A Redu%E7%E3o de Prociclicidade e o Incentivo a Buffers Anticiclicos - URS Bluemli

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Basel III:

Reducing procyclicality and promoting

countercyclical buffers

Urs D. Bluemli

Firm-wide Risk Control & Methodology

22 October 2012


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Introduction

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

Key objectives

dampen any excess cyclicality of the minimum capital requirement;

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promote more forward looking provisions;

conserve capital to build buffers at individual banks and the banking sector that can beused in stress; and

achieve the broader macroprudential goal of protecting the banking sector from periods

of excess credit growth.


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Cyclicality of the minimum requirement


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Volatility of RWA

Design of Basel II contained safeguards to avoid undesired RWA volatility over time

Use of long term data horizons for PD estimation

Downturn LGD

Risk sensitivity is a key feature of Basel II (A-IRB) How much is desired?

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

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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 theface of a potentially fundamental change in an economy?


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"Through-the-cycle" parameter estimation

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

Availability and significance of data

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Portfolio composition

Changes to credit policy and underwriting standards

New developments in core markets

Penetration of new markets


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"Through-the-cycle" parameter estimation

Backtesting of model performance is difficult

Relatively little rating migrations year-on-year

observed defaults in any year

Role of downturn LGD

Structural changes may be missed

Increasing judgemental overlays andinterpretations

Less proof of accurate risk measures

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

Day-to-day risk management and pricing decisions must be based on a shorter-termview (point-in-time)

Many banks may have used a Whilst the average observed defaults remain

rather stable over time, cyclical movements

hybrid system (t-t-c and p-i-t) often a clear differentiation

between the two concepts isdifficult

Managing loan portfolios often with a short to mediumterm maturity cannot be

based on averages

may be considerable

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If "non cyclical" parametersand regulatory "floors" become

more relevant banks will haveto promote a parallel systemfor risk management purposes


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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

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 evenmore difficult

The introduction of the "leverage ratio" will already provide a floor for low risk portfolios

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ny c arge or uncer a n es n e es ma on s ou pre era y e par o e an

specific Pillar 2 assessment


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Forward looking provisioning


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"Too little too late"

This broad criticism should be considered in more detail

During the financial crisis criticism was heard (G-20, FSB, BCBS) that banks did notonly increase their provisions late in the cycle, but were also slow in changing theirestimations of future losses

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 loansaccounted 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

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much to the challenge of estimating future loan losses in an accrual book


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"Too much too early?"

The creation of "buffers" should arguably be required through capital

The perceived (regulatory?) preference of creating reserves "in good times" caneasily lead to a prudent build-up of "buffers", which distort the true and fair valueparadigm

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 alreadyreflected 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, therealisation will depend on many factors and carry significant uncertainties that will

dominate the outcome

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in a downturn pessimistic views may become more pronounced


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IASB and FASB response

Discussions concerning a review of the accounting rules started late in 2009

The accounting standards boards were asked to revise the rules for impairmentrecognition and to harmonise them

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 su ort b re arers, investors

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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


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Estimating expected loss

Banks a l in the Standardised A roach due to lack of modellin ca abilit will have

Whatever the final changes to the accounting rules will be, the fundamental issueof having to estimate future expected losses on (parts of) the portfolio will be a

critical feature

to use models to estimate EL for accounting purposes with differing degree ofcomplexity

Banks under A-IRB will have to adapt their predominantly through-the-cycle calibrationmethod

All banks will have to expand the outlook period from one year to multiple years or thelifetime of a portfolio

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Forward looking estimation

Short term outlook

Most reliable forecasts for economic conditions

Use indicators that we would also use toda for collective loan loss rovisions etc.

A combination of approaches may yield the best results

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 lossescan be established

Use some judgement where models cannot be used to link loss performance to the businessplan (base case)

Longer term

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-

Combination of input

Forecast central tendency of expected loss for the segment by aligning the results from the threeinitial steps to create a time series of estimations covering the full lifetime of the asset / durationof the portfolio


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Forecasting expected loss over a planning horizon

Set of scenarios

Focus on various triggers which may have an effect

Critical input: Macro-economic scenarios

auses: cyc ca sw ngs n t e economy, expecte mpact o geo- po t ca events etc.

