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Consumer Risk and the Basel II Proposal

Presented by Michael E. Collins, Executive Vice President
Federal Reserve Bank of Philadelphia

Remarks Before the 6th Annual Consumer Risk Management Conference
Philadelphia, PA
June 11, 2001

In just the last few years, the financial industry has experienced more change - political, economic, and technological - than in the century that preceded it. Banks have been transformed from passive transaction processing institutions into aggressive customer-focused entities.

Now we must prepare for the future and the additional changes that are ahead for our industry in the 21st century. Some say the future is unknown. But I believe there is a degree of predictability. Astronaut and Senator from Ohio John Glenn once said, 'People are afraid of the future, of the unknown. If a man faces up to it, and takes the dare of the future, he can have some control over his destiny.'

In banking, we have taken the initiative and we are controlling our destiny. That's exactly what we are doing today as we make the transition from what was right for the 80s to what's right for now. We are formulating a new Basel Accord that will define the best practices in bank capital regulation for the future.

I would like to acknowledge all of the work the Risk Management Association has done to help us all understand the implications of Basel and generally keep us abreast of developments within our industry. This conference is a fine example of the important work that RMA does.

While the Basel Committee's work is tremendously influential, the committee itself is hardly well known. Even such basic details as the spelling and pronunciation of its name are seemingly in dispute. Is it the 'Bazel' Committee, the 'Baisel' Committee, or the 'Baal' Committee? I have seen respected publications spell it both 'E, L' and 'L, E.' While residents of the Swiss town for which the committee is named may have their preferences, I will not hold it against anyone here if your pronunciation is different from or more precise than mine. I may need you to return the favor.

Regardless of how you spell it, the Basel Committee simply could not be more influential. It isn't going too far to say that when it comes to defining best practices in global risk management and bank capital regulation, the Basel Committee is Webster. With the recent proposal, the committee seeks to begin the process of establishing new standards and redefining the state of the art.

The new proposal, like the 1988 Accord, represents the broadest possible agreement for the supervision of internationally active banks. But it is a skeleton without flesh. The unilateral application of detailed and specific regulations across international borders would be neither politically acceptable nor practical. Wisely and unavoidably, the Basel Committee left to individual nations the work of filling out this skeleton. In the United States, the Federal Reserve and OCC are charged with establishing specific supervisory schemes for domestically chartered banks. A top goal for the Federal Reserve is developing detailed regulations to incorporate the premises of the Basel Accord that meet the needs of our myriad financial institutions. But I submit to bankers that it is a goal we must share with you. Reaching it will require ongoing dialogue and partnership between federal regulatory agencies and the men and women managing banks. The proposal itself should be viewed more as a discussion draft than as a finished product. With this in mind, I hope that my remarks will serve as the basis for dialogue and open discussion so that our joint mission can be as successful as possible.

Bankers from retail-focused institutions are among those with the most questions and concerns about how the proposed Basel Accord will apply to their institutions. This is fitting, since the proposal's guidelines were designed with the commercial loan portion of the largest internationally active banks foremost in mind. Many aspects of how these guidelines can best be applied to consumer portfolios are matters for debate and discussion. Knowing this, I will place special emphasis on the fundamental aspects of the proposed Basel Capital Accord, the ways it will affect the consumer portfolio, and its effects on specific areas of retail banking. First, a brief explanation as to why the Basel Committee is so influential and an overview of the Accords themselves.

The Basel Committee was established in 1974 by the central bank governors of the 'Group of Ten' countries in recognition of the fact that the financial marketplaces of the world were unifying into a single global financial marketplace. Since that time the committee has fostered cooperation and understanding among the world's bank regulators by sharing global perspectives on industry and regulatory best practices. Through these discussions, they have acted to harmonize international bank regulation as necessary to keep surprises from impacting the global economy. President McDonough of the Federal Reserve Bank of New York currently serves as chairman of the Basel Committee. Similarly, the world's most prominent central banks are also represented on the committee. As an intergovernmental organization, the Basel Committee possesses no formal authority and its conclusions have no legal force. But because the committee's recommendations carry the weight of global consensus, this lack of formal authority has had little effect on their implementation.

