American Society Of Appraisers

2006 International Appraisal Conference

Brooklyn, New York

Collateral &
Risk Based Capital Standards

James E. Condolff, SVP

Citigroup Risk Management Global Risk Architecture
Wednesday, 2 August 2006

Program
1.

Introduction to Collateral & Risk Based Capital Standards

y Recent developments in global capital adequacy schemes.
y Scope of todays session.
y Key points and objectives.

2.

New Risk Based Capital Standards In The Banking Industry

y A (very) brief history of Basel II.
y Primer on capital calculations using advanced risk based models.
y Advanced risk management and practical challenges.

3.

Credit Risk Mitigation & Collateral Requirements

y Collateral, asset protection and credit risk parameters.
y Accounting for collateral valuations and other requirements.
y Collateral and its influence on risk parameters.

4.

Observations - Collateral Risk Measurement & Asset Management

y
y
y
y

The new emphasis on collateral risk - management or measurement?

Collateral - the risk capital versus credit risk view.
Asset valuations and capital adequacy.
What will the models reveal?
2

Part I:
An Introduction.
Collateral & Risk Based Capital Standards

The New Capital Accord

1.

Banking Regulation and Minimum Capital Requirements

y Banks are required to adhere to minimum capital standards.
y There are significant changes proposed to the existing standards.
y The new standards are far more risk sensitive than existing.

2.

Significant Changes Required For Complex Global Banks

y Means major investment in risk technology and infrastructure
y Use of advanced risk models and practices.

3.

Progression to Risk Based Measures

y The largest US banks will move to Basel II beginning in 2008.
y Some other countries have already started to implement the
standards on varying timelines. Most will phase in over next two years.
y There is ongoing dialogue between the industry and regulators, and
final rules are not yet issued.

Scope of Todays Session/Key Points

1.

Discussion will be focused primarily on requirements under Basel II and

per US Guidance.
y Treatment of direct and contingent wholesale credit exposure
y Market and Operational Risk are out of scope
y Credit Risk Mitigation and collateral one of many areas of focus

2.

Key Points
y Basel II raises the bar on industry best practices
y Major banks are improving risk infrastructure to more effectively

measure risk.
y Collateral types and values covering individual exposures will
likely influence capital requirements under Basel II.
y Banks will begin to focus on Collateral Risk Reporting as an
advanced form of risk management.

Objectives
1.

Provide understanding that as a result of new regulatory

requirements, banks are permitted to account for the mitigating
impact of collateral on credit risk capital.

2.

Review reasons for increased emphasis on collateral management

and related processes among financial institutions subject to Basel II
rules.

3.

Review how collateral considerations might impact the calculation of

risk-weighted assets and regulatory capital under Basil II.

4.

Discussion of changes that might result from Basel II in collateral

policy and processes among financial institutions.

Part II
An Overview: New Risk Based Capital Standards
In The Banking Industry

What is Basel?
1.

Basel Committee On Banking Supervision Was Established By Central Banks Of G-10 Countries In
1974.
Committee today consists of central bankers and supervisory regulators from 13 countries.

Committee has no supranational supervisory or legislative power. Any agreement or accord issued by

the Basel Committee is simply a template which has no power until a country chooses to implement and
enforce it.
The Basel Committees Capital Accord thus may be implemented within each country with local
variations in content, scope of application and timing of implementation.
This has raised potential and actual home/host issues. Citigroup must implement Basel II on a
consolidated basis in accordance with US rules but also has to implement Basel II processes for
subsidiaries in each host country according to local rules. (see below)

2.

Basel Capital Accord Covering Credit Risk Was Issued In 1988.

Established a minimum ratio of required Tier 1 capital to RWA (risk weighted assets).

RWA assigned only for credit risk, based on simplistic categorization of types of assets and obligors.

3.

An Accord Amendment Was Issued In 1996, Covering The Market Risk Of Trading Portfolios.
RWA assigned for market risk, based on either the onerous Standardized Approach or on scaled VAR

derived from an internal simulation model (if approved by regulators).

4.

Basel II Proposals Introduced In June, 1999. FRAMEWORK COMPLETED in JULY 2005.

Basel II:

9
Enhances measurement of RWA for Credit risk to increase risk sensitivity of risk weights.
9
Expands requirements for measurement of RWA for market risk, and
9
Requires RWA for operational risk.