Possible effect: deterioration (recession, deflation/depression, stagflation) or improvement inthe macro-economic situation

Translation of descriptive effects of a given economic condition into changes to keymacro-economic indicators

GDP, interest rates, fx movements ...

covering all major economies

and ideally linked to the business plan

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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


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Example: Approach for credit risk PDs

STEP 1

Sensitivities

STEP 2

Application toPlan Scenario

STEP 3

Determination ofExpected Central

Tendency of Default

Statistical analysis ofdefault indicators

Aggregate forecasts fordefault indicators for planscenario

Link to the actual portfolio: Translation into default rates

Break down to single names

Define stressed PDs/Default rates foreach individual counterparty

Default

)30( mT )63( mmT )96( mmT )19( ymT )5.11( yyT )25.1( yyT

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Estimations of dependencies of defaultindicators on macro-economic variablesper region/industry cluster, e.g. GDPgrowth decrease by x%

default rate increase by y%

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10d 3m

OriginalPD

9m 1y 1.5y time6m 2y

Stressed defaultrate

(annualized)

0

5

10

1996q1

1997q1

1998q1

1999q1

2000q1

2001q1

2002q1

2003q1

2004q1

2005q1

2006q1

2007q1

2008q1

2009q1

2010q1

2011q1

time

Defaultindicator:

observed,

fitted

,

inclusivebandwidths


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Capital conservation


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Flexibility of minimum capital requirements

The conservation buffer aims atmanaging capital shortfalls due to

The minimum requirements contain a capital buffer for managing shortfalls underthe minimum required in "normal times"

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

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Protection from excess credit growth


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Temporarily increased capital requirements

The countercyclical buffer applies whensystem-wide risk is increased

Adjustment of the capital buffer range in periods of high credit growth aims atleading to higher capital levels once the tide turns

Protection not only of individual banks butalso the entire financial system

Rebuilding capital levels

Reduced earnings distribution

Prevention of share buy-backs

Restrictions on staff bonus payments

Up to 2.5% of additional capital

phased introduction from 2016 to end 2018

Application on an infrequent basis Basic measures to determine times of

"excessive credit growth"

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Other country-specific variables Consistency with other observables, e.g.

asset prices

funding and CDS spreads

real GDP growth


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A critical review of several aspects

Effectiveness,Precision

Activation and De-activtion

G20CountercyclicalBuffer

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Overlap with otherpotential measures

Capital Planning


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Effectiveness

Higher capital requirements apply to the stock and not to the risky flow

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

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)

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Activation and de-activation

Timing will be critical

Activation

c va on w no s mp y e mo e ase cre o ra o

Judgement and room for discretion by governments / regulators

Late activation will turn the instrument into a pro-cyclical measure as it may coincide withalready higher loan losses

De-activation

Timing of de-activation may be delayed beyond the trough of the cycle

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ower cap ta requ rements at ust a ter t e pea o a cr s s may not conv nce ana ysts

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 analystsmay compare throughout the years RWA against CET capital ratios


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Activation and de-activation

National buffer decisions

Countries have to assess the political and institutional framework within which the bufferdecisions will be taken

Whilst following the general principles issued by BCBS there will be a significant roomfor 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 particulareconomic sectors in the country

The "level la in field" is assured as the buffer a lies to domestic and forei n based

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lenders depending on the assets domiciled in the affected country


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Historical performance of the guidance

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

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Overlap with other measures

Other measures could be introduced with much more focus on areas of excessivegrowth

Targeted measures for hot portfolios" could offer a better solution

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 astandard 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

...

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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


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Capital planning

A three to twelve month grace period to build capital is not in line with practice

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

Capital planning process requires a known and stable framework

A rapid response to the introduction of a countercyclical buffer will potentially lead to areduction of RWA in areas not actually targeted by the measure

Side effect

Stalling of short term lending to SMEs

Sale of good assets

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Conclusion


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The common goal for all these measures

stabilise RWA whilst potentially increasing the base level through additional floors under A-IRBand Pillar 2 measures

Will the medicine applied work when needed?

Conclusion

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 toincreased cyclicality?

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a e ac va on o coun ercyc ca u ers

potentially coinciding with higher loan loss allowances and provisions for EL which are basedon cyclical point-in-time estimations

"non cyclical" parameters for RWA determination may be viewed as insufficient in a prolongeddownturn with severe market dislocations

investor and analysts' perception of the stability of banks at times of temporary breach of theminimum capital requirements in "normal times"

A Redu%E7%E3o de Prociclicidade e o Incentivo a Buffers Anticiclicos - URS Bluemli

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