Impact of Basel II on Australian Banking

Transcription

1 Impact of Basel II on Australian Banking Philip Chronican Chief Financial Officer SLIDE 1 TITLE SLIDE Thank you and welcome to this CEDA lunch focusing on the impact of Basel II on the Australian Banking environment. 1

2 Basel II - Agenda What changed? - Basel I Basel II evolution to more sophisticated risk measurement and management - Three pillars Australian banking system well placed to benefit Challenges of introduction are surmountable Westpac likely to see significant benefit Understanding the barriers SLIDE 2 BASEL II I thought it would be appropriate to provide you will a quick summary of some of the topics that I will be talking to today. Recap on what is changing Basel I to Basel II and the three pillars of bank supervision Explain why the Australian banking system is well placed to benefit from Basel II Look at a few of the challenges that Basel II poses, but also why none are insurmountable Why we are very positive about the introduction of Basel II and what it means for Westpac And finally some of the barriers to achieving the full benefits of this new approach and how these should be overcome 2

3 Basel II - what changed? 120% 100% Basel I Corporates 100% 600% 100% Basel II Internal Ratings Based (IRB) approach +600% Risk Weights 80% 60% Mortgages 50% Risk Weights 80% 60% Risk weights assigned across the spectrum 40% 20% 0% Governments 0% Banks 20% 40% 20% 0% 0% More risk sensitive New capital charges added for operational risk Allows different approaches to measure capital required to support credit and operational risks SLIDE 3 BASEL II WHAT CHANGED? The first standardised global approach to assessing the capital adequacy of banks was the first Basel accord, which was implemented in This focussed primarily on the minimum levels of capital a bank was required to hold. Basel II, due for implementation in January 2007, is more about risk sensitivities, in particular assigning risk weights across the spectrum rather than into just four risk buckets, as was the case with Basel I. In refining the risk weightings there is now the ability to differentiate between corporate loans ie: a company such as BHP versus a corporate like Pasminco, with risk weights now rising to over 600%, depending on the risk profile of the corporate involved. Importantly, particularly for Australian banks, the risk weighting for mortgages will drop from 50% to around 15-25%, reflecting the very low loss history. In addition, the more comprehensive approach of Basel II will see new capital charges added for operational risk, something that was not previously identified by Basel I. 3

4 The three pillars Pillar 1 Minimum capital requirements Standardised Foundation IRB Advanced IRB Risk weights established from external credit assessment Probability of Default provided by internal bank estimates Loss Given Default, Exposure At Default and Maturity Coefficients set by Basel formula Internal bank estimates used for all data input into Basel formula Operational Risk Pillar 2 Pillar 3 Charge added to RWA of between 8% to 12% Supervisory review process Market discipline and disclosure SLIDE 4 BASEL II THE THREE PILLARS Basel II is about more than just capital. There are three pillars: Pillar 1 Minimum capital requirements Pillar 2 Supervisory review process Pillar 3 Market discipline and disclosure Pillar 1 has three approaches: Standardised where risk weights are established from external credit assessment such as Moody s & S&P ratings. Internal Ratings-Based (IRB) approaches foundation where the probability of default data is supplied by the bank but the other default data is provided by formula set by the Basel II committee. In the advanced approach, which Westpac will be targeting, all default data is provided by the bank. The capital charge for operational risk is also covered by pillar 1. Under this approach RWA will increase in the region of 8-12%. It should be noted that the Australian regulator APRA has indicated that it will only permit banks to target IRB methodology if they are able to comply with the Advanced Measurement Approach (or AMA) for operational risk. Pillar 2 focuses on regulatory oversight and allows national regulators the discretion to add additional capital charges above the Pillar 1 minimums such as charges against interest rate risk management (banking or ALM book), which APRA have already indicated will be applied by them. Pillar 3 is about market discipline. Primarily around the disclosure of information about a bank s balance sheet. While not the most well known of the three pillars it will probably have the biggest impact on the investment community, providing further insight into banks risk exposures. 4

