Category Archive

Continuing the re-aging thread, a note circulated by APRA had a clear grip of the issue, and proposed:

“APRA’s proposed solution is to only allow the recording of a second default event after the loan has been in the non-default status for a period of at least 12 months”

‘Fraid I can’t give a direct reference as I only have an undated photocopy to hand, entitled “Multiple defaults in the retail portfolio” - it would have been about 2004. Please post to the blog any update on these issues that you may know of.

APRA’s concern was to “require the number of observations in bank’s PD and LGD databases to be equal” because of the traps of otherwise having mis-matched bases for PD and LGD. My preferred way of describing this - via “bad episodes” - is semantically different but hopefully faithful to the essence of the problem; it also lends itself to other difficulties that will be met.

Re-capping points from the last couple of posts:

• recognise that default definition starts with a point-in-time definition but also has a derived episodic dimension: every transition from good to bad at a point in time begins a bad episode which is a relatively long interval of time.
• the rule which specifies when the bad episode can end is an integral part of the default definition and is called the re-aging rule.
• these bad episodes will then be relatively few in number and will be the basic units of modelling

‘Relatively long’ and ‘Relatively few’ represent implicit recommendations to choose a re-aging rule that produces few, long, congealed bad episodes rather than the opposite. Technically, you could get out alive with a rule that makes many sporadic episodes but you will get a lot of unnecessary headaches: multiple non-independent episodes, large numbers of zero-loss LGD points, multiplicities within a year, and in general a dilution of modelling power through not aligning model constructs with a sensible grip on reality.

With this understanding, the APRA proposal says that the re-aging rule should allow a bad episode to end after 12 continuous non-bad months have elapsed. This seems a good choice and will produce well-congealed bad episodes. A particular merit is that two bad episodes for any particular account within any 12-month period is never possible. This is helpful because a lot of modelling (e.g. behavioural) has a 12-month OW and the chance of any multiplicity would be a nusiance.

Thinking in database terms, one would have only one source of default information: a table of default episodes, keyed by account and start date. Of course, bad episodes are well behaved constructs being distinct for any account and not overlapping. Depending how one implements the rule there can be a slight wobbly about whether a new episode can begin immediately that the previous one ends - imagine an account with B then 12G then B again - you decide how you like to treat this case - it’s not a showstopper.

For any longitudinal modelling, looking for the first default is equivalent to looking for the first start of a bad episode.

APRA’s concern that number of observations should be equal is trivially met because the table of default episodes is the common data source for either the PD modelling or the LGD modelling.

So does that solve everything? Not quite, just clears some problems so that we can face the more subtle ones standing in the shadows behind, AWML.

PS any corrections or updates on APRA or other regulatory opinions would be most welcome. 

Media release, requirements and forms relating to the Basel II reporting requirements were today released by APRA - only half way through the period for which the reporting will be needed. Good timing. Maybe the next changes will be released before we have to comply with them. I don’t ask for much.

By the way, there is a slightly misleading title to this piece, as the standards released today are plainly not final. In the response to submissions paper APRA moot two further changes, both to undo changes that have been made to this version. These are covered below.

One other little gripe - I had some trouble finding the response to submissions paper on the Basel II home page at APRA, as, silly me, I was looking for a paper released in 2008. Perhaps in a cunning plan to make it look like they were early, the release date on the page is 6 February 2007, not 2008. I trust this will be fixed shortly. If you are with APRA, you may want to talk to your web people and get his fixed, pronto. On the other hand, maybe not.

OK, onto the actual content. I will use the APRA paragraph numbers from the response paper to talk through them. If you are really interested, print the thing out. Double sided, it is only 7 pieces of paper. Don’t ever print all the requirements. Read the rest of this entry »

Just a quick note to welcome the (sort of) full implementation of Basel II in Australia - and its full implementation in most other jurisdictions (apart from, of course, the USA).

I say sort of in Australia as a few banks are staying on Basel I for some things, not others. The usual sort of “phased implementation” (AKA foul-up) you often get with major changes like this. Anyway, welcome Basel II.

The sideline on liquidity risk is to note that the one area that has caused the recent problems has been liquidity, not a lack of capital or other problems. Liquidity is the one area that is not really covered by international standards, with all differing regulators following different mechanisms (as noted below). The next project of the BCBS really should be to establish some standards in this area, and it looks like (thanks GRR) this is underway. While not a great fan of regulation, common standards I always believe to be useful, so perhaps some principles-based standards would be a very useful thing here.