By the mid 1980s, bank supervisors on the Basel Committee concluded that many large banks needed to hold more capital in reserve and that international standards for bank regulation were necessary. There were several reasons for these findings. Generally, the capital requirements of many nations were not sensitive enough to risk. Differences in regulatory requirements were placing some banks at a competitive disadvantage and less-well-regulated institutions had perverse market incentives to take unadvisable risks. Technology and innovation were creating a single global debt and credit marketplace. U.S. bank failures and problem Third World debt also contributed to the growing consensus favoring a global risk management framework.

In 1988, the committee introduced the Basel Capital Accord. This agreement featured broad weighting adjustments to reflect the riskiness of assets. It also recommended an international standard for risk-weighted minimum capital of 8 percent for international banks. Many countries, including the United States, also adopted Basel guidelines for the regulation of smaller and domestic-only institutions. Non-Basel members followed the lead of the larger committee-member nations in instituting Basel-based reform, and the Accord quickly became the world standard for measuring and regulating bank risk.

The 1988 Basel Accord has been successful, but the rapid pace of change that fostered its adoption only accelerated in its first decade. Bank innovation, new financial instruments, and complex bank practices have acted to disassociate actual risk from the capital requirements. Amendments to the original Accord, such as the market risk amendment, heightened its sensitivity to broader risks. But while broadly adopted, such steps did not sufficiently counter these developments. By the late 1990s, the Basel Committee concluded that more substantial change was necessary. Seeking to better ensure that all bank risk is accounted for, the Basel Committee broadly agreed on a proposed Accord in 1999.

For ease of digestion, the Basel Committee describes these many changes in terms of 'pillars.' Pillar 1 refers to capitalization standards. Pillar 2 refers to the methods of supervision. Pillar 3 refers to disclosure and the involvement of markets.

The differences between the proposed and old Accords are profound. Most prominent is the new Accord's reliance in Pillar I on an internal ratings based (or IRB) approach to more accurately assess risk. In a nutshell, the IRB approach seeks to harness banks' own expertise and risk models to help determine the amount of regulatory capital a bank needs to hold. Because the committee realized that risk varies greatly within categories of assets, the proposed Accord would base risk weights on bond ratings, credit ratings, and other measurements of market sentiment when possible. In addition, the proposal recognizes that computer failure, fraud, and other kinds of risks exist within banks, and it requires the quantification of these operational risks as well.

Other elements of the 1999 Accord are just as innovative. In Pillar II, the proposed Basel Accord requires a closer working relationship and more mutual understanding between banks and their supervisors. In Pillar III, the Accord relies on the complementary power of a well-informed marketplace and requires that banks and regulators make public more information on the riskiness of holdings.

A walk through these pillars will assist in detailing the Accord's effect on the regulation of retail portfolios.

The entire 1988 Basel Accord focused on regulatory capital requirements. In the more extensive proposed Accord, the standards for capital are contained within the first pillar. Realizing that the 1988 Accord became the de facto standard for banks of different sizes and business models, the Basel Committee sought to better tailor the proposed Accord to all institutions regardless of size, resources, expertise, and risk profiles. As a result, the proposal affords banks options as to how regulatory capital is assessed.

The IRB approach is certainly the centerpiece of the proposal, but it might not be appropriate for most banks. Small, traditional institutions do not employ the most advanced, complex, and expensively high-maintenance capital and risk management systems. For these institutions the cost of implementing substantial bankwide changes would not equal the benefits of using an IRB approach. Most banks would be best served by the proposal's revised standardized approach, which is similar to the 1988 Accord, but more risk sensitive. The total capital required for the risk-weighted value of bank assets remains at 8 percent under the revised standardized approach. But increased accuracy will come from better methods of determining the proper risk weights. Bank efforts to mitigate risk through collateral, loan guarantees, and other methods will be better accounted for, and the external assessments of borrowers' creditworthiness will be used.

