1

Practical and Business Practical and Business Implications of Basel 2 for Implications of Basel 2 for

UK Mortgage Lenders.UK Mortgage Lenders.

Bruce T PorteousBruce T Porteous

29 April 200429 April 2004

2

Important, but Exciting?Important, but Exciting?

3

Basel Overview.Basel Overview.

Basel 1 ObjectivesBasel 1 Objectives– Consistent minimum capital adequacy standard for banks

worldwide.

Basel 2 ObjectivesBasel 2 Objectives– Better align capital with risk.

• Regulatory capital arbitrage is harder.

– Promote best risk management practice.

Timetable for Basel IITimetable for Basel II– Basel Committee publishes final accord Summer 2004.– EU Capital Adequacy Directive adopted by end of 2005.– Transposition into national laws for implementation at 31/12/2006.– In practice, kicks in from 31/12/2008.

4

Basel II Overview.Basel II Overview.Key proposals:Key proposals: 3 Pillar approach.3 Pillar approach. New capital charge for operational risk.New capital charge for operational risk. Market risk essentially unaltered.Market risk essentially unaltered. Choice of basic versus advanced approaches.Choice of basic versus advanced approaches. Advanced approaches allow firms to hold less capital Advanced approaches allow firms to hold less capital

per unit of risk, versus basic approaches.per unit of risk, versus basic approaches. Waiver from basic methods requires a demonstration Waiver from basic methods requires a demonstration

of threshold competency levels of: of threshold competency levels of: • Data volumes.• Quantitative risk management.• Systems and controls.

5

Pillar 1.Pillar 1.

Minimum capital requirements.Minimum capital requirements. Credit, Market, Operational.Credit, Market, Operational. Basic and advanced approaches.Basic and advanced approaches. Formulaic.Formulaic.

6

Pillar 1. Pillar 1. Credit Risk Capital Credit Risk Capital

Requirements Requirements for Residential Mortgages.for Residential Mortgages.

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

3 10 25 50 75 100 500 1000 2000

PD (Basis Points)

Cap

ital

Req

uir

emen

t

Basel 1

Basel 2 Standardised

Basel 2 Advanced (LGD 50%)

7

Pillar 1. Pillar 1. Practical Implications.Practical Implications.

Clear capital incentive to get onto advanced credit Clear capital incentive to get onto advanced credit approaches.approaches.

Operational risk still generally unclear.Operational risk still generally unclear. FSA waiver requirements (CP189) look onerous, FSA waiver requirements (CP189) look onerous,

bureaucratic and unclear.bureaucratic and unclear. Need to be compliant by 31/12/2004 (advanced Need to be compliant by 31/12/2004 (advanced

retail credit).retail credit). Big bank advantage (more resources and “data”). Big bank advantage (more resources and “data”). But capital win is mainly retail.But capital win is mainly retail. Banks with clean data, good MIS, integrated IT Banks with clean data, good MIS, integrated IT

systems should also be well placed.systems should also be well placed.

8

Pillar 1.Pillar 1.Practical Implications.Practical Implications.

Can the FSA cope with all of the firms Can the FSA cope with all of the firms who want on the advanced train?who want on the advanced train?

Can the big banks book their tickets in Can the big banks book their tickets in advance?advance?

9

Pillar 2. Pillar 2. Supervisory Review.Supervisory Review.

Qualitative requirements.Qualitative requirements. Basel 2 embedded in business as usual risk Basel 2 embedded in business as usual risk

management processes (e.g. underwriting management processes (e.g. underwriting decision). The “use test”.decision). The “use test”.

Appropriate systems in place to:Appropriate systems in place to:– Measure risk.– Monitor risk.– Manage risk.– Report risk.

Consistency of approach across supervisory Consistency of approach across supervisory regimes?regimes?

10

Pillar 2. Pillar 2. Supervisory Review.Supervisory Review.

