Reality check on Basel II

Methodology

Accenture, Mercer Oliver Wyman and SAP commissioned FT Research to conduct a research study into how banks are approaching the implementation of Basel II.

The research involved telephone and face-to-face interviews with senior banking executives responsible for coordinating these change programmes.

The study focused on the leading banks globally, with half of the top 200 interviewed.

For the purposes of this survey, we describe large banks as those with total assets over $100bn and medium banks with total assets of $25bn-$99bn.

Accenture, Mercer Oliver Wyman and SAP have supplemented the survey findings with their industry knowledge and experience.

Since the release of the first draft in January 2001, the road to Basel II has been a long and bumpy one with intensive lobbying and debate by banks, politicians and other market participants. So far, there have been four revisions and several extended delays to the implementation schedule – the most recent of which, in May this year, postponed implementation of the advanced approaches for credit risk and operational risk to the end of 2007. However, despite the continued wrangling, the new Basel Accord is to be released as The Banker goes to print, largely unchanged from the draft released in May 2003. In spite of the uncertainty around the final shape of the requirements, banks have sought to push ahead with their preparations, recognising the scale of change needed across organisational structures, processes, risk measurement tools and systems. The impact of Basel II is wide-ranging. Banks not only need to measure their risks accurately across the institution, but also show they have embedded these risk measures in both their strategic and tactical decision-making processes.

Key trends

So how are banks progressing? The key findings from the survey include:

• European banks are further ahead than their US and Asian counterparts.
• Most banks expect significant organisational and corporate governance changes to result from a combination of Basel II and other initiatives (eg, Sarbanes-Oxley).
• Basel II is expected to significantly affect the competitive landscape, with increased competition in retail lending, and shake-outs in corporate lending, specialised lending and emerging markets.
• Banks see substantial benefit from more economically-rational allocation of capital and more robust risk-based pricing as a result of Basel II.
• Planned spending on Basel II seems lower than documented in previous studies as banks seek to ensure maximum re-use of existing systems and look to adopt more centralised solutions where new systems are required.
• While spending on IT infrastructure and resources are the major costs, many programmes in the US and Asia appear to lack sufficient IT involvement.
• Over 75% of European, North American and Australian banks are targeting an Internal Ratings Based approach (IRB) solution for credit risk by 2007, with a similar figure targeting IRB-advanced by 2010.
• Short-term ambitions for operational risk are more modest – less than half of the banks surveyed are targeting Advanced Measurement approach (AMA) by 2007, although this rises to 70% by 2010.
• Significant work remains to be done to satisfy the requirements of Pillars 2 and 3, with commensurate changes to capital management and investor communication strategies.

European banks steal a march

The survey shows that progress varies considerably across regions, with European, Canadian and Australian banks stealing a march on competitors in the US and Asia. Europe’s progress reflects the more proactive approach taken by the region’s regulators, including the early requirement by the Bank of Spain on countercyclical provisioning based on expected losses. In the US, regulators and politicians have been slower to reach consensus on whether Basel II should be adopted and, if so, in what form. Many US banks have also been among the most vociferous opponents to Basel II. Both of these factors have slowed progress. Regulators in Asia have remained relatively quiet regarding the implications for their banks.

With respect to overall readiness the study shows that over 60% of banks in Europe have moved into implementation phases (build, test and roll-out) of their Basel II programmes, while the Asian & emerging markets and US banks lag behind with only 27% and 12% respectively at this stage of preparation (see graph 1).

Addressing credit risk

The incentive of implicitly lower regulatory capital requirements for banks employing more sophisticated risk management approaches seems to be working, with the majority of banks planning to adopt IRB-advanced by 2010. Japan is the notable exception where only one of the 11 banks surveyed was targeting IRB-advanced (see graph 2). However, there are other factors at play including, most notably, the attitude of regulators in each region.

