Stephen Timewell looks at the Basel Committee on Banking Supervision’s latest, and final, consultative paper and considers the impact the New Basel Capital Accord will have on financial institutions and the markets in which they operate.
After four years of extensive debate, which included 350 banks from 40 countries, the Basel Committee on Banking Supervision issued its third and final consultative paper (CP3) on April 29. With this new capital adequacy framework in place, the New Basel Capital Accord (Basel II) is set to be finalised by November and implementation is due to take effect by year-end 2006. This may sound straightforward but the Basel II process has been anything but; the challenge of strengthening the regulatory environment has evoked extraordinary complexity and raised many critical, unanswered questions.
“Basel II represents the most complex regulatory changes to hit financial markets in decades, and financial institutions must not underestimate the impact on their business,” says Charles Ilako, lead partner of the European financial services regulatory group at PricewaterhouseCoopers (PwC). “Implementing the Accord will not just be a technical, systems-led exercise, it will affect how financial institutions behave and how they do business, and it will affect the markets in which they operate.”
Basel II will provide a catalyst for change for banks and financial institutions around the world. But how much change depends on the options that national regulators take and how aggressively banks use it as a competitive tool. According to the CP3, Basel II is suitable not only within the G10 but also for banks and countries around the world.
Contrasting approaches
Later this month, the European Union (EU) will issue a consultative paper covering how it intends to implement Basel II in the EU capital adequacy framework. This will apply to all banks and to all investment firms in the EU. The intention is that the EU Directive (known as Capital Adequacy Directive III or CAD III) should come into force at the same time as Basel II and, consultants note, the EU regime will look very much like the Basel version with one or two adjustments on the operational risk side. Some argue, however, that by 2006 and after lobby groups have chipped away at them, CAD III and Basel II may look quite different.
The US has already delivered its view on Basel II. The authorities there have unambiguously declared that Basel II should only be applied on a compulsory basis to around 10 internationally active banks with another 10 banks expected to adopt it voluntarily. This leaves the remaining 8000 or more US banks subject to a national version of the 1988 Basel Accord, avoiding both the complexity and the cost of Basel II. This approach is at odds with the EU and any idea of a level playing field.
John Tattersall, chairman of the UK financial services regulatory group at PwC, is worried by the use of different applications of the new Accord in different places. “Industry concerns about issues of competitive equality between different countries are also still very much alive given the reliance on national supervisory discretion in many parts of the proposals, and the extent of national implementation of the Accord in some countries,” he says.
Baffling complexity
While the 1988 Basel I was applied consistently across a large group of countries and contributed to an overall increase in regulatory capital, it was simple and crude. Basel II was intended to be more sophisticated and consists of three pillars: 1) minimum capital requirements; 2) supervisory review of capital adequacy; and 3) public disclosure. This is where the complexity starts.
Within the first pillar, three approaches were proposed to deal with credit risk: a) the standardised approach with risk weights based on external credit assessments, and two internal ratings-based (IRB) approaches; b) the foundation IRB; and c) the advanced IRB. The latter two approaches would be open to sophisticated banks, if authorised by supervisors. The proposals also included a new requirement for capital to be held against operational risk.
Not surprisingly, the consultative process and drafting of Basel II have been highly complex, subject to considerable political pressures with the outcome rather different than that envisaged by many. CP3 has also come in for heavy criticism.
The European Shadow Financial Regulatory Committee (ESFRC) stated in mid-May: “We consider it to be excessively focused on the regulation of risk management by individual banks. In addition, we strongly object to the treatment of operational risk, the politically influenced issues around lending to the small and medium sized enterprises (SMEs), the insufficient consideration of the issue of pro-cyclicality, and the reduced emphasis on market discipline.”
Possible drawbacks
Professor Harald Benink, chairman of the ESFRC, is particularly concerned that the complexity of Basel II and the intensive role assigned to national supervisors make an arm’s length relation between regulators and the regulated nearly impossible. Under CP3, supervisors are closely engaged in risk management decisions that may threaten both independence and supervision itself. This raises the issue of regulatory capture as well as the core problem of whether the regulators have the resources and staff to face the challenge.
The CP3 acknowledges this deficiency and notes: “The [Basel] Committee recognises that home country supervisors may not have the ability alone to gather the information necessary for effective implementation of the revised Accord. Consequently, the AIG [Accord Implementation Group[ is developing a set of principles to facilitate closer practical cooperation and information exchange among supervisors.”
The ESFRC, however, concludes: “The deep involvement of supervisors as regulators and risk managers implies that any bank failure may be viewed as the failure of the supervisor, and indirectly the government. The reluctance to allow banks to fail may increase further, with the consequence that risk-taking incentives of banks are not reduced as intended in Basel II. The risk of systemic crisis may actually increase rather than decrease as intended.”
Impact will vary greatly
The CP3 is also seen to be weakening information disclosure requirements, notably on internal ratings – something the banks appear happy about but that remains contentious. The ESFRC statement notes: “Moreover, it leaves the detailed decisions on information disclosure to national supervisors, who may compete in laxity. We continue to recommend mandatory issue of subordinated debt to improve market discipline.”
Meanwhile, the global results of the third Quantitative Impact Study (QIS3) were published by the Basel Committee on May 5 and they demonstrate clearly that the CP3’s overall impact on banks will vary greatly, depending on their activities and risk profile. For the standardised approach, the QIS3 reports a moderate overall (i.e. credit risk and operational risk) increase in regulatory capital requirements. Larger banks face an 11% and 6% average increase in the G10 and EU respectively, while smaller banks (Group 2) are confronted with a 3% and 1% increase respectively.
But it is important to note that the averages mask the fact that variances on capital required for individual banks were quite considerable.
The results are very different for the IRB approaches. In the foundation IRB approach, the average capital requirement for smaller banks decreases by 19% and 20% in the G10 and EU respectively, while it remains about the same for larger banks (3% increase in the G10 and 4% decrease in the EU).
Analysing the data, some observers believe the QIS3 estimates are too conservative and there will be a substantial overall reduction of the regulatory capital requirement. Basel itself noted that the QIS3 results were inflated by the banks to provide all the information required to calculate the impact of the proposals. In other words, much needs to be done to improve data quality in order to reap the possible capital benefits.
In strategy terms, PwC notes that the average result suggests that the biggest and most diversified institutions should seek to move to the more sophisticated approaches as soon as possible. It adds that real capital savings can be made on credit risk and that the banks with the largest exposure to the retail market have the opportunity to make the most significant gains.
Stability in question
If QIS3 implies that regulatory capital requirements will be substantially lower, is this good for the stability of the banking system? There are no easy answers. Like much of Basel II, the outcome is different to what many expected.
As Jane Leach, UK head of KPMG’s Basel advisory group, concludes: “The Basel capital proposals are now set to progress full steam ahead towards implementation substantially unchanged. There is minimal reduction in complexity as the Committee has only tinkered with the proposals.
“Those concerned about the extent of change and the associated cost of implementing the proposals, or about the effects on the lending market and hoping for fundamental change, will be disappointed.”
