.
In the Basel II framework, the assessment of credit
risk is delegated to non-banking institutions, such
as rating agencies, subject to possible conflicts of
interest.
51. The Role Played By Basel II In The Financial
Crisis
The key assumption that bank’s internal models for
measuring risk exposures are superior than any
other has proved wrong.
The new framework provides incentives to
intermediaries to deconsolidate from their balance
sheets some very risky exposures
The interaction between minimum capital
requirements, a supervisory review process and
market discipline is the way to pursue the
soundness of banks as well as the stability of the
entire financial system. This interaction was
lacking!
52. The Revised Framework: As It Should Have
Been, But . . .
Capital Requirements
for Credit Risk
Standardized Approach
Foundation IRB Approach
Advanced IRB Approach
Traded Market Risk
Standardized Approach
Internal VaR Models
Operational Risk
Basic Indicator Approach
(Alternative) Standardized
Approach
Advanced Measurement
Approach
Regulatory Framework
for Banks
Internal Capital Adequacy
Assessment Process
(ICAAP)
Risk Management
Supervisory Framework
Evaluation of Internal
Systems of Banks
Assessment of Risk Profile
Review of Compliance with
all Regulations
Supervisory Measures
Disclosure
Requirements of Banks
Transparency for market
participants concerning
the Bank’s Risk Position
(Scope of Application, Risk
Management, Detailed
Information on own funds,
etc.)
Enhanced Comparability
of Banks
Financial Stability
Pillar II: Minimum
Capital Requirements
Pillar I: Supervisory
Review Process
Pillar III: Market
Disclosure & Discipline
53. Pillar I: Supervisory Review of
Capital Adequacy
Pillar I is based on four Key Principles:
Bank’s own assessment of capital adequacy (i.e., the
principle of Proportionality) irrespective of size and/or
complexity.
Supervisory Review Process
Capital Above Regulatory Minima
Supervisory Intervention
54. ICAAP: Internal capital Adequacy
Process
Risks Analyzed: An identification of the major risks faced
in each of the following categories:
Credit Risk
Market Risk
Operational Risk
Liquidity Risk
Insurance Risk
Concentration Risk
Residual Risk
Securitization Risk
Business Risk
Interest Rate Risk
Pension Obligation Risk
Any other risks which have been identified
55. ICAAP Total Variations in a
single Process
Un-Anticipated
Variations
Anticipated
Variations
(Provisions, Transfer, Etc)
Process Capability Study Discover And
Eliminate Causes Of Un-Anticipated Variations
Compute Central Tendency And Variability
Natural Limits / Appetite for Risk/
Tolerance for Risk
Risk Financing
Catastrophic
56. 1) Regulatory Arbitrage
2) Insensitivity to Portfolio Diversification
3) A Substitute for Management Judgment
4) Procyclicality
5) Capital for Subsidiaries versus Group
Level
Key Features in Basel II To Be
Reconsidered
57. Regulatory Arbitrage Drives capital
Out of the System
Large variations in risk
weights (and CCFs)
encourage regulatory
arbitrage which
reduces capital
requirements as
portfolios are weighted
toward favored asset
classes.
As total risk-weighted
assets decline as a
share of actual total
assets, the leverage
that a given amount of
capital can support
under the regulations
rises.
Lending without additional
capital backing
Return capital to
shareholders
The end result: very low
levels of equity backing for
the balance sheet.
Banks face very low risk-
weights under Basel I so long
as investment grade credit
ratings (BBB- or above) are
maintained; this continued
under Basel II.
Incentives
to Increase
Leverage
58. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Regulatory Arbitrage Drives capital
Out of the System
Residential mortgages, which have constituted the underlying
assets in many of the asset backed securities that have been at
the root of the crisis, have been strongly privileged under all
versions of the Basel framework.
Banks originating securitizations have great scope to reduce
their risk-weighted exposures or to exclude them all together.
