Credit Risk Irb Approach2

Credit Risk
Internal Rating Based Approach
Laurent Balthazar
1
Agenda
1. Introduction to IRB
2. Risk parameters in IRB
• PD: Minimum requirements and operational implementation
• LGD: Minimum requirements and operational implementation
• EAD: Minimum requirements and examples
• Maturity: Minimum requirements and examples
3. Risk quantification
• Understanding the Risk weighting function
• Detailed issues of Risk quantification
4. Credit Risk Mitigation
5. Securitization
6. Application for supervisory approval 2
Agenda
5. Securitization
1. Introduction to IRB: The 3 pillars
Basel Committee
• The BCBS was formed in 1974 by the Group of 10 central bank

governors following the failure of West German bank Bankhaus
Herstatt
• Committee members include representatives from Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain,
Sweden, Switzerland, the U.K. and the U.S.
• From its inception, its primary mission has been to promote stability in
the global banking system in the pursuit of two guiding principles
• No foreign banking system should escape supervision
• Supervision must be adequate for all banks operating internationally
• Its primary objective is to formulate standards, guidelines and best
practices that individual authorities will implement
4
The 3 pillars: mutual re-enforcement
Pillar 1 : menu of evolutionary approaches

• Credit risk
• Operational risk
• Market risk
Pillar 2 : 4 principles
• Internal assessment
• Supervisory review
• Capital > minimum
• Supervisory intervention
Pillar 3 : disclosure requirements
5
Scope of application
Holding => Basel 2 rules apply
International Bank => Basel 2 rules apply
International Bank => International Bank =>

Basel 2 rules apply Basel 2 rules apply
Domestic Bank => Control Investment Bank => Control

of national supervisor of national supervisor CRD Directive
6
Treatment of participations – Financial Companies
Financial companies (Insurance excluded)
Majority-owned / Minority investments

Controlled
Significant investment Minor investment

Deducted (e.g. EU : 20%-50%) (e.g. EU < 20%)
Deducted or
consolidated on a pro Risk Weighted
rata basis
7
Treatment of participations – Insurance Companies

Insurance companies
Majority-owned / Minority investments

Controlled
Significant investment Minor investment

Deducted or other (e.g. EU : 20%-50%) (e.g. EU < 20%)
method (national
discretion)
Deducted or other
method (national Risk Weighted
discretion)
8
Treatment of participations – Insurance Companies

Commercial companies
Majority-owned /
Controlled and Minority
investments
Amounts of participations up to 15% of banks Amounts superior to

capital (individual exposure) or 60% of banks those thresholds
capital (aggregated exposure)
Risk Weighted Deducted

9
1. Introduction to IRB: Pillar 1
Pillar 1 : menu of evolutionary approaches

Credit risk
• STA
• FIRBA Rough weights
• AIRBA
Operational risk
• BIA
• STA
• AMA
Market risk Economic Models
• STA
• AMA
10
1. Introduction to IRB: Pillar 1
Pillar 1 : solvency ratio
Total Eligible Capital
≥ 8%
Credit Risk Market Risk Operational Risk
- Standard - Standard - Basic Indicator

Approach Approach Approach
- IRBF Approach - Internal Model - Standardized Approach
- IRBA Approach Approach - Advanced Measurement
Approach
11
1. Introduction to IRB: Credit risk
Credit risk
Standard approach
• Continuation of Basel 88
• New: internal ratings (+ asset class): 0%, 20%, 50%, 100%, 150%
Foundation Internal Rating Based Approach

• RWA= f (PD, LGD, EAD, M, Confidence level, Correlation)
• Banks estimates only PD
Advanced Internal rating Based Approach

• RWA= f (PD, LGD, EAD, M, Confidence level, Correlation)
• Banks estimates PD, LGD, EAD, M
12
1. Introduction to IRB: Why IRB ?
Why choosing IRB ?
Standard approach
• Simpler, less requirements

• Not always more capital requirements
IRB
• If there should be only one reason:
Banks should be managed in a economical way !
13
Why choosing IRB ?

STD vs IRB Standard IRB
• Only external ratings • Internal ratings and PD

• Implied PD given by • All portfolio might be
regulator covered
Individual Risk • Large part of portfolio • Internal LGD
Assessment unrated (externally) • Extended recognition of
• No explicit LGD collateral
• Limited recognition of
collateral
• Simple weights •Complex function
• No economical integrating risk parameters
Portfolio Risk foundation • Derived from state of the
Assessment art economical model
14
Why choosing IRB ? => Macro view

QIS 3 – G10 Banks Standard Approach FIRB approach AIRB approach
Portfolio Group 1 Group 2 Group 1 Group 2 Group 1
Corporate 1% -1% -2% -4% -4%
Sovereign 0% 0% 2% 0% 1%
Bank 2% 0% 2% -1% 0%
Retail -5% -10% -9% -17% -9%
SME -1% -2% -2% -4% -3%
Securitised assets 1% 0% 0% -1% 0%
Other 2% 1% 4% 3% 2%
Overall Credit Risk 0% -11% -7% -27% -13%
Operational risk 10% 15% 10% 7% 11%
Overall Change 11% 3% 3% -19% -2%
¾ % are contribution from portfolios to total capital change

¾ Average gain for advanced approaches
15
Why choosing IRB ? Macro view

Portfolio Group 1 Group 2 Group 1 Group 2 Group 1
Corporate 1% -10% -9% -27% -14%
Sovereign 19% 1% 47% 51% 28%
Bank 43% 15% 45% -5% 16%
Retail (Total) -21% -19% -47% -54% -50%
- Mortgage -20% -14% -56% -55% -60%
- Non-Mortgage -22% -19% -34% -27% -41%
- Revolving -14% -8% -3% -33% 14%
SME -3% -5% -14% -17% -13%
Specialised Lending 2% 2% n.a. n.a. n.a.
Equity 6% 8% 115% 81% 114%
Trading book 12% 4% 5% 4% 2%
Securitised assets 86% 61% 103% 62% 129%
¾ View by individual portfolio

¾ Retail are the winners, Equity and sovereign the losers
16
Why choosing IRB ? Micro view

Group 1 Group 2 Group 1 Group 2 Group 1
Maximum 84% 81% 55% 41% 46%
Minimum -15% -23% -32% -58% -36%
Average 11% 3% 3% -19% -2%
¾ Min and Max impact at bank level

¾ Average variation low, but at individual bank level might be very important
17
1. Introduction to IRB: From proposal to law
IRB in national laws
3-level structure
• Basel Committee : recommendations and best practices
open
options
• EU : directives
open
options
• Countries : local law
18
1. Introduction to IRB: Exposure classes
Exposures class => Determine the risk weight function

1) Corporate, sovereign, banks: same function (>< Standard)
• Corporate:
- SME specific treatment (adjustment of RWA)
- Specialized Lending: SPV, reimbursement based on cash-flows of
financed asset.
Project finance e.g.: power plant, chemical plants, mines…

Object finance e.g.: ships, aircrafts, satellites …
Commodities finance e.g.: oil, metals, crops …
Income producing real High correlation between PD and cash
estate flows generated by the property
High volatility Real estate with high volatility. To be
Commercial real estate defined by regulators. 19
• Sovereign:
- Countries
- Central banks
- Multilateral Development Banks
- Public Sector Entities (PSE) considered as sovereigns by regulators
(tax raising power)
- International organizations RW 0% in standard (e.g.: BIS, IMF …)
• Banks:
- Financial institutions
- PSE not considered as sovereigns
20
2) Retail: 3 functions (>< Standard)
• Mortgages:
- Exposure covered by residential mortgage
- No size limit
- If rented must be limited
• Qualifying revolving exposures:

- Exposures: revolving, unsecured, uncommitted
- On private person
- Max 100.000 EUR
- Bank must demonstrate low volatility of loss rate
21
• Other retail:
- Loans on a group < 1Mio EUR
- Large number of exposures in portfolio
- Must be managed on a pool basis
- Individual analysis does not prevent mass treatment
3) Equity: 1 function (but standard method allowed in IRB)
- Recovery only by selling or when bankruptcy occurs

- No obligation form issuer
- Obligation from issuer but: can be delayed, reimbursement can be
done in equity
- Includes securities when income is function of equity
- Includes securities eligible as Tier 1
22
4) Eligible purchased receivables: function Corp or retail
- Claims purchased to another counterparty

- can be retail or corporate in function of the nature of the claim
5) Securitisation exposure: special treatment: Standard or SF
- Not based on legal definition but economical one

- Securitised exposure as soon as there are at least 2 tranches
- Special attention as often used for regulatory capital arbitrage
23
1. Introduction to IRB: Terminology
IRB ingredients
Symbol Name Comments
It is the probability that the counterparty will not
PD Probability of Default
meet its financial obligations
It is the expected amount of loss that will be
LGD Loss Given Default incurred on the exposure in case the counterparty
defaults
It is the expected amount of exposure at the time
when a counterparty will default (the expected
EAD Exposure at Default
drawn-down amount for revolving lines or the off-
balance sheet exposure times its CCF)
M Maturity The average maturity of the exposure
A measure of association between the evolution of
ρ Asset correlation
assets returns of the various counterparties
The degree of confidence used to compute the
CI Confidence Interval
economic capital
24
IRB : sources of parameters estimation
IRB Foundation IRB Advanced

Exposure type
Internal data Regulators data Internal data Regulators data
Corporate, Sovereigns,
Banks, Eligible PD, LGD,
PD LGD, EAD, M
purchased receivables EAD, M
Corp
Retail, Eligible
Purchased receivables Internal PD, LGD, EAD, M mandatory
retail
Equity PD/LGD approach or market based approach
NB: ρ and CI always given by regulators
25
IRB : for each exposure class, 3 components
1. Risk Components
3. Minimum
2. Risk weight function
Requirements
Capital requirements
26
1. Introduction to IRB: Roll out
Principle: if IRB, must apply to all asset classes.
Exceptions:
• Specialized Lending
• Securitisation
• Non-material exposures
For the rest:
• Roll out plan

• Timing and resources
• To be approved by regulators
27
1. Introduction to IRB: Transition period
Transition period of 3 years

• Beginning at implementation (31/12/2006 IRBF, 31/12/2007 IRBA)
• Data requirements may be relaxed :
P a ra lle l
ru n
R e la x e d : 2 ye a rs
R a tin g s ys te m : 3 y e a rs (*)
R e ta il: 5 y e a rs (*)
P D : 5 y e a rs (*)
L G D : 7 y e a rs
E A D : 7 y e a rs
T ra n s itio n p e rio d : 3 ye a rs
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
(*): re la xe d d u rin g tra n s itio n p e rio d
28
1. Introduction to IRB: Transition period
Transition period of 3 years

• But Capital Gains are limited
Approach From Year-end From Year-end From Year-end From Year-end

2005 2006 2007 2008
IRBF Parallel run 95% floor 90% floor 80% floor
IRBA - AMA Parallel run or Parallel run 90% floor 80% floor
impact studies
• 2009 … ?
29
Agenda
5. Securitization
2. Credit risk in IRB: PD Minimum
Requirements
Dimension of rating system

• Corporate, Sovereign and Banks
- 2 dimensions: PD and LGD (>< issue rating !)