5 Basel II shows Australian banks to be high quality APRA expects the 4 Australian majors to comply with the most sophisticated models (IRB & AMA approach) International peer analysis shows Australian major bank riskadjusted assets to decrease by more than any other jurisdiction - APRA expects moderate capital relief for the 4 majors and modest relief for regional banks Differences are attributable to: - balance sheet structure - different risk profiles SLIDE 5 BASEL II SHOWS AUSTRALIAN BANKS TO BE HIGH QUALITY Given the sophistication of the Australian banks, APRA expects all the major banks to comply with the IRB and AMA approach for credit and operational risk. The recent Quantitative Impact Study conducted by BIS highlighted the reduction in RWA that Australian banks could expect (~36%) were significantly better than G10 group 1 banks. Unfortunately for Australian banks their QIS3 results were grouped with the non-g10/eu banks, such as Malta, Tanzania and Chile. Australia banks results were not immediately apparent. The reasons why Australian banks saw such a reduction in RWA can be attributed to two key factors: Balance sheet structure with Australian banks having a higher proportion of lower risk products such as mortgages in their portfolios; Lower risk profile - corporate and institutional portfolios of the Australia banks are generally of a lower risk profile compared to global peers Although the QIS3 results show a greater decrease in RWA than any other jurisdiction, it is still unclear as to how this will be reflected in capital levels and credit ratings. In fact, capital relief may be moderate on day one (Basel II itself restricts any reduction in regulatory capital to 10% in the first year) but in the medium term the impact will be more pronounced as balance sheets adjust dynamically. 5

6 Pillar 3 reducing the black box perception Transparent risks Increased transparency Transparent risks Risks Opaque risks Reduced Black Box Opaque risks Today Basel II SLIDE 6 PILLAR 3 REDUCING THE BLACK BOX PERCEPTION Banks have long agreed that Basel I was a rudimentary measure of risk. Accordingly banks turned to internally assessed economic capital as a much better measure. However, as an external indicator of risk, these measures failed as methodologies were not comparable and there was no transparency on the inputs. Basel II provides a basis on which risks can be compared globally. And for stakeholders, Pillar 3 will deliver the framework that will reduce the black box component of a banks business. Pillar 3 has evolved through the positive interaction between regulators and banks. In 1999 the perception from regulators was that it would be a data dump ie: the theory that more information is better. This approach risked bogging down analysis and diluting the usefulness of the pillar s objective. In 2003 the current form of Pillar 3 information is more targeted and disclosure more closely aligned to the original policy objective of focusing on what information is useful to the market. This is not to say that we will start to see a homogenised global reporting framework because Pillar 3 is designed to augment not replace existing accounting or reporting requirements. We do believe however that Pillar 3 will improve: The rigour of balance sheet analysis Better understanding of the relative risk between banks; and Understanding of the risk reward balance and ultimately the determination of the fundamental value of a bank. 6

7 Westpac disclosed Basel II results early SLIDE 7 WESTPAC DISCLOSED BASEL II RESULTS EARLY You can see on this slide some of the information that Westpac has already started to deliver to its investors regarding Basel II. We are committed to continuing to keep our investors informed on the outputs that they can expect Basel II to deliver long before the January 2007 implementation date. 7

8 Challenges in implementing Basel II Data and systems changes Pro-cyclicality amount of capital required to support a business capable of absorbing losses through the cycle Some vagaries in interpretation of the Accord Discretion by regulators needed to avoid market disruption in some sectors (ie: the Australian Securitisation Industry) Accuracy of credit risk parameters SLIDE 8 CHALLENGES IN IMPLEMENTING BASEL II The implementation of Basel II is not without its challenges. There will be hurdles we need to address such as data and systems changes, but none of these challenges are insurmountable. Delivering the credit data that Basel II requires is a huge job. Westpac s credit MIS project has been going for over 3 years but is not just a Basel II compliance project it is an integral part of the reengineering the lending process and further improving internal MIS. In discussing the impact of pro-cyclicality some commentators have suggested that Australian banks may need to hold more capital than the current estimates, given there has been 10 years of expansion and economic growth and hence recent history is not representative of a true cycle. While on the surface this hypothesis may have some merit, consideration must also be made for the diversity of a bank s balance sheet and the reduction of single name exposures and limits on sector concentrations areas that Westpac has continued to be a market leader in. Regulators have discretion under the Accord to ensure that it does not cause market disruption. One such area that has been a focus of concern is the treatment of Securitisation under Basel II. Under Basel II there is an apparent expectation that all issues through a conduit of an IRB measured bank would also need to be IRB measured. It is difficult to imagine how that would work in practice it would be better to allow conduits to adopt a standardised approach which would be more consistent with the likely Basel II approach taken by its customers. If it is not changed it would make the operating costs of a conduit and therefore the cost of funding for small banks prohibitive. And also the accuracy of credit risk parameters, which is a challenge that I want to delve into in a little more detail in the next two slides 8