Under the IRB approach of Basel II senior trenches of
securitized claims rated BBB+ or above carry low risk weights
(7 to 35%)
This system clearly provides incentives and great scope for
channeling credit to home mortgages, many of them funded in
wholesale markets and eventually securitized, with very little
equity capital backing.
59. Insensitivity to Portfolio Diversification Encourages
Excessive Exposure to Favored Asset Classes.
The capital
required as
backing for
any given
loan should
only
depend on
the risk of
that loan
and must
not depend
on the
portfolio it
is added to.
It reduces complexity by allowing the analysis to focus on
the specific loan or investment while avoiding the need to
take account of portfolio composition or how it influences
that composition.
It reduces the calculation of minimum regulatory capital
to a simple additive process once risk weights have been
determined.
It allows the framework to apply to a wide range of
countries and institutions, which facilitates agreement in
a highly political context (Single Global Risk Factor)
It involves building a system for the calculation of capital
requirements that systematically fails to reflect the
importance of diversification as an influence on portfolio
risk.
The minimum capital requirements associated with any
type of loan due to credit risk simply rise linearly with the
holding of that asset type, regardless of the size of the
exposure.
60. The Rules of Basel II Provide a Government Stamp of
Approval and Can Substitute for Management Judgment
Pillar 2 accords great
discretion and authority to
supervisors . . .
Supervisors are not
auditors and are not
participants in the
business environment.
Supervisors have the
authority to obtain any
information they need from
the supervised institution,
but they don’t know what
to ask for.
They are not well paid by
the standards of senior
bank executives and
limited in their access to
resources.
Supervisors are poorly placed to
question the judgment of bank
management so long as the
objective minimum standards are
met.
This makes it easy for explicit
capital requirements formulas of
the first pillar to dominate the
supervisory judgment foreseen
as part of the second pillar.
Senior Management of banks can
be tempted to delegate
responsibility for what should be
management judgment by
treating regulatory requirements
as satisfactory targets for which
supervisors could be held
responsible.
61. The Revised Framework is pro-cyclical and
can Exaggerate Booms and Busts
Rising profits in the upswing usually generate increases in
retained earnings and hence Tier 1 Capital, and prudent banks,
ideally, should use these to build a cushion to see it through the
downswing which inevitably follows. More specific factors include:
If asset values do not accurately reflect future cash flows, pro-
cyclicality results. Leverage ratios depend on current market
values (and are therefore high in good times and low in bad times).
Banks’ risk measurements tend to be point-in-time and not holistic
measures over the whole cycle.
Counterparty credit policies are easy in good times and tough in
bad,
Profit recognition and compensation schemes encourage short-
term risk taking, but are not adjusted for risk over the business
cycle.
Capital Regulation under Basel did nothing to counter this pro-
cyclicality.
62. Capital Requirements for Banking Subsidiaries
May not be Adequate at Group Level
Basel II is to be applied on a consolidated basis to internationally
active banks to ensure that it captures the risk of the whole
banking group.
It is not clear this works well since:
Wide scope exists for parent groups to maintain high levels of
capital in depository subsidiaries by simply shifting funds within
the group
Parent groups are often less well-capitalized than their subsidiary
depository institutions
Large balance sheet expansions have occurred at both banking
subsidiary and parent group levels without requiring meaningful
increase in capital at the parent group level.
63. Subjective Inputs
Risk inputs are subjective.
Some prices are of the over-the-counter variety and are not
observable, nor do they have appropriate histories for
modeling purposes. Banks can manipulate inputs to reduce
required capital.
64. Unclear and Inconsistent Definitions of
Capital
Regulatory adjustments for goodwill are not mandated to
apply to common equity, but are applied to Tier 1 and/or a
combination of Tier 1 and Tier 2.
The regulatory adjustments are not applied uniformly
across jurisdictions opening the way for further regulatory
arbitrage.
Banks do not provide clear and consistent data about their
capital.