While an early assessment of Basel II appears to suggest higher capital requirements for retail portfolios, there is and will be an ongoing effort to better align risk with capital. Clearly, provisions of the Accord still need work. Segmentation standards do not reflect best practices, and the proposed capital requirements might be punitive on credit card type exposures. We are working with RMA and others to address these and other concerns.

Large and complex banks will use an internal ratings based (or IRB) approach, whereby capital requirements will be based on a bank's own assessment of its borrowers' credit quality. Under the IRB system, banks use data to estimate a set of measures that will be the basis for their minimum capital charge. These risk measures are probably familiar to you now, if they weren't before — probability of default (PD), loss expected given default (LGD), and expected exposure at default (EAD). IRB banks would be expected to meet fairly high standards to demonstrate the accuracy of these measures. They must be empirically based and closely linked to the condition of borrowers. These standards are tailored to specific asset classes, and regulatory capital requirements would be based on these ratings.

The first step of determining risk would be to divide the bank's assets into six broad categories: corporate, project finance, sovereign, bank, retail, and equity. Banks would be expected to further break down these categories into groups of similar exposures. Large banks could be expected to have dozens of exposure groups within each asset class, each with its own PD, LGD, and other measures. A credit card portfolio might be broken down into many exposure groups based on similar characteristics, and those exposure groups may represent thousands of assets of similar risk.

Just as the Basel Committee provided an option for less complex banks to use a standardized approach, so it has provided two IRB options. Some banks will have the sophistication to determine default probabilities but not to estimate loss given default or exposure at default. Regulators would determine the loss rates and exposure at default of assets for these banks. This is the foundation IRB approach. Banks with the sophistication to determine advanced loss estimates would be permitted to do so under the close supervision of their regulator. This is the advanced IRB approach.

The three tiers of the first pillar establish a path for banks to evolve and advance their risk assessment systems. Banks using the revised standardized approach or foundation IRB approach will see the benefits of moving on to the next level and will strive to update their systems to realize those benefits. In this way, the Basel Committee believes that the first pillar establishes incentives for banks to enhance their risk assessment systems.

Enhancing risk sensitivity is the goal of Pillar I. One way the proposed Accord seeks to do this is by requiring banks to measure and hold capital against operational risk, which the Basel Committee defines as 'the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, and from internal events.' Direct and indirect losses from failed internal processes, fraud, theft, external events, and acts of God are typical operational risks. It is doubtlessly harder to assess the proper capital requirements to cover these kinds of risks, and Basel II notes that banks with internal capital systems generally allocate approximately 20 percent of their economic capital to offset operational risk. Details of how operational risk will be quantified are still evolving, and again, your input will be of help to regulators.

Pillar II advances the current supervisory trends toward strong internal controls, self-policing, and joint Board and senior management oversight. Accordingly, enhancing understanding between bank managers and bank supervisors is at its heart. Pillar II requires each bank to begin the assessment of its internal capital adequacy. Bank supervisors are then directed to review these internal assessments and certify that internal risk targets are based on realistic, quantitative data. Supervisors would expect banks to operate above the minimum regulatory capital ratios. When necessary they would intervene at an early stage to require additional capital. For several years, U.S. bank supervisors have placed a special emphasis on examining the internal controls of the banks they supervise. In many ways, Pillar II represents the logical expansion of policies put forth by the Federal Reserve in policy statement SR 99-18. The Basel Committee continues to develop the nature of bank supervision along these lines.

Pillar III introduces the complementary, yet vital, element of market discipline to the Basel framework. There are well-known risk management benefits that accrue from the discipline brought by informed stakeholders and counterparties. The intent of Pillar III is to harness the regulatory power of the marketplace by improving transparency and making more information about a bank publicly available. Information to be disclosed would include both quantitative and qualitative data. For example, information on holdings and portfolio quality, a bank's organizational structure, and risk management techniques would be made public. Disclosure of this kind of information is intended to buttress the decisions of bank regulators.