- 2 exposures on same borrower => same rating (except sover. Ceiling and
guarantees)
- There must be policies to guide to classification in a rating grade
• Retail
- Exposures must be classified in homogenous pools that share risk

characteristics
- For each pool a PD must be estimated (and LGD and EAD)
31
Requirements
Rating structure
• Corporate, Sovereign and Banks
- Concentration issue (no more 30% in one grade)

=> Concentrated portfolio ex: PSE at Dexia ?
- Min 7 pass ratings and 1 for default
• Retail
- Number of pools and number of exposures in each pool sufficient to

validate PD, LGD and EAD parameters
32
Requirements
Rating criteria
- There must be clear and coherent definition to classify exposures in rating

grades, which means:
• Consistency across businesses, departments and geographical locations

• Third parties (auditors, regulators…)should be able to reproduce the
process
- Bank should integrate all available information

- An external rating can be a basis but other info must be incorporated
33
Requirements
Rating horizon
- PD on 1 year
- Ratings on longer horizon
- Rating: reimbursement capacity under adverse economic conditions
- PIT Vs. TTC issues (procyclicality…)
Business
Cycle ¾PIT rating
?
¾Average TTC
rating
¾Stress TTC
rating
Today Time
34
Requirements
Use of models:
Current market practices
Weight of human expert in final rating
Expert
Bank and sovereign portfolio Models
Corporate portfolio
Weight of scoring model in final rating
SME Portfolio
Constrained
expert models
Retail portfolio
Statistical
Models 35
Requirements
Use of models:
Requirements
- May be used as a primary input for the rating

- But only uses a subset of available info => cannot be the only tool
- Human oversight necessary
- The bank has to demonstrate the discriminatory power of the model
- The bank must have procedures to check quality of inputs
- Bank must demonstrate that the dataset used for construction is
representative of the bank borrower
- Human judgment must integrate elements not taken into account in the
model
- Ongoing monitoring, validation and assessment of the quality of the model
36
Requirements
Documentation of rating system
- The bank must document extensively its IRB system

- Documentation should highlight:
rating criteria
rating responsibilities
rating exceptions
review frequency (in principles min 1 per year)
management overview
- Documentation of default definition
- If a model is used:
Mathematical hypothesis
Validation out of the time and out of the sample
Model weaknesses
37
Requirements
Coverage
- Each Corp/ sovereign/ Bank exposure should have a facility rating

- Each retail exposure should be classified in a pool
- Each guarantor should be rated
Integrity
- Independency of the rater (FO / RM separation)

- Yearly review (may be done by sampling for retail)
- Efficient procedures to collect new info on a borrower
38
Requirements
Overrides
- Overrides = change to the model rating

- The bank must define in which cases it is allowed
- Overrides must be identified and followed separately
- Each guarantor should be rated
Data maintenance
- The bank must collect and historize all the data necessary for re-rating
- Corporate, Sovereign, Banks: Store rater name, rating data, Default Rates,
Migrations
- Retail: Store data that allows to classify in pools, observed DR
39
Requirements
Corporate governance and oversight
- The board must validate main aspects of the rating system and must
understand it
- There must be regular discussion about the rating system quality between
management and risk control.
- Ratings included in reporting to senior management
- The bank must have an independent risk control unit: model development,
monitoring, policies …
- Independent review at least once a year by audit or other similar
independent function
⇒ Regulators will look at reports of meetings (Board, Risk Control,

audit…), and they will question them !
40
Requirements
Use of internal rating systems
Ratings and PD must be used for
- Credit Approval
- Risk Management
- Economic Capital Allocation
- Corporate Governance
⇒ PD’s of Basel 2 and Internal PD’s might be different (e.g.:pricing…)

but coherency must be demonstrated.
IRB Compliant systems must be used at least 3 years before

implementation
41
Requirements
Overall requirements
- PD must be long term average of 1 year default rates (except for retail)
- Pooling authorized but data must be comparable
- Estimations must be grounded in experience
- Economic climate at the time of collection must be taken into account
- Usually a margin of error is included => conservatism
⇒ Often not enough data internally: conservative bias that might not be
used for internal risk management
42
Requirements
Default definition
90 days delay
Unlikely to pay Calibration issue !
- Default indicators:
Non accrued status
Provisions
Selling at material loss
Restructuration with lower NPV
Filled for bankruptcy
- Retail: default might be at facility or obligor level (no contagion mandatory)
43
Requirements
Re-ageing policy
Regulators do not want the bank to play with rules:
There must be a clear policy for past due credits:
Who can approve them ?

Minimum age of facility to be eligible for re-ageing
Number of re-ageing authorized per facility
New risk assessment for re-aged facilities
Use test (treatment of re-aged exposures >< defaulted exposures)
Overdrafts
If new limit, must be communicated to the client ! (no internal game)
44
Requirements
Requirements specific to PD estimation

Corporate, sovereigns, banks:
- Internal long run experience must be incorporated
- Judgment must be taken into account
- If mapping to external data: default definition and rating criteria must be
documented
- Minimum 5 years of data
Retail
- Internal data should be primary source

- It should integrate seasoning effects in case of portfolio growth
45
Requirements
Requirements specific to qualifying purchased

receivables
- Legal certainty: the bank must ensure it has control on reimbursements

- Monitoring of the quality of the pools:
correlation between seller and receivables
sellers/ servicers monitoring
fraud detection
historical data on the pool
concentration monitoring
- The bank must be able to verify that the seller/ servicer respect the contract
covenants
46
Requirements
Validation of internal estimates
- The bank must have clear policies and pre-defined triggers to determine
when the deviation between expectations and observed values should lead
to a review of the parameters
47
2. Credit risk in IRB: PD operational
implementation
How to estimate a PD on each exposure and

fulfilling those requirements ?
Operational development
of a rating framework
48
implementation
1st issue: do we need a model ?
• Not mandatory in Basel 2 text

• Even, in CP3 warning about the use of models
⇒ But: how to fulfill requirements otherwise ?

Model advantages Models weaknesses
• Systematic in the rating • Uses only a part of the info

process • Is correct in 80% of the cases
• Can be reproduced by third • Cannot treat outliers
parties • If fundamental underlying
• Statistical tests can prove characteristics of the population changes,
discriminatory power the model does not integrate it
49
implementation
Solution: take the best of the 2 worlds
⇒ Construct a rating framework that combines the use of models with

human oversight and adjustment (constrained expert model)
Automated Traditional
Scoring Model Expert analysis
Basel 2 Credit Analyst 50

implementation
Which quantitative technique to use ?
1) Regression techniques
- Multivariate Discriminant Analysis
- Ordinary Least Square
- Logistic regression
e.g. Logistic regression
1.2
default (1) / not default (0)
0.8
0.6
0.4
0.2
0
0 2 4 6 8 10 12 14 16 18
Financial ratios 51
implementation
2) Structural Models: e.g. KMV
PD= f (asset value, asset

volatility, debt value)
Current
asset Potential
value value of
Current assets in
value of the future
debts
1 year
52
implementation
3) Expert systems: e.g. Decision trees
53
implementation
4) Inductive learning: e.g. Neural Networks
Inputs
M
T O
R D
I I
A F
L Y
Wi
Results 54
implementation
Statistical Inductive learning
Criteria Structural models
techniques techniques
- (Limited to listed
Applicability + +
companies)
Empirical validation
(out of the sample
+ + +
and out of the time
tests)
n.a. (Parameters must
not be statistically
- (No weights that
tested as they are
Comparison Statistical validation + can be statistically
derived from an
tested)
underlying financial
theory)
+ (We can see if the
weights of the + (The impact of the ++ (Structural
Economical various ratios ratios can be models are the only
validation corresponds to the estimated using derived from a
weight expected by sensitivity analysis) financial theory)
specialists)
+ (No model directly
based on neural
++ (Riskcalc of
networks to the
Moodys, Fitch IBCA
extend of our
scoring models,
Market reference knowledge, but a + KMV model
various models used
model of S&P is
by central banks of
based on Support
France, Italy, UK…)
Vector Machines that 55
is derived from NN)
implementation
Finding data: 3 sources
• Default data
- Most objective
- But often scarce data
- Basel 2 definition ?
• External ratings
- Especially for certain portfolios (Corp, Sovereign, Banks)
- Indirect way to modelize defaults
• Internal ratings
- When no other data available 56
implementation
Regression techniques
• Default data
- Binary issue (default=1, not default=0)
- e.g. Binary logistic regression
• Ratings
- Multi-class issue
- e.g. Ordered logistic regression
- Rating coding: AAA=1, AA+=2, AA=3, … B-=16, CCC=17
57
implementation
How many models to construct ?
• Should integrate
- Number of type of counterparties (retail, Corp, banks…)
- Model by sector, region … => Data availability issue !
- Model use outside its development population (Generic Vs
Specific model)
• 2003 Study
- US banks: 5 non retail and 3 retail on average
- European banks
58
implementation
Sector issue ?
• A specific model may be constructed on a given sector, or sector

variable may be included (1/0)
• But pay attention !

- More overfitting risk
- Variation in sector fundamentals not anticipated
- e.g.: utilities sector and deregulation

- e.g.: sensitivity to the stage of business cycle if few data
59
implementation
Modelization steps
1. Data collection and cleaning
Regular
2. Univaried analysis
Feed-Back
3. Ratio transformation
4. Regression analysis
5. Validation
6. Calibration to Credit
7. Test phase analysts
60
8. Production
implementation
1. Data collection and cleaning
- Which data sources are available ?

=> Internal, external DB, data pooling …
- What kind of data do they contain ?

=> potential explanatory variable (fin. statements, age …)
- What is the quality of the data ?

=> Missing values, extreme values …
=> Potential bias (survivor bias, size bias …)
- How to clean the data ?

=> rating or default date vs fin. Statement availability
=> replacing or excluding missing values
=> polluted data (Shareholders, country ceiling …)
61
implementation
- Rating distribution issue
Classical distribution Concentrations
14 14
12 12
10 10
frequency
frequency
8 8
6 6
4 4
2 2
0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
rating rating
Which distribution ?
=> Bell shaped ?
=> Flat ?
=> keeping concentration ?
62
implementation
- Fraction issue
Profit / Equity Equity/ LT fin debt

Profit Equity Result Equity LT fin Debt Result
10 100 10% - 10 100 -10%
-10 10 -100%
-10 -100 10%
-100 10 -1000%
Which ratio is the best ?