This means that in a crisis the ability of banks to absorb
losses is compromised and different between countries –
exactly as seen in the crisis.
65. Supervisors Have Not Been Known To Be
Forward Looking.
Building capital buffers under Pillar 2 (Stress Testing, . . . )
requires supervisors to be forward looking., that is, to keep up
with changes in market structure, practices and complexity.
This is inherently difficult.
Supervisors may be even less likely to be able to predict
future asset prices and volatility than private bankers.
Supervisors have smaller staff (per regulated entity).
Supervisors are mostly less well paid.
If supervisors practices lag the policy makers will be
ineffective in countering defects in Pillar 1. Pillar 2 is not likely
to be effective in a forward-looking way.
66. Markets Just Aren’t Efficient
Pillar 3 relies on disclosure and market discipline that will
punish banks with poor risk management practices.
Underlying this is an efficient markets notion that markets
will act in a fully rational way.
At the level of markets, the bubble a the root of the sub-
prime crisis, and crises before it, suggest the systematic
absence of informational efficiency.
67. Strengthen the Global Financial System by:
1) Raising capital Requirements,
2) Increasing Capital Levels,
3) Improving Risk Management Practices,
and
4) Expanding Disclosure.
Basel III
68. Improving the Quality of Capital
Equity is the best form of capital, as it can be used to write off losses.
Goodwill. This can’t be used to write off losses.
Minority Interest. That if a company takes over another with a majority
interest and consolidates it into the balance sheet, the net income of
the 3rd party minorities can’t be retained by the parent as common
equity.
Deferred Tax Assets (net of liabilities). These should be deducted if
they depend on the future realization of profit (not including tax pre-
payments and the like that do not depend on future profitability)
Bank investments in its own shares
Bank investments in other banks, financial institutions and insurance
companies.
Provisioning shortfalls
Other Deductions. Projected cash flow hedging not recognized on
balance sheet that distorts common equity; defined benefit pension
holdings of bank equity; some regulatory adjustments that are
currently deducted 50% from Tier 1 and 50% from Tier 2 not addressed
elsewhere.
69. The Proposed New Basel III
Framework
Minimum Common Equity: The highest form of loss-
absorbing capital, this threshold will be set at 4.5% of risk-
weighted assets.
Tier 1 Capital Requirement will be set at 6%.
Total Capital Requirement will be set at 8%.
For each category, there will be a 2.5% Conservation Buffer
to absorb losses during periods of financial and economic
stress. If an institution “uses up” the conservation buffer
and approaches the minimums, it will become subject to
progressively more stringent constraints on dividends and
executive compensation (. . . Until the buffer is replenished).
Minimums will be phased in between January 2013 and
January 2015, and the conservation buffer will be phased in
from January 2016 to December 2018.
Raise
Min.
Core
Tier 1
to
4.5%+
2.5% =
7%
70. The Proposed New Basel III
Framework
A Counter-Cyclical Buffer (0% to 2.5%) also could be imposed by
countries in order to address economies that are building
excessive risks as a result or experiencing rapid economic (i.e.,
credit) growth. It must consists of fully loss-absorbing capital.
In addition to raising the capital requirements, Basel III imposes
more criteria in order for instruments to classify as common
equity and to count as Tier 1 capital. Instruments that no longer
will qualify as common equity will be excluded beginning in
January 2013.
There will be higher capital requirements for certain trading,
derivatives and securitization activities. These will be introduced
at the end of 2011.
A liquidity coverage ratio (Liquidity Coverage Ratio, Net Stable
Funding Ratio) will be introduced in 2015 and the net stable
funding ratio will be applied starting in 2018.