Anyway, happy new year. My wishes for this year are:

1. May we get better risk management from our banks;
2. Less regulation from the regulators; and
3. More principles-based standards to follow.

I also believe porcine aviation will make great leaps this year. If you have any similar wishes, feel free to add them in.

Just a quick clarification on my earlier piece on APRA’s announcement process. APRA have apparently, and informally, let it be known that the answer to the question on how much capital BankWest and NAB will have to carry next year is that it will be the Basel I number until they get Advanced credit risk clearance.

Now - how long before they formally tell the banks concerned? So far, as far as I have heard, they have not yet been told. You would have thought it would be polite to tell them.

As you can read from the post below, the approvals for various banks to use some of the advanced approaches for Basel II compliance have been released. An interesting point that arises from it is the approach to the announcement.

With about 20 days to go, the banks were simply told this morning whether they were going Advanced or not and what they were allowed to do. It included a couple of real surprises - not about which banks, but a whole approach.

APRA have been consistent from their first letter on Basel II (23/6/2003) that “…AMA will not be available to non-IRB banks.” Yet their announcement this morning gives AMA to two banks not going IRB - NAB and BankWest. Better yet, these ones are not even going Basel II Standardised yet - they are staying Basel I for credit risk.

Of course, that leaves a very big question for these two - what will our capital requirement be next year? Basel I implicitly included the capital for operational risk within the credit risk component. Basel II explicitly splits these - meaning the banks going Basel I plus AMA are having their operational risk capital double counted. APRA will need to clear this one up - and fast. For Australia’s biggest bank (never mind BankWest) this is only a slightly important question.

Macquarie’s announcement to the exchange this morning was very interesting, claiming to get the “advanced approaches”. Note the (presumably very careful) omission of the capital “A” on advanced. This is because they have gone “Foundation” not “Advanced” for credit risk. To me, this comes close to “misleading and deceptive conduct” - but probably not quite there.

Likely attitudes to the announcement:

• ANZ - happy and able to crow about excellence in the usual things that banks like to crow about;
• BankWest - wondering what APRA was thinking about to come up with this approach;
• CBA - happy and able to crow about excellence in the usual things that banks like to crow about;
• Macquarie - reasonably content (and quite smug on the wording of their press release);
• NAB - wondering about how to calculate their capital requirement for next year and how the market will digest this over the next few days (and how to phrase their press release - not out yet);
• St. George - feeling a bit sore but confident they can fix it; and
• Westpac - happy and able to crow about excellence in the usual things that banks like to crow about.

All in all, an eventful day.

With 21 days to go to the start date of Basel II in Australia, APRA have announced those banks that will be able to use the Advanced methodologies for compliance. They are:
Advanced Everything -

• ANZ
• CBA
• Westpac

Foundation and AMA -

• Macquarie

AMA only -

• NAB
• BankWest

There is a lot of gossip in here. Just as a first cut, I went to the banks’ websites to have a read - at this point only CBA had their media release out. The rest still had their usual “we are wonderful” media releases.

Macquarie going Foundation is interesting. The difference between Foundation and Advanced is really only in the Retail area and, as Mac Bank does not have a huge exposure to retail lending (except through securitisations) this seems a sensible approach.

NAB not getting Advanced credit risk is really a smack in the eye. They have (according to rumour) spent the most on their project of everyone and have failed to do it. For Australia’s biggest bank this is not good. They, and BankWest, can beexpected to catch up soon, though. APRA originally said that no-one would be able to go AMA without an Advanced credit risk approach, o this means they, and the Millionaires’ Factory can be expected to go Advanced credit risk soon.
The notable absence is St. George - who seem to have disappeared off the radar. Anyone with decent gossip on this?

[BTW - if you do leave gossip I maintain I will not hand out contact details or other information unless compelled to do so by a court of law. Keep it factual and there should be no problems.]

With just over a month to go, (and not a moment too soon) APRA have release the final versions of all of the Basel II standards, applying from 1 January 2008.

Go here for the announcement and here for the standards. I will be writing up a review of them if there is anything truly different about them. I hope there is not, as we all have to apply them only a month from now - well, almost all of us. See below.

I will also be retiring my page on the standards, as it is now redundant.

In all the excitement going on about the US implementation and several other matters (like work) I have not been saying much about how the Australian banks are going on their applications for “Advanced” accreditation.

Just out of interest, I did a search for Basel II on each of the Bank’s websites earlier this week. Hit stats went something like:

Majors:

ANZ - 36
Commbank - 4 (2 identical documents in two places)
National - 1 (an employee profile only)
Westpac - 1.

