The Baham as Association of Com pliance Officers Sem inar Novem ber 1 5 , 2 0 0 6 The I m plications of Basel I I on Banking in the Baham as Steve Patterson Head of Credit Risk RBC, Baham as & Caribbean Slide # 1
Agenda � The Evolution of Basel I I � Highlights of Basel I I � RBC’s Approach to Basel I I � Regional I m plications � Questions Slide # 2
Basel I I Evolution � Basel nam ed after Basel, Sw itzerland, hom e of Bank of I nternational Settlem ents ( “BI S”) � BI S Mission Statem ent “ Excellence in Service to Central Banks and Financial Authorities” Slide # 3
Basel I I Evolution The BI S � Aim s at prom oting m onetary and financial stability � Acts as a forum for discussion and cooperation am ong central banks and the financial com m unity � Acts as a bank to central banks and international organizations Slide # 4
Basel I I Evolution History of the BI S � Established in 1 9 3 0 1 . to handle reparation paym ents im posed on Germ any after the First W orld W ar 2 . to provide Central Banks w ith an institutional forum for cooperation Slide # 5
Basel I I Evolution History of the BI S � 1 9 3 0 ’s “The Great Depression”. Central Bank m eetings continued although w ith understandable lim itations � I n 1 9 3 9 , w ith Advent of Second W orld W ar, all m eetings suspended, BI S rem ained neutral � 1 9 4 4 Bretton W oods Agreem ent called for abolition of BI S, w ith Bretton W oods fram ew ork, I MF and W orld Bank taking over � Central banks in Europe favored keeping BI S alive Slide # 6
Basel I I Evolution History of the BI S � Bretton W oods era saw international m onetary system based on freely convertible currencies at fixed but adjustable exchange rates � Rem oval of foreign exchange controls facilitated free trade and BI S played significant role in assisting w ith this in Europe � BI S continued to play roll in coordinating crisis m anagem ent am ong central banks ( gold price, reserve currencies & other m onetary im balances) Slide # 7
Basel I I Evolution History of the BI S � By the early 1 9 7 0 ’s, value of the dollar determ ined by m arkets, m arked the end of the Bretton W oods system � Bretton W oods legacy is one of institutionalized cooperation am ong central banks � I n 1 9 7 3 EEC put lim its on exchange rate fluctuations betw een participating European currencies ( “Snake m echanism ”) & BI S appointed agent for it � European Monetary System introduced in 1 9 7 9 w ith BI S responsibilities rem aining Slide # 8
Basel I I Evolution History of the BI S � 1 9 7 0 s saw grow th of international financial m arkets and cross-boarder m oney flow s � Collapse in 1 9 7 4 of Bankhaus Herstatt in Germ any and Franklin National Bank in the US prom pted G1 0 central bank governors to set up Basel Com m ittee on Banking Supervision � I n 1 9 8 8 this Com m ittee issued the Basel Capital Accord introducing a credit risk m easurem ent fram ew ork for internationally active banks that becam e a globally accepted standard Slide # 9
Basel I I Evolution History of the BI S � I n June 1 9 9 9 , the Com m ittee released a proposal to replace the 1 9 8 8 accord w ith Basel I I , w hich captures operational risk and relates the allocation of capital to actual risk � Basel I I addresses not only capital regulation but also encom passes supervisory review and m arket discipline ( the Three Pillars) Slide # 1 0
Basel I I Evolution History of the BI S Som e exam ples of destabilizing events: � Several Bank failures � Barings Bank in Far East � Recent exam ple of Hedge Fund w hich lost significant portion of value in less than 1 w eek � Mexican crisis in 1 9 9 4 -9 5 � Thailand & Korea in 1 9 9 7 � Russian debt default � Turkish & Argentine crises Slide # 1 1
Basel I I Evolution W hat has changed over tim e? � More com plex econom ies � Econom ies m ore intertw ined, events in one econom y m ay have w orldw ide im plications 1 . Financial institutions over reach m any geographies 2 . Revenue drivers in an econom y m ay be dependent on outside interests ( e.g. tourism ) 3 . Reliance on external com m odities ( e.g. oil) Slide # 1 2
Basel I I Evolution W hat has changed over tim e? � Financial institutions have changed too 1 . Far larger array of products 2 . More different lines of business 3 . Larger institutions active in m any countries, difficulties/ m istakes in one country can destabilize bank across entire operations ( Barings Bank) 4 . More com plex products, som e of w hich are off balance sheet ( interest rate sw aps, foreign exchange forw ards/ futures etc) Slide # 1 3
