OSFI Basel II An overview of the IRB Credit Risk Approval Process and Using Credit Data Reporting as an Approval

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Presentation to the CSRSA Conference June 13, 2006 by Peter Cheung, Manager Basel Implementation Division, OSFI

Contents
‡ ‡ ‡ ‡ Overview of IRB Approval Process Key Supervisory Considerations Credit Data Reporting Overview Questions

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Contents  Overview of IRB Approval Process ‡ Key Supervisory Considerations ‡ Credit Data Reporting Overview ‡ Questions Page 2 .

2007 Page 3 . Formal Application date .Oct 31. 2005 Parallel run ± Nov 1.Nov 1. 2006 OSFI conditional approval of applications ± July 31. 2007 Accord Implementation .Basel II Implementation Milestones ‡ ‡ ‡ ‡ ‡ Basel Committee released the Revised Framework in May 2004 Quantitative Impact Analysis(QIS) completed IRB Gap analysis onsite reviews commenced in Jan 2004 on a quarterly basis OSFI Consultative Paper on the New Basel Framework issued in June 2004 OSFI Discussion papers on the following AIRB Guidelines were issued in July 2004: ± ± ± ± ± ± ± Approval of AIRB approaches Collateral Management Principles for AIRB Banks Data Maintenance at AIRB Banks The Use of Ratings and Estimates of Default and Loss at AIRB Banks Validating Risk Rating Systems at AIRB Banks Risk Quantification of IRB Systems at IRB Banks Corporate Governance and Oversight at IRB Banks ‡ ‡ ‡ ‡ ‡ AIRB Banks submitted draft Rollout plans in Dec 2004.

Formal application (Feb/06 to July/06) Phase 3 ± OSFI approval reviews (Aug/06 to July/07) Phase 4 ± Pillar 1 approval ( Aug/07 to Dec/07 or Feb/08) Phase 5 Ongoing monitoring (from Nov/07) We are currently at Phase 3 Page 4 .Approval Review Phases ‡ ‡ ‡ ‡ ‡ Phase 1.Monitoring of implementation efforts (Nov/04 to Jan/06) Phase 2 .

Key Approval Review Principles IRB Approval Review principles are consistent with the key principles of the OSFI Supervisory Framework: ‡ Approval is risk based ‡ ³Reliance based´ ‡ Approval is a µwork-in-progress¶ and will evolve ‡ No surprises ‡ Reviews are tailored to the institution ‡ The Basel II ³minimum requirements´ are the IRB entry requirement standard and OSFI Approval of IRB Approaches Implementation Note ‡ Capital impact assessment ‡ Effective cooperation with foreign-country supervisors Page 5 .

updates to extensions/waivers.Credit Risk Approval Review Process (April/06 to Dec/07) Approval reviews will consolidate the results from: ‡ ‡ Reviews of application packages and Self-assessment process Supervisory Activities Supervisory Activities: ‡ Gap Meetings and status updates ± ongoing activity. focused on implementation progress against rollout plans. timeliness & completeness ‡ ‡ Page 6 .verification of self-assessments ( in coordination with IA work). specific sampling using criteria/standards focused on Minimum Requirements & Implementation Notes Review & monitoring of data submissions for accuracy. changes to PMO & budgets RRS Specific Reviews (Examinations) . Microlevel.

Risk Quantification Capital Adequacy Assessment Use Test Waivers and Extensions Integrated Review Decision Page 7 . Internal Audit PMO RRS Design and Operations Data Management Validation.Approval Review Structure Approval Review Structure Self-Assessment Process Corporate Governance And Oversight.

Contents ‡ Overview of IRB Approval Process  Key Supervisory Considerations ‡ Credit Data Reporting Overview ‡ Questions Page 8 .

banks must show an implementation consistent with IRB ± Banks can use µpoint-in-time¶ measures for capital planning and µthrough-the-cycle¶ measures for IRB. viz. ± IRB processes should be integrated with overall risk management ± Banks should use the most appropriate measure for the purpose at hand.Use Test Considerations: Overview ‡ Three key use test areas to consider in the assessment of use test performance: ± Macro-use related to governance and oversight ± Performance track record and demonstration ± Micro-use related to internal loss estimates ‡ Domestic Use Test expectations are set out in OSFI¶s IRB Implementation Note ‡ Use Test is an entry condition for IRB approaches. however. but both measures should be consistent with a underlying common model Page 9 .

unconditional PDs ± Comparison (reconciliation?) of Economic and Regulatory Capital ‡ This is a key requirement for greater flexibility in strict µuse¶ ‡ Different estimates should be demonstrated as consistent ‡ Banks are responsible for making the case ± Performance Measurement ‡ Contract definition and incentive-compatibility Page 10 .Use Test Considerations: Individual Elements ‡ Use test is about understanding and demonstrating the internal pressures that affect the development of IRB estimates ± Systems and estimates should be developed for use outside of regulatory reporting ‡ There are a number of individual elements related to use test that could potentially be considered: ± Pricing ‡ The use and application of risk-based pricing ‡ Conditional vs.