Quantitative requirements.Quantitative requirements. ICA process in place and business as usual.ICA process in place and business as usual.

– ICA ~ economic capital, but loosely defined.– Risk targets set (consistent with controls and risk

profile).– ICA covers:

• Risks not captured by Pillar 1.• Internal risks not covered (banking book market risk).• External risks not covered (business cycle).

Consistency of approach across supervisory Consistency of approach across supervisory regimes?regimes?

11

Pillar 2.Pillar 2.Retail Mortgage Bank Retail Mortgage Bank

Example.Example.

0

1

2

3

4

Capital Charge (%)

Basel 1 Basel 2 EconomicCapital

12

Pillar 3.Pillar 3. Risk exposures, risk assessment Risk exposures, risk assessment

processes will be comparable across processes will be comparable across firms.firms.

Market discipline will drive good Market discipline will drive good practice.practice.

Increased amount and frequency of Increased amount and frequency of disclosure.disclosure.

Web based disclosure etc.Web based disclosure etc.

13

Securitisation.Securitisation.

Basel 2 securitisation rules are still Basel 2 securitisation rules are still unclear and evolving.unclear and evolving.

Under Basel 1, securitised mortgages Under Basel 1, securitised mortgages require less capital than “on balance” require less capital than “on balance” sheet mortgages.sheet mortgages.

Arbitrage possibility (plus additional Arbitrage possibility (plus additional funding source, of course).funding source, of course).

Some current business models Some current business models securitise heavily. securitise heavily.

14

Securitisation.Securitisation.

Basel 2 => Basel 2 => – “on balance” sheet capital ~ securitised capital.

Securitisation allows Basel 2 benefits Securitisation allows Basel 2 benefits now.now.

Capital/funding management in the Capital/funding management in the run up to Basel 2? run up to Basel 2?

Long term future of RMB securities Long term future of RMB securities market?market?

15

Business Environment Business Environment Impact.Impact.

Advanced approach banks will have a Advanced approach banks will have a competitive advantage:competitive advantage:– Higher ROC?

– Cheaper mortgages?

Loan books of standardised firms may have Loan books of standardised firms may have more value to advanced banks (consolidation?).more value to advanced banks (consolidation?).

Retail business may become strategically more Retail business may become strategically more attractive (versus more risky types of banking attractive (versus more risky types of banking activity). activity).

Harder for new entrants, less innovation?Harder for new entrants, less innovation?

16

Demands on Lenders.Demands on Lenders.

Increased workload:Increased workload:– Corporate governance, risk framework, internal

reporting.– Data cleaning and analysis. IS impact.– Business as usual processes.– Interactions with FSA (waiver application).

The market will expect the big banks The market will expect the big banks to be on the advanced approaches.to be on the advanced approaches.

Most pressure on smaller firms. Can a Most pressure on smaller firms. Can a standardised firm compete?standardised firm compete?

17

Costs and Benefits.Costs and Benefits. Costs.Costs.

• Group/Firm specific.• Upgrade governance processes.• Upgrade business processes.• Data cleaning, consolidation and analysis.• IS costs.• Staff costs (numbers and skills).

Benefits.Benefits.• Best risk management practice.• Probable capital reduction benefit for retail lending.

Cost Benefit Analysis.Cost Benefit Analysis.• Likely to be favourable for mortgage lending.

18

Clear?Clear?

19

Conclusions.Conclusions.

Substantial and ongoing work by/from 31/12/2004 Substantial and ongoing work by/from 31/12/2004 (for advanced credit risk approach).(for advanced credit risk approach).

Risk management should improve across the Risk management should improve across the board.board.

More sophisticated (“big”?) lenders favoured.More sophisticated (“big”?) lenders favoured. Increasing pressure on margins and smaller Increasing pressure on margins and smaller

lenders.lenders. Consolidation?Consolidation? Future of securitisation markets?Future of securitisation markets? End customers should win. End customers should win.

20

Questions?Questions?