Basel II

1. 1 Basel II Ayaz Ahmed CFO Habib Bank Limited

2. 2 Need of Capital Adequacy in Banks All business are funded by a mixture of debt and equity; Debt comprises: Creditors; Financing; Creditors and financers will set their own debt/equity ratio at the time of lending; Enron Parmalat

3. 3 Need of Capital Adequacy in Banks Banks are special class of business (along with insurance / prize bonds) where special regulations are needed to protect the depositors; Non-willingness of depositors to participate in profit and loss sharing (true Islamic Banking); Debt/equity ratio is extremely high as compared to the normal entity, which exposes depositors’ to unforeseen losses;

4. 4 Need of Capital Adequacy in Banks Pricing mechanism may not reflect the underlying business risks due to competitive pressures; Above issues clearly indicates that adequate capital level is a necessity for any bank to maintain to ensure that it have sufficient buffer against unforeseen losses. This is because bulk of the business is ‘Promise’ based.

5. 5 Debt Creates Risk Consider business 100m of financing req and profits available are 20m pa. ROE = 20% Company can bear loss of upto 100m Fund 50m by debt at 15%, ROE now=25% If returns fall to 10%, ROE = 5% If returns fall to 0% ROE=-15% if loss is greater than 50m then it becomes insolvent Leads to bankruptcy of Company

6. 6 We Need to Ask Ourselves As bank’s management, do we have any process of determining optimal level of capital? If no regulatory capital is defined we will set arbitrary target of: un-necessary high level of capital , thus affecting shareholders value in long-term; Low capital which does not provide sufficient insurance against all losses and solvency of banks;

7. 7 We Need to Ask Ourselves Over-reliance on regulatory capital is itself the biggest hindrance in implementation of new BASEL II as this tendency on part of the bank management does not allow them to develop self-assessment process of determining capital level.

8. 8 Drivers of Capital Levels 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.

9. 9 Drivers of Capital Levels 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.

10. 10 What Does Basel II Requires From the Bank’s Management Development of efficient capital allocation process within the organization, which can identify all the associated risks and determining the capital charge for the same; Requires self assessment by the bank management of the required level of capital. As bank managers initiate the business risks they are in a best position to determine the level of capital charge for any risk. In any case over-dependency on risk models should be avoided. These models should only be used to support management assessment of capital level;

11. 11 What Does Basel II Requires From the Bank’s Management Unlike the 1998 Accord, Basel II, attempts to cover capital charge for all the associated risks; AJK taxation issues and big frauds discovered recently expose the banks failure to determine adequate capital level and relying on regulatory capital. Basel II attempts to cover these issues through capital charge assessment for operational risks.

12. 12 Pitfalls in Capital Management Setting optimistic targets for high capital ratios thereby compromising on return on equity. Subsequently going for buy-back options to reduce the capital level and ensure required level of return on equity, Solely focusing on return on equity, thereby compromising on market share, Over-reliance on risk models that may not cover all the risks

13. 13 Before We Review Basel II Financial reporting requires very little emphasis on risk. Recently being handled by disclosure not valuations; All financial ratios are effectiveness or efficiency and not risk reward; Opportunity of regulatory arbitrage available for banks (Asset Management Companies etc); Anomaly in accounting treatment of held to maturity investments and other assets not required to be mark to market. These items does not require capital charge but definitely dilutes shareholder value.

14. 14 How not to manage Risk

15. 15 Bank Failures in Mature Economies Failures can be classified in many ways, including: By Risk Type Shock that precipitated the crisis State of banking system Impact on banking system How the crises was resolved Whether the failure resulted in regulatory changes. Following is the summery of Banking Crisis in G-10 countries.

16. 16 Bank Failure Example

17. 17 Bank Failure Reasons Credit risk (real estate lending) and market risk caused major failures in banking industries; Recession in economy causing decline in real estate value cause banking failures; Financial liberalization and poor supervisory controls a common cause of major banking crises;

18. 18 Bank Failure Impact The impact of crises varied considerably ranging from only small banks to whole banking system; The types of resolutions used ranged from the liquidation of failed banks to Government take over and recapitalization; Regulatory changes during or after the bank failure was very common. The main emphasis were on: Improve the risk adequacy of banks Strengthen market and supervisory discipline

19. 19 BASEL ACCORD II – An Overview Based on three mutually reinforcing pillars: Minimum Capital Requirements; Supervisory Review Process; Market Discipline; Intended to provide a world standard; More differentiated system of risk groups; Operational risk is focused in addition to credit and market risk; Bank’s own risk assessment methodology is preferred; A forward looking approach to capital adequacy has capacity to evolve over time.