- denominator negative values !
- Ordering !
=> Those values have to be treated

63
implementation
- Treatment of size variable
=> To get good results in regression analysis, variable distributions should

not be too far from the bell shape
Frequency of total assets
1600
1400
1200
Frequency
1000
800
600
400
200
0
84 5
26 6
1, 858
2, 899
2, 940
2, 981
3, 022
3, 063
4, 105
4, 146
5, 187
8
42 4
22
73
77
81
0,
0,
0,
0,
0,
0,
1,
1,
1,
1,
1,
1,
68
10
52
94
36
78
20
62
04
1,
Assets in 000 EUR
=> Some variable may need to be transformed

64
implementation
- Studying outliers
• “Quick and dirty” model to identify outliers
• May we find a reason for that ?
• if it is the case, can we exclude those observations ?
=> Pay attention to keep objectivity and to document choices
65
implementation
- Analysts feed-back
=> OK with potential variable ?
=> OK with treatment of missing values ?
=> OK with treatment of extreme values ?
=> OK with sample composition ?
=> ratio definition ?
=> Outliers excluded ?
66
implementation
2. Univaried analysis
- Study of the relationship between each variable and the average PD / the
average rating
Graph 11.4 ROA - rating dataset

Graph 11.5 ROA - default dataset
18
60% 16
Average Default rate
50% 14
12
40%
Rating
10
30% 8
20% 6
4
10%
2
0% 0
-20% -10% 0% 10% 20% 30% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
ROA ROA
67
implementation
- Univariate predictive power
- Shape of the relationship (monotonic or not)
- What is the range of efficiency ?
- Does the relationship make sense ?

18
16
14
e.g. Liquidity ratio 12
on large corporate 10
Rating
8
rating dataset
6
4
2
0
0.0% 50.0% 100.0% 150.0% 200.0% 250.0%
Cash/ ST debts 68
implementation
=> Does the relationship makes sense ?
=> OK with rejected ratios ?
69
implementation
3. Ratio transformation
- Can be done in many ways:
Polynomial function (e.g. Moody’s uses DR)

Cap: minimum and maximum values
- Mandatory for non monotonic ratios, usefull for other
- Univaried analysis can be a basis for Caps
70
implementation
=> Does the function makes sense (no overfitting) ?
=> Does min and max values seems reasonable ?
71
implementation
4. Regression analysis
- e.g. Logistic regression
1
π=
1 + exp[− (b1 x1 + b2 x 2 + ... + c )]
- Divide sample in construction and backtesting sample
- Selection process:
9 Forward
9 Backward
9 Stepwise
9 Manual
- Choose a performance measure: economic vs statistical 72

implementation
=> OK with selected variables ?
=> Replacing ratios with correlated one even if less performing ?
=> Model acceptance is key issue
73
implementation
5. Validation
- On construction sample and on backtesting sample, ideally out of the sample

and out of the time.
- Performance measures:
Statistical tests Economic tests

- p. value - Accuracy ratio (default)
- Log likelihood - Cumulative notch difference
- Wald test (ratings)
- R squared - Cost function
- Goodness of fit
74
implementation
- Main tools
% of defaults AR
CND
100%
90%
Perfect model
80%
70%
60% Naive model
50%
40%
Tested model
30%
20% 0%
10%
0%
0 1 2 3 Default rate of Score
the sample
75
implementation
- Benchmarking performances:
• Publicly available models (Altman, gloubos grammatikos …)

• External commercial tools
• Performance level published by other banks
• Best ratio
• Blind tests
=> but performance depends on particular sample characteristics !
76
implementation
=> opinion on model performance
=> opinion on zone where model is under performing
=> rating stability versus reactivity
=> weight of the different variables (e.g.: size for Corp at Dexia)
77
implementation
6. Calibration
- If default dataset is used:
• Does it correspond to Basel 2 definition

• If not, which adjustments (constant over rating scale) ?
- If rating dataset:
• Which source of info on default (e.g. public statistics of rating agencies) ?

• Coherence of reference dataset and default definition
=> Calibration function of application (pricing, Basel 2 …)
78
implementation
7. Test phase
- Double run of some month for the analysts

- Feed back from analysts (validation)
- Detection for underperformance
8. Production
- Building definitive IT tools (feed back from analyst on user-friendliness)
79
implementation
Qualitative assessment
- Scoring tool delivers a first rating, but only based on financial assessment
- Qualitative elements have to be integrated
Flexibility Subjectivity
=> in analyst freedom ? + -
=> or scorecard approach ? - +
80
implementation
Qualitative scorecard
- Develop list of questions with credit analysts

- Expert weighting of questions
- Rate a sample of counterparties
- Study link between qualitative score and rating
- If ok, combines qualitative score and financial score
Qualitative score
Impact in steps Very good Good Neutral Bad Very Bad
AAA 0 0 0 -6 -7
Financial score
AA 1 0 0 -5 -6
A 2 1 0 -4 -5
BBB 3 2 0 -3 -4
BB 4 3 0 -2 -3
B 5 4 0 -1 -2
81
implementation
Typical rating sheet
82
implementation
Typical rating system structure

Scoring module based
on financial ratios
=> Financial rating
Qualitative scorcard based

On a list of questions
=> Qualitative score
Combination of both
=> Model rating
Potential second
Overruling of the analyst
rating after
=> Final rating before sov ceiling
sovereign ceiling
83
implementation
Pre-defining the overrulings
- Shareholders
- New credit
- Exceptional year
-…
=> Allows a more formal follow up of them
84
implementation
Typical timing (15 months)
Final
Data collection validation
Model IT tools
and cleaning and first
Construction definition
backtesting
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Univariate Test Training

analysis phase and
production
85
implementation
Organizational issue
- We have a model to systematize the rating process
- But there is still freedom for the analyst
- Statistical development is not complicated, but will the model be used
correctly ?
=> operational implementation in organizational structure is the key
Model developers Credit analysts
Quality control
86
implementation
Quality control: role
- Function appearing in a lot of banks
- Main roles:
• Control that models are applied correctly

• Quality of the inputs
• Coherency of answers to questions
• Support model use and testing
=> Main role: analysis of overrulings
=> This function is key for regulators (reports)
87
implementation
Credit Analysts
Quality control:
Fill ratios and Give the final functioning
qualitative rating to the No agreement
scorecards borrower on overruling:
discussion
(rating
committee)
Model rating Analysts

rating
Difference is
within accepted
Both analysts and model
degree of freedom Independent review (senior analyst)
agrees on the rating – no
(e.g. 1 step)
additional control needed
Agreement on
overruling:
Regular joint report to
back-testing of the developers
model
Model developers
88
implementation
Organization at Dexia
- Who is involved in rating models ?
Credit analysts
Validation
Model developer department
Rating system
Rating Committee
Quality Control
Group of rating
Audit
follow up
=> Risk= too much control …

89
implementation
Conclusions on setting up rating models

Key issues for success
- Data, Data, Data …
- Model acceptance by users => Integration of experts in the whole

development process
- Support from senior management => resistance to change (micro view ><
macro view)
- Role of quality control => also for model acceptance
90
Agenda
5. Securitization
2. Credit risk in IRB: LGD Minimum
requirements
Basic requirements for LGD estimation in IRBA
- History of recovery data in databases

- Conservative bias
- Business cycle of collected data taken into account
- Compliance with Basel 2 default definition
- A LGD must be estimated on each facility
- Min = long run default weighted average loss rate
Corporate, Bank, Sovereign
- Min 7 years of history
Retail
- Min 5 years of history 92

2. Credit risk in IRB: LGD measures
How to estimate an LGD on each exposure

and fulfilling those requirements ?
Operational measurement
of LGD
93
Introduction
- Requirements are less numerous than for PD

- Might seems easier at a first sight
But …
- less research than on PD

- More country specific issues
- When going in the details, complexity increases importantly
Challenge…
- PD is based on fixed event at a given date

- LGD is a dynamic issue that may last several years
94
Source of LGD data

Market LGD
- Secondary bonds prices

- Objective as assets can effectively be sold
Implied LGD
- Derived from asset pricing model

- e.g. Bond spreads
Workout LGD
- Effective recoveries after workout process

- Discounted at time of default
95
Quality of LGD data

Market LGD
- limited to listed bonds

- Secondary prices OK if it is the policy of the bank
- If default weighted, might be bias because of demand / supply
Implied LGD
- no standard asset pricing models

- e.g. Bond spreads: part of PD, LGD, Liquidity, influence of interest rates …
Workout LGD
- Internal data, objective

- few historical data available in most cases
96
Workout LGD
- Economical loss => including costs and discount effects
re cov eriest − cos ts t

∑ (1 + r ) t
LGD = 1 −
EAD
EAD is directly linked to LGD

=> Both should be treated at the same time
97
Example
- A default occurs on a facility of 1 Mio EUR

- At the time of default, the facility is used for 500.000 EUR
- There is a cost for a legal procedure of 1.000 euro one year after the default
- After 2 years the bankruptcy is pronounced and the bank is paid back 0.2 Mio
EUR
-The discount rate is 5%
− 1000 200.000
+ 2
LGD = 1 − 1 .05 1 . 05 = 64%
500.000
98
Issues around LGD Computation
1. Costs
2. Null LGD
3. Default duration
4. Discount rate
99
1. Costs
- All costs (direct + indirect) should be integrated
- Scope: legal department, credit analysis, risk monitoring … limit ?
- Allocation key for indirect cost: fix, by exposure amount, …
=> Not important at portfolio level, but might be important at facility level
(pricing …)
100
2. Null LGD
- LGD might be bull or negative (when contract penalties, or settlement

through physical collateral)
• A/ Integrating negative values in average LGD ?

• B/ Censoring data (min 0%) ?
• C/ Censoring LGD + PD for coherency ?
⇒ B preferred by regulators
⇒ C coherent but changes Basel 2 default definition
⇒A…
101
3. Default duration
- If credit is called by the bank at default => OK

- But if it is not the case (intensive care), what is the treatment of …
• Lines at default that do not exist at the end ?

