a new capital adequacy framework basel ii presentation by osfi july-august 2004

1. A New Capital Adequacy Framework (�Basel II�)

2. July-August 2004 2

3. July-August 2004 3 Overview of Basel II

4. July-August 2004 4 Pillar 1 Options

5. July-August 2004 5 Credit Risk - Internal Ratings Based Approach (IRB)

6. July-August 2004 6 Credit Risk - IRB � Key Elements Four variables: Probability of default (PD) of borrower Loss given default (LGD) Maturity (M) Exposure at default (EAD) Risk weights are a function of these four variables and type of exposure (e.g., corporate, SME, retail)

7. July-August 2004 7 Credit Risk �Standardized Approach

8. July-August 2004 8 Credit Risk - Standardized Approach Compared to current CAR (Capital Adequacy Requirements) Recognition of external ratings Broader recognition of collateral and guarantees Reduced capital for retail and mortgage portfolios Increased capital for commitments Increased capital for past-due loans Capital charge for operational risk

9. July-August 2004 9 Current CAR Under current CAR, there are four risk-weights based on the type of asset 0% - Cash and Government Securities 20% - OECD Banks and Securities Firms 50% - Uninsured Residential Mortgages 100% - Everything else

10. July-August 2004 10 Basel II - External Ratings Banks may use assessments by qualifying rating agencies to determine risk weights for the following exposures: Claims on sovereigns and central banks Claims on non-central government public sector entities (PSEs) Claims on multilateral development banks (MDBs) Claims on banks and securities firms Claims on corporates

11. July-August 2004 11 Eligible ECAIs National supervisors are responsible for determining whether an External Credit Assessment Institution (ECAI) meets the qualifying criteria Supervisors must also assign eligible assessments to the applicable risk weight categories OSFI proposes to develop a self-assessment template and work with agencies to develop a mapping process

12. July-August 2004 12 Claims on Sovereigns and Central Banks Current CAR - all sovereigns weighted at 0% No longer distinction between OECD and non-OECD Based on a sovereign�s external rating Preferential treatment can apply to exposures: to a bank�s own sovereign (or central bank) denominated and funded in national currency Sovereign risk-weight creates a floor for other exposures in that jurisdiction

13. July-August 2004 13 Claims on Sovereigns and Central Banks Another option is to use ECA (Export Credit Agencies) risk scores Can use either: the risk scores published by individual ECAs or the consensus risk scores of ECAs participating in the �Arrangement on Officially Supported Export Credits� through the OECD OSFI will allow this treatment for sovereign exposures that are not externally rated

14. July-August 2004 14 Claims on Public Sector Entities (PSEs) Current CAR - PSEs weighted at 0%, 20%, or 100% Under Basel II, all PSEs will receive a risk-weight one category higher than its sovereign of incorporation with two exceptions: Claims on Canadian provincial or territorial gov�ts � treated as claims sovereigns PSEs in competition with private sector � treated as corporate exposures; Definition of PSEs remains unchanged

15. July-August 2004 15 Claims on Multilateral Development Banks (MDBs) Current CAR - receive 20% risk weight Under Basel II, split into two groups: (1) Highly rated MDBs that meet eligibility criteria receive 0% risk weight (2) For all others, risk weight is based on the external credit assessment of the MDBs

16. July-August 2004 16 Claims on Banks and Securities Firms Directly linked to risk-weighting of sovereign: one category less favourable than the sovereign risk weight Securities firms may be treated as banks if these firms are subject to supervisory and regulatory arrangements comparable to those under Basel II; otherwise treated as claims on corporates

17. July-August 2004 17 Claims on Corporates Current CAR - risk-weighted at 100% Under Basel II, DTIs can choose between two options: Use external ratings to determine the risk weight Risk weight all corporate exposures at 100%

18. July-August 2004 18 Claims on Retail Current CAR - 100% risk weight Under Basel II � risk weight reduced to 75% Criteria for inclusion in retail portfolio: Exposure to an individual person or small business Exposure takes the form of certain products Retail portfolio should be sufficiently diversified Aggregated exposure to one counterparty cannot exceed � 1 million (approx. CAD 1.6 million)

