Jaime Caruana: Basel II - the road ahead
Remarks by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, at the Institute of International Finance Annual Meeting, Dubai, 21 September
2003.
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Ladies and gentlemen,
It is an honour and a pleasure for me to address the members of the IIF. In the kind invitation to
participate in this meeting, two topics were proposed to me, the first being the economic situation and
Spain's experience in the euro area, and the second the new Basel II capital accord.
I thought that Basel II would be more appropriate, given the very crucial stage we have now reached.
But these two topics, the economic situation and the new accord, have suggested to me two
preliminary comments.
First, while policymakers have long understood the importance of price stability to the health of an
economy, in recent years we have all learned much about the concurrent need to promote broader
financial stability as well. A number of different episodes of economic crisis and financial disturbance
have plainly illustrated the threats that weak financial systems and poorly managed banks can pose to
the macroeconomy.
This is why I have always stressed that banking regulation should be analyzed not only from a micro
viewpoint but also from the macro perspective. Creating the right incentives, consistent with good
market practices and sound risk management, appears to be an important way of promoting the safety
and soundness of the financial system and therefore a good way of sustaining both the stability and
growth of the economy. This is not only relevant for prudential regulation; other areas such as
accounting should also be consistent with this broad perspective.
This consideration underlines the importance of taking seriously certain concerns such as
procyclicality. In my view Basel II goes in the right direction. I am convinced that when banking
systems are adequately capitalised, well-managed and risks are correctly assessed within the
appropriate time horizon and the financial system becomes more stable, less procyclical, better able to
promote sustainable growth, and more resilient during periods of distress.
My second reflection is that one of the most significant conclusions of the analysis of the recent
economic and financial evolution of the world economy has been the resilience of banking systems in
most countries. In my view, this resilience has been the result not just of the presence of sufficient
capital in the system, but also of improvements in banks' risk management systems.
I think we owe the industry a special vote of congratulations with respect to the latter, but we also owe
it a commitment on the part of supervisors to continue to support such developments. This is exactly
what we are all trying to do with the proposals for a new Capital Accord, which I would like to address
now.
As you are aware, the comment period for the third consultative paper (CP3) closed at the end of July.
If you have seen the "comments on CP3" page of the BIS website, you will not be surprised to hear
that we have received over 200 responses. I must admit that this is more than we had expected, even
if it is below the 250 responses we received on the second consultative document two years ago.
Obviously, not all of the comments are mutually compatible, nor would it be feasible to incorporate
them all. However, there are some substantive issues which have been raised, and I will mention
some of these briefly in a moment. But just let me say first that the Committee is taking the comments
very seriously and working extremely hard to resolve the issues that have been raised. What is most
important to the Committee is the quality and consistency of the new Accord, and we are clear that this
cannot be unnecessarily constrained by deadlines and timetables.
Michelangelo once said that, having seen an angel in a block of marble, he carved until he set it free.
From most of the letters of comment received by the Committee this summer, it seems that the
industry sees an angel in the proposals and wants to carve away at the text until it's been set free.
Indeed, even among the most critical of respondents we had support for the Committee's three pillars
and its intent to align capital more closely to risk; to introduce greater consistency in the supervisory
review of capital adequacy; and to promote effective market discipline by enhancing transparency. It
was, moreover, satisfying for us that most commentators acknowledged substantial improvements in
the proposals since the release of the second consultative paper in early 2001.
Respondents have raised a large number of issues for consideration, including several that address
some very fundamental concepts and many that have been debated throughout the entire process. In
addition, some member jurisdictions will continue to receive responses through their national
rulemaking processes up until late autumn of this year, during which time we can expect to hear additional
views on the proposals.
For those of you who have not yet managed to make it through all of the responses posted on the BIS
website, I would like to mention some of the most common issues which have been raised. First of all,
the complexity of the proposals. This has also been raised in the past, and is, I think, a valid concern.