• Drawn dawn amounts after default (LGD or EAD) ?
• Changes of collateral
End of
Default Credit is workout
called process
- Lines paid back - Lines - Recovery

- New lines are process
- New collateral
frozen
102
4. Discount rate
- One of the more fundamental questions

- Basel 2 text not clear on this issue
‘Firms should use the same rate as that used for an asset of similar risk. They
should not use the risk free rate or the firm’s hurdle rate…’ (CP 189, FSA)
‘A bank must establish a discount rate that reflects the time value of money
and the opportunity cost of funds to apply to recoveries and costs. The
discount rate must be no less than the contract interest rate on new
originations of a type similar to the transaction in question, for the lowest-
quality grade in which a bank originates such transactions. Where possible,
the rate should reflect the fixed rate on newly originated exposures with term
corresponding to the average resolution period of defaulting assets’ (pub
8/4/03, Federal Reserve).
103
- Then, in principle market rates for such assets
• But how to estimate ? By comparing secondary market prices of bonds with

future cash-flows from worked out recoveries
• Basel 2 default definition >< market (rating agencies)
• Assets without secondary markets (e.g. Mortgages) ?
• Historical rates or implied future ones (Rf 70’s 10%, 90’s 4%)?
104
- Impact might be important: Study of Moral and Oz (2002) on Spanish

mortgages
- Applied 3 scenarios
• Rate specific to each facility (rate before default)

• Average discount rate (ranging from 2% to 6%)
• Forward rates on several periods
⇒ Discount rate +1% = increase of LGD by 8%
⇒ Using different forward rates (rolling period 900 days) results in a

maximum difference of 20%
105
Author Period Sample LGD Type Statistics

Altman and 1.300 Corporate - Average 62.8%
1982-2001 Market
Vellore bonds - PD and LGD correlated
- Average 39.8%
Araten, 3.761 large
- Stand. Dev. 35.4%
Michael and 1982-1999 Corporate loans of Workout
- Min/ Max (on single loan)
Peeyush JP Morgan
Public studies 2.013 commercial
–10%/173%
- Average 30.6%
Ciochetti 1986-1995 Workout - Min/ Max (annual)
mortgages
20%/38%
- Often banks do not 5.782 customers
- Average business loan
31%, Median 22%
have sufficient (large consumer - Average Consumer loans
loans and small 27%, Median 20%
internal data Eales and business loans) - Distribution of LGD on
1992-1995 Workout
Edmund from Westpac secured loans is unimodal
Banking Corp and skewed towards low
- Public studies usually (Australia), 94% LGD
secured loans - Distribution of LGD on
rely on market LGD unsecured loans is bimodal
- Beta distribution fits
1800 defaulted
Gupton and recovery
1981-2002 loans, bonds and Market
Stein - Small number of LGD<0
preferred stocks
- Beta distribution skewed
toward high recoveries
Hamilton,
2.678 bonds and - Average LGD 62.8%,
Parveen,
1982-2002 loans (310 Market Median 70%
Sharon and
secured) - Average LGD secured
Cantor
38.4%, Median 33%
- PD and LGD correlated
106
Main findings
- High volatility of LGD
- LGD distributions far from normal
Bimodal distribution Unimodal (Beta ?) distribution

80
70 70
60 60
Frequency
50
Frequency
50
40 40
30 30
20 20
10 10
0 0
0%
0%
0%
%
%
0
10
20
30
40
50
60
70
80
90
10
20
30
40
50
60
70
80
90
10
10
LGD LGD
107
LGD drivers
- Moody’s launched a model Losscalc that try to predict LGD
- What influences the LGD level
• Seniority Clear, no doubt

• Secured/ unsecured
• The rating Seems confirmed by several

• The country studies
• The industry
• Macro economic drivers More data needed to confirm
• Capital structure
108
PD/ LGD correlation

- One of the most crucial and controversial issue in the industry
- Often modeled as a fix parameter in risk management
- Most recent studies tend to show that it is correlated
- But based on market LGD … supply / demand bias ?
=> Study of Altman: fixed LGD against moderate correlation with PD.
30% of difference for capital at 99.9%
Statistic Fixed LGD Volatile LGD Correlated LGD Diff fix/ correl
99% VAR 435 437 564 29.6%
99.9% VAR 809 814 1053 30.1%
109
Stressed LGD
‘A bank must estimate an LGD for each facility that aims to reflect economic
downturn conditions where necessary to capture the relevant risks…In
addition, a bank must take into account the potential for the LGD of the
facility to be higher than the default-weighted average during a period
when credit losses are substantially higher than average... For this
purpose, banks may use averages of loss severities observed during
periods of high credit losses, forecasts based on appropriately
conservative assumptions, or other similar methods.’
(see article 468 of ICCMCS)
=> Link to PD / LGD correlation issue
110
Arguments against stressed LGD
- The industry had an important reaction against this issue

- LGD is the more sensitive parameters in capital requirements, they argued:
• Already conservative bias in other parameters (PD, CCF,…)

• Add-on of 6% (Madrid compromise)
• Correlation hypothesis high against market standards
• Double default effect limited
• Conservatism in collateral valuation
• Diversification of different portfolios (sectors, geographical locations …)
• Diversification of product types
=> An additional stress on LGD is not necessary, and correlation at

global level has still to be proved
111
Model complexity
Complex
: LGD Basel II
: (costs
LGD Basel II
add-ons)
Basic LGD Recovery (transitions)
Step 1 Step 2… 3 Advanced Basel II

compliance
112
Assess Loss Given Default and...

Basic stepping stones
• First step
• rely on the most observable data, on a best effort basis
• start from a legal fixed point, namely the recovery world
• take the obtained results as a Basel II conservative point of view
• Second step
• translate the “recovery” results to the Basel II world
• Third step
• enhance the results by costs estimation
Increase afterwards the modelling complexity
… solve the EAD issues at the same time

As similar data sources addressed
113
Model complexity
Country dimension
Complex
: ...
P
: UK
L
Basic NL
B
Step 1 Step 2… 3 Advanced Basel II

compliance
114
The country dimension

• brings a lot of issues related to
• the processes (e.g. legal framework)
• the data chains (less developed), and the necessity of,
• and… the inherent scarcity of the data
• and therefore forces us to retain a pragmatic approach
It is our aim
• to privilege the developments where this can be ensured on a larger data scale,)
• to derive from the Loss Given Default rates developments rates for the other
countries (= second direction), by applying an expert country correction
coefficient function of:
• the legal framework
• internal or external benchmarks
115
Conclusions on LGD measures

- Fewer focus received from the industry up to now
- But has the greater influence on capital level
- Principles are easy but in practice we face a lot of questions
- Most banks will start with “recovery LGD” as a prudent first guess
- LGD very dependant on local regulation => limited international data

pooling
- Stressed LGD required by regulators will be discussed
116
Agenda
5. Securitization
2. Credit risk in IRB: EAD requirements
and examples
Basic requirements for EAD estimation in IRBA

- History of exposure data in databases
- Conservative bias
- Business cycle of collected data taken into account
- Compliance with Basel 2 default definition
- A CCF must be estimated on each facility
- On balance min EAD= exposure
- Off-balance: EAD must estimate possible drawn dawn amount at default

and after default
- Long run average default weighted, with safety margin if correlation

between PD and EAD 118
and examples
Corporate, Bank, Sovereign
Retail
2 types of EAD
- The one linked to the behavior of the client: will he draw its line, will it use
its guarantee
- The one linked to derivatives instruments, they are function of the evolution
of risk parameters (interest rates, exchange rates,…)
119
and examples
EAD linked to client behavior

- CCF have to be estimated on each product type (e.g. double CCF for
guarantee lines ?)
- E.g. CCF of foundation approach
0% - Commitments unconditionally cancellable without prior notice.

-Short term self-liquidating trade-related contingencies (e.g.:
20% documentary credit collateralized by the underlying goods)
- Undrawn commitments with an original maturity of maximum 1 year
- Transaction related contingencies (e.g.: performance bonds)
50%
- Undrawn commitments with an original maturity greater than 1 year
- Direct credit substitutes (e.g.: general guarantees of indebtedness…)
- Sale and repurchase agreements
100%
- Forward purchased assets
- Securities lending
120
and examples
EAD= Current exposure + CCF x undrawn part of credit line
- For LGD we need to look at default time and after

- For EAD we need to look at default time, after, and before
1 year before Default
Line
Exposure
⇒Is the CCF 100% ? Bank penalized for a good management of risky
clients ?
121
and examples
EAD linked to market parameters
OTC Derivatives Credit Risk is a function of two major drivers :
• The Current Credit Risk: equal to current Mark-to-Market
• The Potential Future Credit Risk or Add-On: due to potential future evolution of
Mark-to-Market
Total Credit Risk = Current Credit Risk + Add-On
Credit Risk
Add-on = Potential Mark-to-Market or
Current Mark-to-Market
Maturity
OTC Derivatives contract residual maturity 122

and examples
The current value of a transaction: assessed by calculating the value this transaction
would have if it were immediately hedged in the financial markets.
Default
Positive Mark-to-Market
Default
Negative Mark-to-Market
Forward Buy
Nov 2002
Positive MtM: The value of the transaction is positive. The transaction is ‘in the money’.
Fortis Bank has a credit exposure on the counterparty.
Negative MtM: The value of the transaction is negative. The transaction is ‘out of the
money’. The counterparty has a credit exposure on Fortis Bank.
123
and examples
Reflect the evolution of the OTC Derivatives Credit Risk in the future
Add-On
?
Maturity
OTC Derivatives contract residual maturity
• Modelled as depending on the future volatility of the market risk factors

underlying the derivative contract
• Statistically build by MB Risk Management: comparable methodology to
assessment of market Risk
124
and examples
Regulatory add-on
Residual Interest Exchange rate Precious Other

Equity
Maturity rate and gold metal commodities
≤ 1 year 0.0% 1.0% 6.0% 7.0% 10.0%
1 – 5 years 0.5% 5.0% 8.0% 7.0% 12.0%
≥ 5 years 1.5% 7.5% 10.0% 8.0% 15.0%
For instance, if a bank has concluded a 3 years interest rate swap with
another bank, on a notional amount of 1000 EUR whose market value is
currently 10 EUR, the credit-equivalent would be
10 EUR (MTM value) + 1000 EUR × 0.5% (PFE) = 15 EUR

125
and examples
In order to reduce Economic Derivatives Credit Risk, it is

possible to apply the following Credit Risk Mitigation
Factors:
• derivatives collateral management: securities posted to cover net

MtM above a specified trigger
• derivatives close-out netting: Offsetting of receivables and

liabilities in case of an event of default of the counterparty (only
with MtM deals)
• break clause: bilateral contingent option to early cancellation at

pre-fixed dates
126
and examples
Definition: Offsetting of receivables and liabilities in case of an event of default

of the counterparty (only with MtM deals)
Conditions requested by Regulator for each counterparty to apply Close-Out
Netting :
• Signed Master Agreement with the counterparty.
• Favourable legal opinion on the Close-Out Netting in the country of incorporation of
the counterparty
• Legal opinion define the products and type of counterparty (corporate, bank, financial
institution, etc...) that can be accepted in a Close-Out Netting process.
Offsetting takes place within Netting Pools : set of transactions that are eligible
for Close-Out Netting
Countries allowing corporates to apply for Close-Out Netting: Australia, Austria,
Canada, Denmark, Finland, Hong-Kong, Ireland, Italy, Japan, The Netherlands,
Norway, Portugal, Singapore, UK, USA, South Africa, Sweden, Switzerland
127
and examples
Exposure calculation in case of netting
The PFE is adapted with the following formula:
0.4+0.6×NGR
with NGR being the ratio of the netted MTM value (set to zero if negative) to
the gross positive MTM values.
=> Offset of collateral agreement partially recognized at the add-on level
128
and examples
Example
Notional CCF MTM

Contract 1 1000 EUR 1.0% +100 EUR
Contract 2 2000 EUR 5.0% -30 EUR
Contract 3 3000 EUR 6.0% -40 EUR
NGR = 30 EUR (netted MTM of 100 – 30 – 40) / 100 EUR (sum of positive
MTM)=0.3
PFE (without netting)=(1000 × 1% + 2000 × 5%+ 3000 × 6%)= 290 EUR
PFE (corrected for netting) = (0.4 + 0.6 × 0.3) × 290 EUR = 168.2 EUR
Credit-equivalent = 30 EUR (net current exposure)+168.2EUR= 198.2 EUR

129
and examples
Derivatives collateral management implies

• Daily Mtm value calculation
• Daily Margin calls if the Net Current Mark-to-Market is bigger than a predefined
threshold
• Threshold often equal to zero in order to eliminate the capital consumption
• Only Cash and OECD government bonds are accepted as collateral
• Internal Add-ons are less severe (one month add-on is used)
• Documented by a Credit Support Annex to ISDA Agreements
Example : FX deal collateralised - Residual maturity : 4 years
14.0%
Add-on value [% of the Notional Amount]
11.5%
9.2%
7.0%
4.9%
3.5% Maturity
One month Add-on due to collaterisation
130
1m 6m 1Y 2Y 3Y 4Y
and examples
• Total maturity is considered to select add-ons curve.