19. July-August 2004 19 Claims secured by residential mortgages (uninsured) Current CAR - 50% risk weight Under Basel II � risk weight reduced to 35% Criteria for residential mortgage treatment: Property occupied by borrower or rented Limited to 1-4 unit building Loan-to-value ratio cannot exceed 75% Uninsured collateral mortgages that would otherwise qualify as residential mortgages except that their loan-to-value ratio exceeds 75 percent will receive 75% risk weight

20. July-August 2004 20 Claims secured by residential mortgages (cont�d) OSFI proposes to modify its definition of qualifying residential mortgages, To include condominium residences and To require that the mortgage loan be to a person(s) or guaranteed by a person(s) Excluded are investments in hotel properties and time-share properties Claims secured by commercial real estate will receive 100% risk weight

21. July-August 2004 21 Past due loans Currently, no distinction between performing and non-performing loans Under Basel II, unsecured part of a non-mortgage loan that is past due by more than 90 days receives following risk weight: 150% when specific provisions are less than 20% 100% when specific provisions are 20% or more Residential mortgages (uninsured) that are past due by more than 90 days receive 100% risk weight

22. July-August 2004 22 Off-balance sheet positions: commitments RWA = CCF x RW Apply credit conversion factors (CCF) Short-term commitments (i.e. up to one year original maturity) receive 20% CCF (increased from 0%) Commitments with maturity of greater than one year remains unchanged at 50% CCF Only commitments that are unconditionally cancellable receive 0% risk weight Apply risk weights based on the counterparty

23. July-August 2004 23 Standardized Approach - Credit Risk Mitigation (CRM)

24. July-August 2004 24 Definition of CRM Techniques Techniques used to reduce credit risk, encompassing: Collateral (cash or securities) Third party guarantees Credit derivatives On-balance sheet netting

25. July-August 2004 25 Changes to CRM framework under Basel II Expanded range of eligible collateral and guarantors Explicit guidance for credit derivatives Recognition of netting effects in on-balance sheet positions Special treatment for repo transactions Two approaches for determining the effectiveness of collateral Simple Approach Comprehensive Approach

26. July-August 2004 26 Collateral - Minimum operational requirements Legal certainty: a bank must ensure that it has the right to liquidate or take possession of collateral in a timely manner Low correlation with exposure: credit quality of the counterparty should not be positively correlated to the value of collateral Robust risk management process to ensure that legal conditions are met, that collateral is liquidated promptly and that the custodian (if any) properly segregates collateral from its own assets

27. July-August 2004 27 Collateral in Current CAR A short set of eligible collateral� Cash on deposit at the lending bank OECD sovereign securities OECD non central government public sector entity (PSE) securities Some multilateral development bank securities

28. July-August 2004 28 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

29. July-August 2004 29 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

30. July-August 2004 30 Collateral - Comprehensive Approach Adjust the exposure amount and value of collateral using haircuts to account for fluctuations in the future market value of each 3 different methods are available to determine the appropriate haircuts DTIs using the Standardized Approach may use one method: application of supervisory haircuts

31. July-August 2004 31 Supervisory Haircuts

32. July-August 2004 32 Formula of Comprehensive Approach General formula of the comprehensive approach E* = the adjusted exposure E = the gross amount of exposure C = the amount of collateral Hc = the haircut for the collateral

33. July-August 2004 33 Comprehensive Approach - Example Step 1: Calculate adjusted amount of exposure (E*) Step 2: Multiply the adjusted amount of exposure by the risk weight of the counterparty Example: Loan of $100 to a 100% risk-weighted counterparty, collateralised by bonds up to $80 Risk weight of the borrower is 100% and the haircut is 10% Adjusted exposure: 100 � [80 x (1 � 0.10)] = 28 Risk weighted loan: 28 x 100% = 28

34. July-August 2004 34 Guarantees and Credit Derivatives Contracts must be direct, explicit, irrevocable, and unconditional Capital treatment remains unchanged � substitution approach Minimum operational requirements Eligible guarantors : Sovereigns, PSEs, banks and securities firms attracting a more favourable risk-weighting than the obligor Other entities rated A- or higher

