GOING ADV ANCED - Oliver Wyman− Scope of aggregation: Risk category vs. aggregate RWA (Risk-Weighted Asset)-based floors, potential additional floors based on exposure class −
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AUTHORSAdrian Murphy, Partner Rico Brandenburg, Principal
POINT OF VIEW
Financial Services
GOING ADVANCED IMPROVING ACCURACY OF RISK WEIGHTED ASSETS AND DRIVING CAPITAL EFFICIENCY IN BRAZIL
Copyright © 2015 Oliver Wyman 2
EXECUTIVE SUMMARY
Brazil’s robust banking system has been and remains a key strength for the country. To
date, regulatory capital has not been a major constraint for the largest players. Banks
pursued double-digit growth and supported robust returns allowing them to cover losses
incurred and generate sufficient capital through retained earnings to sustain future growth
and reward shareholders. Hence, over the past years, banks have focused on enabling the
front-office, through growth strategies, optimization of channel management and more
robust underwriting and fraud detection, rather than strategic capital and risk management
initiatives, such as capital efficiency improvement, stress testing, scenario planning and
management of distressed debt.
The Brazilian financial system is a high loss environment with high provisions across the
economic cycle. This is significantly driven by structural factors in the market including the
business mix (e.g. more unsecured, less real estate), segment mix (e.g. new and emerging
segments) and credit market infrastructure (e.g. positive credit bureau still in formation).
Nonetheless there have been significant losses in individual portfolios over the past
number of years that could have been mitigated with the right risk and capital management
infrastructure in place.
Exhibit 1: Cumulative net write-off percentage for top 100 global banks since 2008 (total cumulative write-offs (adjusted for write-backs) as percentage of average customer assets)*1
20%
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40%
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*1 Source: Company annual reports, SNL Financial data, Oliver Wyman analysis. Ranking of total cumulative net write-offs from 2008 to 2014 normalized according to average customer assets during period. Sample consists of top 100 global banks according to asset size, plus Santander Brazil (#103) and HSBC Brazil (#256). Top 25 results shown.
Copyright © 2015 Oliver Wyman 3
Brazil is now in an economically difficult period with zero or negative GDP growth, high
inflation and fiscal pressure. Although the new finance team is taking actions to combat
inflation, control expenses and improve productivity, there are still some tough years ahead.
This will likely imply a slow-down in credit growth and increasing pressure on delinquencies
and provisions. Whilst there is some opportunity to mitigate the impact in certain segments
(e.g. through limit management, selection, pricing etc.), the effective management of risk and
capital will become an increasingly important strategic issue in the low growth environment
in Brazil over the coming years.
Brazil has signed up to the G20 agenda and as such the banks in Brazil will be impacted by
new global regulation. A significant part of this new regulation is already factored in through
the new Basel III rules, however, there are a number of outstanding proposals to tighten
up and make more conservative the standardized approaches that the majority of Brazilian
banks use under Basel III. This will likely exert downward pressure on CET11 ratios and there
is a very significant downside risk if banks do not prepare. The main changes that will impact
Brazil include:
• Basel III: Higher quality core capital, more conservative capital requirements, more stringent counterparty credit risk treatment (this is largely already in progress including the capital components and additional liquidity and leverage requirements)
• Revised standardized approach: Increased conservatism in the standardized approach for credit risk capital and potential capital floors
• Revised operational risk approach: Increased conservatism and potential removal or modification of alternative standardized approach
• Capital adequacy: Use of stress testing and additional buffers to inform capital adequacy
• IFRS 9: Move to expected loss approach for provisioning
In this context, we believe it is important for Brazilian banks to make a step change in the
sophistication of their risk and capital management capabilities towards:
• Improved accuracy: a more precise understanding of risk and capital will help guide senior management, in particular given the significant skews in returns across segments and products
• Optimized capital: tactical reductions in capital can be achieved under both standardized and advanced approaches enabling growth and returns
• Better business decisions: the new risk capabilities and capital planning processes can be leveraged to support portfolio optimization and improved business decisions
1 Common Equity Tier 1 Ratio (CET1): Measurement of a bank’s common equity compared with total risk-weighted assets as defined under Basel III.
We estimate that with a strategic capital optimization program supported by
implementation of IRB advanced, almost all of the players could realize a significant
improvement of 10-20% in capital requirements. The trend through time will be to
dis-incentivize standardized approaches, so ultimately the relative impact may be
significantly larger.
Hence there is clear upside for banks in building in the optionality to allow an easy and cost-
effective transition to more advanced approaches as conditions merit. Banks should improve
“bottom up” approaches to identify and measure risks (e.g. credit risk, operational risk etc.)
and implement robust tools to provide an integrated view of risks across the balance sheet
and the ability to rapidly run stress testing and scenario analysis. This will ensure a robust
risk management framework and allow Brazilian banks to capture the full business benefits
of risk management upgrades, in addition to meeting regulatory requirements. In our view,
this will be an increasingly important strategic issue for senior management and the board
over the coming years, and banks that lead may realize significant competitive advantage.
