Day 3 Establishing a Modern Risk Management Department

1. Day 3Establishing a Modern Risk Management Department Basel II and Bank Risk Management Garrett R. Glass FSVC/Central Bank of Libya Seminar - January 2009

2. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009 Prepared by Garrett R. Glass

3. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • (1988) • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk 6. Trading Book/ Market Risk (1996) Basel I FSVC/Central Bank of Libya Seminar - January 2009

4. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs 2. Credit Risk – Standardised Approach Notional Amounts x Risk Weights = Risk Assets Investment Banks Treated Like Banks Off-Balance-Sheet Assets Get New Risk Weights Acceptable Collateral Expanded 5. Operational Risk 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009

5. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs 3. Credit Risk – Internal-Ratings Based Approach Calculate Probabil- ity of Default; Loss Given Default; Exposure at Default; Effective Maturity New Risk Weights and Parameters Assets Now in 5 Categories Securitised Assets Provide Deductions 5. Operational Risk 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009

6. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs 4. Securitisation Framework New standardised table provides risk weights for most securities Banks can use internal measures with approval 5. Operational Risk 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009

7. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk New capital charge but excludes legal and reputation risk Basic Indicator Approach = 15% charge on gross annual income Standardised Approach looks at 8 businesses, and 12% - 18% charge on income of these businesses Advanced Approach only with approval 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009

8. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk 6. Trading Book/ Market Risk Book must have daily MTM and S/T horizon Position limits and liquidity controls required Mark to model allowed if used prudently FSVC/Central Bank of Libya Seminar - January 2009

9. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Helps banks improve risk management Captures risks and risk factors not in Pillar I (such as business cycle effects) Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009

10. Pillar One Pillar Three Pillar Two BIS Capital Adequacy Framework – Basel II Setting Minimum Capital Requirements Supervisory Review Market Discipline Judges quality and type of public informa- tion Greater disclosure leads to less capital 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk 6. Trading Book/ Market Risk FSVC/Central Bank of Libya Seminar - January 2009

11. Challenges to Basel II from Credit Crisis • Tier 1, 2 and 3 Capital ratios were inadequate • Off-balance-sheet assets not counted correctly • Securitisation seen as a benefit, not a risk or cost • Liquidity risk not incorporated • Systemic risk not captured, measured or managed FSVC/Central Bank of Libya Seminar - January 2009

12. Challenges to Basel II from Credit Crisis • Parallel banking structure not brought into system (investment banks, securities firm, hedge funds, private equity, insurance companies) • Mark to market leads to Ponzi finance (demand for ever greater volumes of business to meet growth targets) 8. Mark to model abused: • Models too complex and opaque (black boxes) • Over reliance on quantitative assumptions of market behavior • Data non-existent or limited FSVC/Central Bank of Libya Seminar - January 2009

13. Challenges to Basel II from Credit Crisis • Monetary policy issues: • No controls over growth in fiat currency (paper/electronic money); inflation was targeted but inflation measurements were altered, giving false impression of inflation risk • U.S. eliminated M3 • U.S. claimed it was impossible to identify or control asset bubbles • Reliance on public debt ratings to determine risk categories is questionable now that ratings agencies have shown that their rating system is flawed FSVC/Central Bank of Libya Seminar - January 2009

14. Challenges to Basel II from Credit Crisis 11. Pro-cyclical banking culture as economy expands _ Credit pricing and covenant standards weaken _ Maturities are extended _ Products become more complex and harder to value _ Increased profitability leads to demands for higher growth rates _ Risk managers lose power to line managers _ Regulators reduce their oversight and vigilance _ Impossible to shut down a profitable but high/risk business FSVC/Central Bank of Libya Seminar - January 2009

15. Pillar One Pillar Three Pillar Two Areas of Basel II Framework Likely to be Revised Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk 6. Trading Book/ Market Risk Areas likely to be revised FSVC/Central Bank of Libya Seminar - January 2009

16. Pillar One Pillar Three Pillar Two Areas of Basel II that Libyan Banks Can Implement Setting Minimum Capital Requirements Supervisory Review Market Discipline 1. Defining Parent/Subs • 2. Credit Risk – • Standardised • Approach • Credit Risk – • Internal-Ratings • Based Approach • 4. Securitisation • Framework 5. Operational Risk – Basic Indicator or Standardised Approach 6. Trading Book/ Market Risk (1996 Accord only) Libyan Central Bank may implement Pillar II FSVC/Central Bank of Libya Seminar - January 2009 Opinion of author only!