North American Banks Prepare for Double Whammy

Banks, especially those operating in North America, could be forgiven for feeling over-regulated at the moment. Not only are they having to deal with a wholesale revolution in measurement and management of credit risk under Basel II, Sarbanes-Oxley and its upcoming Canadian counterpart place heavy penalties for failure to report credit risk data in a timely and accurate fashion. Here, Jack Bensimon of SC Risk points out that where Basel offers incentives and ever-moving deadlines, SOX gives a clear, if severe, compliance framework. And both have weaknesses that banks need to consider in order to thrive in the newly-emerging regulatory framework.

gtnews: What are the biggest problems faced by banks in implementing ratings-based models?

Jack Bensimon: There are three main challenges that banks are faced with in this area. First, if you consider the foundation internal rating approach, banks use their own internal estimates of credit worthiness (via regulatory standards), for example, to calculate the estimated probability of default (PD). The problem is that there are often material discrepancies between external credit assessment institutions (i.e. standardized approach) and internal rating-based metrics. This creates implementation challenges as external credit firms have their own built-in biases in determining a rating, which may not accurately represent the underlying credit risks, especially at credit divisional levels.

The other problem is that varying assumptions/inputs are calibrated into internal PD models, while external ratings may fail to capture different distributions of default estimates. For example, sovereign, bank, and corporate exposures are subject to the advanced internal rating-based approach, where loss given default (LGD) and estimated annual defaults (EAD) have yielded 17% reduced capital requirements for the industry. I get concerned when there is close to one-fifth less capital in the system, and may not necessarily bode well for the long-term interests of shareholders and depositors. This is particularly acute if one considers the high level (extreme) of concentration in the global derivatives market (ex: a single player having over 40% of all notional contracts). However, perhaps the operational risk charge (ORC) of 12% may mitigate such lower capital requirements – it’s too early in the game to tell, especially in light of ORC being difficult to quantify and the inconsistency of measures across the board.

Basel is not country-specific, industry-specific or sector-specific nor should it be. What I am suggesting is that it should have some kind of provision that considers not only concentration risk, but how those concentration risks are accounted for and the current state of certain markets, such as the swaps markets. Basel looks at different markets as if they were all the same as they have similar risk profiles. In fact they don’t and modelling challenges are far greater in some sectors than others.

The second major challenge in implementing such internal models is that any model that is to be seriously considered with any level of confidence, must unequivocally consider the heightened regulatory environment. In the US, the newly heralded and onerous Sarbanes-Oxley (2002) corporate reform controls have elevated the stakes for financial misrepresentation. Although SOX is US mandated, it has implications abroad for credit risk implementation and modelling since banks are heavily exposed to credit risk and have obligations to accurately and timely report on it. Sections 302, 404 and 906 of SOX impose very heavy penalties for non-compliance, while any internal rating system must be adequately defended by a bank when called to do so. What this means is that as a result of the new regulatory environment, models need to be more broadly based to capture elements that were not previously priced.

For example, extreme risk events can be modelled, but their probability distributions are most likely to be non-stochastic in nature, throwing a few curve balls in estimating the credit risk. This will become more of a challenge over time. This is where SOX is strong here, and Basel II is weak: SOX has set definitive timelines (phase-in approach) while Basel II has been dragging on its feet for far too long. SOX has had a profound positive impact on the behavior and corporate governance of companies, their boards, their auditors, their lawyers and investment advisors. Solutions are needed now as the multiplicity and complexity of accounting rules and regulations have elevated the importance of quantifying certain types of credit risks from complex accounting treatments (e.g., Special Purpose Entities (SPEs), Off-Balance Sheet (OBS) transactions).

The third challenge in implementing internal rating models is that banks don’t have an effective means of ensuring, within reasonable confidence intervals, that their internal models accurately represent the level of risk inherent in the portfolio. For example, the effect of modelling assumptions on estimates of extreme tails of the distribution is not well understood – this needs further probing, analysis and policy implementation. Consider for a moment if a major derivatives player, who holds over 35% of all global derivatives contracts, suddenly experiences a rash of counter-party credit defaults in their swap inventory book. The unwinding of all these positions will most certainly affect the aggregate credit risk. Has the bank quantified this risk, which may have seemed extreme but yet probable? We need to look at the short-term liquidity implications of such an extreme, but probable event. The bailout of Long-Term Capital Management hedge fund comes to mind, where weak internal controls fostered a lax environment of questionable risk mitigation strategies.

