BASLE II AND ECONOMIC CAPITAL BY DR. EMMANUEL ABOLO

1. BASLE II AND ECONOMIC CAPITAL BY DR. EMMANUEL ABOLO CHIEF ECONOMIST & GROUP HEAD, MARKET & OPERATIONAL RISK MANAGEMENT ACCESS BANK PLC 16December, 2008

2. Our philosophy V I S I O N M I S S I O N To transform our bank into a world-class financial services provider. To go beyond the ordinary, to deliver the perceived impossible, in the Quest for Excellence BRAND DRIVER The Quest For Excellence

3. Our values

4. Outline • Introduction/Conceptual Clarifications • Development of Economic Capital • Economic Capital & Basle II: • Comparison of Economic Capital & Basle II (Regulatory capital) • Recent Developments Encouraging the Use of Economic Capital • Measurement of Economic Capital • Basle II Accord – Objectives, Benefits & Banks’ Readiness • Economic Capital Allocation for Commercial Bank Credit Risk • Recap on Pillar 2 • Challenges & Way Forward

5. Introduction/Conceptual Clarifications • Economic capital represents the emerging best practice for measuring and reporting all kinds of risk across a financial organization; • It is called "economic" capital because of the following factors: • it measures risk in terms of economic realities rather than potentially misleading regulatory or accounting rules; • Part of the measurement process involves converting a risk distribution to the amount of capital that is required to support the risk, in line with the institutions target financial strength (eg. credit rating). • Economic capital is the amount of risk capita, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, and operational risk. It is the amount of money which is needed to secure survival in a worst case scenario.

6. Introduction/Conceptual Clarifications • Typically, it is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as value at risk.

7. Introduction/Conceptual Clarifications • Economic Capital Economic capital is a measure of risk, not of capital held. As such, it is distinct from familiar accounting and regulatory capital measures. The output of economic capital models also differs from many other measures of capital adequacy; • Economic capital is based on a probabilistic assessment of potential future losses and is therefore a potentially more forward-looking measure of capital adequacy than traditional accounting measures; • The development and implementation of a well-functioning economic capital model can make bank management better equipped to anticipate potential problems;

8. Conceptual Clarifications (Cont’d) • Conceptually, economic capital can be expressed as protection against unexpected future losses at a selected confidence level. This relationship is presented graphically in the chart below:

9. Conceptual Clarifications (Cont’d) Expected loss: • Expected loss is the anticipated average loss over a defined period of time. It represents a cost of doing business and are generally expected to be absorbed by operating income. In the case of loan losses, for example, the expected loss should be priced into the yield and an appropriate charge included in the allowance for loan and lease losses. Unexpected loss: • Unexpected loss is the potential for actual loss to exceed the expected loss and is a measure of the uncertainty inherent in the loss estimate. It is this possibility for unexpected losses to occur that necessitates the holding of capital protection.

10. Conceptual Clarifications (Cont’d) • Economic capital is typically defined as the difference between some given percentile of a loss distribution and the expected loss. It is sometimes referred to as "unexpected loss at the confidence level.“ Confidence Level • The confidence level is established by bank management and can be viewed as the risk of insolvency during a defined time period at which management has chosen to operate. The higher the confidence level selected, the lower the probability of insolvency. • For instance, if management establishes a 99.97 percent confidence level, that means they are accepting a 3 in 10,000 probability of the bank becoming insolvent during the next twelve months. Many banks using economic capital models have selected a confidence level between 99.96 and 99.98 percent, equivalent to the insolvency rate expected for an AA or Aa credit rating.

11. Development of Economic Capital The concept of Economic Capital was developed in the banking sector. • Basel I requires holding appropriate levels of capital for different financial risks: • S&P AAA rating requires banks to hold capital at the 99.90% level • Basel II expands the concept to operational risks: • Quarterly reporting of operational risk exposure • Insurance companies have picked up the EC concept only in the last several years; • Rating agencies are starting to give credit for internal models; • Regulatory changes are accelerating pace of change; • Larger companies are setting up proprietary stochastic models • The European CRO Forum is in the process of recommending standards for the acceptance of internal models for compliance with the new Solvency II capital standards.

