Credit Risk of Traded Products under Basel II

Credit Risk of Traded Products under Basel II HEC Conference Montreal April 13, 2007 Niall Whelan, Director Research & Model Risk Management Scotiabank The views expressed here are those of the author and not necessarily those of Scotiabank.

Introduction and Terms Three components of regulatory capital from trading activities: 1. Credit Risk 2. Market Risk 3. Operational Risk Credit Risk: Counterparties may default, leading to losses Market Risk: Market conditions may be adverse, leading to losses in the trading portfolio Operational Risk: Fraud, terrorism, pandemics, weather disasters etc. may occur, leading to losses to physical or other assets 2

Layout of Talk Focus: • Credit risk with some discussion of market risk • Excluding: operational risk Agenda/Topics: • The need for a special treatment • History of regulatory capital and traded products • pre-Basel • Basel II • Overview of Basel II requirements • 5 chapters of Trading Book document • Implementation • “use test” and connections to other risk measures • Pillar 1, 2 and 3 issues 3

Credit Risk of Trading Portfolios Trading activities are significant businesses for most large banks: • OTC derivatives • repo and reverse-repo transactions • security lending and borrowing They can all generate losses when counterparties default and should therefore be capitalised. . . HOWEVER. . . we do not generally know how much our exposure will be if and when the counterparty defaults: • values of traded products are intrinsically uncertain • we do not know what the portfolio of transactions will be when default occurs 4

Market Risk of Trading Portfolios Derivatives portfolios are marked-to-market on a daily basis • Typically well hedged but not perfectly so • There is some residual net open position This net open position can deteriorate in value under adverse market conditions This effect is captured by Value-at-Risk (Va. R) capital provisions. Based on extreme movement over 10 days of exposure • No banking book equivalent • Illiquid positions may require special treatment • Idiosyncratic risk factors may require special treatment 5

History of Regulatory Treatment for Capital Pre-Basel • There was no international consensus on setting of capital • Regulators did not adhere to rigid capital ratios • relied on judgment of risk by the banks and themselves • echoed in current "principle-based" approach • Capital ratios fell through time • 1840 ratio was about 50% • deposit insurance, access to central bank funds acted to buffer bank risk • 1940 ratio was about 6 -8% • Huge bank failures in the US during the Depression lead to much more active regulatory environment • 1973 collapse of Bretton Woods coincided with emergence of a significant Capital Markets industry to create a more dynamic and volatile FX and interest rate trading environment • 1980's: Latin American debt crisis as well as the S&L crisis in the US led to more concern about the robustness of the banking industry. The US brought in a series of ever tightening capital requirements • 1988: the Basel I accord. . . 6

Traded Products under Basel I What is the exposure associated with an OTC contract? OTC credit risk is the mark-to-market plus notional times the following add-on factor: Residual Maturity Interest Rates FX and Gold Equities Precious Metals (except Gold) Other Commodities < 1 year 0% 1% 6% 7% 10% 1 -5 years 0. 5% 5% 8% 7% 12% > 5 years 1. 5% 7. 5% 10% 8% 15% Consider: • is silver really so different from gold? • what about a cross-currency equity derivative? • is a 1½ year swap really identical to a 4½ year swap? • etc. . . only reverse repos attract credit risk capital (not repos), due to collateral only securities lending attracts capital (not securities borrowing), due to collateral 7

Basel I cont. . . Further multiply by the counterparty riskfactor weight Counterparty Type Riskfactor Weight OECD governments 0% OECD banks and public service entities 20% Corporate and other 50% Capital is then 8% of the product Consider: • shouldn't the perceived risk vary with economic conditions? • are all OECD banks of equal credit risk? • is a CCC corporate really identical to a AA corporate? • etc. . . 8

Netting under Basel I Netting is the legal ability to settle on the net value of a portfolio of derivatives upon default by one counterparty (vs. deal by deal) Potential to lessen the exposure at default First recognised as an amendment in 1995 A' = 0. 4*A + 0. 6*NGR*A A is the add-on ignoring netting NGR =(net current replacement cost) / (gross replacement cost) Consider: • this is very ad-hoc • what about netting with collateral? • deeply out-of-the money portfolios still attract significant capital • not "coherent"/sub-additive 9

Market Risk Capital under Basel I In 1996 Basel outlined capital treatment of market risk (Va. R). • Based on the 99'th percentile of market loss over a 10 day horizon, multiplied by 3 • Banks have wide latitude in deciding how this is determined • Regulatory focus on self-consistency, back-testing, internal controls and validation • The result is a key internal risk measure that is regularly reported in financial statements • “Prototype” for internal modelling approach now embedded in Basel II • Separate charge for "specific risk" for derivatives subject to idiosyncratic entity-specific risk (equity derivatives, credit derivatives etc. ) 10

