Capital Adequacy Framework - Rev.1 English 27-02-09 · Bank’s capital adequacy framework and ......

AFRICAN DEVELOPMENT BANK AFRICAN DEVELOPMENT FUND ADB/BD/WP/2009/10/Rev.1 ADF/BD/WP/2009/09/Rev.1 2 March 2009 Prepared by: FFMA/FFCO Original: English/French

Probable Date of Board Presentation : 18th March 2009

FOR CONSIDERATION

MEMORANDUM TO : THE BOARDS OF DIRECTORS FROM : Kordjé BEDOUMRA Secretary General SUBJECT : CAPITAL ADEQUACY FRAMEWORK AND EXPOSURE MANAGEMENT

POLICY REVISED VERSION * Please find attached, the revised version of the above‐mentioned document, following the joint AUFI/CODE meeting of January 29th 2009. This version incorporates changes related to comments and feedback received from Board members as well as complementary information requested on the implementation cost and timeline of the capital adequacy framework. Attach. Cc : The President

*Questions on this document should be referred to:

Mrs. K. M. DIALLO Director FFMA Ext. 2147 Mr. C. BOAMAH Director FFCO Ext. 2026 Mr. P. VAN PETENGHEN Director FTRY Ext. 3631 Mr. J. BILE Advisor FNVP Ext. 2260 Mr. P.KEI‐BOGUINARD Manager FFMA.1 Ext. 2136 Mr. M. KALIF Acting Manager FFMA.2 Ext. 2217 Mr. T. DE KOCK Manager FFMA.3 Ext. 2138 Mrs. C. AKINTOMIDE Manager GECL.1 Ext. 2101 Mrs. M. AKIN‐OLUGBADE Manager FTRY4 Ext. 2453

SCCD:N.A.

AFRICAN DEVELOPMENT BANK

CAPITAL ADEQUACY FRAMEWORK AND EXPOSURE MANAGEMENT POLICY

February 2009

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TABLE OF CONTENTS

ABBREVIATIONS.......................................................................................................................................3

I. INTRODUCTORY BACKGROUND ............................................................................................................5

II. RATIONALE FOR THE REVISION OF THE CAPITAL ADEQUACY FRAMEWORK ......................................6

2.1 RISK BASED CAPITAL ALLOCATION AND CAPITAL UTILIZATION LIMIT .....................................................................6 2.2 PRUDENTIAL EXPOSURE LIMITS .......................................................................................................................8 2.3 OTHER RELATED POLICIES RELATED TO THE FRAMEWORK....................................................................................9 2.4 REVIEW PROCESS.......................................................................................................................................11 2.5 PHASED APPROACH, DYNAMIC AND CONTINUOUS REVIEW ................................................................................11

III. THE PROPOSED REVISED FRAMEWORK .............................................................................................12

3.1 KEY PILLARS OF THE POLICY FRAMEWORK ......................................................................................................12 3.2 METHODOLOGY FOR INTEGRATED CAPITAL ADEQUACY FRAMEWORK ..................................................................12 3.3 PRUDENTIAL EXPOSURE LIMITS.....................................................................................................................17 3.4 IMPLICATIONS FOR OTHER RELATED FINANCIAL POLICIES..................................................................................19

IV IMPLICATIONS OF THE PROPOSED ENHANCEMENTS ..........................................................................20

4.1 IMPLICATION FOR THE RISK CAPITAL UTILIZATION RATE....................................................................................20 4.2 IMPLICATION FOR THE PRUDENTIAL LIMITS .....................................................................................................21 4.3 IMPLICATIONS FOR THE BANK’S LONG TERM FINANCIAL CAPACITY .....................................................................23

V IMPLEMENTATION IMPLICATIONS OF THE PROPOSED FRAMEWORK ..................................................23

5.1 REVISION OF THE SOVEREIGN AND NON‐SOVEREIGN RISK MANAGEMENT GUIDELINES ..........................................24 5.2 ESTABLISHMENT OF COLLATERAL MANAGEMENT FRAMEWORK .........................................................................24 5.3 ENHANCED EXPOSURE MONITORING ............................................................................................................24 5.4 DEVOLUTION OF EXPOSURE MANAGEMENT RESPONSIBILITY TO TASK MANAGERS.................................................24 5.5 RISK OVERSIGHT AND GOVERNANCE .............................................................................................................25 5.6 RESOURCE REQUIREMENTS AND TIMELINE TO IMPLEMENT THE PROPOSED CAPITAL ADEQUACY FRAMEWORK.............25

VI CONCLUSION AND RECOMMENDATIONS...........................................................................................25

ANNEXES

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ABBREVIATIONS

1. AfDB African Development Bank

2. ADB Asian Development Bank

3. IRB Internal Ratings Based Approach

4. ALCO Assets and Liabilities Committee

5. EBRD European Bank of Reconstruction and Development

6. IADB Inter‐American Development Bank

7. IBRD International Bank of Reconstruction and Development

8. IFC International Finance Corporation

9. MDB Multilateral Development Bank

10. MTS Medium Term Strategy

11. RMCs Regional Member Countries

12. OPSM Operations Private Sector Management

13. ORVP Operations Regional Vice‐Presidency

14. PD Probability of Default

15. LGD Loss Given Default

16. MSP Maximum Sustainable Limit

17. RCUR Risk Capital Utilization Rate

18. IFI International Financial Institution

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EXECUTIVE SUMMARY

Over the past decade, the African Development Bank (“the Bank”) through a combination of prudent lending policies, risk management practices, stringent expense controls and steady additions to reserves has consolidated its financial position. The consolidation of the Bank’s financials has been accompanied by a steady decline in its development‐related exposures (loans and equity participations) primarily due to significant prepayments. The combination of these factors also resulted in a steady decline in the Risk Capital Utilization Rate (RCUR)1. The relatively low level of RCUR has triggered a debate amongst key stakeholders of the Bank regarding the optimum use of its risk capital to fulfil its development mandate. Management therefore directed that a review of the Bank’s Capital Adequacy Framework be undertaken. This proposal has been prepared in response to that request.

The objective of this document is therefore to seek Board’s approval for the proposed enhancement in the Bank’s capital adequacy framework and its related policies, which have been discussed at the Joint AUFI/CODE meeting of January 29, 2009.

Management’s proposal derives from a series of independent reviews, technical notes, briefings and papers presented to the Board between March and November 2008 on potential revisions and enhancements to the Bank’s methodologies for capital adequacy and other financial policies. It factors in comments and feedback received from some Board members during bilateral meetings and the joint AUFI/CODE meeting.

The proposed risk management framework which uses Basel II Internal Rating Based (IRB) approach as a reference, is based on three key pillars, namely: (i) the development of a transparent and flexible methodology and the determination of minimum capital requirements for each risk asset in the Bank’s portfolio; (ii) The establishment of prudential exposure limits for country, private sector operations and equity investments to minimize potential losses and ensure efficient monitoring of the risks assumed by the Bank; and (iii) The implementation of sound risk management governance to enhance transparency in the Bank’s internal assessment process to comply with best banking practices.

Overall it is proposed that the Bank adopts: (i) Basel II risk based methodology which differentiates risk charges between sovereign and non‐sovereign operations to better match the Bank’s risk profile and covers all risks involved in the Bank’s operations; (ii) the strategic prudential limits for non sovereign‐operation and equity limit be adjusted to 40% and 15% of the total risk capital of the Bank, respectively to reflect the Medium Term Strategy and the global country concentration limits to be directly linked to the Bank’s risk capital ; and (iii) the Bank maintain a single debt limit which caps the total outstanding debt to 100% of the usable capital.

Management also recommends that the capital adequacy and related policies should be reviewed periodically in line with best practices and the review processes of other MDBs. It is important to note that all parties involved in the review of management proposal (risk advisory services, rating agencies, peer group reviewers) consider the proposed approach prudent given the migration in the medium term towards a riskier portfolio.

An assessment of the implication of this enhanced capital adequacy framework indicates that the Bank currently has sufficient financial capacity for an upward adjustment of its prudential limits in order to play

1 Risk Capital Utilization Rate (RCUR) is the capital adequacy metric. It is calculated as the ratio of total risk capital used to back up risk assets and shareholders equity (reserves + paid in capital). RCUR was 75% in 2000 and declined to 45% in December 2007

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the required catalytic role for private sector development and thereby be relevant to all RMCs through increasing its development credits. However, it must be underscore that potential sharp deterioration in the credit quality of the portfolio as result of aggressive lending above the lending scenario of the MTS will put pressure on the Bank’s risk bearing capacity. In recognition of this fact an Institutional tolerance for risk is embodied in the proposed enhancement of the Bank’s capital adequacy and related policies. This seeks to maintain a prudent risk profile consistent with the Bank’s highest credit rating and adequate risk governance.

I. INTRODUCTORY BACKGROUND

From end March to early May 2008 the Board examined through a series of informal meetings the two independent reviews of the Bank’s Capital Adequacy Framework and Management responses to these reviews. There was a broad consensus on the need for a revised capital adequacy policy based on the proposed two‐tier risk based methodology indicated in the document2.

This proposal is developed in response to the commitment made by Management. It follows the technical note3 presented to the Board in September 2008 and the resulting questions and answers briefing note on potential revisions and enhancements to the Bank’s methodologies for capital adequacy and other financial policies.

The Board at its meeting of September 2008 requested Management to work with AUFI/CODE to develop a final enhanced framework for subsequent Board consideration. Due to the technical complexity of capital adequacy issues and the need to have an objective external assessment, Risk Analytics and Advisory services firms were engaged to review Management’s proposal. The revised proposal was subsequently presented to AUFI/CODE and examined on January 29, 2009.

This paper builds on these series of enhancement reviews as well as feed back from AUFI/CODE members.

The proposal uses the Basel II IRB (Internal Ratings Based) approach as reference in line with current industry best practices and for the sake of transparency and simplicity. It advocates for a flexible, gradual and phased approach, avoiding the setting of hard rules that may be difficult to reverse in the future.

The Bank’s overall capital adequacy and exposure management policy proposal consists of: (i) a risk based methodology to determine risk capital charges to support the Bank’s operations, (ii) a policy on capital adequacy that caps the total capital utilisation (iii) associated policies on prudential exposure limits, pricing and leverage, and (iv) risk governance and infrastructure to enhance transparency.

This document consists of six sections focusing on the 3 pillars of the enhanced framework. After the introductory and background section, the second section reviews the Bank’s Current Capital Adequacy Framework with focus on the limitations and rationale for changes. The third section presents Management’s proposal for enhancement. The fourth section examines the Risk Management implications for other related financial policies. The fifth section focuses on key implementation pre‐requisites. Finally, the sixth section presents the conclusions and recommendations. A set of key annexes are also provided as references.

2 Management response to the Independent Review of the Bank’s Capital Adequacy ADB/BD/IF/2008/86 3 Technical note on the Capital Adequacy Framework – ADB/BD/IF/2008/196

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II. RATIONALE FOR THE REVISION OF THE CAPITAL ADEQUACY FRAMEWORK

The current framework developed in 20004 has served the Bank well. While it has achieved the desired results in terms of providing an adequate risk and exposure management framework to the Bank changing operating environment and rapid developments in the financial markets, growing complexity of the Bank’s development credit and treasury operations (introduction of new products, more complex financial transactions) have called for its enhancement.