12. Economic Capital & Basle II • The amount of capital a bank holds is an important factor supporting its soundness and solvency; • The Basel II framework is designed to improve the linkage of key factors which contribute to bank solvency to a bank’s level of capitalisation. Not only does capitalisation become more a function of the risk profile of the organisation than under Basel I; and • The Basel Committee aims at improving individual bank soundness through reinforcing sound risk management practices. These include: • Sound governance and compliance disciplines; • Improved (statistical) quantification of the various risks a bank faces; • Sophisticated tests of a bank’s ability to withstand and manage changes to economic conditions; • Greater market discipline on reporting and disclosure

13. Recent developments encouraging the use of EC • Basle II Accord, a regulatory standard for international active banks; • Solvency II/European Chief Risk Officer Forum • General need to develop risk profiles and perform hedging analysis • Measuring exposure to catastrophic events; • Demands and increasing scrutiny by rating agencies/regulators

14. Recent developments encouraging the use of EC The European CRO Forum is establishing guidelinesfor admissibility of internal EC models for Solvency I • European Chief Risk Officer Forum is establishing guidelines for calculation of EC and diversification of risk; • “Principles for Regulatory Admissibility of Internal Models” (June 2005); • Solvency Capital should be set to ensure a standardized likelihood of economic loss to policyholders; • Internal models should be based on adverse movement in Economic Value of (Assets – Liabilities), calibrated to a target annual level of 99.5% probability of solvency; • All material risks affecting the balance sheet should be modeled; • Internal risk models should be fully implemented inside the company, and reviewed (at least) annually; • The CRO Forum advocates the admissibility of diversification benefits. • In December 2005, the CRO Forum published a subsequent report discussing suggested solutions to major issues in Solvency II • EC is to be based on a market-consistent approach

15. Recent developments encouraging the use of EC • All major US rating agencies are developing or enhancing their capital adequacy models. These include: • Standard & Poor’s (S&P); • Fitch; • AM Best and Moody’s are also in the process of enhancing their capital adequacy models

16. Measurement of Economic Capital • When calculating Economic Capital, three alternative approaches are commonly used to measure risk: Risk of ruin, VAR and TVAR; • TVAR captures the full extent of losses in the event of ruin; • VAR quantifies the capital required to withstand losses at a particular probability level; • Risk of ruin is the probability of loss given the capital held; • Required Economic Capital (REC) = “sufficient surplus capital to cover potential losses, at a given risk tolerance level

17. Measurement of Economic Capital When calculating EC, financial services companies use a range of different confidence levels; • Most banks use VAR • Choice of confidence level and implied rating: • Most European insurers are using one-year confidence levels ranging from 99.5% to 99.99%; • European regulators appear to be converging towards a one-year 99.5% confidence level for Solvency II; • Confidence levels are typically linked to a target risk appetite and financial strength rating; • Where longer time horizons are used, a lower multi-year confidence level can be justified (e.g., AA over five years vs. AA over one year); • Moody’s and S&P have suggested using 99th percentile for AA financial strength rating; and • Fitch is using a 98.2 CTE level for AA rating.

18. Basle II Accord Objectives • Maintenance of overall capital levels globally; • Promote competitive equality; • Promote comprehensive risk management; • Sensitive to risk; • Focus on internationally active banks but applicable to all Objectives.

19. Basle II Accord (Cont’d) Benefits of Basle II • Better risk assessment; • Improves Industry risk management infrastructure; • Actively encourage and support the shift to the new framework (eg use of Basel II by rating agencies); and • Consider impacts on the current business model: • Look for opportunities to grow; • Optimise capital structure; • Exploit pricing opportunities; and • Seek out takeover opportunities.

20. Basle II Accord (Cont’d) Banks’ Readiness for Basle II Generally, banks need to improve in the following areas to achieve accreditation at the advanced levels within the new Accord: • Time series data on defaults; • Loss of information and meeting the cycle adjustment requirements of Basel II; • Enhancements to existing risk management systems; • Increased rigour in rating tool development, testing and validation to meet the more stringent requirements of Basel II; and • Improvements to data warehouses, data interrogation and back testing capabilities.