Very poor outcome - but try the same using Google site search and the results change a bit:

ANZ - 26 (a drop?)
Commbank - 21
National - 1 (the same)
Westpac - 52.

Others:

BankWest (HBOSA)- 0 (I cannot find a search facility. Odd)
Macquarie - 29 (but many repeats)
St. George - 8 (again, a few repeats)

Google:
BankWest (HBOSA)- 0 (looks like the search facility would not have helped)
Macquarie - 13 (no repeats this time)
St. George - 3 (again, no repeats)

Additionally, not many of the documents are recent. This is, I suspect, for a good reason - several of them will not be ready on time or have been otherwise failed by APRA.

Under the prudential standards, this leaves them in an interesting place - the existing prudential standards will be withdrawn on 1 January and the Basel II ones will come in - but the banks that APRA have “delayed” accreditation for will not have done Standarised projects, and so will not be able to go to either system.

In practice, as Bernie Egan (APRA Basel II program director) made plain, these guys will stay on Basel I until they are cleared.

The big question is - who has already been cleared? Maybe those making the most noise about it?

APRA have released a discussion paper on Pillar 2 of Basel II - the Supervisory Review Process.

Most of the content has already been well telegraphed ahead, either by the prudential standards already released (particularly APS 110) or in the other discussion papers and speeches. The one real disappointment is the decision to maintain a 10% capital drop “floor ” for the next two years - “…pending a review of experience…”.

The levels of conservatism here are getting frustrating. APRA have already added floors (or is that flaws) into several places, both on a general level (the 20% LGD on housing loans for example) and specifically into many individual ADIs, for example many smaller ADIs have been hit with higher capital levels seemingly in preparation for Basel II.

All of the regulators around the world, and APRA no less than others, have been boosting Basel II as a much better risk management framework than Basel I. I would entirely agree. The new frameworks will make banks generally much safer. Why, then, do they need to keep capital at or near levels that had no justification when they were implemented?

To me, this is akin to a road regulator saying that, despite the improvements in car design, road safety and everything else since the early days of motoring we still need to have a person walking in front with a red flag “as it is just safer that way”. The only difference now is that the guy in front may be allowed to run.

APRA today released a discussion paper on the Basel II reporting requirements to apply from January next year - with the first reports to go to APRA for 31 January 2008.

On a first detailed read the proposals look fairly non-controversial, with the changes to current forms largely down to the changes needed for Basel II compliance. A few interesting points, though:

1. In a speech in March this year (see the top of page eight) Bernie Egan (APRA Basel II program director) indicated that banks having trouble meeting the advanced Basel II requirements may stay with Basel I calculations. There is no room for the “pragmatism” he indicated in that speech to be reflected here - these forms (and APS 330 for that matter) will apply. I am currently presuming that the flexibility will be reflected in the transition arrangements mooted in para 5.2.3 of this discussion paper.
2. For the banks going advanced there are a lot of forms, at least 24 and possibly more if there are some portfolios going standardised. Fortunately these will all be electronically submitted and, in a way, this reduces the difficulty. A fault in one item of data or formatting will not invalidate the whole process, just one file. I am just glad (or is that praying) I will not be the poor sod who has to review all these forms prior to transmission.
3. Para 4.3 asks for the banks to report actual operational risk losses - not just the modelled amounts and the resulting capital requirement. This seems sensible - it allows back-testing - but I wonder what happens when an operational risk loss event (such as a fraud) appears a fair way down the track? Do you re-submit an old form or add it into current period losses? Small point, but one that should be cleared up.

Other than that and as far as I can see “Nothing to see here, move on, move on.”

I was forwarded a link to an article earlier today for comment. Reading it, I just felt like putting my head in my hands and crying - how could a financial journalist write something like this and get it so wrong? It looks like he has taken a press release or a letter to APRA from an LMI (Lender’s Mortgage Insurance) provider and tried to rework it - while misunderstanding it.

I thought writing this up into a piece here would be a good start - but where to start? Can I question his journalism, use of stats or factual issues first? Maybe paragraph by paragraph.

The first two paragraphs are error free - good start, but these seem to be just a rewording of the press release / letter.

The third and fourth start the rot. A 50% risk weight the capital required to be held for a $100 loan is not $50, as stated, but $4 ($100 *50% * 8%). The 8% figure is the full risk weight capital ratio, and is not changing under the new regime. If you are interested in why 8%, my take on it is here. He has also totally missed the new operational risk capital amount, so the drop will not be from 50% to 35%, even for the safest, it will be (probably, but not certainly) a drop from 50% to a number that depends on the operational risk calculation. Read the rest of this entry »

Latest from APRA on Basel II - information in two areas.