June 26, 2004 the Final Framework issued by Basel Committee

July, 2005 the Application of Basel II to Trading Activities and the Treatment of Double Default Effects.

This was integrated into the Final Framework in the Nov, 2005 document.
8

The Three Pillars of Basel II

Minimum Capital

Credit Risk
More risk
sensitivity

Operational Risk
New

Trading Market
Risk
Enhanced
Standards

Pillar I

Supervisory Review

Supervisory
assessment of
banks:
Risk management
policies and
practices

Market Disclosure

Mandates increased
minimum public
disclosure of banks
risk information.

Economic capital
process.
Can result in
additional capital
requirements

Pillar II

Pillar III

Pillars are intended to be mutually reinforcing and interlinked.

9

Pillar I Three Credit Risk Approaches

Increasing sophistication, with more advanced qualitative criteria

10

Pillar II Supervisory Review Process

11

Key Requirements For Advanced Bank Reporting

12

Advanced Calculations Default Risk Capital

Basel II defines six Risk Weight formula, three for wholesale and three for retail, that make
different assumptions about asset value correlation, the effect of maturity and the benefit
of size (SME). Proposed US rules would allow five Risk Weight Formula (no size).
The model utilizes a formula-based calculation, where banks are required to provide the
internal risk parameters associated with each obligor (Probability Of Default) and facility
(Loss Given Default, Maturity, and Exposure At Default). These parameters are used to
determine Default Risk Capital.

What is Default Risk Capital Under Basel II?

The potential unexpected loss at a nominal 99.9% confidence level, over one
year, specified by an analytical equation. The Basel model is derived under
two broad assumptions:
1.

Correlations between obligor default are driven by a single factor (e.g. the state
of the economy). There are six risk weight functions that differ, in part, by their
stipulated asset value correlations.

2.

The portfolio consists of an infinite number of infinitesimal obligors for each

probability of default.

These two broad assumptions are why the model is referred to as a single
factor asymptotic limit approximation.

13

Advanced Calculations Default Risk Capital

Water level of the Nile River
Meters

100-year
flood

Dam

Average Level

River Bank

1900
How high to
build the dam?

1950

2000

Question 1.

How safe do you want to be?

Question 2.

What is the distribution of expected and

unexpected flood levels?

14

Advanced Calculations Default Risk Capital

Potential Portfolio Losses
$ Millions

100-year
catastrophic loss

Bank
Capital

Average
expected loss
level

Loss
Reserves

Historical or simulated loss patterns

How much
capital do you
need?

Question 1.

How safe do you want to be?

Question 2.

What is the distribution of expected and

unexpected losses?

15

Advanced Calculations Default Risk Capital

Risk parameters are used to determine the Risk Weighted Asset equivalent for
the Credit Risk Asset (exposure). Capital requirement remains at 8% of RWA:
Risk Weighted Asset = 12.5 x EAD x Risk Capital Per Unit Of Exposure

Risk Parameter

Description

Probability of Default
(PD)

The obligor one-year probability of default, expressed as a percentage.

Loss Given Default

(LGD)

Facility measure of loss severity on an economic basis, calculated as the

present value of all cash flows from date of default through resolution.
Expressed as a percentage (of the exposure at the time of default).

Exposure At Default
(EAD)

provides an estimate of expected exposure at default, and the focus of the

EAD estimation process is generally on unused committed amounts

Maturity
(M)

Weighted average maturity of expected cash flows, subject to 1 year

minimum and five year maximum.
16

Advanced Calculations Default Risk Capital

Required Risk Capital Per Unit Of Exposure under Basel II*:

Default Risk Capital function:

Maturity Factor:

17

*wholesale corporate exposure

Advanced Risk Management

and Practical Challenges
1.

Implementation of Basel II differs from country to country in areas

such as approach and national discretion. Such differences
present unique challenges to large complex internationally active
banks.

2.

Credit risk models historically focused on systematic risk in

defaults (first order risk) and paid less attention to recovery rates
in default (second order risk). However, banks are required to
provide estimates of both risk parameters for the Advanced
Internal Ratings based method.

3.

Generally, significant investments in risk infrastructure and

technology is required.

4.