The enhancement review is grounded on the following factors: (i) the current framework is based on externally benchmarked and static risk parameters which do not fully reflect the Bank’s current risk profile; (ii) there have been several developments in the Bank’s operations recently with the approval of both the Private Sector Strategy and the Medium Term Strategy; (iii) stakeholders are calling for a better utilisation of the Bank’s risk capital ; and (iv) the need for the Bank to be relevant to all RMCs as per its mandate viz. its current credit policy limiting access to its ordinary capital resources to only 13 countries. Moreover, in an environment of market turmoil, heightened uncertainty and increased volatility, the capital adequacy policy needs to be reinforced, henceforth the development of a more robust and resilient framework.

2.1 Risk Based Capital Allocation and Capital Utilization Limit

2.1.1 The current methodological Framework

The fundamental purpose of Bank’s capital adequacy framework is to ensure a prudential balance between the risks assumed and its risk‐bearing capacity. The Bank’s risk bearing capacity is judged in terms of the adequacy of its equity capital (i.e. available paid‐in capital plus reserves, also called risk capital) to absorb its balance sheet risks and continue to support normal lending operations. By enabling it to absorb risk out of its own resources, the Bank risk capital protects its shareholders by minimizing the probability of call on capital. In the current framework the risk capital utilisation rate (RCUR) is defined as the ratio of total used risk capital over total usable risk capital (RCUR). The capital adequacy policy limits the (RCUR) to 100% of risk bearing capacity with an alert which is triggered when the used risk capital level reaches 80% of the total risk bearing capacity.

To determine the risks assumed, the Bank categorizes all its assets (loans, equity investments, guarantees, and treasury operations) into risk buckets/classes and assigns a “risk capital charge” to each asset based on the credit quality of the asset(i.e. its rating). The amount of risk capital required to support the overall portfolio of assets is estimated as the simple sum of the risk capital requirements of the individual assets.

As illustrated by figure 1, the Bank’s internal rating system classifies all Bank assets into five risk classes (Very Low Risk, Low Risk, Moderate Risk, High Risk and Very High Risk) which correspond approximately to the international rating system (AAA to BBB‐, BB+ to BB‐, B+ to B‐, CCC+ to CCC‐, below CC+) respectively. The risk capital requirement (kc) ranges from 25%5 for assets in the very low risk class to 75% for assets in the very high risk category. The risk capital requirement for equity investment is 100% and 1% for Treasury assets.

4 Policy on Capital Adequacy and Exposure Management – ADB/BD/WP/2000/29 5 A capital charge of 25% for very low class asset mean that the Bank sets aside 25 cent for 1 UA of credit committed in that rating class.

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2.1.2 Limitation of the current framework and Rationale for changes

The risk capital charges indicated above are benchmarks that were developed mainly through comparative assessment with other International Financial Institutions (IFIs) at a time when the Bank had limited history on the default probabilities of its sovereign and non‐sovereign borrowers. In the absence of default probabilities, the risk capital charges were conservatively set to factor in the Bank’s high risk operating environment.

There are structural weaknesses and several operational constraints inherent in the current framework that are briefly summarised below:

Limited coverage of risks ‐ The focus is primarily on credit risk related to the Bank’s lending operations and treasury counterparties with minimum consideration for market related risks (i.e. risks arising from the balance sheet structure, equity and quasi equity investments, risk management products). Even for credit risk it has a broad‐brush approach that excludes the un‐drawn commitments (i.e. un‐disbursed loans balances). Operational risk is also not covered.

Static risk parameters – The risk capital charges indicated above are static benchmarks that do not factor risks related to longer tenors, general liquidity and credit squeezes in the market. They tend to result in mis‐pricing of credit risk over time.

Lack of risk differentiation – The risk charges do not make a differentiation between sovereign and non‐sovereign operations, as well as between listed and unlisted equity investments. They imply that sovereign states and corporate borrowers have equal risk weight i.e. one‐size fits all. Also capital charges are set at the same level regardless of the maturity of the credit exposure, while in reality default risk is greater with a longer exposure. Furthermore, they do not provide built in flexibility to Management to support new products’ development based on their inherent risk profile as the portfolio grows.

No scope for credit enhancements ‐ No recognition of credit risk mitigants, which encourage capital arbitration through structured transactions, is another inherent constraint. For private sector operations the current framework does not take into account the seniority of loans as well as the strength of the

Total Used

Risk Capital

All Assets

High Risk

Very High Risk

Low Risk

Very Low Risk

Total Usable

Risk Capital

Unused Risk Capital

Risk Capital

Required

Figure 1: Risk Capital Requirements

Moderate Risk

25%

28%

35%

50%

75%

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collateral; in the same vein it does not factor the preferred creditor status in sovereign operations. Moreover, with the Bank’s lending operations leaning more towards the emergence of new lending instruments (syndication, local currency lending, etc.) the current risk charges may no longer reflect the true risk profile of the portfolio.

Conservative bias ‐ Finally, some stakeholders have expressed concerns that risk charges are too conservative, particularly for the lowest risk class 1 (sovereign investment grade borrowers) that historically have never defaulted on their payments to multilateral creditors. This view that: ”there has never been a default and/or practically a zero write‐off of sovereign loans on sovereigns rated investment grade (BBB‐ and above) within five to seven year period of being rated at that level” was confirmed by the independent reviews of the Bank’s capital adequacy framework.

In the light of the above limitations and given the general view that there is a conservative bias in the Bank’s current methodology for determining risk capital charges for sovereign operations, a review of the current methodology was recommended. However, in refining the methodology and risk parameters, efforts are concentrated in areas where the incremental value is the highest and new measures are cost effective in terms of implementation.

2.2 Prudential exposure limits

The Bank’s exposure management strategy seeks to achieve adequate portfolio diversification by applying a framework of simple exposure limits. These exposure limits are linked to the Bank’s risk‐bearing capacity and the pace at which the limits are consumed depends on the riskiness of the Bank’s assets. There are divided into two broad categories: (i) strategic limits and (ii) operational or ancillary limits.

The Bank’s strategic exposure limits are described below:

− Equity Exposure Limit – The aggregate risk capital required to support all equity investments combined must not exceed 10% of the Bank’s total risk capital. This limit is in line with Article 15.4 (a)6

− Non‐Sovereign Exposure Limit – The aggregate amount of risk capital required to support the Bank’s non‐sovereign portfolio must not exceed 20% of the Bank’s total risk capital.

− Global Country Exposure Limit – The aggregate amount of the Bank’s combined sovereign and non‐sovereign exposure to any given country should not exceed 15% of the maximum sustainable portfolio. This maximum portfolio is the sustainable level of lending in terms of: (i) outstanding portfolio supported by used risk capital, plus (ii) the new commitments that could be generated by the unused risk capital.

The operational limits are defined in terms of:

− Non‐Sovereign Single Country Exposure Limit – The aggregate risk capital required to support all non‐sovereign operations in any single country must not exceed 20% of the non‐sovereign exposure limit.

− Non‐Sovereign Single Sector Exposure Limit – The aggregate risk capital required to support all non‐sovereign operations in any single sector must not exceed 35% for the financial sector and 25% for other sectors of the non‐sovereign exposure limit.

6 Board Document ADB/BD/WP/99/46/Rev.4/Add.2 related to Article 15(4) of the Bank’s agreement (limitations on Operations: Equity Investments). Resolution B/BG/2001/09.

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− Non‐Sovereign Single Obligor Exposure Limit – The aggregate risk capital required to support all non‐sovereign operations with any single obligor or group of related obligors must not exceed 4% of the non‐sovereign exposure limit.

The major issue associated with these limits is that they have been instituted at time when the Bank’s portfolio was marked with a steady growth profile dominated by sovereign operations, and with a limited experience in private sectors operations and complex treasury activities. Since then the Bank portfolio risk profile has shown a significant shift in line with a current economic environment which is quite different from what was prevailing in the early 2000s. Furthermore, with the current financial crisis an increasing number of MICs realized the importance of having access to a stable long term funding source to finance their social and economic development. The international capital market can no longer provide such funds at cheap cost. This results in more pressure from stakeholders to increase lending to creditworthy borrowers. Responding to this business imperative within the framework of the current limits becomes challenging.

More importantly, the current limits are no longer consistent with the Bank’s Medium Term Strategy and shareholders’ expectations.

Notwithstanding the above, the concentration and exposure limits review should factor in the need for a capital buffer to support a sustained growth without jeopardizing the Bank’s triple AAA rating.

2.3 Other Related Policies related to the framework

In addition to the Risk Capital Utilization Rate, the Bank uses other policy metrics to monitor its capital adequacy. These include leverage and gearing ratios all linked to the Bank’s risk bearing capacity.

2.3.1 Leverage policy

The leverage policy governs the total volume of borrowed funds that can be mobilized by limiting the Bank’s debt to its risk bearing capital and callable capital. By doing so it establishes the maximum size of the total liabilities for a given level of risk bearing capacity. The Bank manages its leverage through three key debt ratios presented below. By linking the debt level to Capital, these ratios provide comfort to bondholders and recognize callable capital as the “last‐resort” resource for debt repayment in the unlikely event of the Bank’s being unable to face its financial obligations.

These ratios have been the subject of extensive internal review by ALCO sub‐committees, and external review by risk advisory services and rating agencies and were endorsed by ALCO with the following conclusions:

− Leverage Ratio 1‐ which specifies that total debt shall not exceed 80% of Total Callable Capital introduces an arbitrary haircut of 20% on callable capital which has no justification.

− Leverage Ratio 2 ‐ which requires that total senior debt, shall not exceed 80% of the callable capital of non‐borrowing member countries. This ratio is no longer relevant because the Bank no longer issues subordinated debt.

− Leverage Ratio 3 ‐ which stipulates that total debt, shall not exceed 100% of Usable capital.

Also, further to the independent reviews of the Bank’s capitalization level, ALCO requested an investigation of whether the total debt to usable capital ratio (Ratio 3) should not introduce the concept of Net Debt.

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The Net Debt concept takes into account debt raised to finance Development Related Exposures, while debt raised to fund liquid investment securities (rated above AA‐) is excluded.

DEBT – LIQUID INVESTMENT (for securities rated above AA‐) Net Debt =

Usable Capital (for shareholders rated at or above AA) < 100%

Preliminary consultations with rating agencies indicate that most of the agencies do not have any objection with the implementation of the net debt to usable capital ratio as the Bank’s key borrowing limit. However, there were differing views amongst sister institutions and risk advisory services on the proposal, articulated around its strengths and weaknesses, more importantly, this ratio can result in an increase in the Bank’s debt level with no policy limit when the additional debt contracted is invested in liquid assets. In a volatile market environment, the assumption of liquidity of highly rated assets is questionable.