The amount of information required or recommended to be disclosed would vary from bank to bank. Generally, the amount and types of information that needed to be released would be proportional to the degree to which the internal ratings based approach is used. As banks benefit from the risk sensitivities of the IRB approach, more market discipline will be applied. Indeed, more information will be demanded by the investing public.

Basel II has been broken down into three pillars for ease of exposition. But it is vital to view each of them as parts of a cohesive plan for ensuring that individual banks, their supervisors, and the markets adequately comprehend bank risk. Dialogue between industry and regulators is critical in all cases, and is but one example of how the pillars will work together to augment the effectiveness of the Accord. While there is plenty of room for banks to give input and help improve the pillars, it is impossible to disregard one pillar in favor of another. Just as a stool relies on three legs to stand, so this Accord relies on three pillars to achieve its goals.

So how will this framework be applied to the retail portfolio? How well does it fit? As you are all aware, consumer credit now has a substantial impact on the American and global economies. Last year the total amount of retail debt reached levels of $1.6 trillion in the United States alone. Over the past five years, risk management techniques have encouraged banks to accept more risk even as losses from retail credit have risen. The percentage of personal income spent to service debt has grown to 14.3 percent. And evidence suggests that the recent economic slowdown has started to stretch consumers into relying on credit even more. While Basel II was formulated with large international banks in mind, it has not been haphazardly applied to the retail portfolio. As America has become a nation reliant on credit, ensuring the solvency of retail lenders has increasingly become a priority.

The Basel Committee recognizes the importance of the consumer credit portfolio and has taken several steps to make sure the retail portion of the proposed Accord reflects an understanding of the best practices of banks as well as the best regulation of consumer credit. There are important differences between the new Accord's retail and corporate provisions, but there are also strong similarities. An examination of the fundamental aspects of Basel II shows that its application to the retail portfolio is well within reason.

As I described earlier, the first pillar requires banks to categorize their portfolios into similar classes of assets to be scored and evaluated jointly. While the use of a fixed ratings scale and the assignment of borrower ratings are less common, banks routinely divide their retail portfolio into segments of similar exposures. The credit card industry has long embraced the use of credit scores to predict losses within classes of assets. This type of quantification is central to complying with the first pillar. The second pillar requires banks to work closely with regulators. Bank supervisors have similarly been moving to increased reliance on a bank's own internal risk management practices as a result of market and legislative events. And, certainly, retail banks have the wherewithal to release more detailed information on the quality of their loans. In most cases, this information is already available internally.

Despite the growth of the consumer credit marketplace, the basic characteristics of a typical retail asset have remained constant. But with volume have come other changes. Increases in the number of institutions willing to provide credit and the kinds of products available to consumers have spawned different practices for managing the risk of the retail portfolio. Discussions with bankers and industry have revealed a wide variety of domestic and international practices. Retail credit is dealt with in terms of transactions, products, and multiple risk factors rather than the probability of default of key underlying obligations. Many effective approaches to managing retail portfolio risk are in use, and more dialogue is necessary to ensure that the new Accord encompasses them all. Regardless, a comparison of industry practices to Basel recommendations shows that while some elements need rethinking, we have made progress.

For example, RMA's 1999 study on consumer portfolio management best practices noted that leading consumer lenders use information-based support in consumer loan decisions. The research indicated that the decisions of these lenders were superior to those of other lenders because they integrated marketing and risk management with analytical techniques. While the proposal of course establishes no standards for marketing, disciplined risk assessment meshes well with the Basel framework.

Similarly, many retail banks have systems in place to classify their loans by risk, while internal profit centers are charged for equity allocations by risk category and risk adjustments are explicitly made. Large, more sophisticated banks have already begun integrating the formal measurement and quantification of risk into their lending processes. In Basel II, banking agencies are trying to generalize and institutionalize this process. Of course, many banks apply less than state-of-the-art risk practices in the management of their retail portfolios. For smaller institutions, the first pillar's revised standardized approach will allow them to keep doing what they have been doing. But the expectation is that enhancing risk assessment will be essential to remaining competitive.

