The US decision to opt for the most sophisticated approach to measuring credit risk and operational risk for its largest banks will raise the regulatory bar for banks elsewhere. Stephen Timewell reports.The new Basel Capital Accord (Basel II), which is due to be finalised by the end of this year, is no mere regulatory hurdle to be overcome. Due to be implemented in January 2007, it will provide one of the biggest structural shocks to the banking industry for decades, says the latest report from consultants Mercer Oliver Wyman. But, as the shape of the new accord becomes clearer, do banks across the globe fully grasp the implications?

While the 1988 Basel I Accord provided a major step forward in capital regulation, its simplicity is regarded as inadequate to deal with the risks that many large, complex financial institutions face. In the past four years, the Basel II framework has evolved to reflect improved risk measurement and management techniques. Greater risk-sensitivity is seen as the hallmark of Basel II, which aligns the minimum regulatory capital held against credit risk with formal risk assessment of individual counter-parties and specifically assigns capital against operational risk for the first time.

The more sophisticated approach taken under the Basel II framework seeks to link capital more closely to risk. Its three elements, Pillars 1, 2 and 3, undoubtedly provide greater risk sensitivity and complexity than the previous accord.

Implementation doubts remain

As the deadlines for discussion approach, though, severe doubts remain for banks and regulators about why and how Basel II can be implemented, and whether banks have the time and resources to have it in place by the start of 2007.

On top of that come the competitive implications. “Fears abound that competitive distortions will arise through the creation of an unlevel playing field across Europe,” says consultant PricewaterhouseCoopers (PwC) in its latest report on the practical implications of Basel II. “In many jurisdictions there is a fear that some individual national supervisors will be more conservative in the interpretation and application of the accord, whilst others may operate a more lenient approach.”

In these final months, uncertainties surround the process as the EU plans to turn Basel II into law through the new capital adequacy directive (CAD3), and banks and regulators around the world must decide which approach, if any, they will take. The world’s most profitable banking market, the US, has already taken a decisive stand and its position may dictate what many others will do. The competitive impact of the US banks cannot be underestimated.

US plans for the accord

In testimony to the US Senate on June 18, the vice-chairman of the board of governors of the Federal Reserve System, Roger Ferguson, outlined again that in the US, Basel II will only be imposed on a small number of banks, with another small group expected to choose to follow. A key aspect of his ruling is that most US banks will not adopt Basel II but will remain on Basel I.

In a blunt and unambiguous statement, Mr Ferguson said: “When we balanced the costs of imposing a new capital regime on thousands of our banks against the benefits – slightly more risk sensitivity of capital requirements under, say, the standardised version of Basel II for credit risk, and somewhat more disclosure – it did not seem worthwhile to require most of our banks to take that step. Countries with an institutional structure different from ours might clearly find universal application of Basel II to benefit their banking system, but we do not think that imposing Basel II on most of our banks is either necessary or practical.”

Mr Ferguson is not against Basel II, however. In fact, the US authorities have opted for the most sophisticated approaches for their larger banks. “In our view, prudential supervisors and central bankers would be remiss if we did not address the evolving complexity of our largest banks and ensure that modern techniques were being used to manage their risks,” said Mr Ferguson. “The US supervisors have concluded that the advanced versions of Basel II – the advanced internal ratings based (A-IRB) approach for measuring credit risk and the advanced measurement approaches (AMA) for measuring operational risk – are best suited to achieve this last objective.”

Mr Ferguson notes that “to promote a more level global playing field”, the banking agencies in the US will be proposing in the forthcoming Advance Notice of Proposed Rulemaking that a core set of banks (with assets of more than $250bn and/or foreign exposure higher than $10bn) would be required to adopt the advanced versions of Basel II. Mr Ferguson said that 10 US banks are in this core group and about 10 or so large banks outside the core group would choose to adopt Basel II in the near term.

The Banker, from its July listings, suggests the likely core group of 10 banks and shows the Top 25 US banks by assets (see table overleaf). The Federal Reserve, not surprisingly, refused to name the core banks.

While Mr Ferguson claims that there will be “little, if any, competitive disadvantage” to US banks remaining on the Basel I capital regime, others, especially those outside the US, see the competition issue differently. “The US is using Basel II as a Trojan horse in its attack on the international banking market,” says Giles Bryan, director of strategic consulting at GFT.