Reducing the Bank debt ratio to a net debt ratio will not resolve the leverage constraint linked to its medium term business strategy. It might only provide some headroom which will not postpone the leverage constraint problem and thereby the ability of the Bank to response to clients’ demands as result of the financial crisis.

2.3.2 Gearing Policy

Unlike the risk capital utilization rate, the Bank’s gearing policy links its outstanding commitments to the total capital and reserves (including the callable capital) as stipulated in article 15.(1) of the Agreement Establishing the Bank. In other words, loan amounts committed plus equity investments and guarantees should not exceed the unimpaired subscribed capital plus surplus and reserves.

The gearing policy is less restrictive and the ratio stood at 38.1% as at end of December 20087. The projections based on the MTS lending growth scenario and the average portfolio risk profile indicate that the limit will be reached around year 2015.

2.3.3 Loan Loss Reserve and Pricing Policies

Like all other financial institutions, extending credits carries some degree of losses that are an inevitable part of the business: expected losses. There is also a non‐negligible probability of large losses well beyond the expected losses, although the probability is very low: unexpected losses. It is for these large but low‐probability unexpected losses that financial institutions hold risk capital. Expected loss “risk of doing business” is covered by provisioning and pricing (i.e. the minimum lending margin required to break‐even).

Prior to the revision of the relevant International Accounting Standards in 2005, the Bank made both specific and general provisions on its loans. Loan loss provisions were then based on expected losses and restricted to only loan principal. Income was also not accrued on non‐performing loans. With effect from 2005, and in response to the revisions of IAS 39, the Bank now determines impairment on loans using the incurred loss approach. The amount of impairment determined on the basis of such approach is charged against the income statement. Cumulative amounts of impairment are deducted from the loan balances on the balance sheet. Under Basel II, loans are considered to be impaired when 90 days past due. The new capital adequacy framework will adopt and apply the IFRS impairment principles in line with the Bank’s financial regulations and accounting policies.

7 Based on the 2008 un‐audited financial statements.

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With respect to pricing, within the 2000 capital adequacy framework, the Bank approved a flexible, cost‐recovery pricing policy based on a sister institution’s framework for private sector operations dating back to 1998. As the Bank’s portfolio risk profile, instruments and operating markets are quite different from the one experienced at that time the pricing framework is due for revision.

2.4 Review Process

The Bank has followed a thorough and rigorous five‐step process to develop the proposed new capital adequacy framework. The first step involved consultations with the Multilateral Development Banks to complete a peer review and benchmarking exercise. The second step consisted of an independent review of the Bank’s Capital Adequacy Framework by two reputable international financial institutions. These two institutions were asked to provide an independent assessment of the appropriate level of the Bank’s capital, taking into account its anticipated operations expansion, in particular the non‐sovereign lending. The independent assessment of the capital adequacy framework has culminated in a recommendation for a revised capital adequacy framework. The third step involved discussions of Management proposals with rating agencies. In this respect, the proposed methodology and resulting risk capital charges were discussed with international rating agencies to ensure that the changes do not jeopardize the Bank’s financial soundness and integrity as measured by its Triple‐A rating. They have also provided feedback on the revision of prudential limits as summarised in Annex 2. The fourth step involved consultations with the Asset and Liability Committee “ALCO” working groups that have specialized expertise across the Bank’s complexes. The resulting technical note was discussed by the Boards and supplemented by a questions and answers document. This was followed by an independent and comprehensive review of Management proposal by two risk advisory services. Final review was made subsequent to the discussion of the proposal by the Joint AUFI/CODE committee to factor Board members’ comments. This document completes the final step of the five‐step review process and is submitted to the Board of Directors for approval.

2.5 Phased approach, dynamic and continuous review

• From external benchmarking to Basel II and Economic Capital Allocation

The initial capital adequacy framework was based on benchmarking and peer group review. For the revised framework, a phased and gradual approach is proposed, focusing at the first stage on Basel II regulatory capital approach (Internal Rating Based approach‐Advanced) combined with stress testing. At a later stage, this approach will be complemented by an economic capital method. In this respect, it is worth indicating that our benchmarking review indicates that there are several approaches that offer conceptually sound solutions but they are difficult and costly to implement. Therefore a simple and technically more sound risk based‐approach using Basel as reference is more prudent at this stage.

• Periodic review for further enhancement

The proposed framework represents work in progress with respect to the phased approach. It will need to be continuously reviewed during the coming years as the Bank builds up its database of risk parameters related to the methodology. The proposed approach will be more dynamic as risk capital charges will be reviewed annually based on the characteristics of the Bank’s evolving portfolio. During the implementation of the framework, enhanced reporting systems will allow the Board and Management to track the impact of these changes. There is also a proposal to enhance the risk oversight function and to make this review process more flexible in the future.

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III. THE PROPOSED REVISED FRAMEWORK

The Bank’s stakeholders have several expectations that Management’s proposal relating to capital adequacy should be addressed diligently and prudently. However, this necessitates a flexible, gradual and phased approach as indicated above.

3.1 Key Pillars of the Policy Framework

The three essential pillars that will ensure an effective capital adequacy framework are the following: 1. A comprehensive methodology for integrated capital adequacy framework covering all

institutional risks with their commensurate risk capital charges. 2. The establishment of prudential exposure limits for country, private sector operations and equity

investments for an efficient management of the risks assumed by the Bank; and 3. The implementation of a sound risk management framework that integrates capital adequacy

with other related financial policies in line with best banking and risk management practices.

3.2 Methodology for integrated capital adequacy framework

An important component of a sound capital adequacy framework is a transparent methodology that measures risks accurately and allocates adequate capital to the risks assumed. However, it is important to note that there is no single standardised or universal methodology for determining the MDBs’ capital adequacy. Management is proposing a two‐tier risk based methodology:

Tier 1 ‐ Setting of risk capital charges – the methodology would be an enhancement of the existing model based on Basel II regulatory framework to ensure that risk capital charge allocation is transparent, simple to understand and implement.

Tier 2 ‐ Integrated risk‐adjusted system to support all segments of the business portfolio and all risks faced by the Bank (credit, market and operational risks).

3.2.1 Methodology underlying minimum capital requirements ‐ Key risk drivers

The Bank’s risk capital is available for supporting additional loan growth, transfers to development initiatives and waivers for adjusting public loan pricing. In such context, the Bank needs to monitor carefully the key risk drivers of capital utilization and ensure that capital charges reflect the evolving risk profile of the portfolios. In this respect, the new framework ought to be dynamic in order to tailor risk charges to the changing business risk profile for an optimal redeployment of risk capital. The new framework for risk capital allocation seeks to address these concerns of optimal redeployment of capital and those mentioned in the previous section. Instead of using static benchmarked risk capital charges, this methodology maps risk capital charges to the Bank’s portfolio risk profile based on: (i) historical Probability of Default (PD), (ii) Loss Given Default (LGD) and (iii) effective maturity (M) for each asset in the Bank’s portfolio. These are detailed out in Annex 1.

Probability of Default PD Loss Given Default LGD Exposure at Default EAD

Parameters

Risk Charges K Risk Metrics

Risk Capital Utilization Rate RCUR

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The risk capital charges are determined using the probability of default and loss given default that are directly derived from the IRB methodology. They are applied to the exposure at default to determine the total risk assumed and consequently the amount of risk capital used by the Bank.

3.2.2 Risk Differentiation

One of the key features of the new capital adequacy approach is the ability to generate capital charge by type of portfolio, type of product lines and investments factoring credit enhancements. The current approach applies uniform capital charges to private sector and public sector loans, listed and unlisted equity investments. In the new methodology, the structure of the minimum capital requirements provides flexibility to accommodate products of different risks. This enhances the internal risk management and decision process with respect to the marginal contribution of new transactions to portfolio risk and alternative usage of risk capital. The differentiated charges by portfolio type are summarized below.

Sovereign Risk Capital Charges

The sovereign risk capital requirements (ks) for assets in each risk rating category were determined using the Bank’s specific historical information on three key risk parameters: PD, LGD and M. Details on the methodology used to determine the PDs and LGDs for the sovereign sector, as well as the benchmarking results with other institutions is presented in Annex 1. Table 1 below summarizes the current and the revised risk capital charges for the sovereign sector, and shows higher risk capital charges as the credit quality deteriorates. The decrease in risk charges for countries rated between 1 and 4 as compared to the current charges is in line with the observations of stakeholders and independent reviewers about the fact that sovereign borrowers with investment grade ratings have historically rarely defaulted on their payments to multilateral creditors. On the other hand, countries rated between 5 and 10 recorded higher risk charges than in the current framework, primarily reflecting the historically observed long time duration during which these countries remain in default (usually between 10 to 20 years) once they fail to meet their obligations to the Bank. The revised capital charges are considered prudent considering the historical and peer experience. Given the current economic climate, these capital charges will be reviewed periodically with particular attention to regional (not country only) impact, which could trigger a wave of simultaneous defaults.

Table 01: Sovereign risk capital charges under various approaches

ADB Risk Classes ADB Internal Rating 1‐10

Credit Quality Current Risk Charge (kc)

Revised Sovereign Risk Charges (ks)

Very Low Risk 1 Excellent 25% 3%

Low Risk 2 Strong 28% 7%

Moderate Risk 3 Good 35% 15% 4 Fair 35% 35%

High Risk 5 Acceptable 50% 57% 6 Marginal 50% 89%

Very High Risk 7 Special Attention 75% 98%

8 Substandard 75% 100%

9 Doubtful 75% 100%

10 Known loss 75% 100%

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Non‐Sovereign Risk Capital Charges

For the private sector portfolio the determination of the risk parameters (PD, LGD) is less straightforward due to lack of depth in the historical database which dated back less than a decade and consists of only 45 operations. Given the paucity of observable data for the period 1997‐2007 a number of possible scenarios might arise. The Bank should select the approach that is best calibrated to the credit risk profile of its private sector portfolio. Such approaches shall be periodically revisited to factor experience gained by the Bank over time in private sector operations.

Probability of Default (PD)‐Based on the finest evaluation of the private sector transactions default and further measurement guidance provided by external risk advisory services and rating agencies, four options have been considered hereafter: (1) Option 1‐ cohort analysis of ADB Historical Data calibrated; (2) Option 2‐ Implied PD (Private Sector PD anchored to Sovereign PD)‐ This approach is based on developing structural relationship between the sovereign and non‐sovereign PD. (3) Option 3‐ Proxy relationship with MDBs having similar portfolio risk characteristics; and (4) Option 4 ‐ Generic Market consisting of implied default from external data providers. Annex 1 summarizes the various options and their implications for risk capital charges.

Management recommends option 2 (i.e. implied PD) as a transient measure until the build‐up of consistent default history for private sector operations. It is worth noting that the notch difference between sovereign and non‐sovereign may exceed the 1‐2 level suggested by the policy (3 notches for some obligors as per the assessment of advisory services).

