Regulations such as Basel II improve risk management and transparency but they must be well designed and consistent, says ING vice-chairman and CFO Cees Maas.
A Google search on “Basel II” yields a respectable number of hits. What’s more, Basel II accounts for 60% of the total hits on Basel. (Admittedly, this includes the search result of the Champions League soccer game Ferencvaros 1 – Basel 2, but it illustrates that Basel II has a high standing.)
Am I happy with Basel II? Yes and no. Yes, because it is built on sound economic principles and is set to reinforce financial stability in general. No, because I fear that difficulties will arise in its implementation.
Major drawbacks
There is a serious possibility that some national regulators may add too many additional requirements to the basic framework and fail to wholeheartedly co-operate with their fellow regulators in other countries. If the implementation of Basel II brings cumbersome and bureaucratic procedures, it risks not meeting its final objective, which is to bring a bank’s regulatory capital in line with its economic capital.
Basel II is the buzzword for the accord reached in 2004 by the Basel Committee on Banking Supervision. The agreement requires banks to protect themselves against the risks involved in their business activities. It consists of three pillars. Pillar 1 specifies the minimum capital level that a bank needs to hold to cover its exposure to credit, market and operational risk. Pillar 2 is concerned with the supervisory review that aims to ensure that a bank’s overall capital level is sufficient to cover all its risks. Pillar 3 details the guidelines for the disclosure of information on a bank’s risk profile and capital to the outside world. Depending on the sophistication of risk measurement techniques – less or more advanced – banks will have to comply with the new Accord in 2007 or 2008.
The banking sector is undoubtedly supportive of the accord because it has a number of advantages. First, the quality of risk management within banks will improve in general. The new framework encourages banks to use more sophisticated assessments of the different types of risk (credit, operating and market risks). This will lead to a more efficient use of capital.
The second important benefit is an increase in transparency towards the markets. Under Basel II, banks must publish detailed information on their risk profiles and risk models, and also on the amount and quality of their capital. This transparency enables shareholders, investors and analysts to see if a bank is strong enough to absorb possible losses. A bank with an unfavourable risk profile will have to pay higher interest rates on its funding. Also, the share price of such a bank could be negatively affected. The market thus will have a corrective role, which will keep banks focused.
In the EU, the Basel II Accord is now going through the legislative process. The European version of Basel II is called the Capital Requirements Directive (CRD). In late 2004, the European ministers of finance, under Dutch chairmanship, reached an agreement on the draft for the CRD. The agreement is largely consistent with the Basel framework and takes into account specific European circumstances. I am quite satisfied with this achievement, particularly regarding the proposals for removing some impediments to consolidated supervision. This is a good first step.
Keep up momentum
All eyes are now on the European Parliament, which has scheduled a plenary meeting to vote on the CRD in September. As a large, global financial institution, ING is eager to see how this process develops. It is important to keep the momentum going and I sincerely hope that the CRD will be approved in September. In the same vein, it is crucial that supervisors work closely together to avoid excessive red tape. This should be the central approach of governments, supervisors and parliaments in Europe.
Concerning the current proposal for the new CRD, I have three specific remarks.
Lead supervision
First, I favour a quicker movement towards a system of lead supervision in the EU. Such a system is the only mechanism that can deliver an efficient supervisory environment in the EU for internationally active banks. The proposals that are now on the table help to define the right direction, but more – and quicker – action is needed. I always find it difficult to explain to outsiders that the EU, with its clear objective of a single financial market, is unable to achieve a unified approach to banking supervision and so continues to burden banks with multiple reporting requirements and additional capital constraints. Note that the current proposals will not achieve a true single market in financial services until after 2010 – more than a decade after the introduction of the euro.
Waiver problems
Second, the current European proposals require credit institutions to comply with capital requirements on a business unit basis. National supervisors have the discretion to waive this requirement for subsidiaries located in the same country as the parent company, subject to strict conditions, but not for subsidiaries in other countries. This makes consolidated supervision at the European level impossible.
Furthermore, the waiver does not apply to the parent company as is currently the case. The result is that the parent company has to produce both entity and consolidated level requirements. The entity level requirements for the parent company do not serve any prudential purpose and result in redundant capital being held.
This implies an uneven playing field between countries, which is inconsistent with the principle of the single market. It is also inconsistent with the Basel framework itself. Whereas Basel eliminates double gearing and takes full account of increasingly centralised and integrated risk management practices, the draft CRD is applied at the level of individual business units. The reason for this is the fragmented legal framework within the EU. This makes it all the more necessary to remove the impediments to consolidated supervision quickly. It is not easy, but must be done.
Supervisory review process
My third remark concerns the supervisory review process. As the proposal stands, the general capital adequacy assessment (pillar 1) will occur mainly at group level, whereas the supervisory review (pillar 2) will occur at business unit level. This runs counter to good supervisory practice. The general assessment of a bank’s risk profile should take into account diversification and concentration effects at the top level. I acknowledge the role of regulators in protecting the rights of depositors and investors in countries other than a bank’s home country. However, the duplication of work and requirement for additional capital on a business unit level are uneconomical for banks and lead to an additional administrative burden. The home supervisor should, in my view, co-ordinate both the pillar 2 activities as well as the reporting under pillar 3 and ensure that the host supervisors are kept informed.
In this respect, the Dutch Central Bank set a good example. It took the initiative of organising meetings with all host supervisors of Dutch financial institutions to discuss the best way to co-operate internationally. This is an important first step towards more effective communication among supervisors.
Better international co-operation is also desirable because Basel II does not stand on its own. Never before have financial companies faced the prospect of such a broad array of regulatory challenges as they do today. There is an accumulation of regulatory changes, such as new accounting standards (IFRS), corporate governance requirements (SOX, and so on) and rules regarding money laundering and terrorism. A participant at the recent spring meeting of the Institute of International Finance (IIF) aptly described this as “regulatory exuberance”. Evidently, high quality regulation will benefit the financial sector but regulation must be proportionate and thoughtfully designed.
Failing to keep pace
Imagine running a top rank sports team that plays in a worldwide champions league. Competition is fierce, there are many good teams and games are being played all over the world. The time has long gone that you played only in your own country. Unfortunately, the regulators of the game have not been able to keep pace with the changes on the field. You find yourself in the undesirable situation that the referees and linesmen nearly outnumber the players on the pitch and, what is more, they have different understandings of the rules of the game. However interesting such a game may be, the chances of achieving fair play and a good result are not high.
Cees Maas is vice-chairman and CFO of the ING Group and vice-chairman of the board of directors of the Institute of International Finance, as well as a member of the IIF’s Steering Committee on Regulatory Capital