By specifying the use of the A-IRB and AMA approaches by its big banks, Mr Bryan believes the US is getting in early and raising the regulatory threshold, forcing competing banks to do the same or to sink into a second tier of banks that are unable or unwilling to meet the advanced requirements.

Choice is limited

Bankers suggest that the major non-US banks have no real choice now that the US banks have opted for A-IRB: it is A-IRB or the second division. Mercer Oliver Wyman estimates that the total minimum capital requirements in the system would be roughly unchanged if all banks were to adopt the IRB Foundation approach, while they would increase for the standardised approach and drop for A-IRB.

Looking at smaller European retail banks, the analysis shows the potential for capital release under A-IRB, which would translate into an increase in valuation of 18% for a pure mortgage specialist and 12% for other retail banks. And achieving either version of IRB compliance has the potential to reduce minimum regulatory capital by up to 50% for mortgages and 20% for unsecured lending.

Basel II looks set to be a major differentiator among banks. Successful banks are expected to stand out more clearly as transparency increases and capital is used more economically. Mercer predicts that the shake-out will result in a banking market dominated by five types of institutions: large global banks, super-monolines, asset gatherers and packagers, relationship banks and non-bank specialists.

Tight deadline

Are banks ready for this change? To be IRB compliant for 2007 requires a three-year usage test, hence the risk management framework must be substantially in place by the end of this year. Studies suggest there will be serious difficulties. In research commissioned by IBM and SAP, the UK’s Institute of Financial Services (IFS) found that only 38% of senior financial services executives believe the industry will be ready for 2007.

PwC also expressed uncertainties in a recent survey of 21 major European banks. “Firms have focused their Basel preparations predominantly on Pillar 1, yet if they do not make sufficient investment in Pillar 2, capital benefits gained from Pillar 1 may evaporate. Banks are grappling with how to ensure that the substantial investment made in Basel preparations can be made to yield a positive return. Only 10% of survey respondents cited their approach to economic capital as being fully developed and operational, although another 40% described their approach as in an advanced stage.”

For many banks willing to make the investment, Basel II can bring not only better risk management, but also genuine capital benefits. For others, the prospect of possible capital increases and declining profitability is likely to spur increased consolidation and merger and acquisition activity, which would be no bad thing in many overbanked markets such as Germany.

In developing countries, Basel II raises concerns about the potential for encouraging increased pro-cyclicality of bank lending and for reducing the supply of loans from international banks. Professor Stephany Griffith-Jones from the University of Sussex notes: “The introduction of Basel II could excessively and inappropriately increase the cost and reduce the availability of lending, both domestically and for international bank lending to developing countries. As for bank lending within developing countries, the impact of Basel II will be mainly via the standardised approach that, at least initially, the overwhelming majority of developing countries will adopt.

“The recent Quantitative Impact Study (QIS3) in May noted that the standardised approach is estimated to increase capital requirements by 12% in a group largely comprised of developing countries. To the extent that regulatory capital is a binding constraint, banks in developing countries will either have to raise new capital (which can be difficult or costly), reduce their lending and/or increase the cost of their lending, particularly to lower-rated borrowers.”

Not yet set in stone

While many predictions on Basel II have been made, the final outcome of discussions is not set in stone. It is clear, however, that a version of Basel II will emerge; too much effort has been expended for authorities to walk away from it altogether. And a more sophisticated capital model is desperately needed by the top tier institutions. It is not clear, however, if more than 8000 US banks can walk away from Basel II and remain on Basel I, why banks in other countries cannot do the same. The take-up of Basel II and the approaches chosen are still in question.

The coming months will be a critical period when banks and regulators need to decide what to do. Market forces are likely to dictate many decisions and the move by the US authorities to opt for A-IRB and AMA for 10 if not 20 of its banks can be expected to set the pace.

Estimates suggest that banks are spending an average of five basis points of assets on compliance, with the largest players typically investing $100m-$200m over five years. For many banks around the world, the choices and the investment still lie ahead, however, and this picture is blurred further by the scarcity of good quality data available.

The only certainty is that Basel II raises the regulatory bar and those wanting to play at the highest level will have to raise their game to remain competitive.


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