0

Basel III: Reducing procyclicality and promoting countercyclical buffers

Urs D. Bluemli Firm-wide Risk Control & Methodology

22 October 2012

Introduction
Section 4 of Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010, rev June 2011: A number of proposed measures aim at the goal of creating capital buffers as safety measures against future adverse developments

Key objectives dampen any excess cyclicality of the minimum capital requirement; promote more forward looking provisions; conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth.
2

Cyclicality of the minimum requirement

Volatility of RWA
Risk sensitivity is a key feature of Basel II (A-IRB) How much is desired? Design of Basel II contained safeguards to avoid undesired RWA volatility over time
Use of long term data horizons for PD estimation Downturn LGD Calibration of the risk weight function Stress test requirements Pillar 2 ICAAP assessment

Basel II was introduced not so long ago

Banks used data series that they were able to compile and statistically assess Preparations for introduction were made in economically benign times New initiatives launched by BCBS under "Basel III regulatory consistency programme"

New measures could be taken

Pillar 1: Scalar functions for banks' PD models to "non-cyclical PDs" Pillar 1 or 2: Introduction of floors under parameters that may reflect benign periods

Capital adequacy over a cycle vs under severe stress (e.g. 2007/2008)

Through-the-cycle PD and LGD parameters will not cover stress events Will regulators approve the continued use of long-term "through-the-cycle" parameters in the face of a potentially fundamental change in an economy?
4

"Through-the-cycle" parameter estimation

Estimating sound "non cyclical" PD and LGD targets is not as simple as calculating an average

Availability and significance of data Impact of business cycle Portfolio composition Changes to credit policy and underwriting standards New developments in core markets Penetration of new markets
5

"Through-the-cycle" parameter estimation

Backtesting of model performance is difficult Relatively little rating migrations yearon-year High variation between PD and observed defaults in any year Role of downturn LGD Structural changes may be missed Increasing judgemental overlays and interpretations Less proof of accurate risk measures

A challenge for the "use test" paradigm of Basel II

Day-to-day risk management and pricing decisions must be based on a shorter-term view (point-in-time) Many banks may have used a hybrid system (t-t-c and p-i-t)
often a clear differentiation between the two concepts is difficult

Whilst the average observed defaults remain rather stable over time, cyclical movements may be considerable

Managing loan portfolios often with a short to medium term maturity cannot be based on averages If "non cyclical" parameters and regulatory "floors" become more relevant banks will have to promote a parallel system for risk management purposes

Assessment
High volatility of RWA is not desired neither from a bank nor a regulatory view Models grounded in historical observations are blind to changes in circumstances that have not been observed in the past or deemed to be still relevant Introducing judgemental overlay or regulatory conditions may however blur the picture Internal risk management may tend to deviate more from regulatory assessment External comparability of risk characteristics of financial institutions could become even more difficult The introduction of the "leverage ratio" will already provide a floor for low risk portfolios Any charge for uncertainties in the RWA estimation should preferably be part of the bank specific Pillar 2 assessment

Forward looking provisioning

"Too little too late"

During the financial crisis criticism was heard (G-20, FSB, BCBS) that banks did not only increase their provisions late in the cycle, but were also slow in changing their estimations of future losses This broad criticism should be considered in more detail
The international financial crisis was triggered by severe mark-downs of securitised instruments (secured mainly on home loans in the US) accounted for at fair value The subsequent events were often focused on government debt and not corporate or retail loans accounted for on an amortised cost basis

Normal volatility in economic conditions do not pose problems Major changes in valuations are usually the consequence of far-reaching changes in conditions that were not or insufficiently recognised usually by an entire market
Lessons learnt from the rapid changes in valuations of securitised products apply at least as much to the challenge of estimating future loan losses in an accrual book

10

"Too much too early?"