20. 20 Basel Accord II – Basic Structure

21. 21 Applied on a consolidated basis to holding companies of banking group; Applied to all internationally active banks at every level in the banking group; Individual banks must also be adequately capitalized on a stand alone basis; All Securities and Financial Subsidiaries must be captured through consolidation (except for the insurance entities); Basel Accord II – Scope of Application

22. 22 Significant minority investments, where control does not exist, either be deducted form capital or consolidated on pro-rata basis; Significant minority and majority investment in commercial entities will be deducted from capital in excess of materiality threshold (threshold will be determined by national accounting standard-suggested 15% of bank’s capital for a single and 60% for all such investments); 150% category is introduced first time. 150% does not mean loss is greater than 100% but capital requirement is 150% of 8% i.e. 12% of the asset. Basel Accord II – Scope of Application

23. 23 Practical Steps Standardized approach Basic initiatives required for compliance with standardized approach; Database to be extended, primarily relating to loan book: Rating of individual customers; Repricing profile (dates/frequency); Sectoral analysis; Collateral details, will facilitate in advance stage.

24. 24 Practical Steps Operational risk: Database need to be developed for operational risk. However following issues may be considered while determining capital charge for operational risk; Riba decision; Customer service agreement (cash management etc); Agreements relating to mergers and acquisitions; IT related contingency plans; Natural disasters like tsunami;

25. 25 Practical Steps Volatile tax regime (excise duty, minimum tax etc); Credit administration function to ensure proper title documents; Anti money laundering controls; Vetting of agreements, contracts and products. Banks need to specialize this functions as people involved in the finalization of agreement/contract and development of products do not have much time to review in detail all the covenants of the agreement/contract.

26. 26 Practical Steps Advanced Modeling It is improbable that risk models will provide required answer (reduce capital charge) without being supported by underlying business decision.Business initiatives need to be directed towards diversification and mitigation of concentration before relying on the results of risk models; Current crisis in stock market is the classical example of lack of diversification, where risk management tools fail to support the market;

27. 27 Practical Steps A national database needs to be defined and developed by SBP or the national statistics office to collect the industry level parameters. These should be published as a core input for bank’s internal models; Banks needs to test correlation with the national model based on their own portfolio.

28. 28 The banking record keeping system not appropriate to support complex calculations and monitoring of capital adequacy; Lack of awareness of importance of appropriate capital at the top level of management; Management of industrial groups still very concentrated into Family-based. Minimum number of companies are professionally independently managed. Huge risk (Examples- Mohib tex, Schon , Tawakal)

29. 29 Lack of adequately trained and skilled people; Credit Rating culture is still to be developed; Lack of healthy competition; Development of acceptable internal rating systems (IRB Approach) will require significant time and capital expenditure; Lack of awareness with Operational Risk Management System; Management approach that increase in capital is the only way to achieve minimum capital. Implementation Issues

30. 30 Pillar II is based on four key principles Bank’s own assessment of capital adequacy; Supervisory Review Process: Supervisor should review and evaluate banks’ internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratio. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process; Capital above regulatory minima, if necessary. Would be short term until corrective measures are put in place; Supervisory Intervention: Intensifying the monitoring of the bank; or requiring bank to prepare capital restoration plan. etc. Basel Accord II – Pillar II  (Supervisory Review Process)

31. 31 Basic motive for the introduction of market discipline is to increase the disclosures made by the bank regarding its capital adequacy, Pillar III is introduce to complement the minimum capital requirement of Pillar I and supervisory review of Pillar II. Accounting Standards Board – need to become more business oriented; Coordinate with: SECP / Stock Exchange Rating Agencies Analysts Constraints: meaningful timely Basel Accord II – Pillar III  (Market Discipline)

32. 32 To implement New Capital Accord banks in should increase awareness among its top management regarding all aspects of risk and the importance and necessity of having adequate capital backing to support its assets. Conclusion

33. 33 Details of Basel II

34. 34 Capital Definition There is no significant change in the definition of capital from the current Capital Accord, except for following: Deductions of significant minority investment in financial entities and investments in commercial entities above the predefined threshold should be 50% from tier 1 and 50% from tier2; Limit on tier 2 and tier 3 capital and on innovative instruments is based on tier 1 capital after deducting goodwill but before deducting investments. Basel Accord II – Pillar I  (Minimum Capital Requirement)

35. 35 Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

36. 36 Standard Approach Calculate risk weighted assets as product of the exposure and relevant risk weight determined by the supervisor; Risk weights are determined by the category of borrower; Risk weights depends upon external credit assessments by ECAIs; Risk weights are also dependent on the type of product (standby L/C, forward exchange contract, etc); Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

37. 37 Standard Approach-Risk Weighting Scheme Claims on Sovereigns Based upon ECAI’s long term domestic rating for domestic and foreign currency obligation. Risk weights ranging from 0% to 150%; Supervisor may allow use of rating from Export Credit Agencies instead of ECAI; Preferential treatment for domestic claims (i.e 0% risk weight), at national discretion, if the exposure is funded in domestic currency to bank’s own sovereign. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