• Break-clause date reflects date at which the credit risk exposures stops
Add-on value [% of the Notional Amount]
Deal Maturity Date
Break-Clause Date
Credit Risk Exposures
Maturity
131
Agenda
5. Securitization
2. Credit risk in IRB: Maturity
requirements and examples
Maturity calculation
- In IRBF, fixed at 2,5 years (6 months for repo style transactions)
- In IRBA calculated as
∑ tCF
∑ CF
- Min 1 year, Max 5 years
- If the bank cannot apply the formula => Final maturity
- Netting: average maturity
- National discretion: break of the 1 year min (e.g.: Repo, Forex, Securities
Lending…)
133
Agenda
5. Securitization
3. Understanding RWA function
Goal of part 3: understanding the formula …
135
1. The RWA function

2. What is a risk ?
3. Correlation issue
4. The Merton process
5. The formula: stressed default rate
6. The formula: Confidence Interval
7. The formula: expected loss deduction
8. The formula: Maturity adjustment
9. The formula: Madrid issue
10. Weaknesses of the approach
136
1. The RWA function

IRBF
PD
LGD
IRBA
EAD
F(x) = Capital requirements
Maturity
Correlation
Regulators
Confidence interval Capital requirements / 8%= RWA
Full model recognition:

137
Basel 3 ?
2. What is a risk ?
- Formula delivers capital to cover credit risk
- But what is a risk ?
A/ Next year salaries of employees
B/ Next year credit loss on large retail portfolio
C/ Next year amortized value of the building
D/ Next year revenue on corporate business line
=> Risk is the Unexpected
138
Expected versus unexpected loss
• Expected loss
• Anticipated average annual loss rate
• Foreseeable cost of doing business
• Differentiated cost of risk recovered through pricing
• Unexpected loss
• Unforeseeable
• Unanticipated Losses
• Requires balance sheet cushion of capital
• Differentiated capital sustained with appropriate return
139
3. Correlation issue
- What creates the risk is the correlation of defaults (simul 3% PD)
4 .5 0 %
4 .0 0 %
3 .5 0 %
Year 1
Year 2
3 .0 0 % Year 3
default rate
Year 4
2 .5 0 %
Year 5
2 .0 0 % Year 6
Year 7
1 .5 0 % Year 8
Year 9
1 .0 0 %
Year 10
0 .5 0 %
0 .0 0 %
100 500 1 ,0 0 0 1 0 ,0 0 0 5 0 ,0 0 0
P o rtfo lio s ize
140
- S&P historical default rates

Deviation ?
4.0% = Basel 2
3.5% issue
3.0%
2.5%
Default rate
2.0%
1.5% Average
1.0%
0.5%
0.0%
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
Year
141
4. The Merton process
- Default generating process

- E.g.: assets=100, expected return=10%, volatility of asset value 20%,
debt=80
20%
18%
16%
14%
Frequency
12%
10%
8%
6%
4%
2%
0% 100.0
120.0
140.0
160.0
180.0
200.0
20.0
40.0
60.0
80.0
0.0
Assets and debts value
Assets value Debts 142

- Correlation is introduced in Basel 2 as:
R(A) = w1 R(E) + w2 R(a)

R(B) = w1 R(E) + w2 R(b)
Total Return of Stand alone

Return of economy Return of
companies companies
Systemic Idiosyncratic
Correlated risk risk
143
5. The formula: stressed default rate
Probability of Confidence
default interval
With some ⎛ φ −1 ( PD ) + ρ φ −1 (CI ) ⎞
statistical φ⎜ ⎟
developments … ⎜ − ρ ⎟
⎝ 1 ⎠
Asset
(Inverse)Normal correlation
distribution
144
- The formula allows to estimate the loss distribution
200.00 100.00
180.00 90.00
160.00 80.00
Frequency
Frequency
140.00 70.00
120.00 60.00
100.00 50.00
80.00 40.00
60.00 30.00
40.00 20.00
20.00 10.00
0.00 0.00
0.00%
0.03%
0.05%
0.08%
0.11%
0.14%
0.17%
0.21%
0.26%
0.31%
0.36%
0.42%
0.50%
0.58%
0.68%
0.79%
0.93%
1.10%
1.32%
1.60%
1.99%
2.58%
3.69%
7.81%
0.15%
0.33%
0.40%
0.46%
0.51%
0.56%
0.61%
0.66%
0.70%
0.75%
0.80%
0.85%
0.90%
0.96%
1.02%
1.08%
1.15%
1.23%
1.32%
1.43%
1.57%
1.76%
2.06%
2.93%
Default rate Default rate
Corp: PD 1%, Correl 20% Qual. Rev. Expo: PD 1%, Correl 4%
=> Basel 2 capital= 14.6% => Basel 2 capital= 4.1%
145
- The different risk classes are associated to different risk weighting function,
the only difference is correlation
Retail
SME
UL
UL Large Corporates
UL
146
6. The formula: Confidence Interval
Confidence - Used for all statistical measures

interval ?
⎛ φ −1 ( PD ) + ρ φ −1 (CI ) ⎞
φ⎜ ⎟ - Signification: not enough capital =>
⎜ 1− ρ ⎟
⎝ ⎠ Accepted Bankruptcy
- Calibration: Desired PD ?
147
- Used for all statistical measures

1 Year PD CI
AAA 0.01% 99.99%
AA+ 0.02% 99.98% ⎛ φ −1 ( PD) + ρ φ −1 (0.999) ⎞
AA 0.03% 99.97% φ⎜ ⎟
AA- 0.04% 99.96% ⎜ − ρ ⎟
A+ 0.05% 99.95% ⎝ 1 ⎠
A 0.06% 99.94%
A- 0.07% 99.93%
BBB+ 0.18% 99.82%
BBB 0.34% 99.66%
BBB- 0.72% 99.28%
⇒ Basel 2 calibrated
BB+ 0.91% 99.09%
BB 1.15% 98.85% for A- / BBB+ bank
BB- 2.68% 97.32%
B+ 3.95% 96.05%
B 9.07% 90.93%
B- 13.84% 86.16%
148
7. The formula: expected loss deduction
Risk= Unexpected
⇒ Expected loss is a cost that should be integrated in the

pricing
⎛ φ −1 ( PD) + ρ φ −1 (0.999) ⎞
φ⎜ ⎟ − PD
⎜ 1− ρ ⎟
⎝ ⎠
⇒ Up to know only PD was considered, we introduce LGD
⎡ ⎛ φ −1 ( PD ) + ρ φ −1 ( 0 .999 ) ⎞ ⎤
⎜
⎢φ ⎜ ⎟ − PD ⎥ xLGD
⎢⎣ ⎝ 1− ρ ⎟ ⎥⎦
⎠
149
• Likelihood that losses will exceed the sum of Expected Loss (EL) and Unexpected
Loss (UL)
• 100% minus this likelihood = confidence level
• Capital set according to the gap between EL and VaR, and EL is covered by
provisions or revenues, likelihood that the bank will remain solvent over a one-
year horizon = confidence level.
Under Basel II, capital is set to maintain a supervisory fixed confidence level
150
8. The formula: Maturity adjustment
- Input = PD 1 year => output = capital 1 year

- Why not 5 years ? Why not until maturity of the credit ?
We can work on 1 year horizon because we suppose that we can sell all the
bank assets …
Assets Liabilities
100 EUR credit BBB 5 EUR capital
(e.g. 20Bp EL Enough ?
5% at 99.9%
95 EUR debt
5 years)
151
Assets Liabilities
Stressed year ! 100 EUR credit 5 EUR capital
BBB (20 Bp EL
5% at 99.9%
95 EUR debt
- 5 EUR loss because of default => covered by capital 5 years)
- 95 EUR of credit still at risk and no more capital => we sell them
- But … New rating % of
year end portfolio Spread New value
AAA 0% 0.05% 0.0
AA 5% 0.10% 4.8
A 10% 0.20% 9.5
BBB BBB 50% 0.30% 47.5
Spread BB 20% 1.00% 18.5
0.30% B 10% 2.00% 8.9
Default 5%
Intitial Value Final Value
95 89
Delta
-6 152
- Regulators used MTM credit VAR models to calibrate Basel 2 formula

- And smoothed results through regression
30.0%
25.0%
Regulatory capital
20.0%
0.1% PD
0.5% PD
15.0%
1.0% PD
1.5% PD
10.0%
5.0%
0.0%
1 2 3 4 5
Maturity 153
- The formula:
⎡ ⎛ φ −1 ( PD) + ρ φ −1 (0.999) ⎞ ⎤ 1
⎢φ ⎜⎜ ⎟ − PD ⎥ xLGDx
⎟
x(1 + ( M − 2.5) xb)
⎢⎣ ⎝ 1− ρ ⎠ ⎥⎦ (1 − 1 .5 xb )
b = (0.11852 − 0.05478 x ln( PD))²
154
9. The formula: Madrid issue
- Madrid compromise: regulators accepted EL deduction but introduced a

corrective factor (6% add-on)
⎡ ⎛ φ −1 ( PD) + ρ φ −1 (0.999) ⎞ ⎤ 1
⎟
x(1 + ( M − 2.5) xb) x1.06
⎢⎣ ⎝ 1− ρ ⎠ ⎥⎦ (1 − 1.5 xb)
May be
reviewed based
With b = (0.11852 − 0.05478 x ln( PD))² on QIS 5 results
155
SUMMARY
Asset
Proba correl
(Merton) CI for BBB+ /
Default
A- rating
⎡ ⎛ φ −1 ( PD) + ρ φ −1 (0.999) ⎞ ⎤ 1
⎟
x(1 + ( M − 2.5) xb) x1.06
⎢⎣ ⎝ 1− ρ ⎠ ⎥⎦ (1 − 1.5 xb)
Stressed DR EL Recoveries Maturity Safety

adjustment margin
deduction
(MTM)
156
10. Weaknesses of the approach
- Critics of the industry
• Correlation structure too simplistic
• 5 year cap for Maturity adjustment
• Unique confidence interval
• Concentration risk not recognized (single name and industry)
• Fixed LGD
• Single approach (Merton type) kills research
=> Internal credit VAR models ? Future of Basel 3 ? 157

Agenda
5. Securitization
3. Detailed issues of Risk quantification
1. Calibration of RW functions
2. Correlation level
3. Example of RWA
4. Specialized lending
5. Equity exposures
6. Purchased receivables
159
1. Calibration of RW functions
The calibration intended in CP 2 QIS2 results