The perceived (regulatory?) preference of creating reserves "in good times" can easily lead to a prudent build-up of "buffers", which distort the true and fair value paradigm The creation of "buffers" should arguably be required through capital
Accounting for net profit includes the true and fair value of assets at balance sheet date Distribution of net profit should match prudency requirements for regulated institutions as already reflected under Basel III

True and fair relates to both over- and underestimation of loan losses Whilst the ambition is to estimate full lifetime expected losses as reliably as possible, the realisation will depend on many factors and carry significant uncertainties that will dominate the outcome
in a long lasting period of a benevolent economy the downside may be underestimated in a downturn pessimistic views may become more pronounced

11

IASB and FASB response

The accounting standards boards were asked to revise the rules for impairment recognition and to harmonise them Discussions concerning a review of the accounting rules started late in 2009 There is a potential conflict between
matching income and (expected) losses for products accounted for on an amortised cost basis (so-called day-one loss linked to immediate reserving of lifetime EL) and fulfilling the G-20 and FSB demands and current practices applied by preparers using USGAAP or IFRS

Various proposals were made in the meantime with various degrees of complexity No solution could find broad support by preparers, investors Harmonisation proves to be difficult The new approach will require forward looking provision against expected losses, but the details (outlook period to full lifetime etc.) are still open IASB and FASB are expected to publish their latest exposure drafts sometime soon
12

Estimating expected loss

Whatever the final changes to the accounting rules will be, the fundamental issue of having to estimate future expected losses on (parts of) the portfolio will be a critical feature Banks applying the Standardised Approach due to lack of modelling capability will have to use models to estimate EL for accounting purposes with differing degree of complexity Banks under A-IRB will have to adapt their predominantly through-the-cycle calibration method All banks will have to expand the outlook period from one year to multiple years or the lifetime of a portfolio

13

Forward looking estimation

A combination of approaches may yield the best results Short term outlook
Most reliable forecasts for economic conditions Use indicators that we would also use today for collective loan loss provisions etc.

Planning horizon
Apply models to forecast a range of expected defaults and losses over a suitable time horizon, e.g. two years, where a reasonably stable relationship between risk factors and observed losses can be established Use some judgement where models cannot be used to link loss performance to the business plan (base case)

Longer term
Use longer-term averages from observed losses over a period of years

Combination of input
Forecast central tendency of expected loss for the segment by aligning the results from the three initial steps to create a time series of estimations covering the full lifetime of the asset / duration of the portfolio

14

Forecasting expected loss over a planning horizon

Critical input: Macro-economic scenarios Set of scenarios
Focus on various triggers which may have an effect Causes: cyclical swings in the economy, expected impact of (geo-)political events etc. Possible effect: deterioration (recession, deflation/depression, stagflation) or improvement in the macro-economic situation

Translation of descriptive effects of a given economic condition into changes to key macro-economic indicators
GDP, interest rates, fx movements ... covering all major economies and ideally linked to the business plan

Transform, where statistically sufficiently robust, changes to macro-economic factors into

expected movements in "central tendency" probability of default of (sub-)portfolios expected changes in recovery rates (real estate market outlook etc.)

and determine the future expected loss given the chosen scenario

15

Example: Approach for credit risk PDs

STEP 1 Sensitivities STEP 2 Application to Plan Scenario
Aggregate forecasts for default indicators for plan scenario Link to the actual portfolio:
Translation into default rates

STEP 3 Determination of Expected Central Tendency of Default

Break down to single names
Define stressed PDs/Default rates for each individual counterparty

Statistical analysis of default indicators

Estimations of dependencies of default indicators on macro-economic variables per region/industry cluster, e.g. GDP growth decrease by x% default rate increase by y%
15

T (03m ) T (3m6 m) T (6 m9m ) T (9m1y )

T (1y 1.5 y )

T (1.5 y 2 y )

Default indicator: observed, fitted, inclusive bandwidths

10

Default Rat e

St ressed default rate (annualized)

Original PD

1996q1

1997q1

1998q1

1999q1

2000q1

2001q1

2002q1

2003q1

2004q1

2005q1

2006q1

2007q1

2008q1

2009q1

2010q1

2011q1

10d

3m

6m

9m

1y

1.5y

2y

tim e

time

16

Capital conservation

Flexibility of minimum capital requirements

The minimum requirements contain a capital buffer for managing shortfalls under the minimum required in "normal times" The conservation buffer aims at managing capital shortfalls due to stress losses
Less immediate need to raise equity if minimum of 8% is still met

Rebuilding capital levels

Reduced earnings distribution Prevention of share buy-backs Restrictions on staff bonus payments