71. Basel III Minimum Capital Requirements
0
1
2
3
4
5
6
7
8
9
10
11
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
2
0
1
9
2
0
2
0
2
0
2
1
2
0
2
2
3.5%
4%
4.5%4.5%
5.5%
6%
8%
8.625%
9.25%
9.875%
10. 5%
Tier 1 Common Equity
Other Tier 1 Capital
Other Capital
Capital Conservation
Buffer
% of RWA
Year
72. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Equity Instruments that no-longer qualify as Tier 1 or Tier 2 Capital
0
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
2
0
1
9
2
0
2
0
2
0
2
1
2
0
2
2
Year (As of January 1st)
Allowable
recognition
of
instruments
(% of
outstanding
nominal
amounts at
1/1/2013
Phase in of the
required
regulatory
adjustments of
certain items in
calculating
common equity
(% of full
adjustment that
will ultimately
apply)
73. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Leverage and Liquidity Ratios
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
2
0
1
9
2
0
2
0
2
0
2
1
2
0
2
2
Leverage Ratio
Net Stable
Funding Ratio
Liquidity Coverage
Ratio
Observation
Period
Observation
Period
Minimum
Standards in
Force
Minimum Standards in Force
Supervisory
Monitoring
Parallel Run
Disclosure
Migrate to Pillar 1
74. The Proposed New Basel III
Framework
A non-risk-based leverage ratio will also be introduced in
2018. It is currently proposed that a minimum Tier 1 leverage
ratio of 3% be tested during a parallel run period and then
subjected to an appropriate review and calibration process,
before migrating to Pillar 1 treatment.
Systematically Important Banks should have loss-absorbing
capacity beyond these minimum standards: A combination
of Capital Surcharges, Contingent Capital, and Bail-in-Debt.
In addition to strengthening the loss-absorbency of non-
common Tier 1 and Tier 2 Capital instruments.
76. Back to the ABC of Bank Capital: The Good Old Days!
It’s a
Wonderful
Life!
77. What is Bank Capital?
Is bank’s net worth, which equals the difference between
total assets and liabilities.
Is a cushion against a drop in the value of bank assets,
which could force a bank into insolvency.
Helps prevent bank failure, a situation in which a bank
cannot satisfy its obligations to pay its depositors and
other creditors.
Helps lessen the chance that a bank will become
insolvent if its assets drop or devalue.
How Linear is the Relationship Between the various Types
of Assets, Liabilities, and Capital that a Bank is Allowed to
Carry on Its Balance Sheet ?????? !!!!!!! Whatever
Happen to Gap and Duration Analysis?
78. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Internal . . .
Internal
The level of capital which the management of the
bank thinks is appropriate, supported by an
internal assessment of the capital at risk;
Based on the capital level, the second step would
be setting of decent Return On Equity. This
hurdle return would be based on market
expectation, exceeding the market expectation
will result in an increase in shareholder value
whereas failing to meet those expectations will
result in a destruction of value.
79. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
External . . .
External
The level of capital which the credit rating
agencies think is consistent with a given credit
rating. No credit rating agencies will give
assurance of up-grading or maintaining current
rating solely based on capital adequacy, but
indication can be obtained through discussion;
The regulatory capital. A margin of error needs to
be built as regulatory capital shortfall can have
very serious consequences.
It will change with experience.
80. Why is Bank Capital Important?
The amount of capital affects return on investment for the equity
holders (owners) of the bank.
Bank capital ends up costing the equity holders because
higher capital reserves generate lower return on equity for a
given return on assets.
The lower the bank capital, the higher the return for the equity
holders of the bank.
Larger bank capital reserves benefit the equity owners of a bank
because it makes their investment safer by reducing the
likelihood of bankruptcy.
81. How Do Banks Raise Capital?
Banks can raise capital by:
issuing new equity (common stock),
Issuing bonds that can be converted into equity,
reducing the bank’s dividends to shareholders, which
increase the retained earnings that can be put into
capital accounts.
Neither option is particularly appealing to existing
shareholders because issuance of new equity dilutes
their profits and reduction of dividends simply
reduces their return on investment.