(January 2002) (Spring 2002)
G10 average, after incorporating some
130 of the working paper proposals
120 130
110 120
100 110
90 100
80 90
Operational Operational
70 80
risk 70
risk
60
50 60
40 Credit 50 Credit
30 risk 40 risk
30
20
20
10
10
0
Foundation
0
Standardised
Standardised
Current
Accord
Approach
Foundation
Current
Accord
Approach
IRB
IRB
Source: CBF
160
QIS2 results Review of the The calibration aimed at

(Spring 2002) Standardised for in CP3
G10 average, after incorporating some Approach
of the working paper proposals calibration 130
120
130 110
120
100
110
90
100
80
90
Operat. QIS2.5(Nov.2001) 70 Operat.
80
risk 60 risk
70
60 50
50 Credit 40
Credit
40 risk QIS3(Oct.2002) 30 risk
30 20
20 10
10 0
0
Standardised
Further
Foundation
Standardised
Foundation
Current
Accord
Approach
review of the
Accord
Current
Approach
IRB
IRB
IRB
calibration
Source: CBF
161
2. Correlation level Retail
SME
UL
Corp, Sovereign, 12%-24% UL
UL
Large Corporates
Banks (function of PD)

SME 8% - 20%
(function of Turnover European pressure
and PD)
Other retail 16%-3%
(function of PD)
QRE 4%
Mortgages 15% High because of maturity
162
Corporate Other retail
Asset correlation for corporate portfolios

Retail Correlation
18.0%
26%
16.0%
24%
14.0%
22%
12.0%
Correlation
Asset correl
20%
10.0%
18%
8.0%
16%
6.0%
14% 4.0%
12% 2.0%
10% 0.0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%
PD PD
163
SME
25.0%
20.0%
Correl 15.0%
10.0%
5.0% 45
0.01%
0.80%
25 Turnover Mios
1.70%
2.60%
3.50%
4.40%
5.30%
EUR
6.20%
5
7.10%
8.00%
8.90%
PD 164
Impact on SME: a revised pricing ? Customer Condition

Profit margin
Business Line
Shared
Fixed Costs Cost BL
?
Costs
Marginal Costs
Product
Capital
Crédits
(Unexpected Loss)
Provision YES
(Expected Loss) Transfer price
Options:
ALM
• Reservation
• Max. Price
• Early Term.
NO Market price
Funding
165
Capital Required For €100 Unsecured Loan

Basel I €100 X 100% X 8% = €8.00
Corporate Retail
20% €1.60
Basel II 50% €4.00
Standardised €100 X X 8% = €100 X 75% X 8% = €6.00
100% €8.00
Approach
150% €12.00
€5m €50m
Basel II *11.3% - 14.4% €0.90 to €1.16 4.45% €0.36
IRB Approach X
€100 X 8% = €100 X X 8% =
(PD 0.03% to 20%;
LGD 45%)
X
188% to 238% €15.07 to €19.06 100.3% €8.02
*Shows Firm –size adjustment effect
From Basel II Annex 3
for Sales of €5m and €50m
166
3. Example of RWA
Original calibration !
PD (%) BRW PD (%) BRW
0.03 14 1 125
0.05 19 2 192
0.1 29 3 246
0.2 45 5 331
0.4 70 10 482
0.5 81 15 588
0.7 100 20 625
167
Risk Weight IRBF / Standard
300,00%
250,00% BBB+ BB+ BB- B+

Risk Weight IRBF
Corporate
200,00%
Risk weight IRBF SME
150,00%
Risk Weight Standard
ECAI RATED
100,00%
Risk Weight Standard
ECAI UNRATED
50,00%
0,00%
%
0%
00
05
14
33
75
30
00
00
00
,0
0,
0,
0,
0,
0,
1,
2,
3,
5,
10
168
THE 4 CURVES
Maturity : 2,5y Sovereign Retail Other Retail
LGD : 45% Corporate Residential Retail Qualifiying
PD Bank Mortgage Revolving
0.03% 14.44% 4.15% 45.00% 0.98% RISK WEIGHTED ASSET
0.05% 19.65% 6.23% 6.63% 1.51%
0.10% 29.65% 10.69% 11.16% 2.71%
DERIVATION for
0.25% 49.47% 21.30% 21.15% 5.76% Corporate, Sovereign,
0.40% 62.72% 29.94% 28.42% 8.41%
0.50% 69.71% 35.08% 32.36% 10.04%
Bank & Retail Exposures
0.75% 82.78% 46.46% 40.10% 13.80%
1.00% 92.32% 56.40% 45.77% 17.22% June 2004
1.30% 100.95% 67.00% 50.80% 21.02% Without 1.06 conservative
1.50% 105.59% 73.45% 53.37% 23.40%
factor
2.00% 114.86% 97.94% 57.99% 28.92%
2.50% 122.16% 100.64% 60.90% 33.98%
3.00% 128.44% 111.99% 62.79% 38.66%
4.00% 139.58% 131.63% 65.01% 47.16%
5.00% 149.86% 148.22% 66.42% 54.75%
6.00% 159.61% 162.52% 67.43% 61.61%
10.00% 193.09% 204.41% 75.54% 83.89%
15.00% 221.54% 235.72% 88.60% 103.89%
20.00% 238.23% 253.12% 100.28% 117.99%
169
4. Specialized lending
If NO PD/LGD Corporate Criteria Approach ⇒

Supervisory Risk Weights Estimates („Slotting Grid Approach“):
Strong Good Satisfactory Weak
PF,OF,CF,IPRE Less than 50% 70% 115% 250%

2,5 years
More than BBB- or BB+ or BB BB- or B+ B- C-
2,5 years better
HVCRE (Basel II not CAD III) 95% 120% 140% 250%
170
5. Equity exposures
Approaches:
• PD/LGD based approach (same as Corporate (LGD 90%),

5 years maturity)
• a methodology based on market risk and stress testing (target: equities held
mainly for capital gains purposes)
• Simple risk weight
• Internal models (VAR)
171
Equity exposures subject to PD/LGD Method

• PD determined according to methods for corporate exposures.
minimum PD’s :
• 0.09% for exchange traded equity exposures where investment is part of long-term
customer relationship
• 0.09% for non-exchange traded equity exposures where returns on the investment
based on regular and periodic cash flows not derived from capital gains
• 0.40% for exchange traded equity exposures including other short positions
• 1.25% for all other equity exposures including other short positions
• LGD
Private equity exposures in sufficiently diversified portfolios 65%
All other exposures 90%
• Maturity
M assigned to all exposures shall be 5 years
172
Simple Risk Weight Approach

• Risk weight (RW) = 190% for private equity exposures in sufficiently diversified
portfolios.
• Risk weight (RW) = 290% for exchange traded equity exposures.
• Risk weight (RW) = 370% for all other equity exposures.
• Risk-weighted exposure amount = RW * exposure value
Internal Models Approach

• Potential loss on the institution’s equity exposures using internal value-at-risk
models subject to the 99th percentile, one-tailed confidence interval of the
difference between quarterly returns and an appropriate risk-free rate computed
over a long-term sample period, multiplied by 12.5.
• Risk weighted exposure amounts at individual level not less than the sum of
minimum risk weighted exposure amounts required under the PD/LGD Approach
and the corresponding expected loss amounts multiplied by 12.5.
173
6. Purchased receivables
Retail – “top-down” approach
Corporate:
• If such receivables are purchased, banks are expected to estimate the risk
of their default (“bottom-up” approach).
• The alternative "top-down“ approach is possible as long as:
• receivables are purchased from third parties,
• must not be subject to netting agreements,
• if not secured by collateral, their maturity must not exceed 1 year,
• concentration limits must be kept.
Note.: „top-down“ means that claims are viewed as

one package, each separate claim is not analyzed
174
• Within the IRB approach bank is expected to calculated not only the capital
requirement for default risk (like for any other exposures) but also capital
requirement for so called „dilution risk“
• The essence of dilution risk is the possible existence of a counter-claim of the

debtor against the original creditor.
• For the purpose of calculating the RW for such risk, into the corporate risk
function is set LGD = 100 % and the portion of expected loss from the exposure
will be equal to PD.
• When the receivable is secured by a guarantee, the procedure is the same as for
IRB approach for corporate exposures, regardless whether the guarantee covers
the risk of default, dilution risk or both.
175
Agenda
5. Securitization
4. Credit risk mitigation
1. General issues
2. Funded Versus Unfunded
3. Funded
a. Financial collateral eligible

b. Calculation
c. Other collateral eligible
d. Calculation
4. Unfunded
a. Eligible instruments
b. Calculation
177
1. General issues
• Institutions using both the standardized approach, or foundation IRB, may take
into consideration the effect of Credit Risk Mitigation (CRM) during RW
calculation.
• All possible credit risk mitigation methods must be legally enforceable in all
relevant countries.
• In addition, institutions must ensure the efficiency of the entire process and
address risks connected therewith.
• Institutions must always ensure compliance with minimum requirements for
CRM procedures.
• If all defined requirements are met, the institution may decrease the value of
RW or EL in compliance with CAD.
• No exposure with a CRM instrument may have a RW higher than an identical,
but unprotected exposure.
• In cases when CRM has been incorporated in the calculation of RWA, the
provision on CRM is not further applied. 178
2. Funded Versus Unfunded
Credit Risk Mitigation instruments may be funded or unfunded
For funded instruments the following is required:

• Sufficient liquidity of the underlying assets and their low volatility
• The institution has the right to keep or sell the assets in case of default or
other contractually determined credit event occurrence
• The degree of correlation between the value of the asset and creditworthiness
of the debtor may not be inappropriately high
For unfunded instruments the following is required:

• The providing entity is sufficiently trustworthy (CAD sets binding list of eligible
providers)
179
3. Funded: a) Financial collateral eligible

Collateral
Simple approach Comprehensive approach
approach
Covered exposure receives the Exposures are reduced by the value of
Impact on
risk weight of the collateral collateral and the net result is risk weighted
RWA
with a minimum of 20% as unsecured
• Cash on deposits at the issuing banks
• Gold
• Debt securities rated by ECAI at least: BB- for sovereigns (and
assimilated PSE), BBB- for other, A-3/P3 for short term
• Unrated debt securities if they are: issued by a bank, senior, liquid,
listed on recognized exchange
• Equities (including convertibles bonds) included in a main index
Eligible • UCITS (Undertakings for Collective Investments in transferable
collateral Securities) and mutual funds if: quoted daily and invest only in the
instruments above
• Equities (including convertibles
bonds) not included in a main index but
listed on a recognized exchange
• UCITS and mutual funds which
include such equities
180
Eligibility
• Low correlation between the creditworthiness of the debtor and the value of the
collateral.
• Operational requirements – sufficient documentation, risk management processes

connected with collateral, at least semi-annual frequency of re-pricing and in cases
when the collateral is held by a third party such party may not report it among its
assets.
• In addition, under the simple approach with respect to financial collateral it is required
that residual maturity of the collateral is not shorter than the residual maturity of the
exposure.
181
3. Funded: b) Calculation for financial collateral
• In order to mitigate the capital requirement, banks may use the simple approach
replacing the risk weight of the counterparty by the risk weight of the collateral.
However simple approach is NOT allowed within IRB.
• Comprehensive (FCCM) approach:

• allows a greater ratio of offsetting the exposure by collateral through decreasing
the value of the exposure by the value of the collateral.
• The principle of this approach is that the market value of the collateral is adjusted
for the haircut representing the estimate of volatility of such collateral. A different
haircut is allocated to the exposure itself. The level of such haircut may be
determined:
• by the regulator,
• through an estimate made by the bank (VaR model).
• In case the collateral is denominated in a different currency than the exposure

itself, another haircut considering currency risk is applied
182
Comprehensive approach
Adjusted value of exposure (E*) is calculated as follows:
E* = max{0,[E × (1+HE) – C × (1-HC-HFX)]}

where:
E = is the exposure value according to the standardized or IRB approach
HE = discount (haircut) applicable to the given exposure
C = present value of the collateral received
HC = discount (haircut) applicable to the collateral
HFX = discount (haircut) for the currency mismatch between collateral and exposure
The relevant haircuts can be calculated in two ways:

• use of regulatory estimates,
• bank’s own estimates.
183
Haircuts proposed by regulators

Sovereign (and
Collateral Residual Maturity Other issuers
assimilated) issuers
≤ 1 year 0.5% 1.0%
AAA to AA- and A1
securities > 1 year, ≤ 5 years 2.0% 4.0%
> 5 years 4.0% 8.0%
A+ to BBB- and A2 / ≤ 1 year 1.0% 2.0%
A3 / P-3 and unrated > 1 year, ≤ 5 years 3.0% 6.0%
bank securities > 5 years 6.0% 12.0%
BB+ to BB- All 15.0% Not eligible
Main index equities and gold 15.0%
Other equities listed on a recognised
25.0%
exchange
Highest haircut applicable to any security in
UCITS / Mutual funds
which the fund can invest
Cash in the same currency 0.0%
Collateral and exposures in different
8.0%
currencies
184
Haircuts adjustment
- Those haircuts are for a 10 day holding period and should be adjusted for other
effective holding period with
185
The following minimum holding period should be used
REPO type transactions 5 days

Other capital market transactions 10 days
Secured loans 20 days
• If there is no daily remargining or revaluation, the minimum holding period has to

be adapted upward.
• To transform the supervisory haircuts for the ten days holding period to haircuts
adapted for the transaction-holding period, banks have to use the square root of
time formula.
186
Worked out example
Example :a bank has a three years BBB bond as collateral to cover a three years
secured lending operation. The bond is marked to market every week. The bond
issuer is a corporate and the face value is 100 EUR. The haircut is calculated as
follow:
• The supervisory haircut for a three years BBB bond issued by a corporate is 6%
• The minimum holding period for secured lending is 20 business days
• As the bond is not revaluated daily but weekly (every five business days), the
minimum holding period must be adapted to 24 (as there are five days instead of
one between revaluations)
• Then the supervisory haircut that is based on a ten days holding period is scaled
up using the square root of time formula
24
Haircut = 6 .0 % x = 9 .3 %
10
• The value of the bond is then 100 EUR x (1-9.3%)= 90.7 EUR. 187
Internal measurement of haircuts
- Internal VAR models may be used to estimate haircuts but subject to following
requirements
Qualitative criteria Quantitative criteria

- Estimated haircuts must be used in - Use of the 99th percentile, one-
day to day risk management tailed confidence interval
- Risk measurement system must be - Use of minimum holding periods
documented and used in as for supervisory haircuts
conjunction with internal - Liquidity of the collateral taken
exposures limits into account when determining the
- At least annual review by the audit minimum holding period
of the risk measurement - Minimum one year of historical
framework data, updated at least every three
months
188
Zero haircuts for Repo transaction
At national discretion, some collateral can receive zero haircuts when used in
REPO-style transactions
- if exposures and collaterals are cash or sovereign
- in the same currency
- there is a daily remargining
- the maximum liquidation period is four days
- with core market participants (sovereigns, central banks, banks…).
189
Netting agreements
AE = max [0; (Σ E - Σ C + Σ (Es x Hs) + Σ (Efx x Hfx))]
With AE = Adjusted Exposure
Σ E = sum of exposures (positive and negative)
Σ C = sum of the values of received collaterals
Es = absolute values of net positions in a given security
Hs = haircut appropriate to Es
Efx = absolute value of the net position in a currency different from the settlement
currency
Hfx = haircut appropriate for currency mismatch

190
3. Funded: c) Other collateral eligible
Real estate collateral (CRE / RRE)

• Monitoring the market price of the real estate - with at least an annual
frequency. In case of loans above 3 mill. € or above 5 % of own capital, an
independent appraisal must be performed every 3 years.
• Documentation for all approved types of real estate.
• The real estate must be properly insured.
Financial receivables
• Claims <1y, repayment will occur through the commercial or financial flows
related to the underlying assets of the borrower.
• Legal certainty: the bank can take control of it
• Risk management requirements (collection cost, concentration risk, …)
191
Other collateral
Regulators should ensure that:
• Liquid markets
• Public prices
Banks requirements:
• First claim
• Loan agreements should describe valuation procedure
• For inventories: physical inspection
• Collateral accepted, valuation methods should be described in banks
procedures
192
3. Funded: d) Other collateral calculation
IRBF
1/ Minimum collateralization test

2/ collateral haircut
3/ New LGD
Minimum Collateral
Collateral type Final LGD
collateralisation Haircut
Receivables 0% 125% 35%
CRE / RRE 30% 140% 35%

Other physical
30% 140% 40%
collateral
193
IRBF Worked out example
Exposure of 100 EUR secured by a commercial real estate of 40 EUR would be

valued as follows
• 40 EUR / 100 EUR = 40% which is superior to the 30% minimum

collateralisation level.
• haircuted by 140%, 40 EUR/140%= 28.6 EUR.
• LGD applied on the part of the exposure corresponding to the haircuted value
would be 35%.
⇒The LGD on the 100 EUR exposure would then be 45% (assuming senior
corporate exposure) on 71.4 EUR and 35 % on 28.6 EUR.
194
IRBA
• the rules are less strict as any kind of collateral can be recognized
• deduction from the exposure to compute the capital requirements
• as long as the bank has historical data to support its valuation (at least 7
years of data on average recovery value on the various types of collaterals it
plans to use).
⇒ Collateral effect in IRBA is much more important
195
Maturity mismatch
Maturity mismatch is a situation when the residual maturity of the credit

protection instrument is shorter than the one of the given exposure.
Maturity of exposure is defined as the longest possible residual period until the
debtor meets its obligations (maximum 5 years).
Maturity of protection is defined as the shortest possible delay when the credit
protection can be cancelled.
Calculation:
t − 0,25
• In general, the value of CRM instrument is multiplied by: ,
T − 0,25
• where:
• t … is maturity of protection (in years)
• T … is maturity of exposure (in years)
196
4. Unfunded a) Eligible instruments
Recognized unfunded CRM: only the following credit protection

providers of unfunded protection may be recognized in IRBF:
• central banks and sovereigns,

• local governments and PSE,
• multilateral development banks,
• international organizations (with a 0 % RW with the standardized
approach),
• Financial institutions,
• corporate with A- minimum
• Must cover capital and interest
IRBA:
• No limit
197
Beside above mentioned instruments some types of credit derivatives

may also be used.
Some of them are treated as unfunded (=guarantees)
• Credit Default Swaps: if protection is similar to guarantees

• Total Return Swaps: except if premiums included in P&L and fluctuation of asset
values not in MTM
Some of them as funded (=collateral)
• Cash funded CLN: considered as collateralized transaction
198
Requirements: Guarantees
- Guarantor should be rated (annual review)

- Effect of guarantor can be recognized in PD or LGD (IRBA)
- Cannot result in RWA inferior to a direct exposure to guarantor
- Guarantee should be written, unconditional, non-cancellable, up to maturity
Requirements: Credit derivatives
- Credit events should cover: default, bankruptcy, restructuration with lower NPV
(or partial recognition)
- The one who determines default cannot be protection seller alone
- If a reference asset is used: should be at least pari passu, same issuer
199
4. Unfunded b) Calculation
Base case: substitution

• For the secured part of exposure (coverage adjusted for currency and
maturity haircut), PD of the credit protection provider is used instead of
PD of debtor (and LGD if better).
• The uncovered part of the exposure still has a PD of the debtor and
LGD according the underlying exposure.
• The value of Guarantee must always be adjusted in case of a currency
mismatch between the exposure and protection instrument of a currency
haircut HFX (the haircut is calculated in the same way as under the
financial collateral comprehensive method):
G* = G × (1 − HFX )
200
Critics of the industry
• No recognition of double default effect (e.g. AA covered by AA no effect) => No

incentive for those efficient risk management tools
• But simple PD product supposes independence => again a correlation issue
• July 2005: proposal of Basel 2
• But limited to professional protection providers

201
Agenda
5. Securitization
5. Securitization
• Banks must apply the securitisation framework to determine the capital

requirements for exposures resulting from traditional, synthetic and other
types of securitisations.
• As securitisation can be structured in several ways, the method how it is

treated for capital adequacy purposes must be based rather on its
economic substance than on its various legal forms.
• The economic substance of transactions should indicate whether or not they

should be considered as securitisation.
203
5. Securitization
Traditional securitisation
• A structure when the cash flow from the underlying pool of exposures relates at least to
two different exposures or tranches with different degrees of credit risk.
• The payment to the investor depends on the development of the underlying exposure.
• Categorized structure (in tranches) characterizing securitisation differs from regular debt
instruments in that the “junior” tranches may absorb losses without affecting more senior
tranches.
Synthetic securitisations
• A structure of at least two categorized (stratified) risk positions or tranches taking into
consideration a different degree of credit risk while the credit risk of the underlying pool
is transferred through guarantees or credit derivatives (funded credit linked notes or
unfunded credit default swap).
• The risk of investor again depends on the development of the underlying exposure.
204
5. Securitization
Originator means either of the following:

• an entity which, either itself or through related entities, directly or indirectly,
was involved in the original agreement which created the obligations or
potential obligations of the debtor or potential debtor giving rise to exposure
being securitised;
• an entity which purchases a third party’s exposures onto its balance sheet
and then securitises them;
Investor:
• institution which is not the originator, sponsor or provider of services and
carries the economic risk of the securitisation exposure.
205
5. Securitization
Capital requirements:
Standardized approach (may be used in IRB)
LT rating AAA to BBB+ to BB+ to

A+ to A- Other ratings
(ST AA- BBB- BB-
(A2/P-2) and unrated
rating) (A-1/P-1) (A-3/P-3)
RWA 20% 50% 100% 350% Deducted
- Banks that invest in exposures that they originate themselves that receive an
external rating below BBB- must deduct them form their capital base
- For off-balance sheet exposures, CCF are used (if they are externally rated, the
CCF is 100%).
206
5. Securitization
IRB Approach
The Rating Based Approach (RBA) that must be applied when the securitised
tranche has external or internal ratings.
The Supervisory Formula (SF) is used when there are no available ratings.
The Internal Assessment Approach (IAA) can also be used when there are
no available ratings but only for exposures extended to ABCP programmes.
207
5. Securitization
Rating Based Approach
• a risk weight is assigned in function of an external or internal inferred rating

