Basel II offers banks the chance to take a strategic look at their organisation, say Paul Pilorz and Seth Thomas.
Activity surrounding the complex Basel II adoption process is nearing a climax. New risk processes, models and management responsibilities are being introduced, reaching right into a bank’s innards.
Because of this, implementation teams have rightly focused on preparing their institution to meet the Accord’s requirements, but it is this ‘process’ aspect of Basel II, feeding upwards to the executive boards responsible for compliance, that may blind banks to greater possibilities. Are those boards lost in interpretation, to the detriment of using Basel II as an opportunity to rethink their individual franchises?
Early conventional wisdom focused exclusively on Pillar 1 (capital requirements) and assumed that any half-decent bank would see a substantial capital reduction post-adoption; there was a noticeable movement among equity analysts to calculate the value of potential special Basel II dividends. It was all for naught. When the Quantitative Impact Surveys (particularly 3 and 4) showed that many banks wouldn’t benefit from a potential capital decrease and when smarter analysts factored in the influence of the rating agencies and regulator (through Pillar 2 and capital floors), the early capital windfall euphoria died down and banks knuckled down to systems implementation and reporting requirements.
However, ‘sweating the small stuff’ misses a big opportunity: never before have European banks been faced at the same time with circumstances that give them the opportunity to take a strategic look at their franchise and change it: from the increasing adoption of shareholder-centred bank management to Basel II providing the information catalyst to drive strategic change.
Information will lead to change
Whatever the approach used, Basel II gives banking managements across Europe a granular-level understanding of where regulatory capital is actually used in their businesses. As importantly, with the new Basel II-sponsored information systems, managements will also be able to extract a RoRC (return on regulatory capital) figure for each exposure, and thus for each business unit, leading to comparisons. Economic capital will continue to be different from regulatory capital, but for many less sophisticated banks, using Basel II capital as a tool to manage the business will be a big step forwards. It will become clear which units are performing and which are not.
This information is gold dust for any executive board, as it enables better management of the overall franchise. But such information will not just be available internally. Pillar 3 provides for increased disclosure to the markets. So external stakeholders will be able to see in the annual report where a bank makes its money and where it is taking excessive risk. It is here that mitigating risks will move to the centre of a bank’s risk-taking culture.
Pillar 3 is one reason why 10-15 US banks will volunteer to adopt Basel II, despite it costing them a substantial investment in dollars and management time. They believe that any bank with Basel II-compliant systems will not only benefit from more efficient risk control (and better pricing), but also from greater investor comfort with enhanced risk management and disclosure.
Get the strategy right
Therefore, boards will be under pressure as never before to ensure that they get their bank’s strategy right. Which businesses do they wish to be in and which should they exit? What will Basel II do to markets where, suddenly, less capital is required? How do they organise their internal structure and change culture to ensure that risk-reward works in practice? How can they better price their risk exposure to build market share? How do they refine their credit and risk taking strategy to ensure an optimum return for shareholders, both now and longer-term? But the biggest question is: do they anticipate change and think strategy today, or wait until all their competitors start doing it tomorrow?
Paul Pilorz is Europe head and Seth Thomas is senior industry analyst in Citigroup’s global banking financial strategy group. The views and opinions expressed herein are those of the authors and do not represent those of Citigroup.