Use Test Considerations: Individual Elements («continued) ‡ Individual elements related to use test« ± Role of IRB information in capital decision-making ‡ Information from IRB systems should play a key role ± Granularity of use in decision-making ‡ No prescribed approach ‡ The bank will need to make the case that use is effective ± Common data vs. parameters Page 11 . models. common measures ‡ Common data is a start ‡ Consistent ³vision´ of risk ‡ Risk measures should be consistent but different ± So-called ³capital optimization´ ‡ Use expectation of individuals and groups should be commensurate with their respective role and responsibility ‡ Other perspectives of use test ± Board and senior management oversight of IRB systems ± History of using processes.

and the estimation of all relevant risk components ± Internal validation processes should be designed to provide an EFFECTIVE CHALLENGE to the outputs of internal rating systems ‡ Risk quantification and validation remains a key implementation focus for banks and supervisors ± The Accord Implementation Group¶s Validation Sub-Group (³AIGV´) is a forum for supervisors to promote IRB validation (and implied risk quantification) discussion and information exchange Page 12 . LGD and EAD ± PD estimates must be a long-run average of 1-yr default rates ± LGD estimates must reflect economic downturn conditions ± EAD estimates must be a long-run default weighted average EAD ‡ Banks must have a robust system in place to validate the accuracy and consistency of rating systems.IRB Risk Quantification & Validation: Background ‡ Banks must meet the broad risk-quantification standards for own-estimates of PD. processes.

IRB Risk Quantification & Validation: Downturn considerations ‡ ‡ The Pillar 1 capital formula is driven by an assumption that defaults (and possibly severity of default) is driven by a (single) systematic factor Whether or not a bank accepts the Pillar 1 capital formula. where historical data does not incorporate stress years ± to demonstrate adherence of the capital planning process to the requirements set out in paragraphs 434-437 (³stress testing used in the assessment of capital adequacy´) ± to identify ³stress´ years in order to produce a downturn LGD ± to explain differences between realised outcomes and estimates (validation requirements) Downturn LGD estimates ± some questions to consider: ± Where is this applicable? ± What are the drivers of downturn (where applicable)? ± What are the plausible ranges of drivers that are applicable to downturn and why? Page 13 ‡ . it must develop a view on the influence of systematic factors ± to show that ³long run averages´ really represent the long-run ± to demonstrate conservatism.

However.. much work remains before (and after!) the start date of Basel II ± Basel II won¶t disappear as Y2K did ± Greater comfort and use over time ± Ongoing requirements after the start date of Basel II ‡ What might success look like overall? ± Pillar 1 processes (e.Implementation Considerations: Overarching Points ‡ The completion of Basel II implementation is largely within the grasp of banks. IRB) are seamlessly integrated with overall risk management ± A capital planning process that succeeds in ‡ predicting Pillar 1 requirements (and dynamics) ‡ understanding the interplay of Pillar 1 and Pillar 2 measures ‡ explaining Pillar 1 outcomes to market participants (Pillar 3) ± A flexible system that allows risk management to evolve and permits banks to answer new questions with old data Page 14 .g.

condition ranges. etc) ± Validation processes should create a µmosaic of evidence¶ by combining information from various sources (both quantitative and qualitative) ‡ The effective challenge principle permits a range of possible approaches to structuring this work ± Data limitations mean an increasing and necessary role for expert judgment (credit experts and µquants¶ are complements not substitutes!) Page 15 . condition ranges. the fundamental requirements of risk measurement and risk management often remain ‡ Risk Quantification and Validation (IRB) ± Risk measurement methodologies will need to be innovative in order to appropriately develop IRB estimates ‡ Long-run estimates (history. but not a sufficient condition ± Significant time and resources have been focused on technology and data maintenance solutions ± While important.Implementation Considerations: Some Issues ‡ Technology is a necessary. etc) ‡ Downturn LGDs (drivers.

Implementation Considerations: Some Issues («continued) ‡ Demonstrating a clear understanding of credit RWA dynamics ± Acceptance of IRB approaches will mean that a bank has adequately assessed the dynamic drivers of credit RWA ‡ How is regulatory capital expected to vary through the economic cycle? ‡ How does this dynamic process compare and contrast with that of a bank¶s internal. capital assessments? (Pillar 1/Pillar 2 interplay) ‡ How does stress testing help answer the above? ± Review and explanation of capital reporting requirements is key to managing expectations of different stakeholders ‡ Parallel reporting is the first real opportunity for a meaningful µdress-rehearsal¶ of systems and processes that support capital computation ‡ Analysis of results is essential to promoting greater comfort with the outputs of Pillar 1 approaches ± recognizing and relating changes/differences to risk ± comparing capital drivers over time (and to QIS) ± continued track record. post-implementation ± On going demonstration of compliance Page 16 .