Driven by current Federal Reserve requirements, large US banks have no choice but to target IRB-advanced at implementation of the Accord in 2008. However, this does not mean that these banks are better placed to achieve advanced status. Indeed, many European banks have more well-developed risk management capabilities. Based on their responses, many of the US banks appear to be lagging in some key areas:

• Just 35% of US banks feel their rating models perform well, half that of European banks.
• Less than 30% feel that model validation is done effectively, compared with 59% in Europe.
• Only 6% feel that they are performing well against the use-test requirements, compared to over 40% in Europe.
• Banks in Europe are developing substantially more rating models on average (10 non-retail and eight retail) than the US banks (five non-retail and three retail).

“As far as we all think we’ve gotten, no bank in the US today is up to the standard of reliability of the models that, as a regulator, I would feel comfortable saying, ‘Yes, I will go by what your model says you need for capital’,” says Susan Bies, US Federal Reserve Board governor Source: Global Risk Regulator, May 2004

Achieving goals

Many believe this is the key reason behind the recent announcement that the final implementation date for the advanced approaches in Basel will be put back to the end of 2007, although they will still need to be ready for a parallel run by 2006 with an extra year to iron out the wrinkles in their calculation.

While only the largest US banks are required to achieve IRB-advanced, 67% of medium-sized banks are targeting the same level of sophistication – probably in response to concerns that the enhanced risk management capabilities of the larger banks will allow them to cherry-pick the best customers and transactions.

In contrast, Asian banks are less enthusiastic about IRB-advanced status due to a number of factors. The first is that Asian banks may see regulatory capital ratios deteriorate post-Basel II as IRB-advanced calibrations (and hence regulatory capital requirements) will be influenced by recent credit experiences such as the Asian crisis and Japanese credit crunch. Half of Asian banks (excluding Japan) expect their capital positions to worsen as a result of Basel II.

A second factor is the high cost involved. Banks in Asia Pacific are expecting to spend an average E88m on Basel compliance. Some Asian banks will need substantial upgrades to systems infrastructure and will find it hard to warrant a spend which may lead to a higher capital requirement. To progress their business case, Asian banks need to focus on the benefits of upgrading risk management capabilities (eg, through better asset selection, risk-based pricing, credit portfolio management, etc.).

Plans for operational risk

For operational risk, banks’ short-term ambitions are more modest and the split between those aiming for the Standard approach and AMA by 2007 is even at around 40% each. Very few of the banks surveyed are explicitly expecting to use the Basic Indicator approach. However, in the medium term, most banks (70%) expect to be AMA-compliant by 2010.

More than half of the banks are either developing their own in-house solutions or using/modifying existing systems to support operational risk management. A third of respondents will either purchase a new external system (18%) or multiple systems (11%). In terms of banks’ expectations from their operational risk developments, 41% of European banks expect major benefits from reduced operational losses, but in other regions, benefits are more related to the ‘nuts and bolts’ (ie, reporting, data quality, and capital modelling) than their ability to mitigate risks more efficiently.

Section Two: What changes can we expect and what are the main drivers for change for the next decade?

Perhaps the greatest surprise from the introduction of the Basel I Accord in 1988 was the degree to which the extremely rudimentary risk-weighting formula influenced the financial services landscape. Unsurprisingly, the degree of resulting regulatory arbitrage (for example via 364-day revolving facilities, RWA-driven CLOs, etc) meant that a radically more risk-sensitive approach to regulatory capital calculation was inevitable. Given the degree to which Basel I influenced banks’ decision-making at both strategic and tactical levels, it should be expected that Basel II will have an equal, if not greater, impact on the financial services industry. This is also not a post-2007 issue. Strategically astute banks (and other financial institutions) are already assessing the threats and opportunities expected to arise from Basel II.

“Opportunities may exist to target standardised banks carrying excess capital for acquisition and leverage that excess capital for an immediate benefit.” Top-100 bank

The impacts are becoming clearer

One clear implication from the introduction of Basel II is the wholesale upgrading of banks’ risk measurement and management capabilities. The survey results show that participants regard more economically rational allocation of capital and more robust risk-based pricing as more important benefits from Basel II than potential improvements in regulatory capital ratios.

