Defining capital adequacy rules
Despite the rapid organic expansion of our business and recent large
acquisitions, there is a common misapprehension that the Rabobank Group is
abundantly overcapitalized. In fact, capital has become a scarce commodity:
efforts are underway on several fronts to insure that we make the best of what
we have, and to prepare ourselves for further expected revisions in the Bank for
International Settlement's (BIS) guidelines and the European Capital Adequacy
Directives (CAD).
Solvency project
Credit weightings
Managing exposure
Statistical models
Gaining experience
What'sNewS Issue 2 February 1999 I
Of course, every bank sets aside capital
in proportion to its assumed risks.
he BIS's so-called Basel accord mandates
i 8 percent minimum capital ratio
against total risk weighted assets. Our
own target for net solvency - which at 10
percent is nearly all composed of tier one
capital - helps preserve our Triple-A
rating from IBCA, Moody's and Standard
Poors. Having said that, existing
regulatory rules, for example with respect
to 'netting' with derivatives and the
allowable use of collateral, suggest there is
room for introducing a substantially
greater degree of granularity into our
calculations. The aim is twofold: to better
measure actual risk, and to save capital
under the existing rules. According to Bert
Bruggink, Rabobank Group controller, as
much as NLG 500 million
(EUR 227 million) can be
freed up by more
•itelligent calculation,
luch of it to the benefit
of Rabobank
International (RI).
To this end, the control
department has in itiated
the so-called solvency
project. It involves going
through our books, line- Bert Bruggink
by-line, to ensure that all
transactions are being weighted correctly
and that fitting but not excessive levels
of capital are set aside to cover the
associated risks. For instance, existing
regulations allow different risk
weightings according to whether the
counterparty is a corporate, an OECD
bank, a government, or a mortgage
folder. We need to make a concerted
^ffort to improve understanding of these
different weightings, and ensure that the
booking of all future credits reflects the
full range of existing possibilities.
Jan Bos
Active cooperation will be needed from
all the offices. According to Jan Bos of
control RI, 'these detailed rules need to
be carefully scrutinized and managed,
especially as banking transactions
become more complex. In many offices,
an automated solvency
weighting is made according
to a some programmed
formula. But those risk
weightings aren't always
correct - there are many
quirks in the rules. Not
everyone is aware of the
possibilities contained in the
appendix of the manual
"Reporting Managerial
Entities", our accounting
bible, where a full range of
special credit risk weightings
is described. In one case, an
NEG 2 billion (EUR 91 million)
transaction, the front office people
concluded that we could set aside NLG
16 million (EUR 7.3 million) rather than
NEG 160 million (EUR 72.6 million) in
capital charges. Unfortunately, they
forgot to infornt the back office and the
potential benefits were lost.' Says
Bruggink: 'Too often, people are so
involved in day-to-day business that they
simply forget to implement the rules.
This is a problem that we intend to
address in the solvency project.'
Meantime, on the wider world stage,
financial institutions are gradually
changing the methodology they use to
measure and manage credit risk exposure.
This is set against the background of a
decline in the profitability of traditional
credit products and the emergence of new
ways to manage exposure after it has
been originated, not least through
syndication, securitization, and the use of
credit derivatives. The traditional practice
of applying a limited set of central
solvency requirements to every part of a
banks' loan portfolio fails to take into
account many contextual specifics
associated with this new reality. By
distorting market signals, it can actually
increase systemic risk, for instance by
permitting riskier, high-return business at
the same solvency cost as safer, less
profitable deals. Indeed, under the
traditional model, hedging of crédit risk is
sometimes actually punished.
The long-term trend is towards greater
use of internal statistical credit risk
models to replace the simplistic BIS
framework for solvency calculation (the
CAD already allow such flexibility with
regard to market risk measurement).
New models to better quantify portfolio
credit risk include [Richard: the
following should be italics] JP Morgan's
Credit MetricsCredit Suisse's Credit
Risk+and McKinsey's Portfolio Risk
Model. But before such models can come
into general use, there has to be
agreement on their competitive equality.
This will take some time, but since credit
risk can account for as much as 95
percent of the overall solvency charge,
the incentives are quite clear.
A working group has already initiated an
inquiry into portfolio management based
on credit risk modeling; this will help us
better understand our exposure to
clients, more closely calculate default
probabilities and the level of potential
losses, and to make eventual correlations
between specific exposures. In short, we
will gain valuable experience and tools
to measure actual risk in a more
meaningful way.