At the same time, we mustn't forget that many of the areas of the new Accord have expanded in size
and complexity precisely as a response to calls from the industry for different types of business to be
more finely reflected. Another key issue, mentioned in many comments, is the need to maintain a level
playing field. The Committee is very conscious of this matter, and I will say something about our efforts
in this respect a little later. Finally in relation to the general issues raised in the comments, I would
mention fears of over-conservatism in the proposals when taken as a whole.
I would like also to pick out a few of the more technical comments on CP3. For example, one issue, a
high-level issue, which has also received a lot of attention, is the calibration of capital requirements to
expected and unexpected losses. We have also received many comments on the securitisation
proposals, on the issue of "double default", on the incentive structure and on the recognition of
insurance within the operational risk proposals.
After five years of work, the process has reached a critical stage. Leading market participants and
supervisors alike have long understood that sophisticated banks have "outgrown" the 1988 Accord
and are in need of a more refined regulatory capital regime, and we have all worked extremely hard to
achieve this. So it is important to finalise the new Accord, and open the way to its effective
implementation.
To that end, as I have already said, we appreciate the candour and thoughts that members of the IIF
and other institutions have shared with the Committee and its working groups over the years. We are
studying your latest letters and suggestions carefully.
As you will have gathered from my earlier summary, many comments have focused, as in the past, on
the minimum requirements laid out in Pillar 1, but as we get closer to finalisation, comments about
implementation are becoming more important. I would like to take a few minutes now to talk about
these other aspects of the New Accord that deserve equal consideration.
Let me address four specific issues:
Pillar 2 and consistency

Home / host implementation issues on a world-wide basis

Accounting Standards and Basel II

The recognition of diversification

Pillar 2 and consistency
On the first of these subjects, as you well know, the innovation of the New Accord does not rest solely
on the refinements to the quantitative measures of risk. Another innovation, and one of the most
beneficial, is the incorporation of supervisory review into the international framework. This represents
a real breakthrough for all of us, since supervisors in each jurisdiction have until now found their own
ways to evaluate the adequacy of a bank's capital base. That is an unsatisfactory solution since it can
lead to inconsistencies in the way that a global banking organisation's operations are supervised at a
local level.
By incorporating into the New Basel Accord the requirement for supervisors to evaluate the internal
processes behind a bank's view of its need for capital, the Committee expects that bankers and
supervisors will engage in a more focused discussion of risk management. Pillar 2 recognises that
national supervisors may have different ways of entering into such discussions and provides flexibility
to accommodate those differences. At the same time, Pillar 2 will ensure that supervisors share insight
into their approaches with others and will foster a better understanding among supervisors and
bankers about the differences in national regulatory practices.
Over time, discussions among supervisors will undoubtedly improve our understanding of each other's
processes and promote information sharing and cooperation among regulatory agencies.
Consequently, Pillar 2 should help us to reduce the supervisory burden on globally active banking
organisations and foster more consistent supervisory approaches and practices across national
borders.
This corresponds directly to the mandate of the Committee's Accord Implementation Group, or "AIG".
The AIG was set up at the end of 2001 under the Chairmanship of Nick Le Pan of the Canadian Office
of the Superintendent of Financial Institutions, and Vice-Chair of the Committee. The group comprises
high-level supervisors from member countries, who share planned approaches to implementation. The
intention is that this exchange of information should enhance the consistent application of the New
Accord and thereby promote a level playing field - which we all agree is an important objective. In this
sense, the AIG has a practical focus, while policy issues remain the responsibility of the Committee
itself.
Home / host implementation issues on a world-wide basis.
This brings me to the second topic on my list, which is home/host implementation issues. As part of
the Committee's general efforts in recent years to enhance its relationships with supervisory agencies
outside its member countries, the AIG has itself begun a dialogue with other supervisory agencies. In
fact, based on the AIG's early discussions, the Committee published a paper in August on the "high
level principles for the cross-border implementation of the New Accord".