Basel II The main document: International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2004 A document specific to trading activities was published in April 2005 Two months of industry consultation led to. . . The Application of Basel II to Trading Activities and the Treatment of Double Default Effects, July 2005 1. The treatment of counterparty credit risk and cross-product netting 2. The treatment of double default 3. The short-term maturity adjustment in the IRB approach 4. Improvements to the current trading book regime 5. A capital treatment for failed trades and non-Dv. P transactions 11

Counterparty Credit Risk under Basel II Consider: • 1 -e-50 = 1 -10 -22 is a built-in underflow 12

Counterparty Credit Risk under Basel II cont… Risk-weighted assets = 12. 5*Capital • RWA now a derived quantity, not fundamental to the capital calculation PD and LGD are common to other asset classes Trading book requirement is the determination of EAD and of M 13

Counterparty Credit Risk under Basel II continued. . . Determination of EAD and M for OTC: Three methods 1. Current exposure method (essentially Basel I augmented for credit derivatives) 2. Standardized method (I am not aware of any bank using this) 3. Internal (EPE) method 1. Determination of EAD and M for repo-style: Three methods 1. Standardised haircuts 2. Adapted Va. R 3. Internal (EPE) method 14

Counterparty Credit Risk under Basel II continued. . . EPE method. Use an internal model to estimate expected exposures over a one year time horizon Determine "running maximum" through time (roll-over risk) Average of the running maximum times 1. 4 is EAD M is determined by a similar manipulation of the exposure profile Factor of 1. 4 is regulatory; it can be as small as 1. 2 15

Counterparty Credit Risk under Basel II continued. . . Other considerations: • Can be done at the level of a netting set • Collateral treated as a negative offsetting position • Under certain conditions can net OTC and repo-style • Margin agreements effectively cap the potential exposure • Based on expected exposure, not 99. 9’th percentile • Explains need for the scaling by 1. 4 • Can impose one’s own scaling of: • Subject to a floor of 1. 2 • Industry studies indicate 1. 1 to 1. 2 is typical • Internal economic capital is an explicit component of the calibration • We find about 20 -30% relief relative to CEM 16

The treatment of double default Credit derivatives that are hedging loan exposures do not attract counterparty capital They are treated the same as a credit guarantee Under certain conditions guarantees or credit derivatives can attract "double default treatment" • Reflects the probability that both the counterparty and the guarantor must default to experience an exposure. Consider: This can actually increase capital if Equation "should" be 17

The short-term maturity adjustment in the IRB approach Technical point. By default M is floored at unity but in some cases it can be less than one Repo-style transactions with daily remargining are the most important application 18

Improvements to the current trading book regime Not an extensive overhaul, implying an overall regulatory and industry comfort with market risk under Basel I Changes include: • Greater oversight about what can be held in trading books • Greater concern by regulators about validity of the 10 -day unwind period in Va. R for illiquid positions • More rigorous validation and stress testing standards • Lessening of specific risk charge multiplier from 4 to 3 • Need to capture “event risk” and “incremental default risk” in specific risk • Still somewhat contentious • These are based on 99. 9’th percentile of loss over one year • Difficult to combine with market Va. R defined as a multiple of 99’th over 10 days 19

A capital treatment for failed trades and non-Dv. P transactions Meant to plug a small hole in Basel I: how to treat trades which have failed to settle • Dv. P - treat as a forward contract • non-Dv. P - treat as a loan Typically so immaterial that applying a conservative factor is the best approach 20

Use Test Related credit risk measures • Economic Capital Related market risk measures Desk and business-level market Va. R • Credit Line Utilisation • Credit loss provisions (expected losses) Principle is that the internal model for these measures should be broadly in line (not necessarily identical) to what is done for Basel • Systems/infrastructure • Data 21

Pillars 1, 2 & 3 We have focused mostly on Pillar 1 – the determination of capital Significant Pillar 2 requirements – supervisory oversight. This includes disclosure to regulators, back-testing, stress-testing, usetest and other evidence that the measures are embedded within a robust risk framework • Important consideration for regulators in light of the "principle-based" approach • Connection to Economic Capital particularly important Pillar 3 requirements – public disclosure. This is a relatively light component for the Trading Book 22

Bank Experiences A major improvement. Principle-based/internal modelling approach makes sense • Avoid “regulatory arbitrage” • More granular and dynamic reflection of credit and market risk • Use test requirements Little time for consultation between first and second drafts of Trading Book document • Regulators and Basel Committee were receptive to industry feedback • Still some aspects of the accord that are somewhat contentious Tendency for Trading Activities to be an "after thought" • Basel guidelines came later • Gap analysis from OSFI came later and was not paragraph-by-paragraph • Internally A major piece of work involving multiple departments across the bank A valuable tool to improve banks’ internal processes • Data flows and system information • Consistency of risk assessment across business lines • Improvement and rationalisation of internal risk measures • Va. R • Economic Capital • Loss provisions • Credit line utilisation 23