RISK-SENSITIVE CREDIT RISK MEASUREMENT
Comparative analysis across banks and countries have revealed significant differences
between standardized and advanced modelling approaches in different countries as well
as between advanced approaches in different institutions in the same countries which are
not related to the underlying risk of the credit exposures. The Basel committee is seeking
to address inequalities through revision of the standardized approach and introduction of
capital floors. This in turn will be impacted by convergence in relation to the IFRS accounting
rules, per the table below:
Copyright © 2015 Oliver Wyman 4
Exhibit 2: Summary of main changes impacting credit risk capital requirements
REGULATION DESCRIPTION CAPITAL IMPACT
New standardized approach
“Consultative Document – Revisions to the Standardized Approach for credit risk”
• Main objective is to make the standardized approach to credit risk
− More risk sensitive
− More closely aligned to the AIRB (Advanced Internal Rating-Based) approach (in terms of definitions and scope)
− Less reliant on external credit ratings
• Approach is based on “risk drivers” which
− Are used to determine the standardized risk weights
− Will increase data requirements to determine risk weights in the standardized approach
Significant increase of standardized capital requirements
IFRS 9
“Consultative Document – Guidance on accounting for expected credit losses”
• IFRS 9 (International Financial Reporting Standards) will fundamentally change the level and dynamics of credit provisions and is likely to increase provision levels
• Key drivers of the increase vary by stage of the exposure
− Stage 1 (performing): Change in outcome window to 12 months from typically 3-6 months
− Stage 2 (significantly deteriorated): Move to lifetime EL (Expected Loss), i.e. lifetime default rate, lifetime expected LGD (Loss Given Default) – not most likely
− Stage3 (defaulted): Move to lifetime expected LGD rather than most likely outcome of impairment event (mean vs. median result)
Increase of provisions (alignment of provisions and expected loss under AIRB)
New capital floor
“Consultative Document – Capital floors: the design of a framework based on standardized approaches”
• New AIRB capital floor will be based on Basel III standardized approach instead of Basel I and will become an integral and permanent element of regulation (currently part of the transitional measures)
• Key elements of the capital floor under discussion
− Scope of aggregation: Risk category vs. aggregate RWA (Risk-Weighted Asset)-based floors, potential additional floors based on exposure class
− National discretion: Extent to which national discretion in Basel III standards is allowed for in the determination of the floor
− Provisions treatment: Adjustments for differences in the treatment of provisions between the standardized and AIRB approaches for credit risk
Increase of capital under advanced approaches (depending on the level)
These initiatives will result in a decrease in CET1 ratios across countries and institutions. The
latest QIS results are currently being prepared by Central Banks and so we do not provide
an actual estimate of impact here. We do, however, note that our own client discussions and
insights suggest the impact could be very significant.
Brazilian banks are still under the standardized credit risk approach and have to date faced
challenges in the implementation of advanced credit risk approaches. This is partly due to
the rigidities of the framework, and a limited focus on the optimization of credit risk capital
requirements, as well as a lack of involvement of the businesses in such programs. There is
flexibility in the advanced capital standards that can be leveraged to ensure the approach
is fit for business needs and meets regulatory requirements. This for example includes
flexibility around interpretations of data histories, the choice of modelling approaches
and the ability to reflect business practices to mitigate risk. In this context, an effective
implementation of the advanced modelling approach can deliver a sizeable (if not huge)
capital benefit due to an alignment of capital and risk, and importantly increased
transparency and improved business practices.
Copyright © 2015 Oliver Wyman 5
Exhibit 3: Potential capital impact through advanced modelling under Basel III Advanced Approaches – Emerging market example (percentage of standardized capital requirements)*1
90%
100%
110%
70%
80%
60%
120%
Currentstandardized
Reduction Shortfall AIRBimpact
InitialAIRB
Methodology OptimizedAIRB
Data Businesslevers
OptimizedAIRB impact
INITIAL CALCULATION OPTIMIZATION
100%-10% to
-15%
+15% to+20%
0% to+10%
100% to110%
-5% to-10%
-5% to-10%
-5% to-10%
80% to90%
-10% to-20%
50%
*1 Oliver Wyman analysis.
The example shows that calculations based on first generation risk models and calculation
engines are often likely to overestimate the capital under the advanced credit risk approach.