18

Protection from excess credit growth

Temporarily increased capital requirements

Adjustment of the capital buffer range in periods of high credit growth aims at leading to higher capital levels once the tide turns The countercyclical buffer applies when system-wide risk is increased Up to 2.5% of additional capital
phased introduction from 2016 to end 2018 Protection not only of individual banks but also the entire financial system

Rebuilding capital levels

Reduced earnings distribution Prevention of share buy-backs Restrictions on staff bonus payments

Application on an infrequent basis Basic measures to determine times of "excessive credit growth"
Credit / GDP ratio Other country-specific variables Consistency with other observables, e.g. asset prices funding and CDS spreads real GDP growth

20

A critical review of several aspects

Effectiveness, Precision

Activation and Deactivtion

Countercyclical G20 Buffer

Capital Planning

Overlap with other potential measures

21

Effectiveness
The one-size fits all countercyclical buffer does not aim at the growth business

Higher capital requirements apply to the stock and not to the risky flow No differentiation between individual banks lending practices Strongly capitalised banks may use their competitive advantage and become vulnerable Increased costs of capital irrespective of actual growth who will pay for them? Will higher spreads deter market participants in a boom? Experiences with capital buffers during the past crisis (e.g. Spain)

22

Activation and de-activation

Timing will be critical

Activation Activation will not simply be model based (credit to GDP ratio) Judgement and room for discretion by governments / regulators Late activation will turn the instrument into a pro-cyclical measure as it may coincide with already higher loan losses De-activation Timing of de-activation may be delayed beyond the trough of the cycle Lower capital requirements at/just after the peak of a crisis may not convince analysts about the soundness of the bank or the banking system There is a big risk that such an additional buffer will be a permanent feature as analysts may compare throughout the years RWA against CET capital ratios

23

Activation and de-activation

National buffer decisions

Countries have to assess the political and institutional framework within which the buffer decisions will be taken Whilst following the general principles issued by BCBS there will be a significant room for judgement As this is no pure science, the decision may be influenced by political factors
potentially leading to a late activation of the buffer for fear of stalling the economy accounting for the fact that the measure is not sufficiently differentiated and may harm particular economic sectors in the country

The "level playing field" is assured as the buffer applies to domestic and foreign based lenders depending on the assets domiciled in the affected country

24

Historical performance of the guidance

BCBS established a guidance for national authorities operating the countercyclical capital buffer in December 2010

25

Overlap with other measures

Other measures could be introduced with much more focus on areas of excessive growth Targeted measures for hot portfolios" could offer a better solution
Residential mortgages Legal limit of loan-to-value ratios at inception More prudent lending standards (e.g. focus on debt service capacity) Pillar 2 charges for riskier portfolios and to account for model risks that are not covered by a standard through-the-cycle approach Changes to the tax regime (deduction of interest paid on mortgages) Changes to other incentive systems encouraging high leverage in an economy ...

Caution has to be applied to ensure that such targeted measures are not coupled with a counter-cyclical buffer as this would lead to undesired overlaps

26

Capital planning
Capital planning is a long term strategic task under the responsibility of BoD

A three to twelve month grace period to build capital is not in line with practice Capital planning process requires a known and stable framework A rapid response to the introduction of a countercyclical buffer will potentially lead to a reduction of RWA in areas not actually targeted by the measure Side effect
Stalling of short term lending to SMEs Sale of good assets

27

Conclusion

Conclusion
Will the medicine applied work when needed? The common goal for all these measures
stabilise RWA whilst potentially increasing the base level through additional floors under A-IRB and Pillar 2 measures and provide for a cushion of capital to absorb high losses in crises through indirect capital conserved through changes in accounting rules the capital conservation buffer the countercyclical capital buffer

aims at supporting the stability of the banking system Could there be unintended consequences that make the system potentially vulnerable to increased cyclicality?
late activation of countercyclical buffers potentially coinciding with higher loan loss allowances and provisions for EL which are based on cyclical point-in-time estimations "non cyclical" parameters for RWA determination may be viewed as insufficient in a prolonged downturn with severe market dislocations investor and analysts' perception of the stability of banks at times of temporary breach of the minimum capital requirements in "normal times"
29