Basel II: Progress and Challenges 2006-2007

2006 has been a year of progress for Basel II with the publication of the updated Framework and guidelines on general principles for sharing information between home country and host country supervisors in the implementation of Basel II (a previously contentious issue) in July. Most importantly, the results of the fifth Quantitative Impact Study (QIS5) were released last month.

The Dress Rehearsal

In March 2005, the Basel Committee on Banking Supervision re-discussed the schedules for national rule-making processes within member countries and decided to review the calibration of the Basel II Framework in spring 2006. In order to ensure that the envisaged review was based on the most recent data, and to evaluate the impact of the new proposals for the recognition of double default and trading book-related issues, the Committee undertook QIS5 between October and December 2005.

According to a recent report by Standard & Poor’s, QIS5 is an important test of Basel II’s potential minimum regulatory capital charges for credit and operational risk and can be considered as the ‘dress rehearsal’ before implementation next year. Most significantly, says the ratings agency, it confirms that the quest by bank regulators for stable capital levels and improved risk management practices is achievable. QIS5 indicated that regulatory capital requirements will remain fairly stable for the global banking industry over the next few years.

The Basel II Framework

The Basel II Framework describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are all working on to be implemented through domestic rule-making and adoption procedures. The regulation seeks to improve existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Basel II Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices.
Source: BIS website

Global Implementation of Basel II

The report from Standard & Poor’s says QIS5 prompted regulators to confirm current scaling factor calibrations in May this year, allowing the Basel II framework to be maintained in its present form to avoid any further postponement to implementation. “The results were deemed satisfactory enough by most G10 regulators for them to give the go-ahead to their own current national Basel II versions. Increasing uncertainties regarding future implementation within the US, which will be delayed until at least 2009, could, however, hinder regulators’ goal of creating a competitive global level playing field,” the report warns.

In fact, according to Pamela Martin at RMA, the Basel II implementation process in the US is not going well. “To start with, the US will be implementing Basel II at least two years behind the rest of the world. Also, capital floors will apply for three years instead of two, and capital may not fall more than an aggregate of 10%,” she says. “Recent hearings in both the House of Representatives and the Senate reveal that lawmakers believe capital should not fall in the US, but they are also concerned that, should capital fall elsewhere, US banks could be at a competitive disadvantage.”

In her article, #gtnArticle(6504)#, she discusses what’s happening in the US and why there are so many different opinions regarding progress on the implementation of Basel II.

It is true to say that European banks are well ahead of their peers in progress on Basel II. According to Julian Fowler of ILOG, while most European banks begin to finalise their Basel II implementation, their counterparts around the world are struggling or have chosen to opt out.

This is further complicated by regional differences and development. For instance, the majority of Middle Eastern banks engage in both conventional and Islamic banking, so applying Basel II requires not only compliance with the core principals of the Accord, but also means working out how the concepts outlined in the framework fit in with Islamic law.

In addition, earlier this year the governor of the Reserve Bank of India, Dr YV Reddy, discussed the dangers of Asian banks prematurely adopting Basel II regulation and argued that not all non-G10 supervisory authorities need it to strengthen supervision. Reddy emphasised the point that, under Basel II, each national supervisor is expected to consider the benefits of the revised Framework in the context of its domestic banking system when developing a timetable and approach for implementation.

Read also Comparison of Global Approach to Basel II by Slava Gnevko, AlphaNostrum.

Importance of Pillar II

Despite the affirmation that capital levels and improved risk management practices are achievable, Standard & Poor’s advises caution in reading the results of QIS5. “Its wide data dispersions did not only reflect differences in risk profiles, but also an array of shortcomings due to remaining data inconsistencies, disparities and uncertainties in methodologies, and IT bottlenecks,” says the report. “Consequently, the impact of Basel II on capital at inception and thereafter may differ markedly from QIS5 results, reflecting both potential changes in the economic cycle and ongoing refinements in methodologies. The extent of capital relief might be materially different.”

As a result of these uncertainties, the ratings agency claims that Basel II’s Supervisory Review Process (Pillar II) and effective stress testing will be critical to ensure that adequate capital cushions above regulatory minimum are maintained, and therefore a cautious approach from all market participants is advised.

This focus on Pillar II is supported by Suhas Nayak at SunGard in his article, Basel II: How Ready is your Bank for Pillar II Compliance?, which highlights the results of a Q3 survey on banks and their compliance with Pillar II. “The survey confirmed that banks around the world are now taking Pillar II seriously, with about 77% of banks saying they have a formal Pillar II project and team in place,” he says.

Interestingly, he concludes that banks do not necessarily see Pillar II compliance as the end of the road for improving their internal risk and capital adequacy systems and points out that half of the survey respondents plan to upgrade their Pillar II capabilities within three years after their initial compliance.

Role of Technology: Framework and Approach to Basel II

The QIS5 results confirmed that the adoption of a more advanced internal ratings approach will lead to material capital savings compared to the foundation or standardized approach. Standard & Poor’s comments that this is one of the key drivers behind the ongoing improvement in risk management systems across the banking industry. “The size of regulatory incentives appears sufficient for many banks to justify huge investments to upgrade their risk systems,” says the ratings agency’s report. “While this depends on the individual critical mass of a bank, we expect many specialized lenders, and/or banks gaining in size organically or through mergers, to substantially upgrade their risk management capabilities.”