21. Economic Capital & Basel II Capital provides sufficient assurance to prevent insolvency (i.e. the financial state where liabilities exceed assets). • Economic Capital is the amount of capital that shareholders require in the absence ofregulation. Factors to consider are: • Leverage influencing target debt rating, and the cost of debt; • Earnings volatility influencing analyst ratings, and the cost of equity; • Distress costs (liquidity risks, impact on strategy, increased regulatory burden, management time). • Given the shortcomings of Basel I, economic capital has been the primary focus with regulatory capital as the constraint. The requirements of rating agencies also have to be considered. The actual capital requirement for the Bank will therefore be the amount of capital required to satisfy economic, regulatory and rating agencies.

22. Economic Capital & Basel II (Cont’d) Basle II Pillar 2 • Principle 1: Banks should have a process for assessing their overall capitaladequacy in relation to their risk profile and a strategy for maintaining theircapital levels. • Principle 2: Supervisors should review and evaluate banks’ internal capitaladequacy assessments and strategies, as well as their ability to monitor andensure their compliance with regulatory capital ratios. Supervisors shouldtake appropriate supervisory action if they are not satisfied with the result ofthis process.

23. Regulatory and Economic Capital Comparison

24. Differences Between (BASEL II) Regulatory Capital & Economic Capital Measures Conceptual Differences • Relevant Business Entities; • Confidence Levels; • Time Horizons; • Treatment of Expected Loss; • Allowable Capital Instruments; • Capital Deductions; • Risk Type Coverage; • Risk Type Definitions; and • Cross-risk Diversification.

25. Differences Between (BASEL II) Regulatory Capital & Economic Capital Relevant Business Entities • Regulatory Capital: The individual licensed entity • Economic Capital: The entire business group perhaps including multiple licensedand unregulated entities.

26. Differences Between (BASEL II) Regulatory Capital & Economic Capital Confidence Levels • Regulatory Capital: Probability that the bank will survive and thereby avoid potential systemic disruption; and • Probability that depositors (or their insurer) will not lose any money even if the bank actually fails. • The confidence level implicitly reflects society’s tolerance for the risk of depositor loss and systemic disruption arising from bank failure. However, It may not be explicitly specified.

27. Differences Between (BASEL II) Regulatory Capital & Economic Capital Confidence Levels Economic Capital: • Probability that the bank will survive. • Conceptually, the chosen confidence level should represent the point at which the marginal benefit, in terms of lower funding costs and access to business for which higher credit ratings (confidence levels) are a necessary condition, is estimated to exactly offset the marginal cost of raising and servicing additional equity. • Unlike regulatory capital, theeconomic capital confidence level is not influenced bypotential systemic costs of bank failure, for which the bank’s stockholders are not liable.

28. Differences Between (BASEL II) Regulatory Capital & Economic Capital Time Horizons: • For a given amount of capital, the longer the time horizon the lower the confidence level. Regulatory Capital: • Time needed for supervisors to identify and intervene if necessary to address potentially life threatening problems; • Time required to recapitalise after incurrence of serious losses; • Normal supervisory review cycles. Economic Capital • Time needed to close out losing risk positions or businesses; • Time needed to recapitalise after incurrence of serious losses;and • Normal business planning and performance review and reporting cycles.

29. Differences Between (BASEL II) Regulatory Capital & Economic Capital Treatment of Expected Loss Regulatory Capital (Basel II): • Provision or capital required for expected as well as unexpected losses; • Asymmetry of treatment of expected loss and expected income; • At variance with IFRS (actual impairment only, not expected future impairment). Economic Capital: • Unexpected losses only? • No provision or capital required for expected loss? • Symmetry of treatment of expected loss and expected income?

