BASEL II: ONE CREDIT ANALYST’S PERSPECTIVE

1. BASEL II: ONE CREDIT ANALYST’S PERSPECTIVE Presented November 9, 2004 in Quito, Ecuador, on the occasion of the 10th anniversary celebration of ECUABILITY S.A. Calificadora de Riesgos Roy Weinberger Principal Credit Research, Advisory, Consulting

2. The Three Pillars of BASEL II • Minimum capital requirements • Supervisory review of capital adequacy • Public disclosure

3. Pillar 1: Minimum Capital RequirementsBASEL II vs BASEL I • Significant changes in the treatment of credit risk: BASEL I only risk-weighted by asset class; BASEL II also risk-weights by credit risk of specific asset • Introduction of an explicit treatment of operational risk

4. Three Credit Risk Approaches • Standardised Approach, or Simplified Standardised Approach • Foundation Internal Ratings-Based Approach (Foundation IRB) • Advanced Internal Ratings-Based Approach (Advanced IRB)

5. The Standardised Approach:Relies on External Credit Assessments Issued by Private Credit Rating Agencies An Example: Corporate Risk-Weighting Scale Credit AAA to A+ to BBB+ to Below Unrated Assessment AA A- BB- BB- Risk Weight 20% 50% 100% 150% 100%

6. The Simplified Standardised ApproachRelies on External Credit Assessments Issued by Export Credit Agencies Sovereign Risk Scores ECA Risk Scores 0 - 1 2 3 4 to 6 7 Risk Weights 0% 20% 50% 100% 150%

7. The Simplified Standardised ApproachRelies on External Credit Assessments Issued by Export Credit Agencies An Example: Bank Risk-Weighting Scale ECA Risk Score 0 - 1 2 3 4 to 6 7 for Sovereigns Risk Weight 20% 50% 100% 100% 150% Under this Approach, all corporate exposures, including insurance companies, are weighted at 100%

8. Foundation/Advanced IRB Approaches • Both rely on four quantitative inputs • 1. Probability of Default (PD) - measures likelihood a borrower will default over a given time frame • 2. Loss Given Default (LGD) - measures the proportion of the exposure that will be lost if a default occurs

9. Foundation/Advanced IRB Approaches • 3. Exposure at Default (EAD) - measures the amount of a credit facility or loan commitment that is likely to be drawn if a default occurs • 4. Maturity (M) - measures the remaining economic maturity of an exposure

10. Differences between Foundation & Advanced IRB Approaches • In both Approaches PD is provided by the bank based on its own estimates • In Foundation IRB the other 3 inputs are supervisory values provided by the Basel Committee • In Advanced IRB the other 3 inputs are provided by the bank based on its own estimates

11. BASEL II Implementation Plans of Latin American Banks • Based on a new BIS survey, six of 15 Latin American countries plan to implement BASEL II from 2007 - 2009, five from 2010 onwards, and four are still undecided • Within the 2007-2009 group, close to 60% of banking assets are expected to be under the Foundation IRB Approach, and 40% under the Standardised or Simplified Standardised Approaches

12. Operational Risk Defined by the Basel Committee as: “The risk of losses resulting from inadequate or failed internal processes, people and systems, or external events”

13. Internal fraud External fraud Employment practices & workplace safety Clients, products & business practices Damage to physical assets Business disruption & system failures Execution, delivery & process management Types of Operational Risk

14. Sound Practices for the Management & Supervision of Operational Risk • Developing an appropriate operational risk management culture and environment • Structuring a sound operational risk management process • The crucial role of the supervisor in the operational risk management process • The importance of public disclosure

15. Operational Risk Measurement Approaches • Basic Indicator Approach • Standardised Approach • Alternate Standardised Approach • Advanced Measurement Approach

16. Basic Indicator Approach The simplest Approach - only requires a bank to hold capital for operational risk equal to 15% of positive annual gross income averaged over the past three years

17. Standardised Approach Uses gross income by business line as a proxy for the scale of operational risk. The capital charge for each business line is calculated by multiplying a three year average of gross income for each business line by a factor assigned to that business line.

18. Corporate Finance - 18% Trading & Sales - 18% Retail Banking - 12% Commercial Banking - 15% Payment & Settlement - 18% Agency Services - 15% Asset Management - 12% Retail Brokerage - 12% Capital Charges by Business Line Under Standardised Approach

19. Alternate Standardised Approach A slight variation from the Standard Approach, which allows banks to substitute loans and advances for gross income in two business lines, retail banking and commercial banking. Three year average outstandings for these business lines are multiplied by a fixed factor of 0.035%.

20. Advanced Measurement Approach • Uses a bank’s internal operational risk measurement system to establish an appropriate capital charge • Very challenging qualitative and quantitative standards requiring supervisory approval and review

21. Operational Risk Implementation Plans of Latin American Banks • Based on the BIS survey referred to earlier, it is expected that some 70% of Latin American banking assets will be measured for operational risk during 2007-9 • About 70% are expected to be following the Standardised or Alternate Standardised Approaches, and 30% the Basic Indicator Approach

22. Pillar 2: Supervisory Review of Capital Adequacy • Basel II does not give explicit supervisory guidance about the following subjects: • Interest rate risk in the banking book • Credit concentration risk • Securitizations

23. Pillar 3: Market Discipline • Market discipline = public disclosures of relevant information • Disclosures as qualifying criteria for use of certain advanced methodologies • Disclosures required to qualify for lower risk weights on some financial instruments

24. Will BASEL II Influence Ratings? • BASEL II has the potential for both positive and negative effects • Banks able to effectively implement could see higher ratings • Banks and banking systems that lag could see lower ratings

25. ROY P. WEINBERGER CREDIT RESEARCH, ADVISORY, CONSULTING 1004 MONARCH CIRCLE STATESBORO, GEORGIA, USA 30458 TEL/FAX: 912 764 5073 E-MAIL: rweinberger@frontiernet.net www.frontiernet.net/~rweinberger/