35. July-August 2004 35 Guarantees � Operational Requirements Eligible guarantees : Guarantees provide a direct and unconditional claim on the guarantor The bank acquires the right to pursue the guarantor for monies outstanding, rather than the obligor Explicitly documented obligation Covers all types of payments the obligor is supposed to make

36. July-August 2004 36 Credit Derivatives � Operational Requirements Eligible protection : total return swaps and credit default swaps sold by eligible guarantors mentioned above Operational requirements : Credit events should include failure to pay, bankruptcy and restructuring. If restructuring is not included, capital benefit will be discounted In case of cash settlement, there should be a robust valuation process If obligation delivery, the transfer process must be certain Parties determining credit events should be clearly identified Asset mismatch between underlying obligation and reference obligation is permissible if both rank, at least, pari passu and if cross-default clauses are in place

37. July-August 2004 37 On-balance sheet netting Banks may net loans to and deposits from the same counterparty if there is a netting agreement with this counterparty Operational requirements: Legal certainty of the netting agreement Assets and liabilities must be determinable Bank monitors roll-off risks Bank monitors and controls relevant exposures on a net basis

38. July-August 2004 38 Standardized Approach - Securitization

39. July-August 2004 39 Securitization Different treatment for originating bank vs. investing bank Risk weight for a tranche is based solely on the external rating If a tranche is not rated, it must be deducted from capital Exceptions Look-through for �most-senior� tranche 2nd loss positions in ABCP Eligible liquidity facilities

40. July-August 2004 40 Securitization � Risk Weights

41. July-August 2004 41 Securitization - Off-balance sheet exposures For off-balance sheet exposures, apply a credit conversion factor and then risk weight the resultant credit equivalent amount All off-balance sheet exposures will receive 100% credit conversion factor (CCF) except: Eligible liquidity facilities Eligible servicer cash advance facilities

42. July-August 2004 42 Securitization - Off-balance sheet exposures Eligible liquidity facilities that meet criteria may apply 20% CCF for original maturities of less than 1 year 50% CCF for original maturities of more than 1 year 0% CCF to eligible liquidity facilities only available in the event of a general market disruption Eligible servicer cash advance facilities Servicer cash advances that are unconditionally cancellable without prior notice may be eligible for 0% CCF

43. July-August 2004 43 Operational RiskApproaches

44. July-August 2004 44 Basic Indicator Approach Simplest of the three approaches No specific qualifying criteria; DTIs encouraged to comply with Sound Practices paper Capital charge = Gross Income x 15% Gross Income is net interest income + net non-interest income three-year average positive gross income

45. July-August 2004 45 Standardized Approach Banks must map their business activities into eight Basel business lines (Annex 6) Average three-year gross income used to calculate capital charge

46. July-August 2004 46 Advanced Measurement Approach Banks can use their internal capital assessment techniques to calculate capital charges Both qualitative and quantitative standards Approach must incorporate certain key elements Internal data External data Scenario analysis Business environment and control factors

47. July-August 2004 47 AMA - Subsidiaries Non-significant subsidiary may use an allocated AMA to determine its capital charge Management of subsidiary responsible for own assessment of operational risk and controls Allocation methodology subject to approval Significant subsidiary may be required to calculate a stand-alone AMA capital Cannot incorporate group-wide diversification benefits May incorporate diversification benefits arising at sub-consolidated level AMA capital calculation needs to reflect the risks and control environment unique to the subsidiary

48. July-August 2004 48 Pillar 2 � Supervisory Review Process

49. July-August 2004 49 Pillar 2 Pillar 2 is based on four key principles: Banks' own assessment of capital adequacy Supervisory review process Capital above regulatory minimum Supervisory intervention Target capital ratios of 7% and 10%

50. July-August 2004 50 Pillar 3 � Market Discipline

51. July-August 2004 51 Pillar 3 Enhanced disclosure imposes discipline on management Imposes minimum disclosure requirements on banks qualitative and quantitative credit risk, market risk, operational risk, interest rate risk