Realizing the sizable benefit that is achievable through alignment of capital with risk requires
the implementation of a strategic optimization capability and toolkit that:
• Provides a strategic view of capital across the balance sheet including all of the businesses lines
• Identifies areas of capital efficiency improvement and sizes the impact of technical and strategic improvement levers
• Acts as a mechanism to engage all of the business and provide a unified view across risk and finance
The key to success is to treat this as a strategic issue involving all of the top management
and not simply as an accounting problem. This requires an integrated view across all of the
portfolios and segments coupled with a detailed understanding of the levers that can be
deployed to deliver the required impact. So for example, a low return in the SME segment
may drive actions to push the business towards safer and more efficient collateralized
lending products, or may simply encourage the collection of turnover data to benefit from
moving down the SME capital curve. The business may have enacted a real reduction in
risk appetite, mandating a forward looking risk driver analysis to justify a lower and more
relevant prediction of default rates, rather than slavishly relying on a long period of internal
historic data that is simply no longer relevant. The strategic tool and levers framework
Copyright © 2015 Oliver Wyman 6
(of which there are literally hundreds) allow these issues to be identified quickly and
proactively resolved, in a pragmatic and convincing way, achieving business buy-in and
regulatory approval.
Given the likely adoption of IFRS 9 across G20 countries, a successful delivery of AIRB credit
risk programs will also put banks at the forefront for the implementation of the revised
provisioning rules which will align provisions with expected loss and enforce an earlier
recognition of potential losses. The key advantages of implementing IFRS9 when advanced
models are already in place are:
• Avoidance of confusion around different risk measures between finance, risk and the business
• More efficient use of scarce resources (finance and risk costs, IT investment, data scientists)
• Consistency between provisioning and risk assessment philosophy, i.e. the risk model used to price the product is likely to be the most appropriate to assess whether the credit spread has materially changed
• Typically less systems and data challenges during the implementation
INTEGRATION OF OPERATIONAL LOSSES
The comparatively low capital charge imposed by the basic indicator and in particular
standardized approaches has led to a Basel review of operational risk measurement. Judging
from international precedents, the revised standardized approach is likely to be based on a
composite variable known as the “Business Indicator” rather than gross revenues or assets.
The proposed approach gives weight to activities such as gains and losses from trading, fees
and commissions from services. This is likely to increase the operational risk capital charge
for large global and investment banks and for fee heavy businesses (card issuers, payment
providers, etc.).
The Advanced Modelling Approach (AMA) introduces an operational risk measure based
on internal models using internal and external loss data as well as business expert input.
The proposed changes to the standardized operational risk framework will make the
AMA approach more attractive to a wider set of banks, including the larger Tier 2 banks.
In general, we estimate a capital impact of up to 20% in operational risk capital through
adoption of AMA compared to the revised standardized approach. In Brazil the outcome will
depend on whether a similar mechanism to the current Alternative Standardized Approach
(ASA) is allowed under the new rules.
Copyright © 2015 Oliver Wyman 7
Exhibit 4: Comparison of operational risk capital requirements under different regulatory approaches in Brazil (Sum of operational risk RWA normalized by total RWA – selected banks)*1
8%
12%
16%
4%
20%
AlternativeStandardized
Approach (ASA)
AdvancedMeasurement
Approach (AMA)
The StandardizedApproach
(TSA)
RevisedStandardized
Approach
0%
*1 Source: Annual reports, Oliver Wyman analysis. Estimated sum of operational risk RWAs normalized by total RWAs for selected Brazilian banks.
The ASA which many banks in emerging markets, such as Brazil, currently rely on in order to
derive a significantly lower capital requirement is not currently included under the proposed
new BIS rules. We expect this to be an area of significant lobbying. In our view the general
direction is nonetheless to penalize standardized approaches and there will almost certainly
be an additional incentive to move to AMA when the new rules have been established.
The major benefit of implementing AMA and the associated infrastructure and processes
comes not through capital optimization, but through improved operational risk
management in the businesses. The impact is chiefly through improved risk identification
(including “tail” and “business as usual” events), enforcing an integrated “front-to-back”
view (including business units and support functions) and focussing senior management on
the most important issues. We estimate potential to reduce expected losses by 10-20%.
To realize this benefit it is important to embed the operational risk models in an integrated
operational risk and controls framework to provide a logical structure to identify and manage
risks, and support the necessary controls and remedial actions.