Margin Lending

Margin lending is where an institution lends you money to go trading in shares, secured by a claim on the shares you purchase and requiring that you have a certain proportion more value in the shares than they have advanced to you. The problem (at least as APRA see it) is that most of this type of lending is sufficiently secured that no capital would be needed to back it under the Basel II rules, rather than the full capital weight needed under Basel I (full weight being 8%).

In 2005 APRA flagged this up as an issue - essentially they said they disagree with no capital weight being applied. The reality is, of course, that in most cases no capital is needed - the chances of a loss are very low. As the experience of the last week has shown, though, that can change rapidly at times and, if liquidity is squeezed, getting more security to cover losses can be tricky.

After a good look at it APRA have done as expected here, cutting the capital required substantially - but not to zero. Their approach is that you can use either a risk weight of 20% (i.e. a 1.6% capital allocation) or a model for secured exposures. A simple outcome and an improvement from the current one.

ECAIs

One of the alphabet soup of acronyms that often intimidate newcomers to the Basel II space is “ECAI”. These are the External Credit Assessment Institutions - known in the real world as rating agencies. They appear throughout the accord, mostly in the standardised areas, and their ratings can be used to assess credit risk and therefore affect the capital numbers. Early on in the process (back in the dark days of pre-2003) there was a big debate about the use of these at all. Basing regulatory capital on a rating issued by an agency seemed dangerous. After the sub-prime problems (where even AAA rated bonds have suffered at least liquidity issues) this may have been a sensible debate.

Nevertheless, they are in the Accord, so every regulator has to come up with an acceptable list. With no domestic agencies of any real size APRA have taken the sensible course and (drum roll) used the list issued by the US SEC (guidelines here)- the “Nationally Recognized Statistical Rating Organizations” or NRSROs:

• Moody’s Investor Service
• Standard & Poor’s
• Fitch Ratings
• A. M. Best Company
• Dominion Bond Rating Service, Ltd

If you are dealing internationally you are also allowed to use those accredited by the host country supervisor.

This also looks like a sensible move - if you are confident that the SEC will not make a major blunder, and there are no domestic ones to add to the list, a good approach is to outsource responsibility. I just hope the SEC does not decide to change the acronym.

While I do not believe the sub-prime style problems are likely to happen in Australia as the Australian mortgage market does not have many of the types of deals that have caused the problems (at least not in the institutions I see regularly) it does show why the proposed disclosures under APRA’s version of Basel II Pillar 3 (APS 330) need to change.

The problems flowing through the markets at the moment are not a direct result of the sub-prime issues for the simple reason that the losses are not huge overall - less than 1% of US GDP in total. Even worst case this should not affect corporate profits overall by much. The problem is that the markets do not know where they are concentrated. Until these issues are fully flushed out the uncertainty will remain.

The problem here then is not so much the actuality of the losses, but the uncertainty. The result is that liquidity dries up as counterparties stop trusting each other, dealing slows down and spreads increase. The solution is good, accurate and timely disclosure.

The disclosures for the advanced banks are already good enough. There is enough information in Table 4 (both of APS 330 and Pillar 3) for proper analysis of the likely exposures of the banks going down that path. This should be enough (as discussed in my previous piece on this) to stop or slow down the contagion we see at the moment from spreading to those advanced banks not genuinely afflicted.

As most would know, though, it is not the larger banks that are actually originating these loans - it is the ones that would be going standardised.

The market disclosures for standardised institutions under Basel II in Australia should be increased to include most of the elements of Table 4 and perhaps Table 8 so that the information is published, checked and used regularly by all market participants. The neutering of Pillar 3 by APRA for the smaller participants is of no use to anyone.

This is an article that first appeared in The Sheet.

Over the last three years, APRA’s primary focus in the regulation of banks, building societies and credit unions has been the transition from the old international regulatory standards on bank capital known as Basel I to the new regime, Basel II.

Basel II is due to come into effect in Australia from January next year, which means that the first APRA returns under the new standards will be for the January month end – or about six months from now.

The problem for all banks is that none of the new standards have yet been issued in final form, leaving APRA a busy few months to get them finalised and an even busier few months after that for banks to get them implemented.

For convenience in discussing what is to come I will use the groupings APRA uses when releasing their responses to submissions. Read the rest of this entry »

This is the Australian Prudential Standard that gives Basel II Pillar III effect in Australia. As covered here, it came out for comment in June and the submissions for it are now all in. From the several I have seen one element sticks out like a sore thumb.