38. 38 Standard Approach-Risk Weighting Scheme Claims on Banks Supervisor may apply one of the two options available to all bank in its jurisdiction; Option One – Banks are assigned risk weight one category less favorable then the country of incorporation, in case of countries with rating below B- the risk rate will be 150%; Option Two - Banks are assigned risk weights based on the external credit assessment of the bank itself. At national discretion a preferential treatment exist for claims of 3 months or less (original maturity) subject to a floor of 20%, this treatment also available to unrated banks (not available for banks rated below B-); In case of Multilateral Development Banks (MDB) option two will be applicable. Risk weight of 0% is possible on a predefined criteria formulated by the Basel Committee. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

39. 39 Standard Approach-Risk Weighting Scheme Claims on Public Sector Enterprises (PSE) Claims on domestic PSE will be risk weighted at national discretion according to either option One or Two for claims on Banks; In case of option two the preferential treatment for short term claim will not be used; Subject to national discretion claims on PSEs may be treated as claims of Sovereigns under whose jurisdiction PSE is established. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

40. 40 Standard Approach-Risk Weighting Scheme Claims on Corporate Risk weights are based on the external credit assessment ranging from 20% to 150%; Risk weight of unrated corporate is 100%, where as risk weights for corporate rated below B- is 150%; At national discretion supervisors may allow banks to risk weight all corporate claims at 100% with out regard to external rating. However, single consistent approach is necessary, i.e to use rating where available or not at all. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

41. 41 Standard Approach-Risk Weighting Scheme Claims on Retail Claims Keeping in view the increase in capital requirements for operational risk, additional 150% risk weighting category, revised treatment of sovereigns and bank, the Committee has reduced the risk weights for retail claims as follows, however supervisors may require banks to increase this risk weight: 35% for residential mortgage (past due loans are weighted at 100%); 75% on retail claims meeting the four criteria for regulatory retail portfolio; Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

42. 42 Standard Approach-Risk Weighting Scheme Past Due Loans Past due loans will be weighted as follows: 150%, when specific provision is less then 20 % of out standing amount; 100%, when specific provision is not less then 20 % of out standing amount; 100%, when specific provision is less then 50 % of out standing amount, but with supervisor discretion to reduce the weight to 50%. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

43. 43 Standard Approach-Risk Weighting Scheme Off Balance Sheet Items Credit conversion for commitments upto 1 year of maturity will be 20% and 50% for over 1 year. 0% weight may be applied if commitment is unconditional and cancelable; 100% conversion factor for repo style transaction; For short term self liquidating trade L/Cs a 20% conversion factor is applied to both issuing and confirming bank. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Credit Risk)

44. 44 Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk) Definition of Operational Risk Risk of loss resulting from: Inadequate or failed Internal Process, People, system; From external events; Legal (legal risk).

45. 45 Measuring Operational Risk Basel Accord II mentioned three approaches for the measurement of operational risk: Basic Indicator Approach Standard Approach Advanced Measurement Approach Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk)

46. 46 Basic Indicator Approach Capital charge is based on the average of positive gross income of previous three years; Total Capital Charge = a*gross income; a is relating industry wide level of required capital to the industry wide level of the indicator, which is set by Committee at 15%. Formula: KBIA = [S(G1…n * a)]n Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk)

47. 47 Standardized Approach Activities divided into 8 business lines; Indicator is gross income of each business line; Capital charge for each business line calculated by multiplying gross income by a factor (beta); Total capital charge is the sum of capital charge of each business line: Capital Charge = S(G1-8* b1-8) Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk)

48. 48 Standardized Approach-Qualifying Criteria In order to qualify for use of the Standard Approach, a bank must satisfy its supervisor that: Active involvement of Board and Senior management in implement effective risk management and control; Has sufficient resources in the use of the approach in major business line; Use appropriate reporting system to generate relevant data; Comply with sound practices paper; Track operational risk data by business line; Develop criteria for mapping business lines and activities into the standardized framework. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk)

49. 49 Advanced Measurement Approach (AMA) Under AMA regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement system using the quantitative and qualitative criteria. Use of AMA is subject to supervisory approval. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk)

50. 50 AMA-Qualifying Criteria Active involvement of the board and senior management; Independent operational risk management function; Track operational risk exposure and loss experience; Operational risk measurement system integrated into day-to-day risk management process and regularly validated. Compliance process and review by auditors; Period of initial monitoring before using AMA for capital purposes; Minimum historical observation period is 5 years. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Risk Weighted Assets – Operational Risk)

51. 51 Market Risk Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices. The risks subject to this requirement are: The risks pertaining to interest rate related instruments and equities in the trading book; Foreign exchange risk and commodities risk throughout the bank. Basel Accord II – Pillar I  (Minimum Capital Requirement) (Market Risk)

52. 52 Supervisory Review Process (SRP) is intended to ensure that the bank has adequate capital to support all the risk it faces and encourage banks to use better risk management techniques. SRP recognizes the responsibility of bank management in developing as internal capital assessment process and setting capital targets that are commensurate with the bank’s risk profile Supervisors are expected to evaluate that how well banks are assessing their capital needs to their risk and to intervene where appropriate. Increased capital should not be viewed as the only solution for addressing increased risk. Basel Accord II – Pillar II  (Supervisory Review Process)