82. Role of Bank Capital Requirements in the
Recent CRISIS and How Higher Reserves Could
Have Averted Bank Failures
Higher bank capital reserves
could have provided a means
of satisfying obligations to
pay off depositors and
creditors as assets were lost
or devalued due to risky
investments
Capital is supposed to act as
a first line of defense against
bank failures and their knock-
on consequences for
systemic risk by providing a
cushion against losses.
Capital Serves
One Economic
Purpose: Absorb
Potential Losses
83. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
The Basics: Types of Capital
DEBT CAPITAL
What will be repaid if the bank go into liquidation
Subordinated to the bank’s depositors & lenders
EQUITY CAPITAL
Fully paid ordinary shares
Non-Cumulative perpetual preferred shares
84. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
Basel II Capital Structure, Ratios and Deductions
CAPITAL STRUCTURE
Tier 1: Issued & fully paid
for Ordinary Shares +
Non-Cumulative Perpetual
Preferred Stock +
Disclosed Reserves +
Innovative Tier 1 capital
Tier 2: Undisclosed
Reserves + Asset Re-
evaluation Reserves +
general Provisions +
general Loan Loss
Reserves + Hybrid Capital
Instruments +
Subordinated Debt
Tier 3: Subordinated Debt
for a minimum of two
years (Used to support
Market Risk)
RATIOS BETWEEN THE
TIERS OF CAPITAL
Tier 2 capital cannot exceed
50% of the total equity
Innovative instruments are
limited to a maximum of
15% of Tier 1 capital (after
deductions)
Lower Tier 2 capital
(Subordinated Debt issues)
may only equal up to 50%
of core capital
The use of Tier 3 capital is
limited to 250% of the
amount of Tier 1 capital that
is required to support
Market Risk (28.5% of
Market Risk should be
covered by Tier 1)
85. Mohammad Fheili < mifheili@terra.net.lb > < Mobile: 00961 3 337175 >
( - ) Goodwill: Tier 1 capital of the new
bank (acquired plus acquiring bank) is less
than that which the banks independently
had before the acquisition.
( - ) Investments in Subsidiaries: when it is
not consolidated
( - ) Holding of Shares in Another Bank:
discretion of local supervisors
Basel II Capital Structure, Ratios and Deductions
86. Components of Capital
Components Minimum Requirements
Core Capital (Tier 1)
Common stockholders’ equity
Qualifying, noncumulative, perpetual preferred stock
Minority interest in equity accounts of consolidated subsidiaries
Less: goodwill and other intangible assets
Note: Tier 1 must represent at least 50 percent of qualifying total
capital and equal or exceed 4 percent of risk-weighted assets.
There is no limit on the amount of common shareholder's equity or
preferred stock, although banks should avoid undue reliance on
preferred stock in Tier 1. Banks should also avoid using minority
interests to introduce elements not otherwise qualified for Tier 1
capital.