30. Differences Between (BASEL II) Regulatory Capital & Economic Capital Allowable Capital Instruments Regulatory Capital • Shareholders funds – “Fundamental” Tier 1; • Hybrid debt/equity – “Innovative” Tier 1; and • Subordinated debt – Tier 2. Economic Capital • Shareholders funds only

31. Differences Between (BASEL II) Regulatory Capital & Economic Capital Capital Deductions Regulatory Capital: • Implicitly assumes deducted items have 100% probability of zero value in liquidation; • Intangibles; and • Investments in insurance, certain other financial business and non-financial business subsidiaries. Economic Capital: • 100% probability of zero value unlikely for all deducted assets in combination; • No outright deductions; • Model potential reductions in the value of these assets using the same time horizons and confidence levels as for all other potential sources of unexpected; • loss, taking correlations into account.

32. Differences Between (BASEL II) Regulatory Capital & Economic Capital Risk Type Coverage and Definitions

33. Differences Between (BASEL II) Regulatory Capital & Economic Capital Cross-Risk Diversification Regulatory Capital (Basel II) • No explicit recognition; • Implies perfect correlation; • Correlations unstable; and • Cushion for other risks. Economic Capital • Recognises less than perfect correlations across risks; • Need to reflect “stressed” rather than “normal” correlations; and • Potentially significant reduction in overall risk.

34. Comparison of Economic & Basle II Regulatory Capital

35. Comparison of Economic & Basle II Regulatory Capital

36. Economic Capital Allocation for Commercial Credit Risk Case Studies • At its most fundamental level, credit risk is associated with loan losses resulting from the occurrence of default and the subsequent failure to collect in full the balances owed at the time of default. • Expected credit losses associated with default can therefore be determined from parameters associated with the likelihood of a loan defaulting, or an estimate of the probability of default (PD) during a defined time period, and the severity of loss expected to be experienced in the event of a default, or an estimate of loss given default (LGD). • This ratio would be applied to a measure of estimated exposure at default (EAD) to convert loss expectations to dollar amounts. The resulting formula: • Expected losses ($) = PD(%) * LGD(%) * EAD($).

37. Economic Capital Allocation for Commercial Credit Risk Case Studies • PD and LGD parameter estimates are drawn from the bank's historical performance or from a mapping of internal portfolio risk assessments to external information sources for PD and LGD parameters. • This requires that banks to have in place processes that enable them to periodically assess credit risk exposures to individual borrowers and counterparties with robust internal credit rating systems that reflect implicit, if not explicit, assessments of loss probability. • Definitions of credit grades should be sufficiently detailed and descriptive to clearly delineate risk level between grades and should be applied consistently across all business lines.

38. Economic Capital Allocation for Commercial Credit Risk Case Studies • For example, a bank could have a ten grade credit rating system with associated one-year probabilities of default drawn from their historical default experience within each grade as shown in Table I. • In this example, the historical default rate experienced for loans internally graded as a "6" has been one percent, which is approximately equivalent to the long-term default frequency associated with an S&P credit rating of BB.

39. Economic Capital Allocation for Commercial Credit Risk Case Studies Estimates for loss severity in the event of default could likewise be constructed. LGD grades assigned to loans are often associated with factors such as loan type, collateral type, collateral values, guarantees, or credit protection such as credit default swaps

40. Economic Capital for Operational Risk As the figure shows, regulatory capital should cover (e.g. in the form of provisions) both expected losses and unexpected losses (but excluding extreme events) while economic capital should cover unexpected losses.

41. Economic Capital for Operational Risk (Cont’d) • In addition, economic capital should cover both risk capital with 99.9% scenarios and capital for extreme events. The latter is important for modelling operational risk as “low frequency/high severity” losses often occur. Examples of extreme events, we can list 9/11 events in 2001, flooding in the Czech Republic in 2002 or Hurricane Katrina in 2005.

42. Recap on Pillar 2 Pillar 2 is about assessing risks & implementing appropriate mitigants.

43. Challenges going forward • In practice, managing the relationship between Economic and Regulatory capital is complex, with no simple answers; • Correlation and diversification – critical number; • Benchmarking against peers and market – paramount; • Reporting and disclosure – onerous: • Upside of educating market. • Engagement, training and communication – crucial; and • Complex groups with significant non banking business – what is a common currency for capital

44. Thank you for listening