I have to confess that when I did my first read of it I missed this, but a close read and a bit of a think about the requirements in Attachment B (those relating to quarterly reporting) shows that APRA were, in effect, going to require every bank, building society and credit union in the country to make a quarterly profits announcement through the retained earnings numbers.

I am not sure if APRA meant this or not - I like to think that they just missed it - but it has got a sound raspberry from all the institutions of which I am aware, or at least those who made a submission. I think we can expect this to be the first this ripped out of the next draft.

The recent releases by APRA of near final drafts of APS 110, 111 and 120 means that APRA are getting close to finalising the regulatory requirements that will apply to all Banks, Building Societies and Credit Unions from 1 January next year, arising from the application of Basel II in Australia.

There are a couple that remain as yet not even been published in draft form (the infamous APS XXX on the requirements for Standardised operational risk being the most obvious) and none of them have been published in final form, but the direction is obvious and the discussion is now mostly over exact wording, rather than substance.

Important dates coming up: 30 July (today); close of comments period on the draft APS 110 and 111 on capital adequacy and 10 August; close of comments period on the draft APS 120: Securitisation. None of these is expected to be contentious as APRA have accepted most of the input from the submissions on the previous drafts.

The interesting issues now are in application. A few of the banks working towards using the advanced methods are having real trouble in convincing APRA they are ready, with at least two being told they will be delayed past the start date. Whether this is for valid reasons or not is in dispute, but provided they are allowed to go Advanced soon it should not make a major difference.

The only major bone of contention left is APRA’s insistence that the capital held against losses in the housing loan market will need to be more than double the amount the Banks have calculated – increasing the costs of housing loans. Given APRA’s track record in the area it is unlikely this will be relaxed soon.

The good points? APRA have not made the mistakes that the US regulators have and we are now fairly certain on the regulatory framework to be applied from next year.

The pace is certainly quickening. As I was just a little busy at the time, I missed posting on the release of new drafts of APSs 110 and 111 on 2 July.

Not much to say on them until I have had time to read them. The interesting thing to note is that they are now all bundled into one convenient package, rather than in several documents. Other than that, and for the moment, read them yourselves here:

Draft Prudential Standard APS 110 Capital Adequacy

Draft Prudential Standard APS 111 Capital Adequacy: Measurement of Capital

Discussion paper

Press Release

The prudential standards page should now be up to date, with the usual caveats, of course - E & OE.

Just a quick note to let any interested parties know that a new draft APS 120: Securitisation has been released by APRA. I will write an examination of it if I get some inspiration.

Press Release

Draft APS 120

Response to Submissions

The links on the prudential standards page have been updated. I should add that the draft APG 120 will not be updated at this stage - so no need to print that one out again.

APRA today (or was it yesterday now) released what is probably very close to their last words on how Basel II Advanced methodologies will look in Australia. The good news is that they seem to have taken on board most of the input from the submissions and other discussions they have been having since the release of the drafts of the new prudential standards. The bad news? I have not found much yet.

In the words of one of the guys I respect most in this process “this looks like one of the best papers out of APRA on the subject of Basel II.”

The only real bad news in here seems to be that the nonsensical 20% LGD floor, imposed a few months ago by letter (and covered here), will remain for the time being - although it is not being added into APS 113.

Fuller coverage is over the fold for those interested. Read the rest of this entry »

With just over 6 months to go APRA have today released their draft of the standard giving the market disclosures needed under Basel II.

In short, and as expected, they have largely followed the disclosures under Pillar III of the accord for the banks going Advanced - with the bulk of the disclosures copied (sensibly) word for word. As with any of these, APRA needed to make some changes (discussed below). The real interest is in how scanty the disclosures will need to be for the ADIs (authorised deposit taking institutions) going standardised. For these guys the disclosures are (very) little more than they have to make now.

The other interesting point is in how you may disclose these - release to the website (para 18)! There is no need to formally publish the results in hard copy. Good move.

Many of the changes are simply textual - just making the disclosures work with the previously released standards. I will confine my discussion at this point to the substantial changes from Pillar III. Read the rest of this entry »

APRA released a discussion paper yesterday updating us on their proposed approach to several issues on Basel II that remained open. These areas are:

• Securitisations;
• Credit derivatives under the standardised approach; and
• A few regulatory discretions

The section on securitisations is particularly important, considering their popularity in the Australian market and also for the changes proposed. Read the rest of this entry »