Regulators will require that banks using the IRB approach have the data, processes, and controls necessary to implement the new framework. And, the new Accord proposes minimum requirements for the retail exposures to be considered eligible. An exposure must be to an individual person or persons or guaranteed. Exposures such as credit cards, installment loans, revolving credits, residential mortgages, and small-business facilities lending are automatically regarded as retail in nature. The exposure must fit into a homogeneous pool of exposures that are managed in a similar fashion. Assets of similar type, risk, delinquency status, and vintage will then be grouped together. Banks with retail assets meeting these criteria will be able to use the IRB approach if their own internal ratings scheme can differentiate between the default risks of various borrowers, and if it uses a segmentation approach of sufficient sophistication. Supervisors will use internal and external data to validate a system.

Determination of regulatory risk weights for a pool of retail exposures within a given segment would involve several steps. Under the advanced IRB option, banks would first be required to provide an estimate of exposure at default, measured as the nominal outstanding balance for on-balance-sheet items. The bank would determine the asset class's average probability of default and the average loss given default for each class of exposures. Alternatively, banks could assess the expected loss associated with a segment rather than estimating PD and LGD. A benchmark risk weight would then be assigned to each exposure in that segment, and that benchmark would be calibrated to a three-year maturity. For off-balance-sheet items, banks are permitted to use their own estimates of credit conversion factors on retail off-balance-sheet items. It is important to note here that there is no foundation IRB approach for retail.

Each segment will have to be associated with a particular probability of default over a one-year horizon. The probability of default defines the objective risk characteristics of the ratings and underpins the attribution of regulatory capital. Back testing will be important - the probability of default estimates associated with a rating grade must be grounded in historical experience and empirical evidence. Increasingly, large consumer lenders are using such data.

All of the indicators would be determined using the internal and external data with the approval of the supervisor. Regulators will check to ensure that there is a meaningful distribution of exposure across segments, and that each segment does not represent an undue share of retail credit exposure. Based on federal regulation and their own assessment and in consultation with the bank, supervisors will both require and recommend the release of relevant data to the public.

Beyond the process, several provisions of Basel II will be of specific interest to retail lenders.

A small business loan may be considered retail in nature if the bank's internal risk management and risk assessment process consistently regards it as retail in nature. Because retail loans are characterized by low values, supervisors may choose to set a maximum loan amount for exposures to be treated as retail exposures. This is a difficult area and work is continuing.

Collateral will be reflected in banks' LGD estimates to more accurately reflect reductions in risk. We are just beginning the process of exploring the treatment of guarantees and PMI.

Under the current Accord, there is no conversion factor applied to uncommitted lines. The IRB approach requires this risk to be captured, and the proposal is fairly flexible as to how it is reflected so long as it is treated conservatively.

The Basel Committee believes it is important to construct a more comprehensive framework to better reflect the risks inherent in the many forms of asset securitizaton, including traditional and synthetic forms. More work is to be done in this important area.

It is important to note that existing regulatory guidance for some retail credit segments, such as subprime lending, is consistent with the new Basel Accord. For instance, under SR 01-4 an institution engaged in subprime lending is responsible for quantifying the amount of capital needed to support the additional risk associated with that particular portfolio. The institution must also fully document the methodology and analyses supporting the amount specified. A further requirement of SR 01-4 is that examiners take a more active and ongoing interest in the activities of subprime lenders. Both of these points are consistent with Pillar II. Similarly, other new products and those untested by time and various economic scenarios will have to be integrated into the Basel framework. The industry and regulators will need to work closely to assess other new financial products.

