BASEL II - INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS
SYED MASOOD AKBAR
Dec 04 - Dec 10, 2006
Syed Masood Akbar is a management, scientific, and technical consultant. He creates value for organisations through the application of knowledge, techniques and assets, to improve performance. He achieves this through the rendering of objective advice and/or the implementation of business solutions. He provides an objective analysis, wider expertise and independent specialist skills. He is primarily concerned with initiating and implementing organisational, behavioural and technological changes. His role as a management, scientific and technical consultant quite varies from strategy consulting and human resources to operational, IT and financial consulting. He offers end-to-end solutions, including specialist skills and industry knowledge.
Basel II, also called The New Accord (correct full name is the International Convergence of Capital Measurement and Capital Standards - A Revised Framework) is the second Basel Accord and represents recommendations by bank supervisors and central bankers from the 13 countries making up the Basel Committee on Banking Supervision (BCBS) to revise the international standards for measuring the adequacy of a bank's capital. The Basel Committee is named after the Swiss town of Basel. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders. The Bank for International Settlements (often confused with the BCBS) supplies the secretariat for the BCBS and is not itself the BCBS.
Basel I is the term which refers to a round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992, with Japanese banks permitted an extended transition period. Basel I is now widely viewed as outmoded, and a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries.
The Basel Committee consists of representatives from central banks and regulatory authorities of the G10 countries, plus others (specifically Luxembourg and Spain). The committee does not have the authority to enforce recommendations, although most member countries (and others) tend to implement the Committee's policies.
This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass between recommendations and implementation as law at the national level.
The Basel Committee on Banking Supervision is an institution created by the central bank governors of the Group of Ten nations. It was created in 1974 and meets regularly four times a year.
Its membership is now composed of senior representatives of bank supervisory authorities and central banks from the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States), and representatives from Luxembourg and Spain. It usually meets at the Bank for International Settlements in Basel, where its 12-member permanent Secretariat is located.
The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision in the expectation that member authorities and other nation's authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise.
The present Chairman of the Committee is Nout Wellink, President of the Netherlands Bank, who succeeded Jaime Caruana of the Bank of Spain on 1 July 2006.
HISTORY: The Committee was formed in response to the messy liquidation of a Frankfurt bank in 1974. On 26th June 1974, a number of banks had released Deutschmark to the Bank Herstatt in Frankfurt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators.
This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS).
An earlier accord, Basel I, adopted in 1988, is now widely viewed as outmoded as it is risk insensitive and can easily be circumvented by regulatory arbitrage.
The Basel II deliberations began in January 2001, driven largely by concern about the arbitrage issues that develop when regulatory capital requirements diverge from accurate economic capital calculations.
With the first draft (called Consultative Paper 1) published in June 1999, further consultative papers followed together with a large quantity of other releases, Quantitative Impact Studies Nos. 2, 3 and 4, and papers, a final version was issued in June 2004, with a minor revision released in November 2005. In June 2006 a Comprehensive version was published including all Basel regulations up to this date. Implementation of the Accord is expected by 2008 in many of the over 100 countries currently using the Basel I accord.
The final version aims at:
1. Ensuring that capital allocation is more risk sensitive;
2. Separating operational risk from credit risk, and quantifying both;
3. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place
The Accord in Operation: Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (in this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.
Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America.
Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, however, even within nations of the Group of Ten.
Basel II uses a "three pillars" concept - (1) minimum capital requirements; (2) supervisory review; and (3) market discipline - to promote greater stability in the financial system.
The Basel I accord only dealt with parts of each of these pillars. For example: of the key pillar one risk, credit risk, was dealt with in a simple manner and market risk was an afterthought. Operational risk was not dealt with at all.
The key Accord to come from the Basel Committee refers to capital adequacy - ensuring that financial institutions retain enough capital (see Tier 1 capital and Tier 2 capital) to protect themselves against unexpected losses.
The first Basel Accord was issued in 1988 and sets out the basics - such as credit risk. This was updated in 1996 to cover market risk and to clarify and extend the first Accord.
The second Basel Accord was finalized in 2004 after an extensive consultation process. It is aimed at making the capital measures much more risk sensitive and itemizing and quantifying several more categories of risk.
Work has commenced on preliminary aspects of the third Basel Accord, but, not much is currently known about what this will entail.
THE FIRST PILLAR: The first pillar provides improved risk sensitivity in the way that capital requirements are calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. In turn, each of these components can be calculated in two or three ways of varying sophistication. Other risks are not considered fully quantifiable at this stage.
Technical terms in the more sophisticated measures of market risk include VaR (Value at Risk), EL (Loss function) whose components are PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure At Default). Calculation of these components requires advanced data collection and sophisticated risk management techniques.
THE SECOND PILLAR: The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks that a bank faces, such as name risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
THE THIRD PILLAR: The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
CRITICISMS: There are many criticisms that are made of Basel II. These include that the more sophisticated risk measures unfairly advantage the larger banks that are able to implement them and, from the same perspective, that the developing countries generally also do not have these banks and that Basel II will disadvantage the economically marginalized by restricting their access to credit or by making it more expensive.
A paper on home/host issues on Basel II can be dowloaded from www.nalin.ca
The first of these is a valid point, but it is difficult to see how this can be overcome. More risk sensitive risk measures were required for the larger, more sophisticated banks and, while the less sophisticated measures are simpler to calculate, due to their lower risk sensitivity they need to be more conservative.
The second criticism has elements of truth; the better credit risks will be advantaged as banks move towards true pricing for risk. Experience with these systems in the United States and the United Kingdom, however, shows that the improved risk sensitivity means that banks are more willing to lend to higher risk borrowers, just with higher prices. Borrowers previously 'locked out' of the banking system have a chance to establish a good credit history.
A more serious criticism is that the operation of Basel II will lead to a more pronounced business cycle. This criticism arises because the credit models used for pillar 1 compliance typically use a one year time horizon. This would mean that, during a downturn in the business cycle, banks would need to reduce lending as their models forecast increased losses, increasing the magnitude of the downturn. Regulators should be aware of this risk and can be expected to include it in their assessment of the bank models used.
BASEL II AND THE REGULATORS: One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Banks' senior management will determine corporate strategy ñ as well as the country in which to base a particular type of business-based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators.
To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP.
THE FUTURE: Work is apparently already underway on Basel III, at least in a preliminary sense. The goals of this project are to refine the definition of bank capital, quantify further classes of risk and to further improve the sensitivity of the risk measures.