The Hindu : Business : New Basel norms to change complexion of banking

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Monday, Sep 20, 2004

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New Basel norms to change complexion of banking

Basel-II is bound to unleash a new wave of changes in how banking is conducted. The shape of these changes is still largely in the realm of speculation, says G. Sreekumar.

BASEL IS a `pocket-sized metropolis,' the third largest in Switzerland, ensconced in a triangle bordering Germany and France, where the Rhine takes a sharp northward bend.

A ten-minute stroll from the Rhine, through promenaded avenues, where polite motorists and even cyclists stop and wait patiently for you to cross the road, is the Bahnhof, the rail junction of Europe where North-South and East-West traffic pass through. Overlooking the Bahnhof is the majestic 18-storeyed glass and metal structure of the Bank for International Settlements, established in 1930, and the oldest multilateral financial institution in the world.

The BIS houses, among other things, the secretariat of the Basel Committee on Banking Supervision (BCBS), formed in 1974 following the failure of the Bankhaus Herstatt, which affected mostly the G-10 countries signalling a need to coordinate supervisory efforts across countries and lay down minimum banking standards. The committee's efforts over the last three decades have made Basel synonymous with the best practices and standards in banking regulation and supervision.

Perhaps the most far-reaching of these initiatives was the laying down of minimum capital standards in 1988, known as the Basel Capital Accord, to ensure a level playing field in terms of capital required to be maintained by internationally active banks.

Though the Basel Committee has only 13 members, the fact that its capital standards were implemented by more than 100 countries points to their near universal acceptance.

Original accord

The original accord, now known as Basel-I, was quite simple and adopted a straight-forward `one size fits all approach' that does not distinguish between the differing risk profiles and risk management standards across banks.

Efforts had been on for nearly six years to rectify this and come out with a revised version. On June 26 this year, the efforts fructified with the committee coming out with a final version of the revised accord, titled the "International Convergence of Capital Measurement and Capital Standards: A Revised Framework'' and more popularly known as the New Basel Capital Accord or just Basel-II.

The first version of Basel-II came out in 1999, followed by two other versions in 2001 and 2003. During this period of consultation, Basel-II was both pilloried and acclaimed alike; but opinion is undivided that change from the earlier simpler methods was inevitable and long overdue, and that the revised accord would change the face of banking worldwide.

Revised version

Basel-II aims to correct most of the deficiencies that Basel-I suffered from. To start with, the standards are now more risk-sensitive. This implies that banks with a larger appetite for risk will have to set apart more capital to meet the unexpected losses that go with it. While the 1988 accord provided for just credit risk, an amendment was made in 1996 introducing separate capital charge for market risk. With a provision for capital to take care of operational risk (the risk of loss on account of inadequate or failed systems, processes and people, and from external events), all the three major risks are now covered.

Menu approach

Under the provision for capital, the major innovation, first made for market risk in 1996, is the introduction of a menu approach. This means that more sophisticated banks with better risk management and data collection mechanisms can choose to introduce, with the approval of their supervisors, more sophisticated methods to estimate their capital requirements. These methods are expected to entail lower capital requirements, thereby giving banks an incentive to adopt better risk management practices.

Thus, capital for credit risk can be through a standardised approach, based on external assessments of eligible credit rating agencies and an array of differential risk weights calibrated according to the risk profile of each category of assets. Alternatively, banks can have either a `Foundation' or `Advanced' `Internal Ratings Based' (IRB) approach. But, to be eligible for the IRB approach, banks will have to satisfy their supervisors that they have sound data collection and IT systems, and that their internal models are tested for their integrity and robustness through validation and back-testing techniques. The requirement for market risk remains, by and large, unchanged from 1996, under which there is a Standardised and the more sophisticated Models approach to choose from, the latter requiring prior supervisory approval for its use.

Capital charge for operational risk, which remains perhaps the most controversial of the committee's proposals, can be based on one of three approaches: the Basic Indicator, Standardised, or Advanced Measurement approaches, representing a continuum of increasingly sophisticated approaches and decreasing levels of capital requirement. As in the case of the other risks, eligibility for using the more sophisticated methods will depend on the banks complying with stringent qualitative and quantitative standards.

The Basic Indicator Approach is a relatively crude measure that sets the capital requirement for operational risk at 15 per cent of the average of the positive gross incomes for the previous three years. Under the Standardised Approach, the gross incomes are distributed among eight business lines and the capital is worked out based on predetermined factors for each business line.