Part of the solution is having consistency across the board but the problem with that is that not all bank are on a level playing field. You wouldn’t expect a $500m asset bank in Peru to use the same rating model as Citigroup. In its present format it doesn’t address those inherent weaknesses. A potential solution is to have some kind of modelling structure that considers – either through different discount rates or capital charges – the size of particular banks, division risk levels and other kinds of variables. I do not have the solutions but as a risk management practitioner providing consulting services to banks I see these weaknesses.

Even in the US and Canada, I don’t think the regulators have spent enough time testing the efficacy and robustness of internal rating models. I don’t think enough time has been spent looking at whether the assumptions made in these models really comports with global realities and risk premiums. There are some unique risks out there that have not been captured on existing models.

We should also remember that it’s not clear whether the high-target credit loss quantiles used in the measurement of credit risk and estimates of economic capital can be estimated with an acceptable degree of precision. Under the dictates of SOX, you have to have something to defend as a reliable and robust model, and perhaps this is another area where Basel should look to SOX for guidance.

gtnews: To what extent is Basel II already changing credit risk measurement and modelling?

Bensimon: Basel II has changed some of the landscape in the measurement and modelling of credit risk in two meaningful ways. First, since Basel is global in scope and credit exposures typically cut across geographical locations and product lines, the use of credit risk models offers banks a framework for examining this risk in a timely manner. It also allows the monitoring and analysis of marginal and absolute concentrations to risk. Over time this will provide a gauge of how diversified risks are, and allows greater precision in the quantification of these risks. It also makes it easier to break down those risks so they can be priced into the cost of capital and other opportunity costs as well as the amount regulatory or economic capital allocations required. These properties are, on balance, likely to bolster a bank’s overall ability to identify, measure and manage risk.

Secondly, the incentive structure built into Basel from a supervisory perspective offers incentives to improve systems and data collection efforts in the modelling process, a more informed setting of limits and reserves, more accurate performance-based pricing which raises the transparency decision-making process. Also, by improving the robustness and accuracy of the model it leads to a more consistent basis for economic capital allocation.

gtnews: What is the impact of different approaches to Basel from different regulators?

Bensimon: Most of the experience and judgment in our practise has been in the US/Canadian arena. So, let’s start in the US arena.

U.S.

US regulators increasingly view Basel II as another means of catapulting the existing corporate governance framework (outside of SOX), while at the same time the biggest threat to Basel is its failure to stick to a disciplined timetable. This is where Basel can learn from SOX. As Basel has mandated a 2007 deadline, this is way too far out. Take, for example, the derivatives market. Right now you have a global trillion-dollar derivatives market that has significant concentration risk, with a single player commanding over 35-40% of the global market. It’s an area of the financial industry that has witnessed significant growth, while at the same time many credit exposures have yet to be quantified in any meaningful way nor are there sufficient controls in place to mitigate such risks.

Against this background, the derivatives market may just be the next shoe to drop-exposures are not being accurately modelled nor priced and there are huge regulatory capital risks that may be jeopardized in the process. Basel is viewed as a means to prevent corporate control failures, but is silent on various certification procedures-this is where the strength and spirit of SOX comes out ahead. For example, Basel mandates operational risk charges to the tune of 12% (on average) of the total capital charge, with alphas computed between 17-20%. That alpha set by Basel is really an arbitrary figure predicated on dubious models, which more importantly, fail to account for the quality of internal controls. This is yet another weakness in the accord that has not been sufficiently addressed by banking regulators.

Now let’s look at the Canadian landscape.

Canada

Although Canada does not have the equivalent of SOX, there is a new framework underway that attempts to act as its US analog. Canadian banks tend to be more conservative in credit risk charges than their US counterparts, while at the same time are faced with the same internal ratings-based modelling challenges. What regulators are increasingly commanding from global banking watchdogs is a system that creates and perpetuates a level playing field among all banks.

For example, if capital charges are to be implemented via Pillar II (Supervisory Functions) of Basel II, how can there be any assurance of consistent application throughout the world? Banks located in countries with supervisors that are more aggressive would be at a competitive disadvantage. Hence, Basel II has failed to consider the strategic implications for the larger, more closely supervised banks.

gtnews: How does Basel II address the use of tools by banks that mitigate credit risk?

Bensimon: One of the distinguishing features of Basel II is that there are incentives for banks to comply with the Accord. It allows banks that can prove they have effective and sophisticated enterprise-wide risk management systems to lower the level of protected buffer capital, freeing up potentially hundreds of millions of dollars for investment in profitable activities.

The Basel II reforms also demonstrate that there is a compliance incentive mechanism-that if you can convince regulators you have your internal controls act in gear, it will attract less regulatory scrutiny. This is in stark contrast to SOX – there are no positive benefits under SOX for public companies to distinguish themselves by having good risk and control governance systems. In many respects, the vast majority of US reporting issuers need to “pull-up their SOX” in short order.