Loss Given Default (LGD)‐LGDs estimate depends on several factors such as the seniority of loans and the strength of the collateral. Under the Basel II approach senior claims on corporates and banks not secured by recognized collateral are assigned a 45% LGD, while subordinated claims are assigned a 75% LGD. LGD experience of comparable sister institutions for private sector operations indicate 40% LGD for senior secured loans and 55% for subordinated loans. Also, from the analysis of the Bank’s database, while LGD are not necessarily correlated to ratings, it was observed that for very weak credits, rated below 7, a 100% LGD is observed. Moreover, the historical recovery rate of the Bank’s private sector portfolio was very low.

Based on these assessments and given the more risky operating environment of the Bank’s private sector operations and in order to remain in line with best practice and Basel standards, the following LGD matrix is proposed for the Bank. The matrix was endorsed by ALCO. For the outstanding portfolio, applying this matrix, the LGD obtained for each entity of the Bank’s portfolio will be reviewed on a case by case basis by the Non‐Sovereign Credit Working Group of the ALCO, in charge of monitoring private sector entities ratings and LGDs will be adjusted on a yearly basis.

Senior

Strong security Moderate security Weak security Unsecured Subordinated

LGD8 35% 45% 50% 50% 75%

Using this matrix and applying the structurally determined PDs, the risk charges for the private sector are summarized in Table 02 below. The non‐sovereign risk charges will be continuously monitored. Over time, the need to change the levels of risk charges as additional data and methodological improvements are taken into account, will be communicated to the Board for decision. 8 For all exposure rated between 8 and 10, LGD is 100%

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Table 02: Non Sovereign risk capital charges under various approaches Current Proposed

ADB Risk Classes

ADB Internal Rating 1‐10

Risk Charge (kc)

Senior Secured (kns1)*

LGD = 43%

Senior unsecured (Kns2)

LGD = 50%

Subordinate (kns3)

LGD = 75%

Very Low Risk 1 25% 24% 27% 41%

Low Risk 2 28% 27% 31% 46%

Moderate Risk 3 35% 38% 44% 65%

4 35% 44% 50% 75%

High Risk 5 50% 47% 55% 82%

6 50% 47% 55% 82%

Very High Risk 7 75% 49% 60% 87%

8 75% 100% 100% 100%

9 75% 100% 100% 100%

10 75% 100% 100% 100%

* Average of the three types of security (strong, moderate, weak) It is important to note that this differentiation in private sector risk charges, by adding more risk categories for use of credit risk mitigants, requires active collateral management that is currently not in place. Under the above methodology the risk charge is specific to a given transaction as it is based on its risk characteristics. This implies that for a strongly secured highly risky transaction the risk charge will be relatively lower than a low risk unsecured transaction. Comparative Analysis with IFIs operating in similar business environment – The benchmarking with peer group IFIs summarized in Table 3 indicates that the risk capital charges of the Bank are in line with market standards. It is also important to note that the risk charges do not curtail private sector business growth or prevent the institution to make commitments in high risk countries. The main issue in benchmarking the Bank’s private sector capital charges with other “Private sector oriented” IFIs remains the extent to which charges are determined within the context of specific risk appetite of an institution. Also using a specific allocation process can be replicated to another institution. These benchmarks may provide a valuable comparative basis, but it is evident that they are not yet a potential replacement for the risk charges of the Banks non‐sovereign portfolio. Furthermore, there are issues of risk/reward and profitability concerns that vary as per the mandate and the geographic diversification of the business of each institution.

Table 03: Indicative risk capital charges using peer group IFIs risk parameters

Current Comparable IFI (2)* ADB Risk

Classes


Risk Charge

Comparable IFI (1)* LGD (40%)

Senior (40%) Subordinated (55%) Very Low Risk 1 25% 19% 27% 37%

Low Risk 2 28% 23% 30% 41%Moderate Risk 3 35% 24% 34% 46%

4 35% 29% 36% 49%High Risk 5 50% 32% 38% 52% 6 50% 35% 40% 55%

Very High Risk 7 75% 36% 41% 56%

8 75% 100% 100% 100%

9 75% 100% 100% 100% 10 75% 100% 100% 100%

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3.2.3 Comprehensive approach to risks ‐ Aggregated Weighed Average Risk Profile

The Bank like any financial institution is exposed to three broads types of risks for which risk capital has to be allocated in order to protect it from financial losses: (i) credit risk; (ii) market risk; and (iii) operational risk. The proposed methodology will encompass this whole risk universe by addressing all these risks which are either not fully captured or not captured at all under the current framework and assign appropriate amounts of capital charge commensurate with their risk profile. However, the biggest emphasis still will remain on the development related credit risk (sovereign and non‐sovereign) which is the largest source of risk for the Bank. Table 04 summarizes the coverage of risk and aggregate exposure used to determine the Bank’s total risk capital utilization.

Table 04: Risks covered in the revised Capital Adequacy Framework

Business Activities Type of Risk Methodology for Risk Capital Charge Allocation

Disbursed Loan Portfolio Based on proposed Risk Capital charges for both the Sovereign and Non‐Sovereign Portfolio.

Undisbursed Loan Portfolio

Same as for the disbursed loan portfolio but with a 75% Credit Conversion Factor.

Equity Participation 50%‐75% for Listed Equities 76%‐100% for Unlisted Equities

Direct Credit Substitute (Guarantees)

Loan Equivalent value of the Guarantee to which risk capital charges are applied.

Development Related

exposures (primarily credit risk; market risk

on equity investments)

New products (Un‐hedged local currencies, Portfolio Management)

Capital charges will be determined on a case‐by‐case basis if the estimated potential loss is estimated to be material.

Credit Risk on Treasury Assets

Based on credit rating of the counterparty: 0% for Cash, and sovereign rated AA+ and above‐ ; 1.6% to 4% for all other Treasury exposure depending on the type of instrument & maturity.

Credit Risk on Swaps and other Derivatives

Replacement cost of the derivatives (market value) adjusted for collateral to which a capital charge of 1.6% is applied.

Treasury Operations

(Credit & Market risks)

Market risk on Treasury portfolios

Mitigated by the Bank ALM policy and matching principle for interest rate and currency risks.

Additional risk charges will be applied to the residual exposure if this exposure is material. Value at Risk will be used as metrics in tandem with stress testing.

All Bank activities (Operational Risk)

Operational Risk 15% of the average Operating Income for the preceding 3 years. No provision for Legal or reputation Risk

In managing the overall risk profile of the portfolio, Management will target an average weighted rating of the portfolio between 3 and 4 based on the above coverage.

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3.2.4 Capital Utilization limit (RCUR)

The degree of risk the Bank is willing to assume in achieving its development mandate and its overall risk tolerance, are limited by its risk bearing capacity. In weighing the trade‐offs it faces in its normal business, the Bank seeks to eliminate any material risk of either unacceptable financial consequences (such as a call on shareholder capital) or unacceptable non‐financial consequences (such as severe damage to the Bank’s reputation). RCUR provides a long term view on the parameters of such trade‐offs.

In the new capital adequacy framework, RCUR will be maintained as metrics as it provides a forward looking tool to measure the risk assumed through the Bank business. When combined with the other related financial policies, it would protect the Bank from the potential losses associated with development related exposures and treasury operations.

The trigger of 80% on RCUR for increasing the Bank’s capital base will also be maintained. However this ratio will be monitored in tandem with minimum level of equity to risk assets determined through non‐accrual shock stress testing and market risk stop loss.

3.3 Prudential Exposure limits

Having prudently built its reserves and minimized market and credit risks in its portfolio, the Bank has some flexibility to leverage its risk capital. This provides some scope to take additional risks in pursing its development mandate through: (i) extending credit to high risk private sector transactions with commensurate development impact; (ii) participating in investment funds in countries rated below the average risk to attract private investors; and (iii) committing larger amounts in the form of direct or syndicated loans to single obligors (borrower, country). Such increase in limits would factor in the possibility for the Bank to sell exposure. With respect to operational ancillary limits, the Bank’s exposure management strategy will continue to seek to achieve adequate diversification across portfolios. Accordingly, the guiding principles used to determine the proposed prudential limits are: (i) efficient deployment of the Bank’s risk capital to respond to the call of shareholders, (ii) institutional business strategy marked by significant growth of the private sector exposure, and (iii) maintaining the triple A rating by ensuring that the Bank maintains sufficient capital buffer to sustain risks assumed through its business and being able to respond to shocks. Management’s proposal which factors the above considerations is summarized in Table 05.

Table 05: Proposed Prudential Exposure Limits

Prudential limits Current Proposed Share of

Global Country Limit 15% Maximum Sustainable Portfolio

15% Total Risk Capital

Private Sector Limit 20% 40% Total Risk Capital

Equity limit 10% 15% Total Risk Capital

Single Country Non‐Sovereign exposure 20% 25% Non‐sovereign Risk Capital

Single Sector Limit –Financial Services 35% 35% Non‐sovereign Risk Capital

Single Sector Limit –Other sectors 25% 25% Non‐sovereign Risk Capital

Single Obligor limit 4% 7% Non‐sovereign Risk Capital

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3.3.1 Ceiling on the Bank’s Private Sector Operations

The proposed level of 40% is based on the current size of the Bank’s private sector operations and their projected annual growth over the MTS period. It drives the maximum sustainable volume of operations that would not jeopardise the Bank’s key financial ratios. This ceiling has been determined by stress testing the relationship between new non‐sovereign operations and risk capital utilization and key solvability ratios. The key assumptions include: (i) Growth of the Bank’s risk capital; (ii) volume of new non‐sovereign approvals; (iii) mix of instruments (loans versus equity); (iv) disbursement profiles; (v) repayment profiles; and (vi) risk profiles of new approvals as well as rating migration patterns of outstanding exposures. If the credit risk profile of the private sector portfolio deteriorates, this level will not be sufficient to sustain long term private sector growth. To ensure that in a worse than expected scenario the limit will not be a binding constraint, there is a need to pay more attention to risk sharing instruments to transfer risks from the Bank to third parties able and willing to take such risk. Adequate exist mechanisms in entering into funds and venture capital businesses need to ensure that the Bank’s role remains catalytic.

3.3.2 Limit on the Bank’s Equity Participation

Management proposes that, the aggregate risk capital required to support all equity investments combined must not exceed 15% of the Bank’s total risk capital, an increase from the current 10%. This decision may need to be endorsed by the Board of Governors.

However, given that the equity investments entail higher risk coupled with the inadequate exit mechanism due to limited capital market activity in RMCs, Management is of the view that the increase in the limit should be gradual.

In proposing an increase in the limits, Management is cognisant of the higher risk nature of equity investment but also the necessity to respond to the increasing call from its stakeholders to: (i) play a catalytic role in development of the capital markets and provide seed capital in equity investment funds to attract private investors; and (ii) contribute to the development of SMEs and microfinance through equity participation in local and regional development Banks.

Also, the increase in the equity limit will be accompanied by several initiatives to ensure that the risks inherent in this instrument are properly and actively managed. These measures include but are not limited to: (i) presentation of the equity investment strategy to the Board by the Private Sector Department (OPSM); (ii) enhanced equity portfolio monitoring to ensure new high risk equity transactions are limited as they have significant impact on the weighted average risk rating and net income through provisioning; (iii) disinvestment, exist strategy or sell down of shares to maintain exposure within prudential limits and (iv) annual equity portfolio performance review.