9 Challenges accuracy of credit risk parameters Large variances in the quality and credibility of systems used to collect loan data (QIS3 highlighted wide variations in reported numbers) Credit scoring for investment grade loans relatively new for some banks Banks need to understand ratings migration better (likelihood of loans in one grade moving to another grade) Significant investment in modelling credit risk management is required to ensure robust data Westpac s default data is both compliant and conservative SLIDE 9 CHALLENGES ACCURACY OF CREDIT RISK PARAMETERS Default data is another area requiring focus for banks globally and one of the key points that commentators are focusing on. There are large variances in the quality and credibility of the systems used to collect loan data. The results of QIS3 highlighted this. The concerns for regulators and rating agencies is that credit scoring for investment grade loans is a relatively new concept for some banks and others do not fully understand the impact of ratings migration. To ensure robust data significant investment is going to be required in modelling credit risk management. We believe that focus on default data is warranted and are also comfortable that Westpac data is, not only compliant with Basel II requirements, but is also more conservative. 9

10 Challenges - Westpac s LGDs (conservative and compliant) Benchmark Loss Given Default (LGDs) = indexed to Basel II QIS3 requirement Raw LGD No costs 1 No discounting LGD with costs 1 Cost estimates included No discounting Basel II requirement: LGD with costs 1 and discounting 2 Cost estimates included Discounting at cost of equity QIS3 requirement WBC QIS3 Submission Costs include legal fees and other workout costs 2 Discounting = all cash flows after default are discounted back at cost of equity (12% post tax) Westpac has: - 11 years of LGD data - Westpac has 25 risk grades (19 for performing loans and 6 for non-performing loans) - Basel only requires 8 risk grades Basel requirement for LGD data on a common base = 100 SLIDE 10 CHALLENGES WESTPAC S LGDS (CONSERVATIVE AND COMPLIANT) At Westpac we have over 11 years of robust default data with Basel only requiring 5-7 years. We have over 25 risk grades (19 for performing loans and 6 for non-performing) Basel only requires 8 grades. What this highlights is the Basel II is not necessarily about pushing the boundaries or that Banks will be required to suddenly measure risk in a new or more detailed fashion. As the table shows, when we submitted our data for QIS we in fact used our own internal measure of default which was more stringent than that required by Basel II. (ie: Basel requires 90 days past due which has a high cure rate whereas Westpac used 270 days past due which has a much lower cure rate). Westpac was the second bank to ever publish LGD estimates (after Citibank) back in 1997 and the first to publish LGDs for our SME book (Robert Morris Associates (now RAM Journal) in October 1997). I have taken the Basel II requirement for LGD data (including costs and discounting) and brought it back to a base of 100. Against this I have shown what impact you could roughly expect if discounting was excluded and then if no discounting or costs were included in your data. As you can see for Westpac, our QIS3 inputs were at 160 against the Basel II requirement, but clearly there are large movements in the numbers, if for example the discounting was not included. For Westpac the figure would reduce by approximately half. Feedback from regulators was that LGD estimates in QIS3 were low quality, including some banks submitting LGDs of zero for some portfolios. Basel has since changed the rules insisting on a floor of 10%. 10

11 Westpac to benefit from Basel II Westpac has been working on Basel compliance for three years Early results support the hypothesis that we are safer than previously perceived Feedback from stakeholders has been positive However, barriers still exist SLIDE 11 WESTPAC TO BENEFIT FROM BASEL II Westpac has been working on its Basel II implementation and related compliance for over three years All the early results have supported the view that Australian banks are as safe or even safer than previously thought. What can you take away about Basel II? Westpac believes that it will prove positive for the bank and the early feedback we have received from investors has concurred with that. But there are still barriers to be addressed. 11

12 Addressing the barriers Consistent adoption of the accord globally Implementation delays suggested - Europe - US Augmenting with approaching IFRS changes - dynamic provisioning - hybrid instruments - loan portfolios on-sold Gaining regulatory approval SLIDE 12 ADDRESSING THE BARRIERS There has been plenty of speculation and coverage around what the barriers to successful implementation of Basel II will be. What value will the revised accord have if it is not adopted on a global basis? In the US only 8-10 large banks are being required to adopt Basel II by their regulator. Maybe what should matter most is the quantum of banking assets globally covered by the accord and whether those banks that do comply will start to emerge as a superior tier of banks who are willing to comply and be judged accordingly. Implementation delays have also been suggested with the British Banking Association proposing delaying by 4 years and other countries indicating that perhaps time constraints will not be a focus for them. When Basel II was first proposed by the committee, they expected it would only be meaningful for half a dozen banks globally. What the results of QIS3 showed was that approx 350 banks in 43 counties made submissions, with approx 70 banks targeting the advanced IRB approach. Again this suggests that many banks globally are prepared for Basel s introduction. Augmenting Basel with the approaching IFRS changes is also a challenge, including issues arising around: dynamic provisioning hybrid instruments; and loan portfolios on-sold Finally, approval of regulators must be obtained. 12