Copyright © 2015 Oliver Wyman 8
We highlight six key “lessons learned” that should be considered by banks when developing
and implementing the operational risk measurement approach:
• Be clear about the role of each component in the capital model and risk measurement framework – this should be part of a shared, detailed vision for the overall framework
• Spend time evaluating many different options for how to structure measurement process rather than just “plunging in” – there is no “one size fits all” approach
• Ensure close and continuous coordination across risk measurement elements, capital modelling and other elements of the operational risk management framework, e.g. governance, policies, Risk Control Self-Assessments (RCSAs), Key Risk Indicators (KRIs), Business, Environmental and Internal Control Factors (BEICFs)
• Focus on business relevance and buy-in, take top-down sanity check view and pilot approaches within one or two “friendly” businesses and refine them before group-wide roll-out
• Know expectations of your regulator for operational risk measurement – ideally your approach should be discussed with the regulator before you implement it
• Use all available data sources to reduce subjectivity and generate robust results, including internal, external data, scenario analysis, BEICF and anecdotal evidence in addition to expert opinion
Exhibit 5: Integrated operational risk and controls framework*1
Co
rpo
rate
Bu
sin
ess
area
s
Governance
Risk appetite/loss tolerance
Auditing
Validation
Systems and infrastructure
Veri
ficat
ion
Documentation
Policies,standards,
concepts andmethodologies
External loss data
Risk identification
Op
risk
even
t
Inte
rnal
loss
dat
a
KR
Is
Ince
nti
ves
Cu
ltu
re
Use
test
Key
con
trol
sd
efin
itio
ns
Con
trol
test
an
das
sess
men
t
Capitalmodelling
Scen
ario
an
alys
is
BEICFs
Responses
Management,mitigation,
transfer,outsourcing,
etc.
Reporting
Rel
atio
n w
ith
reg
ula
tor
Identity Assess Respond Reporting andmonitoring
Enablers Tools Cycle
Ris
k as
sess
men
t
Products and processes approval
Project approval
*1 Example of Oliver Wyman integrated operational risk and controls framework.
Copyright © 2015 Oliver Wyman 9
STRESS TESTING AND SCENARIO PLANNING
Central banks and regulators globally are mandating that banks undertake macroeconomic
and portfolio specific stress tests. In the United States and Europe this was driven by a crisis
situation and with the focus very much on regulatory response. By embedding stress testing
and scenario analysis into the strategic capital planning processes, Brazilian banks have the
opportunity to capture the full business benefits of risk management upgrades, in addition
to meeting regulatory requirements.
Exhibit 6: Strategic capital planning processes
INTEGRATED SCENARIOPLANNING
PERFORMANCE MANAGEMENT
BOTTOM-UP CREDIT RISKSTRESS TESTING
Requires input on…
• Projected loss parameters
• Loan balance evolution (performing/NPL)
Assesses and provides feedback on…
• Projected business volumes and overall bank-strategy
• Modelling of other P&L elements(e.g. NII, fees, costs, provisions) and capital components (capital req./avail.)
• Integrated financial performance results (P&L/B-S/Capital)
Requires input on…
• Macroeconomic scenariosand bank strategy underthose scenarios
• Impact of risk drivers on bank's bottom-line (P&L/Capital)
Assesses and provides feedback on…
• Projected loss parameters (PD/LGD/EAD/EL/Provisions)
• Loan balance evolution (performing/NPL)
Requires input on…
• Detailed budget and planning forecasts
• Scenario analysis and stress testing results
• Actual granular performance data
Assesses and provides feedback on…
• Comparison of actual and projected business volumes,P&L and capital results
• Analysis of drivers for planning and stress testing deviation
• Implementation of corrective actions
Copyright © 2015 Oliver Wyman 10
An integrated planning, stress testing and scenario analysis framework improves decision
making across a number of key dimensions:
• Better understanding of key strategic “bets and threats” and overall P&L, B-S and Solvency impacts
• Embed risk and scenario-based considerations into strategic planning (vs. focusing too much on base case)
• Real-time impact evaluation around business plans and performance levers (including mitigation strategies) supporting informed management discussions
• Enhanced consistency, transparency and transversality across individual risk drivers and
stakeholders involved in the strategic planning value chain
In our global client work we regularly observe low to mid-single digit RoE impacts
following the introduction of such capabilities. The impact is driven in part by the improved
transparency and discipline through implementation of the new tools and in part by the
knock-on changes in behaviors and business-led initiatives that this encourages.
CONCLUSION
In conclusion, banks in Brazil are entering a more challenging market and regulatory
environment. There has to date been limited focus on improving RWA accuracy and
efficiency of capital. There is an opportunity to make a step change in the sophistication of
risk and capital management capabilities to meet regulatory requirements, sustain returns
and enable competitive growth strategies. In our view, this will be an increasingly important
strategic issue for senior management and the board over the coming years, and one that
banks should be planning for now.
Copyright © 2015 Oliver Wyman 11
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ABOUT THE AUTHORS
Adrian Murphy is a Partner in the Americas Finance & Risk Practice.
Adrian can be reached at:
adrian.murphy@oliverwyman.com
Rico Brandenburg is a Principal in the Americas Finance & Risk Practice.
Rico can be reached at:
rico.brandenburg@oliverwyman.com
Copyright © 2015 Oliver Wyman
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