3.3.3 Global Country Exposure Limit

The fundamental change in the global country limit relates to its direct linkage to risk capital. In the current framework the global limit was based on the maximum sustainable lending portfolio. The 15% rate remains but is now proposed to be anchored to the Bank’s total risk capital. For comparison purposes the 15% share of risk capital corresponds to around 18% to 20% of the maximum sustainable lending portfolio depending on the product mix and the asset quality composition of the portfolio. Business decisions will continue to be driven by strategic fit, development impact and client needs.

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It is important to note that the global limit applies to both ADB and ADF countries. However, in the case of ADF countries, the limit is meant for private sector operations and enclave projects and sets an overall ceiling on such operations. Global limit changes are within the realm of Board of Directors oversight responsibilities

3.3.4 Ancillary Operational Limits

To build a portfolio that is adequately diversified, the Bank put in place ancillary operational limits. These limits are aimed at reducing concentration exposure across risk segments and essentially related to sector, single country and single obligor limits within the ceiling of private sector operations. For exposure management purposes, 8 broad industry sectors are defined. The total risk capital used for any single industry sector should not exceed 25% of the total risk capital available for non‐sovereign operations. However, because of their diversified nature and fact that financial institutions are regulated by national central banks, the limit for this sector is 35%. The country and single obligor limits increase by 5% and 3% respectively in the revised framework. The single obligor limit is also a consolidated limit across all business lines (development credit and treasury operations). The single sector limits for financial institutions and other sectors remained unchanged.

3.4 Implications for Other Related Financial Policies

3.4.1 Pricing of non sovereign operations

The Bank utilizes a “flexible cost recovery” pricing framework as defined in the non‐sovereign operation guidelines. In this framework, the Bank’s cost of extending its risk bearing capacity (in the form of lending to clients) provides a ‘risk‐based’ benchmark for determining the lending spread for the facility. The Bank’s lending rate to a client is composed of a Base Rate and a Lending Margin: Pricing Components

Base rate Libor

Operating Cost

Economic Contribution

Risk Premium

Of which:

‐ Charges for Expected Losses

Lending Margin

‐ Charges for Unexpected Losses

As indicated in section 2. The risk premium component is based on a sister institution framework and its risk parameters dated back 1998. The Bank has now gained experienced in pricing private sector transactions. The flexible cost recovery policy is still relevant but the risk premium would have to be adjusted to reflect the PDs and LGDs derived from the enhanced framework. The capital charges applicable for pricing will also factor tenor risk to reflect the relatively long tenor of the Bank loans as compared to the market. A more granular internal rating scale based on the 10‐grade function (i.e. expansion of the current grading into sub‐grades) will be used to ensure better differentiation of the transactions and reflect the reality of individual businesses rather treating all businesses within certain country equality.

3.4.2 Provisioning Policy

There will be no change in the Bank’s provisioning policy. However, under Basel II, loans are considered to be impaired when 90 days past due. However, IFRS principles based incurred loss method will be applied

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to impaired loans, treasury investments and equity participations in line with the Bank’s financial regulations and accounting policies.

3.4.3 Leverage Policy

The rationale for changing the Bank’s leverage indicators and limits is grounded on the following pillars: (i) adopting ratios closely monitored by rating agencies in order to ensure that the Bank maintains high standards of transparency thereby supporting its high credit rating in international capital markets; and (ii) maintaining a simplified framework that minimizes probability of call on capital. Ensuring that these fundamentals are embedded in the overall assets and liabilities management framework through pertinent operational limits is the key objective. It is proposed that the Bank maintain a single debt ratio, the debt to usable capital ratio in its current format, a policy similar to other MDBs and providing sufficient limitation to leverage.

IV IMPLICATIONS OF THE PROPOSED ENHANCEMENTS

4.1 Implication for the Risk Capital Utilization Rate

The MTS baseline lending growth marked by private sector expansion entails an increase in exposure over the period 2009‐2015 and increased capital requirement commensurate with that growth. Using the proposed new methodology this increase in risk capital utilization does not constitute a constraint as shown in Table 06. However stress testing of risk profile associated with such growth (i.e. WARR of above 4) indicates that the increased exposure could utilize more than 96% of the risk capital of the Bank by 2012. Therefore, a significant deterioration in portfolio quality could challenge the triple A rating if not managed prudently. The growth in exposure should be accompanied by prudent and active portfolio management.

Table 06: Impact of the proposed Framework in the Risk Capital Utilization Rate* ( UA million and %)

2007 2008 2009 2010 2011 2012 2013 2014 2015

Total Risk Capital 4,708 4,623 4,705 4,802 4,882 4,999 5,124 5,236 5,361

1. Current RCUR (1) 49% 52% 54% 62% 75% 85% 94% 105% 116%

Current Coverage: Sovereign 41% 39% 36% 37% 43% 45% 48% 52% 56%

Non‐sovereign 5% 10% 15% 22% 30% 37% 44% 51% 57%

Treasury 2% 3% 3% 3% 3% 3% 3% 3% 3%

2.Proposed RCUR (2) 39% 44% 48% 56% 67% 77% 88% 99% 110%

Proposed Coverage: Sovereign 32% 27% 24% 24% 27% 29% 30% 33% 36%

Non‐sovereign 5% 10% 16% 24% 33% 40% 48% 56% 63%

Treasury 2% 3% 3% 3% 3% 3% 3% 3% 3%

Operational ‐ 1% 1% 1% 1% 1% 1% 1% 1%

Undisb.

3% 4% 5% 4% 5% 6% 7% 8%

3. Variance in RCUR RCUR (2) ‐ (1) ‐10% ‐8% ‐6% ‐6% ‐8% ‐7% ‐6% ‐6% ‐6%

*The projected risk capital utilization rate is subject to changes linked to the continuous updating of the portfolio, the financials and the assumptions.

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In the proposed framework risk capital limit will reach its trigger level around 2014 assuming steady growth in reserves . The portfolio impact is a reduced consumption of risk capital in the sovereign portfolio and higher increase in risk capital utilization by the non‐sovereign portfolio. Other risks not covered in the old framework such as operational and un‐disbursed commitments will utilize 5% to 9% from 2009 to the end of the MTS planning horizon. Figure 2 illustrates the growth profile of the risk capital utilization.

Figure 2: Risk Capital Utilization

4.2 Implication for the prudential limits

4.2.1 Implications for Global Country Limit

Portfolio diversification is a key risk mitigation rule. For this purpose most of the MDBs manage credit risk and concentration through country limits, although they follow different approaches which reflect the specificity of their credit policy and the nature of financial operations. The risk‐based limit approach proposed in the enhanced capital adequacy framework limits the risk that the Bank takes in the most creditworthy country with the highest debt absorptive capacity to 15% of the total risk capital.

The risk‐based limit approach also requires that the more risky the country, the lower the country limit (i.e. more risk capital is required to back‐up commitments when the Bank takes on more risk). Accordingly, individual countries limits are differentiated by relative risk position vis‐à‐vis the best rated country using a two dimension matrix: (i) risk rating; and (ii) country economic potential. The matrix is illustrated by Table 07. In risk dimension the high credit worthy country (risk class 1) will receive 15% (corresponding to 100% of the limit) of the global limit and the very low credit worthy country will have 2%. In the absorptive capacity dimension, countries are classified in five classes based on economic potential, ranging from Very Small Economy to Very Large Economy using IMF quota and GDP. The country limits for the non‐sovereign portfolio varying, for the same risk class (e.g. very low risk) from 15% for very large economy to 3% for the Very Small economy.

It is important to note that the global country limit is an aggregate limit that integrates all exposures to counterparties and borrowing entities domiciled in the country for sovereign and son‐sovereign lending as well as treasury activities with entities in that country. The matrix is expected to be further refined to reflect the increased granularity of the rating master scale and absorptive capacity.

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Table 07: Individual Country Limits

Risk RatingEconomic Very High High Moderate Low Very Low

Very Large( VLE) 2% 4% 6% 12% 15%

Large (LE) 2% 3% 6% 11% 14%

Medium (ME) 2% 3% 5% 9% 11%

Small (SE) 1% 1% 2% 4% 6%

Very Small (VSE) 0,4% 0,6% 1,2% 2,2% 2,8%

4.2.2 Impact on Non‐sovereign operations

Analysis of the implications of raising the non‐sovereign limit to 40% demonstrates that the Bank has the financial capacity to absorb the higher level of exposure provided that portfolio quality is maintained at average risk level. It is well within the range of comparator institutions. The global non‐sovereign limit will not be a binding constraint based on the growth scenario of the MTS as indicated in Table 08. Also, it will not prevent the private sector from assuming riskier and more aggressive positions which are consistent with the need to catalyze and provide additional support for participation by investors development partners in areas currently considered to be too risky (participation in equity funds, micro‐finance, SME financing, Greenfield project financing in high risk post conflict countries). It however entails that Weighted Average Risk Profile of all outstanding operations remains between 3 and 4 (moderate risk) through pro‐active portfolio management. In addition, the Bank will only process new transactions whose risk rating is 6 or higher when there are exceptional development benefits for the additional risk.

Table 08: Adequacy of the 40% Limit in Sustaining Private Sector Operations over the MTS Period*

Portfolio and Capital 2008 2009 2010 2011 2012

Total Projected Portfolio 1,058 1,802 2,846 3,963 5,036

Existing Commitments 588 625 662 708 580

New Commitments 470 1,177 2,185 3,255 4,457

Risk Capital Allocation 480 758 1,163 1,597 2,013

Share of Risk Capital 10% 16% 24% 33% 40%

‘* These projected estimates are subject to changes linked to the continuous updating of the portfolio, the financials and the assumptions.

The impact analysis also shows that given the linkage between the various non‐sovereign exposure limits, raising the overall ceiling will create additional headroom for all of the sub‐limits (the single country, the single sector, and the single obligor) limits as summarized in Table 09. It is however important to stress that the Bank is not expected to carry‐on full credit risk of the transactions and should sell‐off/transfer risks on a best efforts basis. This would reduce the additional pressures on the risk capital allocated to private sector operations. The rationale is that the Bank’s private sectors operations are meant to be catalytic in attracting other investors in the transactions.