13 APRA have indicated some level of capital relief APRA has provided significant input to the Accord Basel II provides deeper insight into bank risk management - Gives greater comfort in the robustness of risk management practices - Compliance simplifies assessment of operational risk management - Provides an incentive to invest in sophisticated systems Pillar 2 allows APRA to control the degree of capital relief through other charges Reflects the genuinely lower risk characteristics of Australian banks SLIDE 13 APRA HAVE INDICATED SOME LEVEL OF CAPITAL RELIEF Despite the distance from Switzerland, APRA has provided significant input into the Accord. It was the only regulator that we are aware of to co-ordinate the concerns of the banks it supervises and forward them directly to the Basel Committee. In fact key changes between drafts 2 and 3 of the accord were as a result of APRA s submissions. Basel II also provides a deeper insight into bank risk management and more detail on credit risk (including PD, LGD and EAD) than ever before. The AMA approach for operational risk is a systematic approach to management (fairly inflexible) but a flexible approach to the measurement of risk. Importantly it gives companies the incentive to invest in more sophisticated systems. Pillar 2 gives APRA the ability to control the level of capital relief through the addition of additional capital charges including charges for interest rate risk management, credit concentration risk and procyclicality. But Basel also reflects the genuinely lower risk characteristics of Australian banks something our regulators have long known. Overall APRA have sent positive signals to suggest that some form of capital relief will be forthcoming and that they will encourage banks to make the investments needed to obtain the benefits. 13

14 Hesitancy from rating agencies globally View Proposition that capital in the banking industry should not be reduced in aggregate currently optimal Concern not all risks are captured under Basel II Response Agree in principle but QIS shows the average Australian bank was as good as/better than the top bank globally Maintaining capital for the industry as a whole leads directly to lower requirements for Australian Banks Basel II is not perfect but provides a better lens into a bank s risk profile which is transparent to the market Risk grading approach for mortgage lending seen as soft The Australian mortgage market has among the lowest delinquency rates globally SLIDE 14 HESITANCY FROM RATING AGENCIES GLOBALLY Rating agencies also have their concerns on what the Accord will mean for them. They have proposed that the capital levels in the industry are already optimal and do not wish to see reductions in the industry in aggregate. We agree in principle, but the results of QIS 3 clearly show that the average Australian bank is as good as or better than the top banks globally. Maintaining capital for the industry as a whole leads directly to lower requirements for Australian banks. Even if at day 1 no capital benefit is recognised by rating agencies, every loan written after that date will have a lower risk weighting than if written today. Concern has been raised that perhaps Basel II does not fully capture other risks across the spectrum. No one is suggesting that Basel II is perfect but it provides a much better lens into a bank s risk management and profile in a transparent and comparable way. Again I would note that Basel isn t necessarily about taking things to the next level. Banks such as Westpac already operate economic capital models that rely heavily on understanding risk and applying capital to it. At Westpac we already apply capital to risks that are not included under Basel II, such as liquidity risk and credit concentrations and strategic risks. The suggestion by some that risk grading for mortgages is soft, flies in the face of 47 years of Australian experience. The Australia mortgage market has among the lowest delinquency rates in the world. 14

15 Recognition already exists in the global capital markets Senior FRN Spreads to US$ Libor Spread to US$ Libor (bps) Abbey Aa3/AA- HBOS Aa2/AA WBC Aa3/AA Tenor (years) Westpac (Aa3/AA-) HBOS (Aa2/AA) ABBEY (Aa3/AA-) Polynomial (HBOS (Aa2/AA)) Polynomial (Westpac (Aa3/AA-)) Polynomial (ABBEY (Aa3/AA-)) Source: UBS Investment Bank SLIDE 15 RECOGNITION ALREADY EXISTS IN THE GLOBAL CAPITAL MARKETS But for some of our investors this story is not new and in the debt capital markets investors already undertake detailed risk analysis of companies and make pricing decisions measured in basis points. This is already paying dividends for Australian banks, particularly Westpac. The chart shows funding spreads for Westpac and two of its peers in the UK. Interestingly, debt investors are already differentiating between banks with the same ratings and even between issuers, such as HBOS, who are rated higher than Westpac. Rather than relying solely on a rating they look behind the ratings to the underlying risk profile of an issuer and the quality of Australian banks. I am not suggesting that this differential is solely an output from Basel II. There are many other factors in our funding strategy that influence this picture, but Basel II and in particularly Pillar 3 will further enhance an investor s ability to differentiate, with access to more detailed and comparable information. Funding markets are usually leading indicators in this regard. 15

16 Conclusion CONCLUSION In summary let me recap. The Basel II approach is a major step forward for banks, regulators, investors and rating agencies. Australian banks are well prepared for the changes and Westpac does not support any delays in implementation. We expect to benefit from greater recognition of our inherent risk quality and a more risk sensitive capital regime. Thank you. 16