According to Fowler of ILOG, the main problem facing European banks is not whether the necessary systems will actually be in place by 2008, but whether the implementation of these systems will be successful. “Many banks are currently facing ‘teething problems’ in the implementation of new risk information systems, particularly in regard to reconciliation with existing financial information systems,” he says. “A significant contributory factor to the problem is that risk systems and financial information systems have been implemented with scant recognition or understanding of the requirement for such systems to communicate with each other.”

In his article, Basel II – Regulation and Reconciliation, he suggests tools and strategies for banks to address this lack of communication between systems and also the fact that risk management data is often fragmented across organisational silos. This is especially important in light of Pillar III of Basel II (market discipline), which stipulates that data has to flow in a ‘smooth and transparent way’.

Scott Kwarta of OpenPages says that, for financial institutions, the biggest challenge is establishing an acceptable framework, including related policies and processes, for obtaining adequate and complete data. In his article, Technology – Helping Organizations Reach AMA Compliance, he considers the Basel II ‘Use Test’, which is the effective implementation of a risk framework and the demonstrated utilization of the data to manage the business.

“The implementation challenges that financial institutions face in their journey towards Basel II advanced measurement approaches (AMA) compliance include changing the organization’s thinking around risk management, embedding risk management practices throughout the organisation, and demonstrating how management makes decisions and manages risk using the risk framework and processes,” he says. Kwarta also underlines the importance of technology in the process of assessing the organisation’s risk management strategy.

Another area of investment for banks has been in changing and upgrading their credit processes. “Particular focus has been given to the process by which they [banks] evaluate the credit risks arising from their lending portfolios. The sheer growth of the credit risk software business in terms of numbers of vendors, specialist integrators and consultants bears witness to this,” explain Anita Bradshaw and Hari Parekh of CSC. In their article, A Practical View of Risk Modelling: Pitfalls And Promise of Basel II, they claim that while Basel II attempts to connect the amount of capital available to support lending more closely to the actual credit risk, once the capital constraints actually come into effect, the regulation is likely to impose credit rationing, probably at the stage of the economic cycle where borrowers are most sensitive. They suggest one way to avoid this happening is to introduce modelling correlations between credit risk and market risk and eventually also operational risk.

While acknowledging that modelling techniques have not yet fully evolved, Bradshaw and Parekh argue that experienced operations professionals will benefit from analysing the complex relationships between risks.

Unresolved Issues

2006 has been a year of progress for Basel II but there are still some outstanding challenges that need to be addressed. According to the report from Standard & Poor’s, these include different applications of loss given default (LGD) and probability of default (PD); banks’ inability to precisely assess the exposure at default (EAD); the fact that collateral was often not recognized in calculations because credit risk mitigation techniques still pose problems; and differences between regional accounting regimes compared with the international financial reporting standards (IFRS).

“LGD and PD were distorted by different methodology applications due to national and bank specific discretion,” says the report. “In fact, LGD consistency is still far from perfect. In particular, many banks were not able to fully take into account eligible collateral; methodologies for LGD calculations are still under development; calibrations of downturn LGD were often not possible; and time to recovery and discount rate highlighted some inconsistencies.”

These shortcomings are significant because, as John Lewis of Risk Control argues in his article, The Difficulties of Applying Basel II to Advanced Trading Strategies, Basel II is driven by the PD and LGD. “The goal of Basel II is to provide a method to ensure that there are adequate economic capital (EC) reserves within a bank to handle defaults by their clients. The EC is calculated by determining the PD for each client and then multiplying it by the LGD for each client,” he explains.

He says that data to create the PD and LGD require, according to Basel II, three years of data with a further two to three years as verification backup. “The problem with this requirement is that not all instruments that are actively traded in the market have existed for three years. Without three years of data, risk management groups are using tight bounds on new instruments,” he claims.

Conclusion

How will Basel II affect the financial services industry in future? According to the Standard & Poor’s report, Basel II is expected to reinforce the trend of global industry consolidation because larger sophisticated banks using the most advanced approach will benefit from a material competitive edge through their capacity to minimize regulatory capital requirements. The report also foresees an ongoing shift of global business in favour of retail lending as well as reinforcement of the trend of asset-based lending, reducing or making unsecured funding lines more expensive, particularly for corporates.

Hugo Parry-Wingfield and Reyer Kooy of JPMorgan also suggest that proposed changes in capital adequacy under Basel II might change financial institutions’ approach to investing. “The implementation of the revised Capital Requirements Directive is likely to increase focus on the rating of the underlying instruments and the rating of the counterparty for bank exposures,” they argue in their article, #gtnArticle(6503)#. “Investments that manage the exposure to bank counterparties (i.e. by way of controlling the permissible counterparty based on rating) and pooled investments with high ratings such as many money market funds, have the potential to become increasingly popular choices for institutions who have not previously considered placing surplus liquidity in such instruments.”

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