Key challenge is to understanding the potential impact of new risk

sensitive capital requirements on business strategy.
18

Part III:
Credit Risk Mitigation Under Basel II
& Collateral Requirements

19

Credit Risk Mitigation & Basel II

One significant change in Basel II versus the current accord is broader
recognition of the use among banks of various forms of credit risk mitigation.
Provided certain minimum requirements are met, firms are permitted to adjust
risk parameters to account for the use of such risk reducing methods.
There are four forms of credit risk mitigation recognized under Basel II:
1.

Guarantees

2.

Credit Derivatives

3.

On-balance Sheet Netting

4.

Collateral

Note that where banks use other techniques to mitigate risks, they might
potentially benefit from use of such under Basel II. However, Banks would
need to demonstrate such benefit using historical information and analytical
models, before incorporating such benefit in the risk parameters.

20

Credit Risk Mitigation & Basel II

Capital requirement for $100MM 3yr Corporate Term Loan Secured Vs. Unsecured*

Capital Requirement

$20.00
$18.00

Collateral

$16.00

No Collateral

$14.00
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
.00

.03

.06

.17

1.87

8.51

22.13

Probability Of Default

On average, the capital requirement is significantly lower for a secured facility than for the same facility
if extended on an unsecured basis. To recognize this benefit, banks must properly collect and report
collateral information at the facility level, and then satisfy additional requirements associated with
effective management of collateral related to operational, legal, liquidity and market risks. Our ability to
meet both requirements will be critical to the business proposition for many businesses with secured
credit exposures.

21

*Above illustration uses 20% average LGD for secured and 40% LGD for unsecured..

Credit Risk Mitigation & Basel II

collateral defined
Under Basel II, collateral is generally defined as follows:
A collateralized transaction is one in which banks have a credit exposure or
potential credit exposure; and that credit exposure or potential credit exposure is
hedged in whole or in part by collateral posted by a counterparty or by a third party
on behalf of the counterparty.
.but subject to certain minimum requirements.

Collateral eligibility is specifically defined by asset class as follows:

Approach

Eligible Collateral

Standardized Method

Cash, Gold and Certain eligible marketable securities.

Foundation IRB Method

Cash, Gold and Certain eligible marketable securities.

Receivables and Real Estate
Other Eligible IRB Collateral

Advanced IRB Method

No specific class exclusions, provided all minimum requirements are

met.
22

Credit Risk Mitigation & Basel II

minimum documentation and legal certainty standards
There are two minimum standards for legal documentation:
1.

All documentation used in collateralized transactions and for documenting on-balance

sheet netting, guarantees and credit derivatives must be binding on all parties, and
must be legally enforceable in all relevant jurisdictions.

2.

Banks must have conducted sufficient legal review to verify this and have a well
founded legal basis to reach this conclusion, and undertake such further review as
necessary to ensure continuing enforceability.

Additional legal standards:

1.

The legal mechanism by which collateral is pledged or transferred must ensure that the
bank has the right to liquidate or take legal possession of it, in a timely manner, in the
event of the default, insolvency or bankruptcy of the counterparty.

2.

Banks must take all steps necessary to fulfill those requirements under the law
applicable to the banks interest in the collateral for obtaining and maintaining an
enforceable security interest, e.g. by registering it with a registrar, or for exercising a right
to net or set off in relation to title transfer collateral.
23

Credit Risk Mitigation & Basel II

residual risk requirements
Residual risks are defined as those risks arising from the use of collateral and other
forms of credit risk mitigation to reduce risk. These risks include legal,
documentation and liquidity risks.
1.

Regulators are aware that use of CRM techniques create additional risks
(Residual Risks) that render the risk reduction less effective.

2.

Examples of such risks include inability to seize collateral in a timely manner,

refusal by a guarantor to pay, ineffectiveness of untested documentation.

Banks are required to have written credit risk mitigation policies and procedures in
order to control these risks, and must demonstrate that CRM management policies
and procedures are appropriate to the level of capital benefit that it is recognizing.

Banks that are not able to demonstrate that such controls are adequate in relation to
the capital benefit received may be subject to higher capital requirements, among
other sanctions.
24

Credit Risk Mitigation & Basel II

residual risk example
CRM Method:

Collateral

CRM Residual Risk:

Loss Of Physical Collateral Due to Casualty Event.

Risk Mitigant
Require that property/casualty
insurance be maintained whenever
real estate is pledged as collateral.

Required Mitigation Controls (Documented)

1.

2.
3.