Supplementary Capital (Tier 2)
Allowance for loan and lease losses
Perpetual preferred stock and related surplus
Hybrid capital instruments and mandatory convertible debt securities
Term subordinated debt and intermediate-term preferred stock,
including related surplus
Revaluation reserves (equity and building)
Unrealized holding gains on equity securities
Note: Total of Tier 2 is limited to 100 percent of Tier 1
ALLL limited to 1.25 percent of risk-weighted assets
Subordinated debt, intermediate-term preferred stock and other
restricted core capital elements are limited to 50 percent of Tier 1
Deductions (from sum of Tier 1 and Tier 2)
Investments in unconsolidated subsidiaries
Reciprocal holdings of banking organizations’ capital securities
Other deductions (such as other subsidiaries or joint ventures) as
determined by supervisory authority
Any assets deducted from capital are not included in risk-weighted
assets in computing the risk-based capital ratio
Total Capital (Tier 1 + Tier 2 - Deductions) Must equal or exceed 8 percent of risk-weighted assets
87. New Basel Capital Requirements
Old Standards New Standards
Amount
Includable in
Total Capital
Elements of Capital
No Limit
Tier 1
•Common shareholders’ equity
•Non‐cumulative perpetual preferred
•Minority interests in consolidated
subsidiaries
Includible
Only
Up to
Amount of
Tier 1
Tier 2
Amount Includible
In Tier 2 Capital
•Cumulative preferred
(perpetual or long‐term)
•Long‐term preferred
•Convertible preferred
No Limit
•Intermediate‐term
preferred
•Subordinated debt
•Debt‐equity hybrids,
including perpetual
debt
Only Up to 50% of
Tier 1
Amount
Includable in
Total Capital
Elements of Capital
No Limit
Tier 1
•Common shareholders’ equity
•Additional Going Concern Capital
(common shares and retained earnings)
No Limit Tier 2
•Minority interests in consolidated subsidiaries
•Cumulative preferred (perpetual or long‐term)
•Long‐term preferred
•Convertible preferred
• Intermediate‐term preferred
•Subordinated debt
•Debt‐equity hybrids, including perpetual debt
90. Introduction: Why Change Corporate
Governance?
Proposed changes to the internal structure of
corporations can be divided into three primary
categories:
1) Shareholder Empowerment
2) Disclosure Requirements
3) Executive Compensation
The latter two frequently appear as measures designed
to empower shareholders
91. The Corporate Structure of a Bank
The corporate structure of banks is divided into three
branches: Shareholders, Directors, and Managers
Shareholders are the equity holders, or owners, of the
corporation, and can be divided into two types:
1) Diffuse shareholder: small, or minority shareholders
Vote for directors
Vote on matters including mergers and
acquisitions, or other fundamental changes in
business strategies (albeit indirectly through
board member elections)
2) Concentrated shareholder: large, sometimes
institutional, investors
Occasionally elect their own representatives to the
board of directors,
Can negotiate incentive packages to align
management interests with that of shareholders
92. The Corporate Structure of a Bank: Board of
Directors
Board of Directors: besides making employment decisions and
monitoring management, directors in banking firms have further
responsibilities beyond mere fiduciary duties:
1) Ensure the bank’s activities are in the best interest of not only
the shareholders, but depositors as well as the government
(taxpayer)
2) Abide by laws and regulations reflecting the government's
interest in maintaining safe and sound financial institutions
Other responsibilities of bank boards of directors include:
1) Select competent management
2) Supervise the bank’s affairs
3) Adopt sound policies and goals under which management
must operate in the administration of the bank’s affairs
4) Avoid self-serving practices
5) To be informed of the banks position and management
policies
6) Maintain reasonable capitalization
7) To ensure the bank has a beneficial influence on the economy
and the community in which it rests
The board also oversees the level and structure of top executive
compensation; this duty is perhaps the most critical in aligning the
interests of management with that of shareholders
93. The Corporate Structure of a Bank: Managers,
(Focus on CEO)
The CEO is responsible for running the bank on a daily
basis;” the CEO: hires, fires and leads the senior
management team, who “in turn, hires, fires and leads
the other employees in the organization;”
“Develops, along with the board of directors, the
bank vision and sets the strategic direction for the
bank
“Establishes, more than any other individual, the
control culture for the organization
“Oversees the development of the bank's budget and
the establishment of the bank's system of internal
controls”
Ultimately, the goal of management is to formulate a
business plan that incorporates and oversees financial,
administrative and risk functions in order to maximize
the firm’s value