This is encouraging, as a good deal of earlier comment on whether Basel II was a good or a bad thing was simplistically based on whether regulatory capital numbers were going up or down. In terms of regulatory capital ratios under Basel II, the survey is consistent with Quantitative Impact Study (QIS) 3 results, with a slight majority of respondents expecting a reduction in overall capital requirements – this is of course subject to a final recalibration of risk weights prior to final implementation.

In general, European firms seem significantly more optimistic than North American firms in terms of the expected improvement in regulatory capital requirements, which is reflective of the larger number of retail-focused European institutions that retain a significant proportion of assets on-balance-sheet (see graph 3). Interestingly, the higher level of expected benefits has also led those banks to allocate more senior management time and resources to ensure that the benefits are delivered to the bottom line.

Expected changes to business mix

Although the overall effect of Basel II on the banking industry’s regulatory capital requirements is expected to be modest, there are clearly significant differences between different lending portfolios. These changes are well known through QIS 3 results and previous commentary1, but the survey reinforces the industry’s expectation that retail lending (and SME lending falling under the retail treatment) will see increased competition; corporate and specialised lending will consolidate towards those able to measure and price risk accurately; and that emerging markets lending activities will be a more selective undertaking.

It is important to note that the real binding-constraint on a bank’s balance sheet will increasingly be imposed by a more informed scrutiny of its risk and capital position by rating agencies, equity analysts, and investors and peers/professional counterparties. This increase in scrutiny will be facilitated by Pillar 3 disclosure requirements and by much greater understanding and application of economic (risk-based) capital approaches driven by Pillar 2.

Regional differences

There is a distinctive split between European and North American respondents with regard to the incorporation of Basel II into their strategic planning process. Nearly 80% of European respondents have completed some form of strategic assessment of the impact of Basel II – this is over twice the proportion of North American respondents.

Given the level of regulatory pressure in Europe relative to North America, one would expect Basel II to be higher on the senior management agenda in Europe, with the result that, on average, European banks are further ahead in both their strategic development and preparation for Basel II. North American banks also generally expect Basel II to have less of an impact on overall market structure and strategy than European banks – given the two-tier system proposed in the US this is understandable, but the competitive pressures on asset selection and pricing should not be underestimated. As may be expected, a lower level of strategic preparation than both Europe and North America is found in emerging markets.

In summary, the impact of Basel II on the competitive landscape will be significant and signs of adaptation of strategic and market pre-positioning can already be detected. Banks must not lose sight of these more fundamental issues as they continue their internal work to meet Basel II compliance targets.

1 “The New Rules of the Game: Strategic Implications of the Basel II Accord”, Mercer Oliver Wyman, June 2003

Section Three: “Today’s best practice will be tomorrow’s minimum standard”

The next three to five years will see a wholesale upgrading of banks’ risk management capabilities driven by Basel II, other regulatory and accounting pressures (eg, Sarbanes-Oxley, IAS) and peer pressure. This change will affect both underlying risk tools, how they are used in day-to-day business decisions and, importantly, overall risk organisation and board-level risk governance. Expected organisational changes are particularly notable in Europe and emerging markets and with over 70% of North American banks expecting significant governance changes driven by a combination of Basel II and Sarbanes-Oxley.

Beyond Pillar 1

Beyond the minimum requirements of Pillar 1, there is still substantial work to be done in addressing the requirements of Pillar 2. Although banks’ attention is moving from Pillar 1 compliance to the broader implications of Pillars 2 and 3, the majority (62%) describe their enterprise-wide risk management framework and economic capital systems as only ‘poor’ or ‘average’.

Similarly, the perceived ability of respondents to translate their quantitative risk measurement framework into more strategic applications, such as risk appetite setting and value-based management, lags their confidence in the robustness of the underlying metrics. Closing these gaps will be key to delivering the bottom-line benefits that should be targeted as part of the prioritisation and implementation of Basel II initiatives.

