Corporate IRB Implementation: Overview from the U.S. Supervisory Perspective Advanced IRB Forum June 19, 2003

1. Corporate IRB Implementation: Overview from the U.S. Supervisory PerspectiveAdvanced IRB ForumJune 19, 2003

2. Purpose of Supervisory Guidance • Indicate to industry and supervisors how IRB will be implemented in the United States. • Allow banks to continue developing credit-risk management systems consistent with the IRB framework. • Focus the dialogue between industry and supervisors on key issues. • Ensure consistency across agencies in the implementation of supervisory initiatives related to IRB. • Provide a foundation for staff development, training, and continuing refinement of supervisory policy.

3. Structure of the Guidance Guidance is organized into four chapters, reflecting the key elements of any IRB system: • Rating System - a system that assigns ratings and a process to validate the accuracy of those ratings • Quantification - a quantification process that translates risk ratings into IRB parameters (PD, LGD, EAD, M) • Data - a data maintenance system that supports the operation and refinement of the risk rating system • Controls - oversight and control mechanisms that are designed to ensure the system is producing accurate and consistent ratings

4. Overarching Themes • “IRBStandards” will help the industry understand supervisory expectations. • However, application of these standards will require exercise of judgment on the part of supervisors. • Training and consistency will be essential. • Guidance will evolve over time, as we and the industry learn more about ratings based approaches to capital. • Implementation will require extensive dialogue between banks and supervisors to understand, clarify and address key issues. • A conservativebias will be necessary until adequate experience accumulates with the new approach. • Ultimately, better alignment of risk and capital may permit reductions in minimum required capital at IRB banks.

5. Chapter 1: Rating System Design • The first component of an IRB system involves the assignment and validation of ratings. Two-dimensional risk-rating system – Meaningful and consistent differentiations among exposures along two dimensions, reflecting obligor default risk and loss severity. Calibration – Obligor and loss severity ratings must be calibrated to probability of default (PD) and loss given default (LGD). Accuracy – Actual long-run default frequencies for obligor grades close to PD estimates; actual loss rates on defaults close to LGD estimates. Validation process – Ongoing validation processes for rating systems must include (1) the review of developmental evidence, (2) ongoing monitoring, and (3) comparison of predictions to actual outcomes through back-testing.

6. Industry Challenges • Systems Changes: Many banks have recently revamped their rating systems to be two-dimensional; others are preparing for this fundamental change. Most have little experience with this approach. • Experts Versus Models: Commonly used expert-judgment based systems may be used, but may face a challenging hurdle in meeting supervisory standards. • Rating Philosophy: Banks must more fully articulate their rating approach (not just “point-in-time” or “through-the-cycle”) and reflect that choice in other aspects of the rating system. • Accuracy and Validation: Banks must work to develop appropriate tests of ratings accuracy; the exact nature will depend on details of each bank’s rating philosophy.

7. Chapter 2: Ratings Quantification • IRB capital calculations require banks to supply four inputs or “parameters”. Probability of Default: PD Loss Given Default: LGD Exposure At Default: EAD Maturity: M • Challenge for supervisors: In practice, banks use many different approaches, estimation methods, and data sources. Our supervisory approach should be robust to these differences, and should not unduly constrain the industry’s choice of methods and data when so little is known about many aspects of quantification. • Solution: guidance provides principles of sound practice, and a framework for supervisory dialogue with banks.

8. Quantification Framework The guidance presents a four-element framework that can be applied to virtually any approach to ratings quantification: • Data: identify or construct a reference data source • Estimation: apply statistical techniques to the reference data to derive parameter estimates • Mapping: create a link between the reference data and a bank’s actual portfolio data • Application: apply parameter estimates to each exposure in the portfolio

9. Key Quantification Standards Specified Process– Must have a fully specified process covering all four elements (data, estimation, mapping, and application). Complete Documentation – Process must be fully documented, and must be updated periodically. Independent Review – All aspects of the quantification process, including design and implementation, must be subject to an appropriate degree of independent review and validation. Constraints on Judgment– Judgmental adjustments may be appropriate, but must not be biased in the direction of lower capital. Conservatism – Parameter estimates must incorporate a degree of conservatism appropriate to the overall robustness of the process. Comprehensive Validation – A validation process must cover all aspects of IRB quantification.

10. Industry Quantification Challenges • Formalized process: IRB banks will need to formalize their process by documenting their quantification process more thoroughly than currently done in practice. • Reference data requirements: Requirements for number of years and range of conditions covered, using all available data, and establishing comparability. • Independent assessment: Who will independently assess the work of the “quants” who produce the estimates?

11. Chapter 3: Data Maintenance • Ability to implement IRB hinges on having adequate database • Systems to fully implement Basel do not yet exist at most banks • Lack of data has hindered full implementation of idealized risk management frameworks for many years • Uncertainty • IRB Framework has launched banks and supervisors into uncharted territory • Banks and supervisors need more data to gain comfort than if these practices had been in place for a decade. • Supervisors and risk managers should use data to gain comfort that ratings assignments and parameter estimates are reliable

12. Chapter 3: Data Maintenance -- Key Standards • Collect Data Over Life of Loan • “cradle to grave” collection of data • obligors and facilities • beyond the grave: recoveries and costs. • Collect Rating Assignment Data • significant quantitative and qualitative factors • obligors and facilities • Support of IRB System -- data collected by institutions must be of sufficient depth, scope, and reliability to: • Validate IRB system processes, • Validate parameters, • Refine the IRB system, • Develop internal parameter estimates, • Apply improvements historically, • Calculate capital ratios, • Produce internal and public reports, and • Support risk management.

13. Industry Data Challenges • Sophisticated data maintenance will cost banks tens of millions of dollars • New systems will require far reaching cultural and process changes • Data systems must serve the needs of the line, risk managers, and control functions and not the other way around: • The selected IRB framework should dictate the content and structure of the system

14. Chapter 4: Control and Oversight • Linking internal ratings to regulatory capital places new pressures on individuals and systems • Banks are expected to have a strong system of controls for: • keeping incentive conflicts in check • maintaining rating system integrity • Scope of control and oversight mechanisms: • ratings assignment • design of rating system • quantification of ratings • data management and integrity • validation of rating system • Fundamentals: • separation of duties • balancing incentives • layers of review

15. Key Supervisory Standards • Interdependent System of Controls -- IRB institutions must implement a system of interdependent controls that include the following elements: • independence • transparency • accountability • use of ratings • rating system review • internal audit • board and senior management oversight • Checks and Balances -- Institutions must combine the various control mechanisms in a way that provides checks and balances for ensuring IRB system integrity.

16. Control Challenges • Banks will need to change the scope and focus of control functions • creation of new “rating systems review function” • work of high level risk managers and quants has not received intense scrutiny by qualified experts in a control function • audit has not focused on technical quant issues and ratings have focused on problems, not pass grades • Supervisors will need to conduct rigorous on-site reviews that evaluate a complex set of trade-offs, especially around ratings integrity. • Supervisors will need to apply their judgement in evaluating how well checks and balances fit together.