Public responsibilities
94. Managers & Compensation
Managers are paid a contracted salary, and frequently a
performance measured bonus; compensation can be either in the
form of cash or stock options, though usually both
As mentioned before, top management salaries are structured by
the board of directors; however, some consideration include:
1) Capital structure
2) Capital reserves
Compensation and risk: boards have the responsibility of
balancing the firms ability to recruit and retain management talent
while maintaining appropriate risk management systems
Aligning executive compensation with the company’s long-
range objectives
Certain business risks may present opportunities for
managers driven by short-term incentives (e.g. stock price or
earnings per share)
These metrics can be manipulated, for example, by
management decisions related to revenue and expense
recognition or through stock buybacks at the end of the
period
95. Failure within Corporate Governance
• The lingering financial problems with the 2007-08
crisis stem from shaken investor confidence in the
markets, the result primarily of excessive risk-
taking on the part of managers, enriching
themselves via short-term bonuses while
destroying the long-term value of their firms
— Moral hazard
— Consider also that in 2008, 70% of shares in
financial institutions were owned by
institutional investors, thus, this was not
merely a matter of unsophisticated investors
being taken advantage of by large, complicated
banking firms
• Shareholder disempowerment: firms have grown
“director-centric”
96. Failure within Corporate Governance
Personal response: the failure of corporate
governance comes primarily from two sources:
1) Failure on the part of boards of directors
and managers of many financial institutions
to adequately manage or react to the risk
surrounding the types of products these
firms were selling to investors
2) Second, shareholders have become
detached from the boards of firms in ways
that make monitoring and oversight, even
for sophisticated investors, difficult
97. Corporate and Financial Institution Compensation
Fairness Reform
Finally, the Bill directs federal regulators to craft
regulation that requires financial institutions to
disclose the structures of incentive based
compensation sufficient to determine whether it is:
1) Aligned with sound risk management
2) Structured to account for time horizon of risk
3) Reduces incentives for employees to take
unreasonable risks
The goal is to regulate compensation structures or
risk incentives that may:
1) Threaten the safety and soundness of covered
financial institutions
2) Present serious adverse effects on the economy
or financial stability
98. The Pros and Cons of Corporate Governance
Reform
Pros:
Moral hazard incentive problems
Despite decreases in market capitalization between 2003-2008,
several top Wall Street firms paid out an aggregate $600 billion,
giving the impression that compensation packages are not in
line with the best interest of shareholders
Cons:
Zingales: “While popular, actions directly aimed at curbing
managerial compensations would be completely useless if not
counterproductive, just as the 1992 Clinton initiative to curb
managerial compensation had the opposite effect”; Rather, he
continues, “[the] real issue is the lack of accountability of
managers to shareholders, centered in the way corporate
boards are elected”
Micro-managing compensation
Keeping talent
Shareholders tend to be detached from the everyday
management of corporations
100. Background
3 Biggies – Fitch, S&P and Moody’s
Others in US
Basel’s list of internationals
History
Generally good
Last decade of criticism mounting
Current attack
Completely wrong on new securities (standards/duty)
Conflicts of interest
101. What They Do
Issue Rating
Once upon a time paid for by investors, now paid for by
issuers of the securities
Used as a way to lower cost for investors
Theoretically increase market efficiency
Increase market information
Increase liquidity for smaller size issuers/less well
known securities
Rating reflect:
Company’s ability to repay debts
Structure of the instrument
Subordination of the security
102. What They Do . . .
Uses of Credit Ratings
Most issues of bonds need at least one rating in
order to increase their marketability
Avoid under-subscription or low initial
purchase price
Many lenders use credit ratings as covenants in
loans
Defaults can be triggered by a drop in the
borrower’s credit rating
103. What They Do . . .
Advisory Services
Advise issuers on how to structure
instruments in order to obtain the maximum
yield
Use of covenants and subordination
Structured Financing - form trenches
using definitions in the transaction
documents
Advise companies on formation of Special
Purpose Vehicles to maximize their credit
ratings
104. What They Do . . .
Advisory Services create lowest possible quality at
each rating level (regulatory arbitrage-type pattern)
