Everything you always wanted to know about Basel II in 15 minutes

(a real estate perspective)

Erik Kersten
Senior Policy Advisor Supervisory Policy Quantitative Risk Management
Views and opinions expressed in this presentation are those of the author and do not necessarily reflect the position of the Nederlandsche Bank.

Outline
Overview of Basel II Real estate issues under Basel II

Capital requirements under Basel I

Loans 100 (Risk weight 100%) 100 Worst case Performing Loans Loans losses (8) Owners equity Deposits 8 92 100

92 92

Owners equity Deposits

0 92 92

Required Capital = (Risk Weight * Exposure value)*8%

Capital requirements under Basel I

Mortgage Loans 100 (Risk weight 50%) 100 Worst case Performing Loans Loan losses (4) Owners equity Deposits 4 96 100

96 96

Owners equity Deposits

0 96 96

Mortgage collateral under Basel I

Residential mortgages: if LtV is lower then threshold: lower risk weight, less capital No recognition in capital of commercial real estate (with some exceptions) No realistic assumptions Capital treatment fuelled MBS-market

Purposes of the new capital accord

a comprehensive approach to addressing risks Risk sensitive capital requirements Promote soundness and safety of the financial system Enhance competitive equality Accommodate industry best practice Result: Widen acceptance of collateral types used in practise and widen acceptance of internal models to Credit risk & Oprisk

Structure of Basel II

Menu of approaches (pillar 1)

For measuring Credit Risk: Standardised Approach Foundation Internal Ratings-based Approach Advanced Internal Ratings-based Approach For measuring Operational Risk: Basic Indicator Approach Standardised Approach Advanced Measurements Approach For measuring Market Risk: Standardised Approach Internal Models Approach

Credit risk (Pillar I)

The risk of loss due to the fact that an obligor will not meet its credit obligations in full Required Capital = (RW * Exposure value)*8% (no change!) Standardised approach RW Based on External ratings (Moodys, S&P, local rating agencies) Internal ratings based approach RW based on Internal ratings (banks own assessment)

Internal Ratings Based Approach

Capital requirements for an exposure based on VaR and function of: PD, LGD, EAD and M These functions are given by Accord

IRB: the formulae

look up PD 4 74 8 6 1 ( PD ) R 1 1 (0.999 ) 1 + M 2.5 b *1,06 + PD ) K = LGD ( { { 14 4 244 3 141 4 R R 1 1 .5 * b 44 44 43 24 4 4 2441 4 4 3 1 4 4 4 4 4 4 look up 99.9% account for correlatio n in the normal distributi on correct for maturity 444 444 4444 accountfor EL 14 4 2444444444444 3

calculate PD stressed at 99.9%

RW = K * 12,50

1 e 50 PD Correlation ( R ) = 0.12 50 1 e

50 PD + 0.24 1 1 e 1 e 50

Maturityadjustment(b) = (0.11852 0.05478 ln(PD)) Onlyfor Corporates , Banks& Sovereigns

For Corporates, Banks & Sovereigns SME correction : R ranging from 0.08 to 0.20 Retail : Mortgages : R = 0.15; credit cards : R = 0.04 and other retail : R ranging from 0.03 to 0.16

internal refers to the inputs

Foundation IRB Probability of default Loss Given Default Advanced IRB

Own estimates Supervisory formula Supervisory formula Banks own estimates or 2.5 yrs Own estimates Own estimates Own estimates

Exposure at Default Maturity

RW vs PD
R W -c u rve s (P D to t 1 0 % ) (L G D = 45 % , M o rtga ges L G D = 1 0 % M =2 ,5 )
250,00 %

200,00 %

150,00 % RW

100,00 %

C o rp orates C o rp orates(sm a ll) m ortg age s QRE O the r R eta il

50,00 %

0,00 % 0,00%

2 ,0 0%

4,00%

6 ,0 0% PD

8,00%

10,00 %

1 2,00%

Conclusion
IRB is a more risk sensitive way of calculating capital requirements based on statistical properties of portfolio and enhances internal management of loans