When the premium is next due, has the owner paid, is bank named as
loss payee, is the amount of insurance sufficient to cover the risk, will the
insurance company notify the lender of premium default, is non-payment
of insurance premium an event of default in the credit agreement, when
was the last time someone inspected the property to ensure the risk has
not already materialized?
Who is responsible for checking all that and how often?
What is the exception reporting process when such checkings are not
completed, or are completed but not satisfactory? Are issues escalated
and communicated?

Compliance
Banks must demonstrate that controls and procedures are adequate in relation to the amount of capital relief obtained by
incorporating collateral benefits into RWA calculations. How does a firm obtain reliable metrics on this process so as to
demonstrate that such required controls are in place to justify material reductions in risk weighted assets?
25

Credit Risk Mitigation & Basel II

collateral valuation requirements
Overall, Basel II is less explicit on exactly what measure of value is appropriate
for the various types of pledged assets, especially under Advanced Bank.
Method

Risk
Parameter

Explanation

Standardized

EAD

Collateral is subtracted from the exposure and RWA

are calculated for the remaining exposure.

Foundation IRB

EAD
LGD

Financial collateral value reduces exposure, while

collateral value for receivables, real estate and other
eligible collateral reduce LGD to a minimum value.

Advanced IRB

LGD

Influence on collateral types and values determined

according to internal risk models.

Nevertheless, asset valuations have a more direct influence on RWA in the

less advanced approaches for Standardized and Foundation IRB, where asset
value is an input used to calculate risk parameters:

26

Credit Risk Mitigation & Basel II

collateral valuation requirements
The following are minimum standards regarding specific asset valuation
adjustments required in all approaches, although not all adjustments are
applicable to all asset types:
Asset Value Adjustment

Description

Currency

Where exposure and collateral are denominated in different

currency, either a 8% supervisory haircut to the collateral, or
internal VAR based haircut, is applied.

Volatility

Explicit for marketable securities, either use of standard

supervisory haircuts, or internal VAR based haircuts.

Liquidity

Adjustments to reflect extended marketing period due to size of

market position or other factors.

Maturity

Where the expiry of the collateral protection arrangement

expires prior to the credit arrangement, a haircut is required.

Correlation

The credit quality of the counterparty and the value of the

collateral must not have a material positive correlation. Any
such dependence must be treated in a conservative manner.

Period Of Risk

Where the frequency of revaluation is longer than the minimum,

minimum haircut numbers are scaled.

27

Credit Risk Mitigation & Basel II

specific valuation standards under Foundation IRB Approach
The following are minimum standards for collateral valuation under the Foundation
IRB Approach, but they are not specifically required under Advanced IRB:

Objective Market Value Of Collateral

The collateral must be valued at or less than the current fair value under which the property
could be sold under private contract between a willing seller and an arms-length buyer on the
date of valuation.

Frequent Revaluation
The bank is expected to monitor the value of the collateral on a frequent basis and at a minimum
once every year. More frequent monitoring is suggested where the market is subject to
significant changes in conditions. Statistical methods of evaluation (e.g. reference to house price
indices, sampling) may be used to update estimates or to identify collateral that may have
declined in value and that may need re-appraisal. A qualified professional must evaluate the
property when information indicates that the value of the collateral may have declined materially
relative to general market prices or when a credit event, such as default, occurs.
28

Credit Risk Mitigation & Basel II

specific valuation standards under Foundation IRB Approach
Additional minimum standards for collateral management :
1.

The types of CRE and RRE collateral accepted by the bank and lending
policies (advance rates) when this type of collateral is taken must be clearly
documented.

2.

The bank must take steps to ensure that the property taken as collateral is
adequately insured against damage or deterioration.

3.

The bank must monitor on an ongoing basis the extent of any permissible prior
claims (e.g. tax) on the property.

4.

The bank must appropriately monitor the risk of environmental liability arising in
respect of the collateral, such as the presence of toxic material on a property.

29

Credit Risk Mitigation & Basel II

accounting for collateral - standardized approach
1.

Under Standardized Approach, banks can opt for Simple (risk weight
substitution) or Comprehensive (collateral value is subtracted from EAD)
method.

2.

Limited types of collateral are permitted cash, gold and eligible marketable
securities.

3.