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Table 09: Impact on the Private Sector Operational Limits in 2009

Amount in UA million and %)

Limit Current Proposed Difference

Share Risk Capital

Equivalent exposure for average rating

3*

Share Risk Capital

Equivalent exposure for average rating 3*

Share Risk Capital

1. Projected Risk Capital (a) 100% 4 666 100% 4 666 0% ‐

Non‐Sovereign share of (b) 20% 933 2 666 40% 1 866 7 043 20% 933

2 ‐ Non Sovereign Exposure as share of (b) : Single Country 15% 140 400 25% 467 1 761 10% 327

Single Sector ‐ ‐

Others 25% 233 667 25% 467 1 761 0% 233

Financial 35% 327 933 35% 653

2 465 0% 327

Single Obligor 4% 37 107 7% 131 493 3% 93

4.3 Implications for the Bank’s Long Term Financial Capacity

The proposed framework is a strategic management tool to measure and test the capitalization level of the Bank at a certain point in time and with a given a business growth scenario. By design it is meant to determine the current and projected risk capital utilization levels and the adequacy of the Bank’s capital resources in terms of available headroom. The framework also provides more consistent and dynamic stress testing and scenario analysis to better measure the impact of potential downside/upside scenarios on the Bank’s financial strength. It is a neutral framework. The flexibility of the framework was stress tested using the Banks’ financial capacity simulations performed within the context of the Medium Term Financial Performance Outlook presented to the Board on February 18, 2009. This includes increased lending as a result of the financial crisis combined with a credit shock (which involves 2 major borrowers defaulting and a downgrade of loan risk rating across the entire private sector portfolio). In terms of implications, the general conclusion is that given the specific characteristics of the Bank’s operating environment it is important to maintain a strong capital resources cushion. This capital buffer is important in order for the Bank to: (i) achieve the objectives of its Medium Term Strategy, (ii) play a countercyclical role, and (iii) withstand potential market and credit shocks while maintaining its tripe A rating.

V IMPLEMENTATION IMPLICATIONS OF THE PROPOSED FRAMEWORK

While the review of the capital adequacy methodology would result in changes in risk capital charges and exposure limits, the challenges for the institution would be to build adequate risk governance, risk analysis and management, risk infrastructure and staff capacity in order to ensure more effective use of available risk capital, accelerate economic development of RMCs and protect the Bank’s triple A rating. Capital is expensive so reliable quantification is critical for covering the critical risks without over‐capitalization. Automated aggregation of risks results in better capital estimation and mitigation strategy. Clearly defined roles and responsibilities are needed to ensure informed risk decision making.

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5.1 Revision of the Sovereign and Non‐sovereign Risk Management Guidelines

The operational guidelines will be amended to reflect the revised framework. Fundamental revision will concern non‐sovereign operating guidelines with respect to exposures and risk management products. The flexible pricing framework for non‐sovereign operations would remain unchanged while the pricing matrix related essentially to the revision of risk parameters will be amended.

5.2 Establishment of Collateral Management framework

Active collateral management needs to be put in place through collaborative efforts between Legal Department and the Private Sector Department. This will allow to apply private sector differentiated risk charges for private sector business decisions (pricing, portfolio management, trade‐off in contracting deals, etc.). It is equally important to review and classify the existing collateral associated with private sector approved projects with a view of monitoring these over the lifetime of the loans.

5.3 Enhanced Exposure Monitoring

5.3.1 Limit Compliance Monitoring Process

Active management of concentration risk is a key objective to any credit portfolio management effort. Concentration levels as well as all exposures are reviewed by Senior Management and various oversight committees (ALCO through quarterly reports, OPSCOM for any transaction to be approved by the Board) and the Board (through the annual portfolios’ performance review).

Management is responsible for ensuring that the Bank remains within the established limits. Detailed management reports by country, sector and obligor will be prepared each semester to assist country departments and private sector department in the monitoring and compliance with the limit. Reports will be cleared by ALCO.

Before processing any significant transaction to the Board, task managers shall review the impact of the additional exposure on the limits and require formal derogation of Senior Management (ALCO/OPSCOM) in excess of significant deviation to the limits (i.e. above 5%).

5.3.2 Early warning monitoring system and Treatment of Exceptions

An early warning system consists of signals and triggers will provide advance warning when the various limits and thresholds reach 80% of their set limit. In addition, exceptions to Board approved limits would be reported to an appropriate level of Senior Management and the Board to ensure that corrective actions are taken.

The Bank may increase or reduce the country limits if necessitated by compelling circumstances. Such actions require Board approval, although senior management may vet exceptions (for non‐sovereign single country, sector or single obligor limits) and transient deviation on a case‐by‐case basis. Policies and procedures for changing these limits and granting derogations shall be documented in the exposure monitoring guidelines.

5.4 Devolution of Exposure Management responsibility to Task managers

With the revised guidelines and the building of shared risk management infrastructure that allow on line real time monitoring of exposure by task managers and investment officers, responsibility for day to day exposure monitoring for the processing of lending transactions will be devolved to organizational units. Risk management department will exercise oversight and limit breach controls.

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Key to the successful decentralisation of this risk management responsibility is adequately trained staff. Staff responsible for validation and monitoring of exposure, pricing and portfolio monitoring, risk officers, will need to be fully cognizant of the framework and the Bank’s internal rating systems in order to monitor compliance effectively.

5.5 Risk Oversight and Governance

The implementation modalities will remain unchanged and the Board of Directors will retain full control on the strategic allocation of risk capital that will ultimately drive the Bank’s future business and its risk profile. Central to the successful implementation of the enhanced framework are (i) enforcement of guidelines with respect to cut‐off rating for entry in the portfolio when projects are approved by the Board and (ii) the institutionalization of a credit committee/or technical support committee for private sector operations in support to OPSCOM.

5.6 Resource requirements and timeline to implement the proposed capital adequacy framework

The Bank currently does not have adequate resource capacity (including people, systems and tools, guidelines, processes and procedures) to implement an integrated risk management framework and thereby making capital adequacy a business enabler. Detailed resource required in order to adequately implement the proposed framework, are provided in Annex 5 and 6. Annex 7 highlights major roles and responsibilities in the risk culture change process.

VI CONCLUSION AND RECOMMENDATIONS

Management recommends that the Board consider the following proposed methodology and prudential limits:

• Differentiated risk capital charges for sovereign and non‐sovereign operations based on Basel II IRB approach in order to reflect the specific risk profile of the Bank portfolio.

• Global Country Exposure Limit – The aggregate amount of net exposure to support the Bank’s combined sovereign and non‐sovereign operation in any given country must not exceed 25% of the Bank’s risk capital.

• Non‐Sovereign Exposure Limit – The aggregate amount of risk capital required to support the Bank’s non‐sovereign portfolio must not exceed 40% of the Bank’s total risk capital.

• Non‐Sovereign Single Country Exposure Limit – The aggregate risk capital required to support all non‐sovereign operations in any single country must not exceed 25% of the non‐sovereign exposure limit.

• Non‐Sovereign Single Sector Exposure Limit – The aggregate risk capital required to support all non‐sovereign operations is any single sector must not exceed 35% of the non‐sovereign exposure limit for the financial sector and 25% for other sectors.

• Non‐Sovereign Single Obligor Exposure Limit – The aggregate risk capital required supporting all non‐sovereign operations with any single obligor and group of obligors must not exceed 7% of the non‐sovereign exposure limit.

• Equity Exposure Limit – The aggregate risk capital required to support all equity investments combined must not exceed 15% of the Bank’s total risk capital. This may require the Board of Governors’ approval.

• Debt to Usable Capital – Based on discussions with rating agencies, and taking into account best practices and the framework of other MDBs, management recommends replacing the current three debt ratios framework by a single debt ratio which is the debt to Usable Capital).

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APPENDIXES

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Annex 1 – Proposed Capital Adequacy Framework – Methodology, Risk Parameters and Capital Charges

1. Basel II Approach

The proposed capital adequacy framework uses Basel II Internal Rating Based Approach‐Advanced as reference. As a multilateral development finance institution, the Bank is not bound by the Basel accord or any national financial regulators. However, factoring the practice of the banking industry, the transparency and simplicity of Basel II as well as its prudent approach to capital adequacy as result of the financial and market turmoil, Management has used such approach as guidepost. In this respect it is important to note that under Basel II, there are two broad methodologies for calculating minimum capital requirements that are summarized in Table A1 below. The first methodology is the “Standardized Approach” which measures credit risk using standardized risk weights supported by external ratings. The second methodology –the “Internal Ratings Based (IRB) Approach” – under which internal estimates of risk components are used to determine the capital requirements for a given exposure. Under the IRB Approach, two sub‐approaches are available: the Foundation and Advanced approaches. The risk components used in all approaches include measures of the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). The risk capital charges is determined through a complex formula using risk parameters k=LGD x Φ(p=f(PD)) x q.9. The Bank’s approach to capital adequacy is a dual approach, Basel II reference combined with stress testing.

Table A1: Risk Parameters and Mitigation

Basel II Framework

Standardized Foundation IRB Advanced IRB

Risk Parameters

External PD

Credit conversion factor fixed by Basel

PD from internal systems

LGD and credit conversion factor fixed by Basel

PD from internal system

LGD from internal system and EAD from Basel

Risk Mitigation Partial mitigation allowed

Stepwise accounting for mitigation via Basel II collateral bucketing

Full credit mitigation

Collateral changes internal LGD estimates

2. Risk Capital Charges

2.1 Sovereign Risk Capital Charges

For both the PD and LGD the Bank uses internal default history and overdue payments covering the period 1987 to 2008. This was supplemented by credit migration analysis within and across risk classes to calculate the sovereign default probability. The Bank’s LGD is generated from historical recovery rates and is computed as the ratio of Time in Default (TID) to the average maturity of loans in each risk rating. TID is the historical amount of time (in years) that loans are in default.

9 Basel II risk charges’ formula

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Table A2: Sovereign Risk Parameters and Risk Capital Charges

Risk Classes Rating PD LGD M Current Charges

Revised Charges

Very Low Risk 1 0.83% 8% 13 25% 3%

Low Risk 2 4.95% 12% 13 28% 7%

Moderate Risk 3 7.75% 24% 13 35% 15%

4 23.03% 40% 13 35% 35%

High Risk 5 41.11% 56% 13 50% 57%

6 79.49% 81% 13 50% 89%

Very High Risk 7 89.04% 90% 13 75% 98%

8 100.00% 100% 13 75% 100%

9 100.00% 100% 13 75% 100%

10 100.00% 100% 13 75% 100%

2.2 Non Sovereign Risk Capital Charges

For the private sector portfolio the determination of the risk parameters (PD, LGD) is less straightforward because the limited experience of the Bank’s and default history. Given the paucity of observable market data a number of possible scenarios might arise. The Bank should select the approach that is best calibrated to the credit risk profile of its private sector portfolio. Such approach shall be periodically revisited to factor experience gained by the Bank over time.

2.2.1 Probability of Default (PD)

The probability of default “PD” is the probability that a particular borrower/obligor would default with the institution during a pre‐determined time period. It measures the credit quality of the borrower. The lower the probability of default the higher the credit quality and vice‐versa. Based on the finest evaluation of the private sector transaction defaults and further measurement guidance provided by external risk advisory services and rating agencies, four options have been considered. Table A3 summarizes the various options.

Option 1 ‐ ADB Specific Historical Data calibrated

Fortnightly arrears data covering the period 1997‐2007 have been cleaned up, smoothed and calibrated to the various rating classes. Using cohort analysis, calibrated PDs were determined and summarized in Table A3. The basic limitations of these PDs are their statistical validity as some rating classes have few or no relevant data points.

