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Banks need to produce detailed analysis of five years event loss history Back  
Although Basel II won’t be transposed into Irish legislation until 2006/7, financial institutions will need to be able to produce detailed analysis by this date, so they need to start examining their data now, writes Alan Lush, in this overview of how Irish financial institutions, and their European counterparts are preparing for the New Capital Accord.
AAAAnyone in the lending part of the financial services industry will be aware of the new Basel II Accord, due to come into force in 2007. But perhaps not everyone will be aware of the detailed preparation that is underway throughout the industry to enable financial institutions to take best advantage of the Accord.

Timing is everything
The Accord is not intended to be signed into legislation until the 2006-7 D?il Session. This is because it requires financial institutions intending to use the Advanced Approach for the calculation of risk capital and the advanced measurement approach (AMA) for operational risk to be able to produce detailed analysis. This analysis should be of five years loss event history in order to qualify in 2007 for the expected release of capital that will come with the adoption of the Accord.

Many financial institutions have loss event history stored in disparate systems across many locations, lines of business, business units and of course under separate management. In order to aggregate these various data pockets into a single coherent report, work should be underway now to evaluate and adopt new systems. Progress should also be taking place to collect and analyse the data and produce valid output. Failure to initiate such a project now will most likely result in having to use the Standard Approach as defined by the Accord for some time after the Accord itself becomes law. This will no doubt result in loss of competitive advantage for the financial institutions concerned.

Analysis of loss event history
The Accord requires financial institutions who have loans extended to any or several market sectors, to divide their loan book(s) into homogenous pools based on the propensity to default (PD) of the borrower. The number of pools is not prescribed, but for many financial institutions a relatively small number of pools will provide the required granularity, possibly as few as eight pools, although many more may be used. The important thing is to be able to show that the pools are relatively stable and are homogenous in regard to their PD.

PD is calculated based on a number of application and behavioural characteristics of the borrower and is derived from detailed analysis of the performance of the loan book(s) over time – hence the need for five years history. In fact, in Ireland, due to the relatively benign lending environment in many sectors over the past eight years, PDs may be deceptively low. So during 2004, FIs will be required to apply stress to their loan book(s), simulating, for example, higher interest rates and increased unemployment, and for mortgage lenders, a decline in house prices, in order to assess what risk capital requirements might result from a more hostile lending climate.

The Accord then requires this analysis to be fed back into the credit approval process to improve the quality of decisions going forward.

The IT impact
For those financial institutions already using behavioural scoring and single view of customer systems, the IT impact will be significantly less than for those financial institutions that have not yet acquired these tools. Undoubtedly, the biggest IT challenge for the Accord is the quality of the financial institutions basic data. Ideally, the output from the analysis and categorization of the loan book(s) should reconcile perfectly with the financial institutions general ledger. If this can be accomplished, the results can be enormously beneficial. As in the case of a Nordic bank that achieved an improvement in its ratings by being able to demonstrate that its Management Information Systems (MIS) were both comprehensive and reconciled perfectly to its financial accounts.

For many financial institutions, some form of data cleanup exercise, possibly postponed due to complexity or time pressures during earlier initiatives such as Year 2000 or wuro, is now unavoidable. Missing values, values that are not genuine but have been inserted into the data as a default, incorrect values and poor data will seriously impair any prospect of producing results which the financial institutions can stand over and which will convince the regulator that they are reliable. Data cleanup is a daunting, slow and expensive task which should be put in the hands of specialists to execute.

Aside from the data issue, a strong analytical and reporting toolkit will be needed. This should have a data warehousing capability, as results will need to be stored for long periods – long after they have ceased to be of any operational value. As an example, in the United Kingdom, data from the late 1980s and early 1990s, when the spectre of negative equity in the housing market became a reality, is being used to stress loan books today for Basel purposes.

Selecting the correct toolset for your particular environment is key, so it might be worth considering getting a reputable consultancy to assist in this, as the breadth of their experience is unlikely to be available in-house.

It is easy to underestimate the effort needed for your already stretched IT departments, so engagement at an early stage is needed, as well as a practical approach to budgeting both funds and resources to meet the required timeline.

The European scene
While many of the main European based FIs have very large Basel projects underway, the complexity of their operations is such that they need a long time to get things properly organised to meet the timeline. Virtually all-major European players are going for the Internal Rating Based (IRB) approach for credit risk, which allows the financial institution to calculate its own risk capital requirements subject to certain overarching rules.

Many European financial institutions have completed the credit risk work, or are nearing completion, and are now turning their attention to operational risk – another area where substantial amounts of risk capital can be tied up.

Countdown to Basel II: 5 points to note
1. Financial institutions should not underestimate the size of the project – it’s bigger than you think
2. Data cleanup is probably unavoidable so plan to do it as part of the Basel program
3. If you haven’t already started work, you need to do so immediately
4. Your Basel II Program will require very strong project management and governance to be successful
5. There are quite a number of independent firms with extensive knowledge of Basel II and its needs, so don’t be afraid to reach out and seek help

The European financial institutions are expecting sizeable amounts of risk capital to be freed up as a result of using this approach, making their Basel II programs at least self-financing – unlike the earlier ‘must do’ projects such as Y2K and Euro.

The Basel II programme will improve the way in which you do business in any case, regardless of the actual capital release, which it brings.

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