The Basel Committee recently published the Basel II framework. Jaime Caruana, chairman of the committee, responds to The Banker’squeries on it. Q Might the US try to rewrite the framework after its extended QIS4 studies and, if so, will the framework have to be changed? A Firstly, let me say that the framework we published on June 26 is an excellent product, agreed by all Basel Committee members and the result of long and careful discussions, wide consultations and comprehensive impact studies.

Basel Committee member countries have now begun the next stage and are transforming the framework into national rules. These processes may include national impact assessments, as is the case in the US, but also in other jurisdictions. In addition, all member countries will introduce a period of parallel running for the advanced risk measurement approaches, during which time banks will calculate their requirements under the existing rules and under Basel II. Using the information from these processes, the committee intends to review the new framework prior to its implementation to ensure that our objectives will still be met. If we discover that the framework produces unintended effects, the Basel Committee has long agreed that we will resolve them. It is also important to remember that Basel II is an evolutionary process that should keep pace with market developments and advances in risk management practices. We may need to fine-tune certain provisions of Basel II over time. With regard to a few topics – including the treatment of double-default – we already committed ourselves to reviewing the industry’s concerns in the period leading up to implementation. However, I don’t anticipate fundamental changes to the construction of the framework. Basel II should not be a moving target. Q Regulators have been given excess discretion, say banks. They fear regulators will be able to overrule any Basel-based capital cuts in an arbitrary fashion, which means banks will have little certainty about what changes they can make, despite sticking to the agreement. A Your question raises the issue of balance that we seek in Basel II between consistency and risk-sensitivity. We all want a consistent set of capital rules so that all banks face similar expectations. That is the point of pillar one (minimum standards) of the new framework. However, we all agree that no two banks present the same risk profile. Some may engage in unique businesses or have unique risk exposures that may not be captured adequately in the minimum standards. Consequently, pillar two is deliberately expressed differently from pillar one. It reminds us that banks must themselves assess the sufficiency of their capital relative to their unique risk profiles and consider their response. It also recognises that supervisors must evaluate a bank’s own assessment of its capital needs and act if it seems unrealistic. Pillar two does not require supervisors to impose additional capital requirements automatically. On the contrary, supervisors have significant flexibility to determine how best to ensure that banks are sufficiently capitalised relative to their unique risks. This is quite similar to the status quo: some supervisors have chosen to set formal requirements that are above those of the 1988 Basel Accord. Likewise, the committee does not expect perfect uniformity of approaches or results across national jurisdictions under Basel II. However, we do expect supervisors to share their practices under pillar two through the committee’s Accord Implementation Group (AIG). By exchanging information and fostering cooperation, the AIG will promote greater convergence in supervisory practices. Q What guarantee is there that regulators in different countries will adopt a uniform approach? A I should say that our goal is not perfect uniformity in capital supervision, but rather greater consistency. A one-size-fits-all approach to capital requirements is impractical, if not impossible. Legal frameworks, banking structures and market practices may differ between jurisdictions, requiring slightly different supervisory approaches. Of course, this is already true today under the 1988 Accord. What will promote greater consistency in the application of Basel II are the interests of supervisors – and bankers – in creating a more level playing field for internationally active banks. Indeed, this was among the primary objectives of the committee. Therefore, supervisors have an incentive to apply the framework as consistently as possible to minimise competitive distortions. Basel II should foster a better dialogue among supervisors on approaches to capital supervision. Its success will depend in large part on enhanced cooperation and collaboration among supervisors to understand banks’ risk profiles and reduce supervisory burden. As I mentioned, the AIG is playing a key role in fostering this cooperation by providing a forum for sharing implementation approaches and discussing issues that arise, including those related to the cross-border implementation of Basel II for internationally active banks. Q How many years will it take and how broadly will Basel II be implemented in the non-OECD, large emerging countries like China and India? A Whether and when to implement Basel II is a matter for national supervisors to decide, so I cannot comment on any particular country’s plans. However, many countries – including the ones you mentioned – have expressed great support for Basel II as a longer-term goal. A recent survey conducted by the Financial Stability Institute at the Bank for International Settlements suggests that, including the members of the Committee, nearly 100 countries intend to adopt Basel II in the future. Like the 1988 Accord, we expect that, over time, Basel II may become a global standard. It is true that Basel II is a far more challenging standard to adopt than the 1988 Accord. As a result, we do not expect other countries to adopt Basel II on the same timetable as Basel Committee member countries. National authorities in each country must assess their priorities and their industry’s readiness carefully. They should adopt Basel II – especially the more advanced approaches to credit and operational risk – only when it is most appropriate in light of national circumstances. National authorities can take various steps to assist them in the transition, such as beginning to apply the principles set out in pillars two (supervisory review) and three (market discipline) once they have assured themselves that the fundamentals of effective supervision are in place. The Basel Committee, the Financial Stability Institute and others are prepared to assist supervisors in non-G10 countries to enhance their supervisory tools in preparation for adopting Basel II. Indeed, the committee has recently published a paper with practical suggestions for the transition to the new framework, Implementation of Basel II: Practical Considerations. Q Will the increase in capital for lower-rated borrowers mean an increase in cost and a reduction in the quantity of international banks lending to developing countries? A We must consider two key concepts that are sometimes confused: namely regulatory capital, which will be set by regulations based on Basel II, and economic capital, which reflects a bank’s actual capital needs relative to all of its risks. Research and the committee’s discussions with banks indicate that Basel II is not likely to hamper emerging market lending. Fundamentally, individual decisions about the pricing and allocation of credit are driven not by regulatory capital requirements, but by a combination of internal economic capital requirements based on credit risk assessments and competitive factors. While Basel II may result in different regulatory capital treatment of such lending, it should not affect a bank’s assessment of required economic capital. The gap between regulatory and economic capital will narrow under Basel II, but the factors that drive a bank’s assessments of its economic capital needs, and that thereby drive individual credit and pricing decisions, will not change. Consequently, I don’t expect to see material changes in the credit made available to emerging market countries because of Basel II. Jaime Caruana is the chairman of the Basel Committee and governor of the Bank of Spain

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