(that can be assigned in reference to an external rating already given to
another tranche that is of equal seniority or more junior and of equal or
shorter maturity)
(∑ EAD)²
• the granularity of the pool calculated with N=
∑ EAD²
• the seniority of the position.
208
5. Securitization
Not senior
Senior
RW Rating tranches and N<6
tranche, N≥6
N≥6
AAA 7% 12% 20%
AA 8% 15% 25%
A+ 10% 18%
A 12% 20% 35%
A- 20% 35%
BBB+ 35% 50%
Long Term
ratings BBB 60% 75%
BBB- 100%
BB+ 250%
BB 425%
BB- 650%
Unrated and <
Deduction
BB-
A1/P-1 7% 12% 20%
A2/P-2 12% 20% 35%
Short Term
A3/P-3 60% 75% 75%
Ratings
Other and
Deduction
unrated
209
5. Securitization
Internal Assessment Approach
• Only applies to ABCP programmes. Banks can use their internal ratings
if they meet some operational requirements, mainly:
- The ABCP must be externally rated (the underlying, not the securitised
tranche).
- The internal assessment of the tranche must be based on ECAI criteria

and used in the bank’s internal risk management systems.
- A credit analysis of the asset seller’s risk profile must be performed.
⇒Then, the risk-weight associated to the internal rating is the same

as in the RBA
210
5. Securitization
The Supervisory Formula
-is used when there is no external rating, no inferred internal rating and no
internal rating given to an ABCP programme.
-The capital requirement is a function of:
- The IRB capital charge had the underlying exposures not

been securitised (KIRB)
- The tranche’s credit enhancement level (L)
-The tranche’s thickness (T)
- The pool’s effective number of exposures (N)
- The pool’s exposure weighted average loss-given-default
(LGD). 211
5. Securitization
-The tranche’s IRB capital charge is the greater of 0.0056xT or S[L+T]-

S[L]. S[L] is the supervisory formula defined as
212
5. Securitization
- Until the sum of the subordinated tranches and tranche for which the
capital is calculated is inferior to the regulatory capital had the exposures
not been securitised, the capital rate is 100%.
- Then it decreases sharply until the marginal capital rate becomes close
to zero, as illustrated on the following graphs (in this example the capital
had the exposures not been securitised would be 8.14 EUR, and the credit
enhancement equals 5 EUR)
Senior Tranche
Securitised (100 – 3 – X) EUR
assets: 100 EUR
Bank investment
Bank buys
X EUR
K irb= 8.14 EUR
First loss 5 EUR
213
5. Securitization
4
Capital
S iz e o f th e tr a n c h e 3 .1 4
3
C a p ita l 3 .1 4
0
0 5 10 15 20 25 30 35 40 45
1 2 0 %
S iz e o f th e tr a n c h e
1 0 0 % S iz e o f th e tr a n c h e 3 .1 4
C a p ita l r a te 1 0 0 %
Capital / tranche size
8 0 %
6 0 %
4 0 %
2 0 %
0 %
0 5 1 0 1 5 2 0 2 5 3 0 3 5 4 0 4 5
T r a n c h e s iz e 214
5. Securitization
Comparison between Corporate and securitised exposures

1400%
1200%
1000%
800%
600%
400%
200%
0%
AAA AA A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-
Securitisation exposure Corporate Bond exposure
• Ratings of external agencies mainly based on EL measures

• UL may be very different, which is reflected in RWA 215
Agenda
5. Securitization
6. Application for supervisory approval
Nov: QIS2,5
3-6-3 Oct: QIS3

principle 1988: Basel I Accord
Dec: Finalised
Version of the new Accord
Liberalisation Apr&May: QIS1,2
Jan/2001: CP2 Jan: Basel II

comes in force
1960 1970 1980 1990 2000 2001 2002 2003 2004 2005 2006 2007
June/1999: CP1
1996: Market risk
July: QIS3 results
published
May: Release of CP3
1990: 100 countries Jan: start

apply Basel I parallel run
1974: G10 launch
Basel Committee
217
Home-host issue
Consolidated solvency reporting
Consolidated
Consolidating supervisor Supervisory review Bank
College of supervisors Single entry point

Validation & permission Act as
ONE
company
Meeting
all concerned supervisors
Local solvency reporting
local
Local supervisors CRD local implementation legal entities
Current legal requirements 218
Key success and quiet revolution in supervisory world
Framework
• Overall responsibilities (going concern & emergency situations)
• Assessment of compliance with the requirements for FIRBA, AIRBA
and AMA
• Coordination of gathering & dissemination of information
• Planning and coordination of supervisory activities, including Pillar 2
• Other specific provisions
• Permission to go FIRBA, AIRBA and AMA
• Reach a joint decision within six months
• In the absence of joint decision, make its own decision
• The decision of the consolidating supervisor will be recognised and
applied by the local supervisors
219
To get supervisory approval
- Regulators resources limited => regulators will rely extensively on internal

validation
- More important than models is use test => key issue is communication
- 4 key dimensions investigated:
Rating system
(PD and LGD)
Calibration
Monitor
Support
Oversight and
Data management
control mechanisms
system
Quantification
process
220
Rating system
(PD and LGD)
Statistical validation (non-availability of specific

test to be justified)
• Model power statistics
• Build in and out sample
• Model power statistics for a 5 years’ period before default
• Rank ordering comparison with external & internal rating tool
• Justification of calibration
Business and Credit Experts validation

• Business and credit experts blind test
• Business and credit experts pilot phase
221
Quantification
process
- Estimation of PD: internal / external ?
- Coherence with bank portfolio ?
- Conservative bias ?
- Business cycle state at time of collection ?
- Correlation between various parameters ?
222
Oversight and
control mechanisms
- Corporate governance issue ?
- Control of a coherent use of the models ?
- Organization for model approval / review ?
- Follow up of overrulings ?
- Reporting of model results ?
223
Example: Dexia Control of rating quality
Rating Committee
Quality Control
Head of analysts Audit

Rating follow up group
Validation Committee
Model manager Credit analysts
Validation Department
Rating tool
224
Data management
system
-Are the rating tools secured ?

-Are all the data historized (bank able to apply backward model changes) ?
- Do data management systems allows to verify that guidelines are
respected ?
- Integrity of the data used for regulatory capital calculation ?
- Do data management support use test ?
225
Primary Validation responsibility = the bank NOT supervisors
AIG subgroup : 6 principles – January 2005

Assessing the predictive ability & use
• historical experience, forward looking, discriminating power, reassessment when
divergence from expected results, ….RAM EXPERT Function
Iterative process
• changing market and operating conditions
• on-going process
No single method
• statistical tools
• other methods (back testing, benchmarking, …internalisation of ECAI’s)
• combination of methods
Qualitative and quantitative
• not only a mathematical exercise
• must cover structures, procedures, controls, ...
Subject to independent review
226
• validation ≠ audit
Duration 3 months
Regulators 4 2 Quantitative Specialists
2 Process Specialists
Review documentation, interviews ( credit management,
analytics, chief risk officer, business)
Report CEO, CCO, Chief Auditor, External Auditors
Point of attention
Outliers detection
Coherency of default definition
Documentation of methodological choices (test)
Central Documentation Repository
Overruling process
227
Agenda
Conclusions
228
7. Conclusion
• A permanently strong Credit Risk framework is the aim and key driver,
Basel 2 gives the needed leverage
• Model development is not a one shot exercise but a continuous process

based on input from users, refined data and new insights
• USE the models and use them respecting the rules
• A lot of work has been done but still a lot needs to be done : we know we
can rely on your dedication and professionalism to succeed
229
7. Conclusion
• Management empowerment is crucial for validation

• Model validation not an exact science : a model might assess
relative quality of the counterparty but it cannot capture all elements
as it is based on portfolio analysis : this means : on average over
time
• Expert judgement is of critical importance : for modelling and for
communication
• Data issues centre around quantity not quality
• Regional difference in culture and modelling e.g. equity model
versus debt model
• Use test of critical importance: do you believe your model for day to
day financial decision ?
230
7. Conclusion: not meet requirements of directive?
(art. 136)
• Hold on funds in excess of 8 %
• Reinforce arrangements and strategies
• Apply specific provisioning policy
• Restrict/limit business, operations…
• Reduce risk in activities, product, systems
231
Consortium Partners
Under the Auspices of
Local Training Facilitator
232

Credit Risk Irb Approach2

Diunggah oleh

Informasi Dokumen

Deskripsi Asli:

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Credit Risk Irb Approach2

Diunggah oleh

Hak Cipta:

Format Tersedia

Credit Risk

Internal Rating Based Approach

• The BCBS was formed in 1974 by the Group of 10 central bank

The 3 pillars: mutual re-enforcement

Pillar 1 : menu of evolutionary approaches

International Bank => Basel 2 rules apply

International Bank => International Bank =>

Domestic Bank => Control Investment Bank => Control

Treatment of participations – Financial Companies

Financial companies (Insurance excluded)

Majority-owned / Minority investments

Significant investment Minor investment

Treatment of participations – Insurance Companies

Majority-owned / Minority investments

Significant investment Minor investment

Treatment of participations – Insurance Companies

Amounts of participations up to 15% of banks Amounts superior to

Risk Weighted Deducted

Pillar 1 : menu of evolutionary approaches

Pillar 1 : solvency ratio

Total Eligible Capital

Credit Risk Market Risk Operational Risk

- Standard - Standard - Basic Indicator

Foundation Internal Rating Based Approach

Advanced Internal rating Based Approach

Why choosing IRB ?

• Simpler, less requirements

Banks should be managed in a economical way !

Why choosing IRB ?

• Only external ratings • Internal ratings and PD

Why choosing IRB ? => Macro view

¾ % are contribution from portfolios to total capital change

Why choosing IRB ? Macro view

¾ View by individual portfolio

Why choosing IRB ? Micro view

QIS 3 – G10 Banks Standard Approach FIRB approach AIRB approach

¾ Min and Max impact at bank level

IRB in national laws

• Basel Committee : recommendations and best practices

• Countries : local law

Exposures class => Determine the risk weight function

Project finance e.g.: power plant, chemical plants, mines…

2) Retail: 3 functions (>< Standard)

• Qualifying revolving exposures:

3) Equity: 1 function (but standard method allowed in IRB)

- Recovery only by selling or when bankruptcy occurs

4) Eligible purchased receivables: function Corp or retail

- Claims purchased to another counterparty

5) Securitisation exposure: special treatment: Standard or SF

- Not based on legal definition but economical one

IRB : sources of parameters estimation

IRB Foundation IRB Advanced

NB: ρ and CI always given by regulators

IRB : for each exposure class, 3 components

Principle: if IRB, must apply to all asset classes.

For the rest:

• Roll out plan

Transition period of 3 years

Transition period of 3 years

Approach From Year-end From Year-end From Year-end From Year-end

Dimension of rating system

- 2 dimensions: PD and LGD (>< issue rating !)

- Exposures must be classified in homogenous pools that share risk