As I mentioned, many provisions of the proposed Accord are already found in existing regulatory guidance. However, the proposal will place new requirements on IRB banks. For example, stress testing will be essential to ensure that the risk of such assets is accounted for. Supervisors will expect banks using the internal ratings based approaches to demonstrate that the risk assessment process is fully documented, that inputs are reliable and accurate representations of probabilities, and that assumptions are conservative. Banks should expect their models to be subject to comprehensive validation processes as well.

Generally, the information technology currently in use by many banks should provide a quantitative basis for determining probability of default, loss given default, and other data. Most banks use data mining techniques to assess the creditworthiness of consumers. While most banks accumulate good core information on which to base IRB indicators, more information will be necessary in some cases. Further data on the maturity of loans may have to be used. The mitigation of risk will have to be better quantified. More precise details on how past-due and poorly performing loans are managed will need to be made available to regulators. Default may need to be better defined. And, of course, more information will need to be made public for nearly all banks using the IRB approach.

Overall, reactions of bankers to Basel II have been positive. I am aware of backing for the concepts expressed in the three pillars and the Accord's overall emphasis on increasing risk sensitivity. Similarly, many bankers have expressed support for the use of their own internal processes to determine risk. The broad concepts of the Accord have widespread support. Of course, 'the devil is in the details,' and many bankers have expressed concerns over how some provisions of the proposal would affect their retail portfolios.

Many retail banks are specifically concerned by the application of the first pillar to their portfolios. Some have contended that the pillar is not a good fit for their institutions because the level of required capital may focus too strongly on the high default rates of consumer debt, rather than on their margin profiles. Because most retail defaults fall in the category of expected losses in their assessment systems, these bankers argue that risk is already priced into their retail products in a way that the proposed Accord may fail to recognize. The goal of the Basel Committee is not to increase capital levels. However, early comments suggest that some are concerned that the proposal may do just that.

I am also aware that there is some concern that Pillar III may require banks to publish highly proprietary information. The new Accord's requirement to quantify operational risk has been viewed by many in the industry as a wild card. And while some smaller banks have expressed a desire to use the modified standard approach, others are wary of being competitively disadvantaged by larger banks if not permitted to use the IRB framework.

Finally, perhaps the most consistent refrain we have heard from the industry is a concern that they will not be able to implement necessary operational changes in the time allowed.

I do not look at these concerns as disagreements. Rather, I look at them as vital feedback that must be incorporated into the regulations to implement the broad Accord. The questions raised by bankers are among those the Fed will strive to answer over the coming months. Specifically, risk-based pricing can be better incorporated into the capital framework. Many other wrinkles must be ironed out before the Basel Committee's recommended implementation in 2004.These and other goals can only be achieved following meaningful and open dialogue.

Regulators and the Basel Committee are working with bankers toward these ends. Current discussions regarding credit risk management enhancement are focusing on reducing the negative consequences of cyclicality. Can regulators exert more pressure on banks during good times and less pressure when times are tough? Elsewhere the committee is considering whether different risk-weight formulas are warranted for different retail product types. I must also mention that the risk weights in the Accord are illustrative and should not be considered final by those who want to read the consultative documents published by the committee. The committee has not had the data to independently assess the reasonableness of the economic capital estimates reported in the industry surveys. It is our expectation that a final calibration will be lower. Papers on retail loan portfolios and operations risk will likely be available this summer.

There are logistical challenges as well. Basel II calls for implementation by 2004. President McDonough has stated his opinion that the new Accord will not require a large increase in the number of regulators working at the Fed. However, it will require the addition of new skill sets and expertise on the cutting edge of bank risk management practices. Yes, the Fed will need to have more 'rocket scientists' on staff. Implementing a successful strategy to develop and keep such highly skilled people will no doubt require a great deal of effort. So there are many challenges.

I began my remarks today by saying that making Basel II work must be viewed as a joint mission - regulators and bankers must be on the same page and reach mutual agreement if the Accord is to be a success. To further emphasize this point, I will close with it as well. I look forward to working with the banks in the Philadelphia region to ensure the success of the new Basel Accord.

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