Tom de Swaan, chief financial officer at ABN AMRO, tells Jules Stewart what Basel II and IAS will bring to the finance industry and why it’s time to get moving on implementation.

Q: What do you see as the challenges for ABN AMRO arising from Basel II and IAS 39?

A: As yet, we have not seen the final proposals from Basel in respect of the new Capital Accord and accordingly, we can only be subjective in terms of what we think will be the results based on the current drafts that have been in circulation. Similarly the full effects of adopting IAS 39 have yet to be felt by banks, although it is much closer to full implementation than the Basel Accord. Consequently, there are uncertainties with respect to our own balance sheet in the context of these proposals but despite these uncertainties, we do have a clear view as to the likely impact on our business. For example, if you look at our wholesale credit portfolio, given the fact that a high proportion of it comprises investment grade assets, there should be a substantial release of regulatory capital. Again, our sizeable domestic mortgage business is a favourable asset class for us to hold but it is obviously not all one-sided. Our small and medium-sized corporate business loan portfolio in the Netherlands, the US, Brazil and elsewhere, will probably require an increase in regulatory capital. Moreover, there will be an additional risk factor included within the regulatory capital framework; namely operational risk and this could be a significant charge for an institution of our complexity, given our global presence and range of activities.

There is a great deal of uncertainty as to what capital relief will be permitted under Pillar II of the Accord. We also have to consider how the Rating Agencies will assess the impact of Basel. We have set our rating benchmark at the double-A level and this will mean that we will need to maintain a level of Tier One capital well above the minimum regulatory threshold, as part of the support for the rating. I would therefore find it surprising if one of the results of Basel II is that the banking sector suddenly finds itself with an excess regulatory capital position, although this may be the case for a minority of banking institutions. The need for this buffer of excess capital will be more driven by market requirements as regards the appropriate level of capital adequacy, rather than satisfying the Basel II minimum criteria.

What operational changes do you think will come about as a result of IAS implementation?

IAS 39 is not yet finalised but is expected to be in place with effect from the beginning of 2005, so the timetable is much shorter and we are still not dealing with certainty. For ABN AMRO, we will be maintaining two sets of books throughout 2004 as we will be reporting full year numbers on a Dutch GAAP basis but when we publish our 2005 first quarter numbers under IAS 39, we will show comparable figures for 2004. Obviously, we do not now expect any major changes to IAS 39 and although it is a major task, we are more than ready to meet these requirements.

What are the important issues that need to be addressed with IAS?

We have to determine how we measure and interpret increased volatility of earnings caused by the new accounting standard requiring the marking to market of a far greater proportion of the asset side of the balance sheet. My view is that markets will adapt quickly. As long as everybody moves simultaneously to the new standards and has the same increase in earnings volatility, the markets will accept the new situation.

Will the changes to Basel guidelines benefit the banking industry?

Basel I contributed enormously to the soundness of the international banking system. Look at the capital base of the system and compare the late 1980s with 10 years later. The system’s soundness has improved tremendously on the back of the original Capital Accord. The fact that no major bank has failed during recent times, despite the markets in which banks operate having been subject to any number of external shocks is mainly due to the fact that the quality and quantity of banks’ capital bases has improved substantially. However, the need to change Basel I is obvious. It no longer meets the needs of modern risk management and it contains some fundamental flaws where capital adequacy requirements are concerned.

What concerns do you have about Basel II?

Basel II provides a more realistic reflection of banks’ economic capital requirements. There are, of course, a number of concerns about the new proposals that you might say are on our ‘wish list’ for further changes. For instance, the question of diversification of large portfolios from a geographical as well as an industry/sector viewpoint. This question is still not adequately addressed. Another issue is that the proposals are extremely complex. This complexity is understandable but it becomes very difficult to fully apply Basel II to smaller or simpler banks. Furthermore, the investment required in moving to an internal ratings based approach is significant. But perhaps the most important concern is the relationship between home and host supervisor. This problem has existed ever since the Basel Committee began to meet. The complexity of the new proposals makes this home-host relationship more intricate. For instance, our supervisor is the Dutch Central Bank but ABN AMRO has major operations in 65 countries. We are or may be confronted with different legal systems and interpretations of the Basel guidelines. The current system is very simple, so these differences of interpretation are also relatively straightforward. But at the heart of Basel II, with its advanced internal ratings based approach, you have to obtain model authorisation. For example, if the Dutch supervisor says that on a consolidated basis you can apply the model that we propose, it does not automatically follow that other supervisors will accept this. This means that theoretically you have to run a large number of models because the host supervisor may not accept the home country’s model. This is one of our major concerns.

Is this issue being addressed?

The banking industry established a task force to deal with home-host issues, which I have the honour to chair, and which liaises with the Basel Accord implementation group. A key challenge is that many of the positions taken by supervisors are based on local legislation. Hence, the host supervisors usually are bound to make their own assessment of risk management systems. Under the new accord these differences may increase quite substantially. The regulators in the host country have the legal obligation to make their own assessment of the soundness of our systems and that is clearly an area where there is ample scope for interpretation.

What is the likely timetable for implementation?

The Basel Committee has said it will bring out its final proposals by the middle of 2004 and that should not impede implementation by January 1, 2007. As for potential obstacles, there remain some issues to be addressed where we are all working towards a resolution, for example in the area of expected and unexpected loss. But for the Basel Committee, the process of design has now come to an end and their focus has moved to address issues that will arise in the future. This is a dynamic process and a further evolutionary process is inevitability as the banking environment and product complexity evolves. The obstacles now are in respect of the legislative process. The two major legislative centres for the banking and securities industries are Brussels and the US. The big question in the US is whether Congress should be involved in Basel II implementation. Congressman Michael Oxley believes the Accord should be considered as an international treaty and hence should be ratified by Congress. If this is accepted, it could slow down the process and imperil implementation in 2007.

What is your overall assessment of Basel II?

We think it is an improvement but this is not the end of it. The regulators and the private sector should work together on further refinements in areas such as credit risk modelling and how to reflect diversification of risk. We are positive about the Basel Committee’s readiness to continue discussing these issues. We can say with some pride that ABN AMRO is very advanced and ranks as a frontrunner as far as implementation is concerned, on the credit and operational risk side. Obviously we aim to finalise an advanced internal rating based approach as far as credit risk is concerned and an advanced measurement approach for operational risk. All in all, we are advanced in changing the organisation and aim to be ready to manage full implementation by January 1, 2007.

What are your thoughts on how banks are responding to these challenges in respect of market instruments that can be used to manage change?

I do not think that Basel II will affect the issuance of equity and hybrid capital in any meaningful way. These instruments are part of the existing arsenal of capital management, depending on the sophistication of the issuer and I do not really think that we will see a flood of new issues in the final months prior to implementation of the Accord. As far as securitisation is concerned, this is one area where the Basel Committee’s proposals have not yet been finalised, so it is difficult to forecast the impact on this market. I think that securitisation in whatever form you define it, will continue to grow. We are still awaiting clarification on this issue.

All things considered, you sound quite positive about Basel II.

We have come to the end of the process and there are major issues to be addressed in the next couple of years. The bulk of the proposals represent a shift of regulatory capital to a much more risk-based system. This brings a closer alignment between economic and regulatory capital concepts, something that has been our intention from the outset. In general, I think the Basel Committee has done a monumental job, and I think it is very important that they and we finally begin to implement the proposals.

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