Option 2 – Non‐Sovereign PD structurally anchored to Sovereign PD

This approach is based on developing a structural relationship between the sovereign and non‐sovereign PD. It implies a good correlation between the two types of PD. It also means that the Preferred Creditor Status (PCS) associated with sovereign guarantee acts as credit enhancement as opposed to non‐sovereign lending. The PCS is incorporated in the risk parameters assessment as a lower PD and LGD. Such structural link is generally accounted for in the form of 1 to 2 notches deviation between the sovereign and non‐sovereign rating. Some MDBs and rating agencies apply the same principle but in the reverse order (i.e. non‐sovereign PDs adjusted by

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one or two notches to determine sovereign PDs). The 1‐2 notches deviation is confirmed by the fact except in very special circumstances the sovereign rating is higher than the rating of a company located and operating within the host country jurisdictions. These special circumstances are the cases for example of a company which is a strong foreign currency earner with a big part of its operations outside the country or a large commodity export company which earnings are a big source of revenue for the host government itself and earnings ring‐fenced offshore. The structural linked PD are also summarized in Table A3.

Option 3‐ Generic Market Implied PD

This option consists of using implied default from external data providers. These markets based PD are usually generated by rating agencies and do not cover the entire Bank’s universe. They are generally applied to US or European corporate and do not match the Bank’s rating scales (limited to the range of triple AAA to C) and extrapolated to cover risk classes below C.

Option 4‐ Indirectly calibrated PD using proxy relationship with comparable MDBs

The PD generated by comparable peer group MDBs operating in the Private Sector in Africa could be used as proxy for the Bank’s non‐sovereign portfolio. The choice of the proxy relationship shall be guided by the extent to which an historical structural correspondence between these entities and the Bank’s private sector can be established.

Table A3: Non‐Sovereign Estimated Default Probability under various options

Risk Classes Rating

Option 1

ADB specific

Option 2

Sovereign linked

Option 3

Market Generic

Option 4

Proxy Peer MDBs

Very Low Risk 1 11.4% 4.95% 2.0% 9.70%

Low Risk 2 23.2% 7.75% 10.5% 13.40%

Moderate Risk 3 25.9% 23.03% 30.4% 19.95%

4 28.6% 41.11% 50.8% 25.00%

High Risk 5 31.3% 79.49% 52.6% 32.20%

6 34.0% 89.04% 54.4% 39.60%

Very High Risk 7 60.4% 100.0.% 66.3% 43.80%

8 100% 100.0% 100.00% 100.00%

9 100% 100.0% 100.00% 100.00%

10 100% 100.0% 100.00% 100.00%

2.2.2 Loss given default Loss given default is the percentage of total exposure that is projected to be lost in the event of a default. The estimate of this risk metric depends on several factors such as the seniority of loans and the strength of the collateral. Under Basel II foundation approach senior claims on corporates and banks not secured by recognized collateral are assigned a 45% LGD, while subordinated claims are assigned a 75% LGD. A peer group institution has analyzed its LGD experience for private sector operations and applies a 40% LGD for senior secured loans and 55% for subordinated loans for risk classes 1 to 6. Finally, from the analysis of the Bank’s loss

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recovery experience, while LGD are not necessarily correlated to rating, it was observed that for very week credits, rated 7, 100% LGD is observed. Based on these observations, for private sector operations, the determination of LGD on a transaction basis is a more efficient approach for assigning risk weight specific to each asset of the portfolio. However, in the long run, as the portfolio grows and more observations will be made, a more standardized approach tailored to the Bank’s portfolio risk profile should be made. The LGD matrix is summarized in Table A4. Table A4: Non‐Sovereign LGD Matrix

Risk Parameter Senior

Collateral Strength Strong Security Adequate Security Weak Security Unsecured Subordinated

LGD 35% 45% 50% 50% 75%

2.2.3 Non‐Sovereign Risk Charge Matrix

The refinements in the Options for the non sovereign PD and LGD which factor not only internal consultations but also ongoing discussions with rating agencies, risk advisory services, further benchmarking with MDBs on specific risk parameters are summarized in Table A5.(1) through Table A5(4). Among the various options examined, Management recommends Option 2.

Table A5(1) Non‐Sovereign Risk Charges using Historical PD – Option 1

Risk Class Rating Historical PD

Current Revised

(kc) Senior* secured (LDG=43%)

Unsecured (LGD=50%)

Subordinated (LGD=75%)

Very Low Risk 1 11.4% 25% 30% 35% 53%Low Risk 2 23.2% 28% 38% 44% 66%

3 25.9% 35% 39% 45% 68%Moderate Risk 4 28.6% 35% 40% 46% 69%5 31.3% 50% 41% 47% 71%High Risk 6 34.0% 50% 42% 48% 72%7 60.4% 75% 47% 53% 80%8 100% 75% 100% 100% 100%9 100% 75% 100% 100% 100%

Very High Risk

10 100% 75% 100% 100% 100% * Average of the three types of security (strong, moderate, weak)

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Table A5(2): Risk capital charges for non‐sovereign operations using structurally linked PD

Risk Class Rating Structurally linked PD

Current Revised

(kc)

Senior* secured

(LDG=43%)

Unsecured (LGD=50%)


Very Low Risk 1 4.95% 25% 24% 27% 41%

Low Risk 2 7.75% 28% 27% 31% 46%

3 23.03% 35% 38% 44% 65%Moderate Risk 4 41.11% 35% 44% 50% 75%

5 79.49% 50% 47% 55% 82%High Risk 6 89.04% 50% 47% 55% 82%

7 100.00% 75% 49% 60% 87%

8 100.00% 75% 100% 100% 100%

9 100.00% 75% 100% 100% 100%Very High Risk

10 100.00% 75% 100% 100% 100%

* Average of the three types of security (strong, moderate, weak)

Table A5(3): Risk capital charges for non‐sovereign operations using market PD

Risk Class Rating Market PD

Current Revised

(kc) Senior secured (LDG=43%)

Senior (LGD=50%)


Very Low Risk 1 2.0% 25% 20% 23% 34%

Low Risk 2 10.5% 28% 30% 34% 51%

3 30.4% 35% 41% 47% 70% Moderate Risk 4 50.8% 35% 45% 52.2% 78.3%

5 52.6% 50% 46% 52.5% 78.8% High Risk 6 54.4% 50% 46% 52.8% 79.1%

7 66.3% 75% 47% 54% 81%

8 100.00% 75% 100% 100% 100%

9 100.00% 75% 100% 100% 100% Very High Risk

10 100.00% 75% 100% 100% 100%

* Average of the three types of security (strong, moderate, weak)

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Table A5(4): Non‐Sovereign Risk Charges using Proxy Peer Group PD

Risk Class Rating Proxy Peer Group

Current

Revised

(kc) Senior secured (LDG=43%)

Senior (LGD=50%)


Very Low Risk 1 9.70% 25% 29% 33% 50%

Low Risk 2 13.40% 28% 32% 37% 55%

3 19.95% 35% 36% 42% 63%Moderate Risk 4 25.00% 35% 39% 45% 67%

5 32.20% 50% 41% 48% 71%High Risk 6 39.60% 50% 43% 50% 75%

7 43.80% 75% 44% 51% 76%

8 100% 75% 100% 100% 100%

9 100% 75% 100% 100% 100%Very High Risk

10 100% 75% 100% 100% 100%

2.3 Benchmarking Non‐sovereign structurally linked PDs with Rating Agencies PDs With the framework of validating its internally generated PD for private sector operations, the Bank undertook benchmarking with international rating agencies using a common macro rating scale (1‐10). The comparative assessment is provided in Table A5(5). There are a number of issues that arise when comparing risk parameters derived from internal and external sources that should be kept in mind. Internal rating based PD incorporate specific information on borrowers that is unavailable to rating agencies, particularly if the borrower is not rated. The internally generated implied default tends to generate less volatile and more accurate credit assessment on the borrowers. As not all African countries are rated, achieving consistency across countries using external ratings is challenging and may create distortions in determining capital requirements.

Table A5(5): Comparative Analysis with Rating Agencies PDs

ADB Risk Classes


Non‐Sovereign PD (AfDB)

Moody’s

PD for Corporates

S&P

PD for Sovereign & Corporates

Fitch

A, A‐, BBB+, 1 4.95% 2.0% 0.27% N/A

BB+,BB, BB‐ 2 7.75% 10.5% 2.41% N/A

B+,B 3 23.03% 30.4% 4.70% N/A

B 4 41 11% 50 8% 8 14% N/ACCC+ 5 79.49% 52.6% 34.57% N/ACCC‐ 6 89.04% 54.4% 83.21% N/A

CC+,CC,CC‐ 7 100.00% 66.3% 100.00% N/A

C+,C,C‐ 8 100.00% 100.00% 100.00% N/A

D 9 100.00% 100.00% 100.00% N/A

D‐ 10 100.00% 100.00% 100.00% N/A

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Annex 2 – Rating Agencies Views

Table 1 summarizes the views of the rating agencies on risk capital allocation methodology and the exposure limits. All agencies are concerned with the expected growth of non‐sovereign operation without adequate risk mitigation measures.

Table 1: Summary of Rating Agencies’ feedback

Methodological Framework

Agency 1 The proposed methodological change for calculating the capital requirement has no negative impact on the creditworthiness of AfDB. It is sound and more transparent as it is based on the Basel II advanced internal risk‐based approach.

Agency 2

The proposed methodology for the computation of capital charges, although less conservative than the current approach, remains prudent. We believe that it is more appropriate to use differentiated LGD (Loss Given Default) for the public and private sectors.

Agency 3 The methodology is sound however the internal rating system has to be regularly updated.

Agency 4 We do believe, however, that effort is in good hands. We do recognize that some high‐risk projects also have very high potential development impacts.

Exposure limits

Agency 1 Considering AfDB’s current high equity to asset ratio among AAA rated Multilateral Development Banks (MDBs) and high liquidity, the upward revision of exposure limits is not likely to affect its creditworthiness.

Agency 2 Concentration risk is a key risk for MDBs and should be carefully monitored.

Agency 3 Proposed limits appear adequate. However private sector operations related limit is on the high side. It should reflect possibility of transferring risk overtime.

Agency 4

The proposed limit of 35% for private sector lending seems prudent. However, it all depends on the quality of the private sector future lending. The proposed single‐country, single‐sector, and single obligor limits seem to me similarly prudent, with the same caveat.

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Annex 3 – Capital Adequacy Methodology of Other MDBs

Table 1 ‐ Risk Capital Charges

IBRD IFC EBRD

PD: Based on its own historical data, the IBRD estimates historical default rates for loans in different risk ratings.

PD: Based on the analysis of default histories of its portfolio since FY1994, the IFC estimates default rates by risk rating category. The one year default rate for loans in each rating is computed as the ratio of the number of loans that default in a given year to the number of loans that could have defaulted in that rating category.

PD: Due to the fact that EBRD’s empirical risk data is based on a relatively short horizon, EBRD considered it insufficient to use just its own internally computed PD to parameterize the risk model. Accordingly, EBRD opted to adopt S&P PD rates but to revise them downward reflecting the lower risk faced by EBRD operations.

LGD: The IBRD LGD are determined based on borrower’s eligibility criteria to borrow from the Bank as follows: ‐ 30% for IBRD eligible borrowers; ‐ 50% for Blend borrowers (IBRD and IDA) ‐ 100% for IDA‐only borrowers.