Supervisory Activities: Self-Assessment and Approval Recommendation Review of Self-Assessment Packages Self-Assessment Process Review Technical/ RRS Specific Exam Reviews Conclusion on Self-Assessment Data Submission Quality Assessment Basel Readiness Assessment Status/ Gap Meetings Approval Recommendation Page 17 .

Contents ‡ ‡  ‡ Overview of IRB Approval Process Key Supervisory Considerations Credit Data Reporting Overview Questions Page 18 .

‡ ‡ Page 19 . Allowed flexibility in the data requirements during the parallel run period Also provided flexibility in reporting requirements for domestic and international subsidiaries for capital and credit risk data. resulted in revising the capital and credit risk data requirements.Background ‡ OSFI presently collects supervisory data from banks for the following: ± ± ± ± ± ± Financial Statements Credit Risk Market Risk Liquidity Capital Securitization ‡ Basel II requirements for approval and ongoing on-site work and monitoring.

Scope of Credit Risk Data Analytics ‡ ‡ ‡ ‡ ‡ ‡ Tool to compliment the established Approval process in IRB risk rating performance To assess the Financial Institution¶s credit risk profile To determine the need for specific reviews To enable peer comparison and relative benchmarking On-going monitoring to support credit risk assessment Use of early warning capabilities Page 20 .

Work to date . ‡ ‡ ‡ ‡ ‡ Page 21 . taxonomies and technical specifications to the CBA in October 2005. Developed a modified credit risk data call for Standardized banks Internal work efforts underway to develop analytic reporting capabilities using a business intelligence tool (COGNOS). Set up a OSFI support model to answer questions on the above.Credit risk data ‡ ‡ Developed the list of data requirements within OSFI Presented the data tables for Wholesale and Retail metrics to CBA and obtained agreement for the data call during 2005 Final data requirements for both wholesale and retail were substantially reduced from initial data ask based on industry comments Provided data definitions.

even if this is before the ultimate approval date Not Necessarily Internal Ratings Based Standardized / Immaterial ‡ Nothing submitted to OSFI beyond the requirements of the Capital Adequacy Report ‡ Financial Institutions are expected to submit management reporting that is sufficient to characterize the risk associated with these portfolios Credit Data Reporting Page 22 .. 2010 ‡ No impact on Capital Adequacy Report requirements ‡ Financial Institutions are expected to submit internal management reporting that is sufficient to characterize the risk associated with these portfolios ‡ Reports should generally reflect the types and dimensions of data presented in the data call documents ‡ Submission of the electronic data call is expected as soon as the systems are in place. Q2. Q3 and Q4 of 2007) of meaningful dress rehearsal Internal Ratings Based Transitional and To Be Approved Expected by Nov 1. 2007 ‡ Begin reporting Oct 31. Q1.e.Portfolios that intend to report on the IRB Approach. begin reporting Oct 31st 2006 Portfolio Approach Internal Ratings Based Ready and Approved Expected by Nov 1. 2006 for 4 quarters (i.

CBA has received business and data definitions from OSFI. Back testing and Transition Matrices. These to be provided via CD or other electronic medium.Details of the credit risk data call ‡ Credit risk data is to be submitted via either of two means: ± Electronic flat file structure to be submitted via Automated Data Transmission facility ± A standardized Excel template has been created for some Economic Capital. These documents are also available on the OSFI website. ‡ Page 23 . ‡ Initial focus is on the Deposit Taking Institutions adopting the Advanced Internal Ratings Based Approach although similar deliverables have been created for those that have adopted the Standardized Approach.

osfi-bsif.ca OSFI Website: www.Basel II Credit Data Support: Submission of Inquiries Please submit all inquiries regarding credit data to this address using the proposed structure (see appendix): CreditDataSupport@osfi-bsif.gc.gc.ca Page 24 .

Appendix: Basel II Credit Data Support . Page 25 . Background: ‡ Sufficient background information that supports the inquiry.Proposed Structure for Inquiries To expedite inquiries. Proposal: ‡ A suggested or proposed response or solution that the institution has considered in relation to the inquiry submitted. please provide: Full Document Title Document Page Number and Section number (if applicable) Document Schedule Number/Reference (if applicable) Inquiry: ‡ A concise summary of the question. please ensure that the following items are covered in each question submitted: Inquiry References: ‡ For any Business or Technical inquiry.

QUESTIONS? .

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