In terms of organisation and process, the need to move from today’s status-quo and the ability to manage what will become more cyclical regulatory capital ratios, is demonstrated by over 60% of survey respondents expecting capital and balance sheet management approaches to change substantially. Survey respondents also expect investor communication to change accordingly. The importance of enhanced market perception is emphasised in the survey with over 50% of participating banks seeing this as a major benefit of their Basel II programme.

Risk gets a seat at the table

The introduction of Basel II reinforces a trend of an increasing overlap and blurring of responsibilities between what have historically been distinct roles for finance and risk functions and the elevation of risk management issues to board level. To support these discussions, the industry has started to converge on a more consistent set of roles and responsibilities for the chief risk officer and the mix of skills that are required to be successful in this role.

Risk managers are now substantially more involved in the strategy development process and board-level communication than they were five years ago. Despite remaining reservations about the underlying accuracy and stability of some of the inputs, over 60% of survey respondents already use risk-adjusted performance measures extensively (RAROC, Economic Profit, etc) and this proportion will rise as they become de facto standards. These broader framework changes are important since they provide increased visibility of risk and risk-adjusted returns – and the need for management in all areas and at all levels to be able to easily interpret and act on them.

The concept of ‘risk appetite’ has proved powerful for building board level understanding and allowing interpretation of what can often be complex and seemingly extreme down-side risk measures. This approach is also good at making the connection between internal risk measures focused on protecting the ongoing solvency of the bank and market measures which are typically more concerned with valuation and reputation.

Risk as a driver of value

Banks that are best positioned to benefit from Basel II are those who are prioritising opportunities for fundamental business performance improvement first, and opportunities for regulatory capital reduction second. Opportunities for business performance improvement present themselves in:

• better asset selection, structuring and pricing for lending and other credit activities;
• faster, better and cheaper underwriting processes;
• maximising balance sheet value through more active approaches to credit portfolio, asset-liability and capital management and product design;
• general process integrity and efficiency enhancements through targeted application of operational risk management techniques.

All of these opportunities require the fusion of robust bottom-up risk measurement techniques with management approaches that enable pragmatic decisions to be taken. The recent past has many examples of firms who were unable to move fast enough to turn what their risk models were telling them into appropriate management actions. Striking the right balance between sophistication and pragmatism will be what most clearly differentiates between the winners and losers from Basel II.

The need to be pragmatic

There are some warning signs in the survey that banks’ Basel II ambitions may not be supported by their progress in rating tool development and implementation to date – over half of the banks targeting IRB by 2007 have not yet entered the build-and-test phase of rating tool development, with over 20% still performing gap analysis. Given the data histories required and the use-test requirements of IRB, it is likely that a number of these banks will be disappointed in their Basel II ambitions – only 30% of respondents are happy with their readiness for use-tests.

Data quality and reconciliation issues should not be underestimated – currently many banks are working hard to address systems challenges to provide robust reconciliation between Basel II regulatory capital calculations and the general ledger. It is notable that banks who have been working longest with quantitatively-based risk management systems (typically back to the early to mid-1990s) have the most pragmatic view of the challenges ahead and of the tightness of the deadlines if they are to be IRB-advanced compliant by 2007. Other banks taking on this challenge for the first time typically seem less questioning of their project plans and currently promised delivery dates.

Section Four: How will the Basel II programme be delivered and what lessons can be learnt?

As many banks, especially in the US and Asia, now embark in earnest on their journey to Basel II compliance they should draw on the experiences of early adopters who have pushed further ahead. These experiences suggest that banks need to get the following right to ensure programmes deliver:

• a clearly prioritised programme with agreed ownership;
• appropriate governance to ensure that the programme has the right sponsorship and structure;
• sufficient resources to execute the project in a timely and effective manner;
• a coordinated data management strategy which avoids excessive building of new systems.