Basel I I Evolution W hat has changed over tim e? � Financial institutions Risk & Return perspective, all risks are not equal 1 . A residential m ortgage vs. a credit card 2 . Structured finance, bigger spreads, bigger fees and also bigger risks 3 . Lending w ith lim ited regard for TDS in consum er portfolio, higher rates how ever, especially in a dow n turn, greater chance of default 4 . LTV m ultiples on residential m ortgages Slide # 1 4
Basel I I Evolution W hat has changed over tim e? � As capital is the “cushion” for the financial institution, as products and business practices becom e m ore com plex, then capital calculations too have grow n in com plexity � Also review / oversight of these institutions continues to grow in com plexity � I nvestor inform ation and transparency for stakeholders in these institutions also needs to expand � The above are the 3 Pillars of Basel I I Slide # 1 5
Highlights - Basel I I Three Pillars 1 . Minim um Capital Requirem ents 2 . Supervisory Review of institutions capital adequacy and internal assessm ent process 3 . Market Discipline w hich addresses institutions disclosure practices Slide # 1 6
Highlights - Basel I I Minim um Capital Requirem ents Credit Risk - Three key approaches to m easure Credit Risk 1 . Standardised Approach 2 . Foundation I nternal Rating Based ( “I RB”) 3 . Advanced I RB Slide # 1 7
Highlights - Basel I I Minim um Capital Requirem ents Credit Risk - Standardised Approach � Based on external ratings, m ay be credit rating agencies or risk w eights dictated by accord &/ or local regulator � Different asset types w ill have different risk w eightings e.g. Corporate 1 0 0 % , Retail 7 5 % , Residential Mortgages 3 5 % Slide # 1 8
Highlights - Basel I I Minim um Capital Requirem ents Credit Risk - Standardised Approach � Off Balance sheet item s w ill be converted into credit exposure equivalents utilising credit conversion factors � Exam ple w ould be Com m itm ents w here over 1 year attracts 5 0 % CCF, under 1 year 2 0 % & fully cancellable 0 % Slide # 1 9
Highlights - Basel I I Minim um Capital Requirem ents Credit Risk - I RB Approaches � For calculation of Risk W eighted Assets reliant on 4 quantitative inputs 1 . Probability of Default 2 . Loss given Default 3 . Exposure at default 4 . Maturity Slide # 2 0
Highlights - Basel I I Minim um Capital Requirem ents Credit Risk - I RB Approaches � Difference betw een Foundation I RB & Advanced I RB is that w ith Advanced, quantitative inputs provided by bank based on ow n estim ates, w hereas w ith Foundation w ith exception of Probability of Default Supervisors provide values Slide # 2 1
Highlights - Basel I I Minim um Capital Requirem ents Credit Risk - I RB Approaches � Assets divided into classes w ith 3 key elem ents: 1 . Risk Com ponents – estim ates of risk param eters provided by Banks/ Regulators 2 . Risk W eight functions – how risk com ponents are transferred into risk w eighted assets Minim um Requirem ents – requirem ents 3 . that m ust be m et for bank to use I RB approach for given asset class Slide # 2 2
Highlights - Basel I I Minim um Capital Requirem ents Operational Risk - � The risk of loss resulting from inadequate or failed internal processes, people and system s or from external events, includes legal risk. Slide # 2 3
Highlights - Basel I I Minim um Capital Requirem ents Operational Risk - Capital Calculation Options 1 . Basic I ndicator Approach – 1 5 % of 3 year average of gross incom e 2 . Standardised Approach – Divides bank into 8 business lines and in each takes gross incom e tim es a predeterm ined beta ( Retail banking 1 2 % ) 3 . Advanced Measurem ent Approaches – Regulatory Capital w ill equal risk m easure provided by Bank’s internal m easurem ent system utilising specified quantitative and qualitative criteria Slide # 2 4
Highlights - Basel I I Minim um Capital Requirem ents Market Risk - � Defined as the risk of losses in on and off balance sheet positions arising from m ovem ent in m arket prices. Risks subject to this provision are: 1 . Risks pertaining to interest rate related instrum ents & equities in the trading book 2 . Foreign exchange risk and com m odities risk throughout the Bank Slide # 2 5
Highlights - Basel I I Minim um Capital Requirem ents Market Risk - � Direction provided on how to calculate risk w eighting of various elem ents of m arket risk Slide # 2 6
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