• Obvious conflict of interest in rating issuances
and SPV’s which they
advised during formation
oFeel an obligation to rate as promised
o Very few rating agencies have a policy of
not rating projects they have advised on
105. Regulatory Reliance . . .
Basel II – recognized ratings from External Credit
Assessment Institutions (ECAI’s)
Allows regulators worldwide to use ratings from
ECAI’s in order to determine reserve
requirements
Insurance Regulators – Use credit ratings to
evaluate insurance companies’ reserves
107. General Increase in Government
Intervention
• Safety Nets
• Bail outs
• Deposit insurance
• Discount windows
Decrease
industry stability
108. General Increase in Government
Intervention
• Regulations
• Heightened
Supervisory
Power
• Requires market
discipline
• Improves corporate
governance
• Improves bank
function
109. General Increase in Government
Intervention
• Increase market discipline
• Increase cost efficiency
• Increase profit efficiency
• Reduce asymmetric information
• Reduce transaction costs
• Decrease stability
• Economies of scale in
compliance costs
• Discourage entry of new
firms
• Consolidation into larger
banks
• Reduction of competition
110. General Increase in Government
Intervention
Increased Regulation requires increased information
disclosures
Information disclosures are costly
Compliance is expensive
112. Basel III designed in Swiss style.
*A committee has been set up to
discuss the benefits of using a Mark
to “how you feel today” accounting.
methodology” instead of Mark-to-
market
Surrender monkey
says: systemic risk
has a hole new flavor
9 years for
implementation
No discussion of
too big too fail
Counter cyclical
buffers can be 0%No accounting
reform or
harmonization*
113. The Rear View Mirror
• The past 3 years have been unprecedented:
Failure of numerous large institutions across the globe
Large-scale government support of the financial system
Coordinated economic stimulus activity
Record low interest rates
Regulatory reforms
The above promotes the need to continually strengthen risk
management capability, however, it also highlights the
possible inadequacies historically
114. Learning from the past – ‘Rogue Trading’
During 2008, Societe Generale reported a
loss of €4.9bn due to a number of unauthorized
trades
In 1995 Barings collapsed after a Nick Leeson, a trader
in Singapore generated losses of £900m through a
series of rogue trades, caused by serious control
failures
And another
And another
This did not stop the following…
115. Expecting the unexpected
The last few years have seen the demise of significant local,
national and global financial services firms…but what caused
these trusted brands to fail?
116. Complexity of business failures
Often, there will be numerous factors that lead to the
collapse of an organization e.g.
Inappropriate business model
Inadequate systems and controls
Poor oversight and governance
External influences
The interlinked nature of risks requires an appreciation of all
risk types, . . .
117. Key Challenges for the Future of the Financial
Service Industry
• Continued economic uncertainty
Impact of unraveling the Quantitative Easing program
Rising interest rates / inflation
Double-dip recession
Regulatory developments
The Walker Review on Corporate Governance
Capital regime reforms
Solvency II
Basel III
Retail Distribution Review
118. • Regulatory supervision
Intensive / intrusive supervision of larger firms
Greater focus on individual responsibilities and
accountabilities of senior management
High profile enforcement action / fines
A return to the pre-credit crisis practices
Risk v Reward not adequately monitored
Fewer market participants = greater opportunities
Key Challenges for the Future of the Financial
Service Industry
119. What Does this Mean for Risk Managers?
Risk managers will need to adopt the CRO perspective
Appreciation / awareness of other risk categories – multi-
discipline approach
Understand consequential impacts across risk categories
Greater depth / breadth of industry knowledge
Greater profile for risk management in Financial Service
firms, however, this equates to higher expectations
Need to instigate change before regulators impose their
requirements
Increasing need to access and influence senior management
Increasing focus on risks within the business model
Increasing importance on personal skills, credibility and
persuasiveness
120. Greater scrutiny of risk functions and risk managers
Demonstrating success
Increasing demand for skilled individuals with appropriate
knowledge and experience…and qualifications!
What Does this Mean for Risk Managers?