Prioritise efforts & agree ownership

Progress on Basel II initiatives typically varies across business units and functions, with some more proactive than others. However, experience shows that this does not always correlate with the highest business priorities.

To fully understand the impacts on the bank and appropriately prioritise initiatives, banks should first conduct a strategic impact analysis and develop a vision for a new operating model for risk management. These issues should then be combined into a prioritised implementation plan, which is flexible as the programme evolves and the banks generate experience.

Governance structures

Resources and funding for initiatives such as Basel II are driven by the political position of key sponsors. Momentum for many programmes in Europe took a long time to build, but driven by proactive regulators and growing awareness of the scale of the undertaking, the priority has shifted further up the board’s agenda. Resources and budgets have followed. Our research shows that Europe has greater sponsorship from more senior executives, with over two-thirds of programmes sponsored by board members and executive committee members (see graph 4).

Furthermore, banks need to ensure that the governance model is working correctly. Accountability for the work needs to be assigned, ideally at board–level, and the opportunity cost of failure needs to be understood.

Balanced representation

The governance structure for the programme should ensure an adequate and balanced representation from both business, support and IT functions.

More resources are typically involved in the Basel programmes in Europe, reflecting their comparatively advanced stage and the need for increased resources as banks move towards implementation. Banks in the US and Asia need to be ready to increase current staffing levels (typically under 25 full-time equivalents (FTEs) to the 25 to 50 FTEs involved in programmes in Europe.

The survey shows that the Basel II programmes in Europe, Canada and Australia have a more balanced mix of resources with over half of the programmes having over 40% of resources focused on IT, while the same proportion of the programmes in Asia and the US have lessthan 20% IT resources, potentially because they are yet to move into implementation.

Research shows that Europe has greater sponsorship from more senior executives

Delivering on the IT challenge

The more advanced approaches under Basel are heavily dependent on data. Not only are larger volumes of data needed more than most banks currently capture, but it needs to be of significantly higher quality, with greater consistency, auditability, and transparency than before. These changes also demand greater access, sharing and reconciliation of information between a bank’s finance and risk-management functions. There is a common understanding that to meet this need, banks today require more integrated data management solutions coupled with a variety of analytical applications.

There is significant work involved in building the systems required for upfront data capture, linkage, storage, processing and analysis. Many banks see this as the largest implementation challenge they face in their Basel programmes.

“The biggest challenge is systems integration. Getting different tools to interact with each other, feed interlinked data to datamarts, etc., is proving challenging.” Major European universal bank.

Data centralisation

In order to manage all this data many banks are choosing to centralise data management - 70% of banks in the US, Canada, Australia and Asia are aiming for this. Traditionally, business units in banks and financial institutions have developed their own data storage on an ad-hoc basis to manage smaller sets of data, often without an overall data management strategy. However, many banks have realised that continuing with these independent, departmental and uncoordinated data stores is not sustainable in a Basel environment.

Adopting a more centralised data management approach also provides a broader set of benefits to banks, including:

• more powerful data analysis capabilities as data is held in a single location;
• increased accessibility of data to other users for needs over and above risk and financial management;
• potential for coordinating spending to solve other data challenges, such as new accounting requirements (IAS);
• potential to reduce costs significantly.

“Although we do not expect our project to provide a positive return on its investment as a standalone solution, we feel that the data consolidation efforts could be leveraged across other initiatives and could indirectly generate cost savings for the business.” Major global universal bank

The challenge remains whether fully centralised data management is achievable within the tight timeframes involved. Indeed, some European banks have placed more focus on building working solutions within the divisions or by requirement (Basel II, IAS, CRM, etc.), with greater data centralisation a longer-term migration path once all the requirements are clearly understood and the benefits case can be made more strongly.

Polarisation of cost estimates

With increased understanding of Basel II, banks have updated their estimates of the total costs.