LGD: Based on the analysis of historical recovery rates for loans in default, the IFC applies a 40% LGD to senior secured loans and 55% to subordinated loans.

LGD: EBRD used S&P LGD but revises these LGD downward reflecting its preferred creditor status.

IADB AsDB AfDB

PD: For sovereign and non‐sovereign operations, PDs will be determined based on historical default rates.

PD: For sovereign operations, IADB assumes S&P and Moody’s PD for each rated country. S&P corporate default probabilities are used for non‐sovereign operations. IADB maps its own internal rating to S&P risk classes

PD: The expected default frequency (EDF) associated with each rating is obtained from the IBRD. ADB uses the distance to default (DTD) concept to measure the likelihood of default. The DTD is the ability and willingness of the borrower to service its debt and is the “inverse standard normal” of the EDF.

LGD: LGD of 30% and 100% are applied respectively to sovereign and non‐sovereign operations.

LGD: The AsDB assumes an LGD of 30% for “expected loss” and an LGD of 70% for unexpected loss reflecting the opportunity cost of loans going into non‐accrual status.

LGD: For sovereign operations, LGD is computed using historical severity and time in defaults of sovereign defaults. For non‐sovereign operations, an LGD of 45% is assumed for loans senior secured loans, 50% for senior unsecured and 75% for subordinated loans.

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Tableau 2 – Prudential Limits

Non‐Sovereign Exposure limits

MDB Non‐Sovereign Operations

Country Sector Single Obligor Equity Participation

IFC 10% of net worth plus

general reserves for loans for lowest risk; 2.5% for highest risk

12% of PRS10 plus general loan loss reserves

4% of net worth plus general reserves on loans

Disbursed equity plus quasi-equity investments (net of reserves) are limited to 100% of IFC’s net worth.

EBRD

90% of PRS. 20% of non- sovereign portfolio

5% of PRS; 8% for private and non sovereign risk-preferred banks (rated A- or better and based in countries with zero BIS risk-weighted sovereigns)

3% of PRS for equity investments

IADB

Not applicable Not applicable Maximum exposure to any single obligor is 2.5% of bank’s equity at the time of approval.

AsDB

$5.0 billion commitments ceiling for AsDB’s non-sovereign operations is used as the basis to determine prudential exposure limits

25% of the aggregate outstanding committed exposure with respect to non-sovereign operations



Aggregate equity investments to 10% of unimpaired paid-in capital plus reserves and surplus (PRS)

‐ Current 20% of PRS 15% of non-sovereign PRS

35% and 25% of Non-sovereign PRS respectively for financial intermediation and for other sectors.

4% of non-sovereign PRS 10% of PRS

AfDB

‐Proposed 40% of PRS 25% of non-sovereign PRS

35% and 25% of Non-sovereign PRS respectively for financial intermediation and for other sectors.

7% of non-sovereign PRS 15% of PRS

10 PRS =Total Risk Capital : Paid‐in capital plus Reserves and Surplus

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Annex 4 – The Bank’s Debt Ratios

It is important to note that the Agreement Establishing the Bank does not impose any limits on the volume of borrowing that may be carried by the Bank. The current debt ratios are policy ratios that were

established primarily based on discussions with rating agencies.

Table 1 below summarizes the lending and borrowing limitations applied by other MDBs. While there is a general trend for most MDBs to limit lending to capital plus reserves, we can notice that several MDBs do not apply specific borrowing limitations.

The lending limitations applied by all MDBs are similar except for the EIB who allows lending to reach 250% of Paid‐in plus Callable Capital.

The IBRD, EBRD and EIB do not have an explicit borrowing limitation. The AsDB applies a borrowing limitation similar to the Bank’s current borrowing limitation, while the IADB applies a net debt concept, similarly to the numerator of the proposed debt ratio 3.

Table 1: Lending Limits and Gearing Ratios of MDBs

Institutions Limit on Lending Limit on Borrowing

I B R D Loans + Guarantees

< Paid‐in + Callable Capital + Reserves + Surplus

None

E B R D

Outstanding loan commitments11

< Paid‐in + Callable Capital + Reserves + Surplus

None

E I B Loans + Guarantees

< 250% x (Paid‐in +Callable Capital) None

A S D B Outstanding loan commitments

< Paid‐in + Callable Capital + Reserves

Borrowings <

Paid‐in + Reserves +

CC of Non‐borrowing members

I A D B Loans + Guarantees

< 100% (Unimpaired capital + Reserves + Surplus)

Net debt < CC of Non‐borrowing members

11 Outstanding loan commitments are defined as the sum of outstanding disbursed and undisbursed loans, Equity investments and guarantees.

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Annex 5 –Estimated cost for implementing Capital Adequacy and Related policies

The proposed enhancement of the capital adequacy framework supported by the independent assessment of external advisory services also aimed to address the limitations of the current framework in terms of human capital. As an interim solution ahead of full implementation over the next few months broadening the skill mix of risk officers is critical in the areas of new instruments to provide adequate business support to risk takers as the portfolio grows. There is also a requirement for an effective risk management culture across the institution that could not be achieved with training and capacity building.

The infrastructure to support the framework must adjust to risks and scale of operations. The framework is to some extent data intensive and requires high‐quality, consistent time‐series for various borrowers/obligors for a period of 7 to 10 years to enable the computation of the required risk parameters and business impact assessment of incremental risk brought in the portfolio through new lending, treasury operations and operational risk. This requires robust risk management architecture, including a strong stress testing framework for scenario analysis. A system to validate the accuracy and calibrate the internal rating processes would be an essential element of the risk management set‐up. This will enables an accurate assessment and quantification of intrinsic credit risks using quantitative and qualitative factors. Such system must be updated periodically to reflect the continuously‐changing economic environment.

The cost estimates of the resource requirement is summarised in Table 10. The total cost estimates is UA 4.2 million over the 2009‐2011 budget period. The risk/reward of such expenditure can be assessed through sensitivity test of a shift in the risk of total earning assets of the Bank at 99.90% confidence interval that could generate a loss of UA 10 million in a year. These resources need to be provided in the multi‐year budget and consistently maintained with annual allocations to ensure effective delivery.

Table 1: Estimated cost of Capital Adequacy and Related policies Implementation 2009‐2011‐ (Human Capital and Risk Infrastructure)

Type of Resources

Requirement

Cost estimates 2009‐2011

in UA

Additional staff capacity (12) – All in cost UA 2,400,000

Existing Skill Enhancement

(Training of risk officers as well as risk takers such as private sector investment officers and treasury officers)

UA 450,000

Human Capital

Change culture to optimize the use of the framework as business enabler (around 12 Seminars on managing risk and opportunities for key business unit managers, staff and Boards)

UA 90,000

Systems and Tools

Credit Risk systems

Upgrade and external validation of the existing sovereign rating system (consultancy fees only‐ firms)

UA 50,000

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Type of Resources

Requirement

Cost estimates 2009‐2011

in UA

Optimization of non‐sovereign models and calibration of all risk rating systems (Risk advisory services‐firms))

UA 290,000

Treasury risk management system (Summit, Numerix) upgrades and integration with SAP ‐(IT Capital budget)

UA 500,000

Risk report generators (enhancement of Oracle Discovery) UA 50,000

Development of an ALM stress testing and projection models (IT Budget) UA 130,000

Operational risk Business Impact assessment and integration within the ERM framework (Risk advisory services – consultants)

UA 48,000

Guidelines, process & procedures

Review of guidelines and procedures (in‐house development supported by independent assessments)

UA 25,000

KPI and KRI indicators development

Upstream Risk based audit of key sensitive risk procedures

UA 9,000

UA 60,000

Total Cost Operational and Capital budgets 4,123,000

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ANNEX 6 ‐ Implementation Timeline ‐ Key Milestones

March 2008 – August 2008

Gap Analysis

Business processes Current Models Required infrastructure

October 2008 – January 2009

Quarter 1 2009

Model and Data schemes

Credit Scoring and Rating System Mapping

Exposure Limit development (Base Model) Differentiated Credit Limit and Credit Pricing

3 months Quarter 2 2009

Model calibration and validation


Infrastructure Set up

ETL data preparation Migration to Oracle


Capital Allocation Software and Reporting

User testing Final Reports


Final guideline reviews

Phase 1‐ m

onths after App

roval

Operational Model Risk Integration


ICAAP Stress Testing Model Integration

Phase 2

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Defined roles to ensure risk informed decision making

Risk information

R isk tolerance levels

R isk policies/procedures

R isk strateg ies

Signal detect ion

Risks exceeding tolerances

Risk metrics

Consolidated r isk data

Integrated reports(planning, disclosure)

St rategic planning data

Senior Management

OPSCOM /Risk Committee

Stakeholders

Information flow and monitoring

Risk managers

VPUs

Counterpart ies & Risk takers

Risk analysts

Annex 7: Other implementation Considerations

AFRICAN DEVELOPMENT BANK AFRICAN DEVELOPMENT FUND ADB/BD/WP/2009/10/Rev.1/Corr.1 ADF/BD/WP/2009/09/Rev.1/Corr.1 17 March 2009 Prepared by: FFMA/FFCO Original: English/French

Probable Date of Board Presentation : 18th March 2009

FOR CONSIDERATION

MEMORANDUM

TO : THE BOARDS OF DIRECTORS

FROM : Kordjé BEDOUMRA Secretary General

SUBJECT : CAPITAL ADEQUACY FRAMEWORK AND EXPOSURE MANAGEMENT POLICY CORRIGENDUM * Please find below a corrigendum on the above-mentioned document.

1. The single obligor limit should be read 6% instead of 7% in the following sections:

Page 17, section 3.3, Table 5 on Proposed Prudential Exposure Limits: The proposed single obligor limit is 6%.

Page 19 , section 3.3.4 on Ancillary Operational Limits (2nd paragraph):

“The country and single obligor limits increased by 5% and 2% (instead of 3%) respectively in the revised framework”

Page 23, section 4.2.2, Table 9 on Impact on the private sector operational limits in 2009. The proposed single obligor limit is 6%, the corresponding risk capital UA 112 million (instead of UA 131 million) and the equivalent exposure UA 423 million (instead of UA 493 million).

Page 25, Section VI on Conclusion and Recommendations, bullet point 6: The non-sovereign single obligor limit is 6%.

Page 35, Table 02 on MDBs Prudential Limits: The proposed single obligor limit for AfDB is 6%.

2. Global Country Exposure Limit:

Page 25, Section VI on Conclusion and Recommendations, bullet point 2: The sentence on the Global Country Exposure Limit should read as follows:

“The aggregate amount of net exposure to support the Bank’s combined sovereign and non-sovereign operation in any given country must not exceed 15% (instead of 25%) of the Bank’s risk capital.”

cc : The President

*Questions on this document should be referred to:

Mrs. K. M. DIALLO Director FFMA Ext. 2147 Mr. P.KEI-BOGUINARD Manager FFMA.1 Ext. 2136 Mr. M. KALIF Acting Manager FFMA.2 Ext. 2217 SCCD:N.A.

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