Collateral Value calculation under Comprehensive Method of Standardized

Approach:

C (1 H c H fx )

Where:

C = market value or notional value of collateral

Hc = Volatility haircut (VAR based or supervisory)
Hfx = Currency haircut

*Scaling factor applied depending on transaction type and frequency of remarginig or revaluation.
30

Credit Risk Mitigation & Basel II

accounting for collateral - standardized approach
Supervisory Haircut Table
Issue Rating For Debt
Securities
AAA to AA-/A-1

Residual Maturity

< 1 Year
>1 Year, < 5 Years
> 5 Years
A+ to BBB-/ A-2/A-3/P-3
< 1 Year
and unrated bank
>1 Year, < 5 Years
securities**
> 5 Years
BB+ to BBAll
Main Index Equities (including convertible bonds)
and Gold
Other Equities (including convertible bonds) listed on
a recognized exchange
UCITS/Mutual Funds
Cash in the same currency
Currency risk haircut where exposure and
collateral are denominated in different currencies

Sovereign (%)

Other Issues (%)

0.5
2
4
1
3
6
15

1
4
8
2
6
12
15
25

Highest haircut applicable to any security in which

the fund can invest
0
8

31

Credit Risk Mitigation & Basel II

accounting for collateral foundation irb approach
1.

Recognizes eligible financial collateral under the Standardized Approach, plus

eligible IRB collateral:

Receivables

Specified Commercial and Residential Real Estate

Other Collateral types as determined by regulators, and subject to

certain minimum standards.

2.

Eligible financial collateral is used to adjust the LGD:

LGD* = LGD (E * / E )
3.

Where:

LGD = 45% (senior unsecured)

E* = Net exposure after financial collateral.
E = Current value of exposure

Eligible IRB collateral is also used to adjust the LGD, subject to:
LGD Floor

Min. Coverage

Full Coverage

Receivables

35%

0%

125%

CRE/RRE

35%

30%

140%

Other Collateral

40%

30%

140%

32

Credit Risk Mitigation & Basel II

accounting for collateral advanced irb approach

1.

There are no specific exclusions on the type of collateral that may be

considered, banks may use a wide variety of collateral types provided that the
benefit of such types may be demonstrated in analytical models.

2.

Under the Advanced Bank Approach banks are permitted to use their own
internal estimates of LGD.

3.

Minimum requirements apply documentation, legal certainty, residual risk

controls.

4.

Limited additional guidance on collateral values in the advance approach, but

does include that LGDs must be grounded in historical recovery rates, and not
solely based on collaterals estimated value

33

Part IV:
Observations - Collateral Risk Measurement
& Asset Management

34

Credit Risk Mitigation & Basel II

1.

2.

Collateral information must be collected, and then matched to facilities in

central systems and global data warehouses for use in analytical models:
a)

What is the type of collateral?

b)

Where is the collateral located?

c)

To what facility(ies) is the collateral pledged to support?

d)

Are all the minimum legal and process requirements met?

e)

What is the value of the collateral?

9

What valuation method was used?

How was the estimate of collateral value obtained?

In order to collect this information, best practices policies and standards

around collateral types and valuations must be established.
a)

These efforts must be coordinated on a global basis for large, complex

internationally active banks.

b)

Collateral risk management depends heavily on local practices, including legal

and regulatory environment.
35

Credit Risk Mitigation & Basel II

Observations - Collateral Risk Measurement & Asset Management
1.

Asset Valuations
a. What are the correct valuations methods and measures of
collateral value under the various approaches?
b. What due diligence will be required to ensure that reported values
are accurate?
c. How are such standards to be applied across diverse asset classes
in many legal and regulatory environments?

2.

Collateral Allocations
a. Basel models generally require exposure level collateral coverages.
b. Allocations of collateral value to covered exposure is a risk capital
exercise, and generally not required for credit risk management.

36

Credit Risk Mitigation & Basel II

Observations - Collateral Risk Measurement & Asset Management

3.

Collateral Risk Measurement

a. Banks are required to establish global standards around collateral
for reporting purposes. Collateral values and types will influence
capital.
b. Technology infrastructure is required to capture the information and
then associate to the covered exposure.

4.

Collateral Risk Management

a. Collateral will continued to be managed locally, but with improved
controls and process standards coordinated at a global level.
B. How will large complex internationally active firms demonstrate
compliance with requirements for controls as required under Pillar
II?
37

contact information:

James E. Condolff
Senior Vice President
Citigroup Risk Management Global Risk Architecture
399 Park Avenue, 10th Floor
New York, New York 10022
tel
fax

212.559.4649
646.291.3561

james.e.condolff@citigroup.com