Estimates of costs seem to have fallen compared to earlier surveys; although considerable uncertainty remains. For banks involved in a wide variety of business lines, the challenge of meeting Basel II requirements means that their expectations of costs remain high. Of the large banks, 60% expect to spend over E50m with one-third of those spending over E100m. However, for banks with a narrow range of businesses, the costs are expected to be considerably lower than earlier estimates, with most medium-sized banks anticipating costs to be below E50m.

Interestingly, in a number of banks, substantial uncertainty over the costs of Basel II programmes still remains, particularly among medium-sized banks in the US (75% uncertain) and Asia (60% uncertain). This partly reflects that these banks have made less progress in their Basel programmes and are thus less certain about what needs to change. These banks should take heart from the fact that banks further along in their implementation tend to have, on average, lower updated estimates of total costs.

IT spending is the major cost

However, one thing is certain – costs are expected to be heavily focused on IT spending across all regions and bank sizes. The majority of banks expect 40%-80% of costs to be for systems and interfaces and expect more IT than business headcount to be involved in Basel programmes.

Banks are also finding ways to reduce the IT costs:

• re-using and modifying existing systems where possible rather than wholesale replacement;
• reducing the proliferation of systems across business units through greater centralisation, particularly in relation to data management and reporting solutions;
• adopting an approach that favours cheap piloting of new systems, before an expensive production system is installed with insufficient usage experience.

Benefit realisation

Most banks know that there are many benefits to becoming Basel II IRB and AMA compliant but they take a passive approach to ensuring that they are realised. Not surprisingly, many of these banks have yet to deliver substantial business benefits. On the other hand a few banks have taken a very active approach at identifying and tracking progress on delivery of benefits. These banks explicitly define what benefits they expect to get from Basel II related work and then systematically track them.

These banks have often found that by investing slightly more (10%-15%) and focusing energy on driving business changes they can significantly increase the total benefits realised. Banks exploiting the risk measurement tools required by Basel II have typically been able to raise profitability by over 10 basis points of assets. Therefore, the focus should not solely be on delivering the lowest cost solution.

Reaping the rewards

The banking industry is at a crucial phase of its preparation for Basel II. With most of the debate on the finer details over, the focus has now rightly shifted to the design and implementation of tomorrow’s risk management frameworks. Progress has been uneven across different regions with Europe, driven by more enthusiastic and widely applied regulatory support, currently ahead (with some exceptions) of the US and emerging markets.

There are encouraging trends as banks move beyond a compliance-focused view relating to the minimum requirements laid down by Pillar 1 and begin to address the implications of Pillars 2 and 3, as well as the impact of the Basel II Accord on the future shape of the financial services industry. It is the ability to position for these strategic changes that will separate the winners from losers under Basel II rather than changes in minimum regulatory capital requirements.

While the cost of Basel II programmes remains high, budgets can be limited through intelligent programme management as more experience is gained. Through rigorous targeting of business-benefits, leading banks are finding a significant upside in their Basel II preparations, rather than viewing them simply as a regulatory burden.

For most banks, challenges remain in reaching their Basel II ambitions. The programmes under way are large and complex and affect fundamental business processes throughout the organisation. Robust project governance and a firm vision of how enhanced risk management approaches can improve market position and competitiveness are key. Delivering the full range of opportunities arising from Basel II will require the effective coordination of strategy development, risk management, business applications and enabling IT and data systems. The banking industry has played a significant role in defining the shape of the Basel II Accord, it must now make sure that it reaps the rewards.

Accenture is a global specialist in technology, outsourcing and consulting, contact Stephen Kemp, Global Lead, Basel II, Accenture, stephen.j.kemp@accenture.com

Mercer Oliver Wyman is a specialist in financial services strategy and risk management consulting, contact Thomas Garside, Managing Director, Finance and Risk Management, Mercer Oliver Wyman, marketingCE@mow.com

SAP is the world’s leading provider of business software solutions, contact Craig Himmelberger, Director, Financial Services Programmes, SAP AG, craig.himmelberger@sap.com