Supervisory review

The provision for capital is only the first of the three `mutually reinforcing' pillars provided for under the New Accord. `Supervisory Review,' the second pillar, is aimed at ensuring compliance with the minimum standards and qualifying criteria. Through this process, supervisors will assess whether the capital maintained is consistent with the risk profile of the bank concerned and take appropriate and timely remedial steps when the capital is found to be falling below the required standards. Among other things, this may include an upward revision in the capital to be maintained under Pillar 1.

Market discipline is an important element in ensuring that bank behaviour is along desired lines. This forms the third pillar of the New Accord. Banks will be required to disclose, among other things, core and supplementary information on the components of capital, its adequacy and the method of risk assessment and risk management processes.

The committee is not very prescriptive with regard to the elements of market discipline and details such as materiality limits and frequency of disclosure will have to be decided by the banks themselves.

How would Basel-II be implemented? A survey conducted by the Financial Stability Institute (FSI), Basel, shows that more than 100 countries will be implementing Basel-II in the next few years and that, by the year 2009, more than 5,000 banks controlling 75 per cent of banking assets in 73 non-BCBS jurisdictions will be subject to Basel-II.

As for BCBS member countries, the U.S. has already announced that it will be made mandatory for the ten biggest banking groups that account for nearly 70 per cent of the country's banking assets. The European Union is also expected to implement it for all banking groups.

Likely impact

What will be the effects? Just as the original Basel Accord changed bank behaviour, which manifested in a slowing down of lending, moving of assets to off-balance sheet and introduction of new sophisticated products such as securitisation and credit derivatives, Basel-II is bound to unleash a new wave of changes in how banking is conducted. The shape of these changes is still largely in the realm of speculation.

However, with the capital requirements loaded in favour of larger banks having better systems and consequent ability to benefit from the lower capital that goes with implementing the more advanced approaches, there could be a spate of large scale bank mergers worldwide, especially among internationally active banks in their struggle to remain competitive.

What are the criticisms? The biggest complaint is about the complexity of the rules. But, then, so is banking as a business, and increasingly so for the last three decades. Secondly, the risk-sensitive approaches, it is argued, can have pro-cyclical effects that will aggravate the booms and busts and thereby affect the real economy.

This speculation is still at the theoretical level and one will have to wait for implementation to be able to draw firmer conclusions. The anti-cyclical elements in the proposal, such as that for operational risk, and building excess capital, in times of boom, can alleviate the pro-cyclical effects to a large extent.

Implementation issues

The banking sector in the emerging market economies may face unique problems in the absence of well-developed credit rating systems, robust data collection mechanisms and other infrastructure that will entail cruder capital assessment methods and the consequent higher capital levels that will have to be maintained. This will give rise to intra-national and cross-border implementation issues making such banks uncompetitive vis-a-vis the other savvy domestic and foreign banks operating in their terrain. The impact of both the first and the second pillars will be severe on the skills of both bankers and supervisors, which will affect the EME systems more.

The Basel Committee has set up an Accord Implementation Group to facilitate the changeover and assist various countries in this regard. The FSI is also taking initiatives to train bank supervisors.

Can any country afford to wait? The level of implementation of the capital standards, like all other banking standards, is a matter of concern not just to the respective countries.

This has been underlined, time and again, by banking problems (BCCI and Barings, for example) originating in some corner of the world and having reverberations across the world.

So, non-implementation or partial implementation, without justifiable reasons, will finally get reflected in adverse credit ratings, higher borrowing costs and the consequent effects on the real economy. This is one change which no country can delay indefinitely.

The author is with the Reserve Bank of India and has been a Visiting Fellow with the Basel Committee on Banking Supervision, BIS, Switzerland. His views are personal.

(The author is with the Reserve Bank of India and has been a Visiting Fellow with the Basel Committee on Banking Supervision, BIS, Switzerland. His views are personal).

The three pillars

THE OVERARCHING goal for the Basel II Framework is to promote the adequate capitalisation of banks and to encourage improvements in risk management, thereby strengthening the stability of the financial system.

This goal will be accomplished through the introduction of "three pillars" that reinforce each other and that create incentives for banks to enhance the quality of their control processes.

The first pillar represents a significant strengthening of the minimum requirements set out in the 1988 Accord, while the second and third pillars represent innovative additions to capital supervision.

Pillar 1 of the new capital framework revises the 1988 Accord's guidelines by aligning the minimum capital requirements more closely to each bank's actual risk of economic loss.

Pillar 2 of the new capital framework recognises the necessity of exercising effective supervisory review of banks' internal assessments of their overall risks to ensure that bank management is exercising sound judgment and has set aside adequate capital for these risks.

Pillar 3 leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks' public reporting. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation.

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