IIB Bank Qualifies for Basel II

SAS® Risk Management for Banking Releases Huge Capital Assets

IIB Bank, a wholly owned subsidiary of the Brussels-based KBC NV has been active in the Irish market since 1973. Originally a traditional merchant bank, IIB now focuses on the broader business banking arena. IIB has five broad business units: business banking, treasury/capital markets, wealth management and private banking, IFSC operations and residential home loans. One of the most important of these is residential home loans, which accounted for more than a third of the bank's € 8.6 billion (US$10.5 billion) of assets under management in December 2002.

Basel II is an international committee set up by the G10 nations to review and promote good banking practice. Its capital adequacy framework covers market, operational and credit risks. In the case of credit risk, a bank must hold a certain amount of capital to cover itself against the risk of creditors defaulting on their loans. Under the Basel I arrangement, banks simply complied with a "one size fits all" formula (Asset x Risk Weighting x 8%). Thus with a risk weighting of 50 percent for residential mortgages, IIB had to hold approximately € 128,000,000 in risk capital to cover the risk of its € 3.2 billion in home loans.

Rewarding Best Practice
The new Basel II arrangement is a departure from "one size fits all": banks are to be rewarded for good risk management practice. Under Basel II you can bring the risk weighting down to 35 percent (for standardized ratings compliance, with no internal discretion). However, if you can prove that you have implemented an efficient model for internal risk management (subject to any operational or supervisory risk weightings), you could bring the risk weighting down still further. Advanced internal ratings compliance could potentially bring the risk weighting down yet further still. If the risk rating is reduced to say 25 percent or below, do the math and you can see that compliance with Basel II potentially releases a significant sum from the capital requirement. This will enable IIB to offer more competitive mortgage products.

KBC got on board early with the Basel II regulatory process, and was keen that IIB should also qualify. To do so, its internal risk management models were required to run for three full years before Basel II comes into force on 1 January 2007.

In February 2003 KBC formally asked IIB to develop an effective risk management approach that would allow it to a) be compliant with Basel II, b) ensure that the highest standards of Risk Management were used throughout the organization and c) if possible capture any business advantage available. To meet the challenge, IIB Bank selected SAS Risk Management for Banking

Mobilizing the Program
The challenge for IIB was that it did not have the required expertise in-house available to the project to meet the drop-dead deadline of 1 January 2004, let alone KCB's internal deadline of 1 October 2003. Moreover, transferring risk management data to the parent company in Brussels was quickly ruled out as an option. For one thing, the cost of transferring the data to Brussels would be too high. More importantly, the local regulatory authority IFSRA (the Irish central bank) wanted the data managed locally, and the solution had to address the specifics of the Irish mortgage market. Regulatory authorities are not content to be presented with a "black box" risk management system; they want to be able to see for themselves that a bank is proactively monitoring and managing risk, if necessary on a daily basis.

"Finding a vendor and implementing a solution in just six months was a little bit scary," says Tony Barnes, Head of Programme Office at IIB Bank. In March and April Barnes' team carried out a rapid review of what was available on the market and quickly concluded that SAS was best equipped to provide a solution in the timeframe. In May, SAS presented a prototype that inspired confidence.

"We chose SAS entirely on its merits. We'd never used SAS at IIB before, but it was clear that it was the best solution for our requirements, and importantly SAS could provide the depth of statistical and risk management expertise that we needed," says Barnes. SAS' local presence in Dublin was also reassuring. "Suddenly, things weren't so daunting after all." Barnes felt that so long as IIB could provide the relevant underlying data, they could meet the deadline.

Proving the Validity of the Model
"Homogenous pools of mortgage data" are at the heart of implementing an efficient approach for internal risk management in residential home loans. The objective is to correctly weight the risk of lending to a huge number of property buyers. To manage this effectively, customers receive individual credit ratings that reflect their probability of default (PD), the exposure at default (EAD) and the loss given default (LGD). By segmenting the customers into large homogenous pools based on these risks, IIB can treat them as a small number of really large customers rather than say 100,000 individual customers.

Such an approach only works, of course, if you monitor and analyze all of the customers on a regular basis, to identify customers whose credit rating has changed and who therefore need to be moved into another pool. Through its initial analysis using SAS, IIB was able to segment customers into seven pools based on their propensity to default. "From a risk perspective, managing these seven pools is the equivalent of managing seven large corporate customers," says Barnes.

Monitoring the stability of the customer pools is key to proving the reliability of the model. If there is a lot of movement in and out of the bands, the regulators will question the model's validity. The key output of the solution is a "movements report" that shows how the numbers in each pool is determined, and reasons for movement between the bands.

The SAS solution does this by analyzing data extracted from the host system based on 70 key fields and 50 derived ratios from a four-year transaction history. SAS' experience in risk management was vital in establishing the appropriate business definitions and translation rules, according to Barnes. SAS used its Rapid Warehousing Methodology to build the solution within the tight deadlines. The core solution was in place by the end of July 2003, leaving the months of August and September to fine-tune it to meet the high standards of the local and European regulators.

Multiple Payback on the Investment
IIB has already seen a return on its investment. "By qualifying for the three-year rule under Basel II we qualify for the IRB approach that has the potential to reduce the level of risk capital required to support the mortgage book. So the decision to choose SAS has been vindicated and we are well down the road of paying for the investment," says Barnes.

The next challenge will be to stress test the model against external events like changes in interest rates, exchange rate fluctuations, housing deflation or unemployment. As yet the regulatory authorities have not stipulated the tests that they want in place, but IIB plans to put a stress-test application in place early in 2004. "Whatever tests are stipulated, we have the comfort of knowing that SAS can handle them, and we have the necessary expertise," says Barnes.

The information that IIB now has in its data warehouse is, of course, reusable for other risk and non-risk purposes. IIB already has plans to implement an operational risk solution and a customer retention solution. "One of the reasons we chose SAS was that there would be multiple payback on the investment," concludes Barnes.

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