Preparations for the new capital accord trundle on but there are growing fears among bankers and their supervisors that its inconsistent implementation around the world will cause problems.
The Basel II Capital Accord is in danger of becoming a sad case of banking discord. Drawn up by the Basel Committee on Banking Supervision to replace Basel I, the intention of the accord is to encourage internationally active banks to align their capital more closely to the risks they face.
Banks and banking supervisors agree that a new capital adequacy agreement is necessary. The accord was published by the Basel Committee in 2004 and updated last November. Subject to possible fine-tuning, it should start coming into effect on January 1, 2007. The problem is that this supra-national agreement gives so much latitude to individual nations that each will implement it differently.
Without this flexibility the agreement would never have been signed. But with it, the accord will be inconsistently applied around the world. It was supposed to be a case of like-minded nations clubbing together to arrive at a harmonious agreement; instead, it looks as though it will become another example of disunity among nations and a monument to discord. The playing field it will create could be so uneven that participants in the banking game might have trouble standing up, let alone moving in the right direction.
The inconsistencies fall into five categories:
The Institute of International Finance (IIF) has drawn sharp attention to the problem. Its steering committee on regulatory capital published a report in November on what the world’s leading international banks think about Basel II. The IIF says there is a lot about Basel that is good, but it has major reservations. Daniel Bouton, chairman of the IIF steering committee, and chairman and chief executive of French banking giant Société Générale, says: “It is clear that important issues remain to be resolved and that securing co-ordinated implementation poses a growing challenge to us all.” John Hawke, the US Comptroller of the Currency until 2004 and now a partner in a Washington DC law firm, also takes a serious view. He says that because the US has delayed its Basel programme by a year, and made some other changes to its US rules, the entire project should be delayed worldwide.
“A chaotic situation will arise if implementation goes ahead in other countries a year before the US,” says Mr Hawke. “US banks with operations abroad and foreign banks with operations in the US will potentially be caught in a crossfire between their host and home country regulators.”
However, a delay in the EU is almost impossible. The implementation dates are set out in the CRD and cannot be changed except through a further directive, which would be extremely unlikely.
Inconsistent versions
Mr Bouton says the IIF steering committee members “believe that adoption of inconsistent versions of the accord could ultimately disrupt the successful implementation of Basel II, undermine its basic fabric and create serious level playing field issues”.
A specific inconsistency that has emerged is that, although a template for implementing the advanced management approach for operational risk on a cross-border basis was agreed by the Basel Committee in 2004, which allows separate capital allocations for some subsidiaries, several jurisdictions are unwilling to allow such allocations, says Mr Bouton. “It would be highly unfortunate if the advanced methodologies agreed by bankers and regulators would not be applied for subsidiaries in crucial jurisdictions.”
Jo Swyngedouw, deputy director of the Banking, Finance and Insurance Commission (CBFA), Belgium’s banking supervisor, told delegates at the Basel II: Reality Check conference organised by The Banker in December that every jurisdiction would implement different versions of the accord. “For example, the EU’s CRD is different in many respects from Basel II,” he said.
The main differences included the scope of coverage – Basel covers only internationally active banks, the CRD covers all banks and investment firms; the internal ratings-based (IRB) approach – Basel intended this for more sophisticated banks, the CRD has made it more accessible to smaller institutions; and the treatment of private equity – the CRD attaches a lower level of risk to diversified private equity funds, said Mr Swyngedouw.
However, he does not think that the disparities are insurmountable. “The question is: will these differences create an uneven playing field and disturb competition and markets between the EU and the rest of the world? That is not easy to answer but the answer is ‘probably not’,” he said.
Simon Hills, a director of the British Bankers’ Association, told conference delegates that the US regulators’ decision in September to introduce more conservative capital “floors” (the lowest amount of capital that can be held) than those allowed for in the accord is a big difference. “In the EU, we have a 95% floor in 2006 for the foundation IRB approach, reducing to 90% after a year and to 80% in two years, whereas in the US there is a 95% floor in 2009, falling away to 85% by 2011,” said Mr Hills.
“Those floors are a bit more conservative and they will only be removed selectively by the regulators for each bank, on a case-by-case basis. The US regulators have also flagged they might go back to the Basel Committee and ask for rule revisions in certain areas.”
Simon Baker, head of the Basel II programme at Lloyds TSB, told delegates that such inconsistencies between countries would not “derail” the accord. “But we will end up with a system that will have, to some extent, international regulators operating different regimes. Banks are going to have to adapt to fit in with that.”
Howard Davies, director of the London School of Economics, and a former chairman of the Financial Services Authority, writes in the latest issue of the journal Financial Markets, Institutions and Instruments: “If implementation turns out to be different from place to place, that throws into question the process of agreeing the accord in the first place.”
Mr Hawke is blunt in his assessment. “There is certainly a danger that wide variations among countries could undermine Basel II,” he says. “If local supervisors act to provide their banks with significant competitive advantages over foreign banks, the accord could come apart. This danger exists, however, not only where there are explicit differences in the written rules but where there is varying application of common rules by supervisors in different countries.”
Timetable differences
The four US banking agencies’ announcement that they would delay implementation until the beginning of 2009 as well as some changes to the US rules “has caused a lot of concern,” says Mr Hills. “The US regulators announced their decision two days after the European Parliament had voted through the CRD. We have always said we wanted convergence and parallelism in implementation of the Basel framework around the world. We’re not going to get that now.
“The delay raises issues for our member banks. For example, EU banks with US subsidiaries: what approach will they be able to adopt? Basel I becomes illegal at the beginning of 2008 in the EU but they will have to use it in the US until the beginning of 2009.”
Mr Bouton has similar worries. “As yet, there has not been clear guidance about how the practical implications of staggered implementation will be addressed,” he says.
Mr Hawke thinks the only solution is for the Basel Committee to delay implementation worldwide to fit in with the US. Calls for a delay may become harder to resist when the results of the fifth quantitative impact study (QIS 5), carried out at the end of last year, are made known, he says.
The Basel Committee has always said that Basel II should not result in an overall lowering of capital in the banking system. But if QIS 5 shows that this could be an unintended effect, there may be a move from the committee to recalibrate some of the formulae, which could create a need for some delay. “The committee’s past practice has been to insist that deadlines will be met, only to change them when the deadline is imminent,” says Mr Hawke. “I suspect that may happen again.”
BASEL II IN BRIEF The Basel II Capital Accord, written by the Basel Committee on Banking Supervision at the Bank for International Settlements, is intended to improve on the current accord, Basel I, which has been in use since 1988, by encouraging “internationally active” banks to align their capital more closely with credit and operational risks. The new accord, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, to give it its official title, was published in 2004 and updated in November 2005. It is due to be implemented in 2007 and 2008, though US regulators announced in September that they would delay implementation until 2009. The banking community has widely welcomed most elements of the framework. Bankers believe it is necessary and will do much to ensure the stability of the banking system. As well as its defensive capability, it will create commercial opportunities for banks, helping them to recoup some of the accord’s compliance costs. For the accord to be binding, it has to be transposed into national laws. This is where the inconsistencies come in and the discord begins.