Real estate in Basel II

Approaches in pillar 1
Measuring Credit Risk in mortgage lending Residential real estate: Standardised Approach RW down from 50% to 35% Monitoring LtV-ratios (at least every 3 years) Advanced Internal Ratings-based Approach banks now have to estimate PD, LGD & EAD for their retail mortgages (NB collateral management conditions, e.g. LtV-monitoring process)

Approaches in pillar 1
Measuring Credit Risk in mortgage lending Commercial real estate: Standardised Approach RW based on external rating (non-rated => RW 100% Commercial real estate eligible as collateral (NB conditions: e.g. yearly LtV monitoring) Foundation Internal Ratings-based Approach RW based on internal estimates of PD Commercial real estate eligible as collateral (NB collateral management conditions, e.g. yearly LtV-monitoring process!) Advanced Internal Ratings-based Approach RW based on internal estimates of PD, LGD, EAD (&M) Commercial real estate eligible as collateral (NB same conditions, but more freedom in way of meeting those conditions)

Approach in Pillar 2
Banks are free to develop their own models Ensuring sound internal processes to assess risks and capital adequacy Active dialogue between banks and their supervisors,
Identify deficiencies Take prompt and decisive action

Focus on IRB
Most mortgages will probably be subject to IRBregime (Bigger banks use IRB)

What information do we need?

How good is the obligor Probability of default; PD
What determines a PD? Relation between PD and LtV (low LtV tend to have lower PD?)

What information do we need?

How much will we recover after default Loss given default; LGD
What determines a LGD? Relation between LGD and LtV LGD is more then Loans Current Market Value! economic loss: recovery value, time & costs, down turn effect (remember, were talking UL)

What information do we need?

How much money is the obligor likely to owe us when a default occurs Exposure at default; EAD (Credit Conversion Factor)
What determines an EAD? All kind of options with mortgage-lending

LGD: strong effect on RW

LGD = RW
250,00%

Mortgage RW vs PD, at different LGD levels

200,00%

150,00% LGD = 45% LGD = 25% LGD = 10% 100,00% RW 50,00% 0,00% 0,00%

1,00%

2,00%

3,00%

4,00%

5,00% PD

6,00%

7,00%

8,00%

9,00%

Importance?

100%

10% Mortgage Debt to GDP ratio Mortgage debt per capita right hand scale

20%

30%

40%

50%

60%

70%

80%

90%

Overview of EU residential mortgage markets 2005

0% 0 5.000 10.000 15.000 20.000 25.000 30.000 35.000 40.000 45.000 50.000

Importance?

N et he r D la Sw en nd itz ma s er rk Ic lan el d an d U K Ire US Sw lan Po ed d rt en N ug or a l w a G Sp y er ai m n a EUny E 1 Lu F U 5 x e in 2 5 m lan bo d ur B Ma g el lta g F r ium a G nc re e Es ec t e A oni us a La tria tv ia I C tal yp y C r Li ro us th at ua ia H n C u ze S ng ia ch lo a r R va y ep ki u a Po bli Sl la c o n B ven d ul ia g T u a ri R rk a om e a y Se nia R rbi u a U ss kr ia ai ne

Importance?

in 1000
290 270 250 230 210 190 170 150 2000

Gemiddelde koopsom en hypotheeksom (per kw)

Koopsom Hypotheeksom prijsmutatie j/j rechter as

in % 14 12 10 8 6 4 2 0

ratio 116 114 112 110 108 106 104 102 100 2000 2001

Gemiddelde LTV (per kwartaal)

4e kw 2006

2001

2002

2003

2004

2005

2006

2002

2003

2004

2005

2006

Bron: Kadaster

Bron: Kadaster

Mortgage lending important?

Yes