In this document, we reiterate our view that home and host supervisors will retain their traditional
responsibilities in regulating internationally active banks under the New Accord. Nonetheless, the
revised capital framework will require an even higher level of cooperation among supervisors. Let me
mention areas such as the initial approval and validation of "advanced" approaches to credit and
operational risk under Pillar 1; the supervisory review process under Pillar 2; and ongoing
assessments of compliance with the requirements for the use of "advanced" approaches.
Although supervisors must make practical arrangements to carry out these responsibilities, the
Committee wishes to implement the New Accord in a manner that strengthens the quality of
supervision across all countries. Moreover, we recognise the special role we can play in helping to
ensure that all host supervisors, and especially those from emerging market countries, are able to
supervise the local operations of foreign banks effectively. We will continue to work with emerging
market supervisors and the World Bank and IMF, as well as with the Financial Stability Institute and
others to exchange ideas on ways to strengthen the regulation of both domestic and internationally
active banks.
A key question for many supervisors, and particularly for our colleagues in emerging market
jurisdictions, is whether the New Accord represents the next step to take.
The Committee's view has always been that the fundamentals come first. It is only after a solid
foundation for a sound banking and regulatory system is in place that anyone should contemplate the
more sophisticated requirements of the New Accord. Over time, it is our hope that more and more
countries will adopt the new framework, but not before they are ready. The better capitalised and the
better managed that all banking systems are worldwide, the more resistant the global financial system
will become to periods of distress.
For this reason, the Committee developed a "simplest standardised approach" during the consultations
leading up to CP3. This approach has been developed with the assistance of some of our non-G10
colleagues. More recently, we have developed guidance to assist non-G10 supervisors in making
decisions about adoption of Basel II and to help them achieve the transition in the way best suited to
their national circumstances. Emerging market supervisors have welcomed both the simplest
standardised approach and the transition guidance.
And we will do more in this regard. We are currently considering how we might best enhance and
upgrade our structures for co-operation with non-G10 countries at the Committee level.
Accounting Standards and Basel II
I would like to turn now to the third topic on my list. One trend in the market environment that we must
track concerns the increasing harmonisation in accounting rules and practices internationally. The IIF
has quite correctly noted the need to align the supervisory framework more closely with the emerging
framework for harmonised accounting guidelines. A greater "meeting of the minds" is warranted
especially now that the New Basel Accord includes explicit disclosure requirements intended to
promote greater insight into a bank's risk profile.
Yet as the Institute's comment letter reminds us, there are also other areas of the New Accord, such
as its treatment of provisions and the valuation of financial instruments, where supervisors and
accounting professionals should continue to work toward convergence.
We think that In order to contribute to financial stability, accounting standards should be consistent
with sound risk management and control practices in banks and should facilitate market discipline. The
Committee has, therefore, attached great importance to taking an active role in the international
debates on accounting and to promoting the supervisory perspective on key accounting issues.
The Committee has consulted extensively with representatives of the accounting profession and this
dialogue will continue. I should add that we are interested in pursuing new opportunities for discussion
on issues of mutual concern with accounting-standard-setting bodies and private sector accounting
professionals. In this respect, we very much welcome your initiative to enhance this important
dialogue.
Recognition of diversification
An area of change that capital rules must mirror is the constantly evolving state of the art in risk
management. The 1988 Accord became outdated to a large extent because it was a relatively simple
and static document: its one-size-fits-all approach to capital regulation represented an important
advance as a universally accepted standard, but it did not provide a means to recognise more
advanced risk measurement techniques. It quickly fell behind as the pace of innovation in technology,
financial products, and markets accelerated.
In response, the Committee designed the New Accord to be a more flexible document and one that
would be more welcoming of improvements in risk management techniques. Its evolutionary
approaches to credit risk and to operational risk, for example, give banks a range of options to choose
from and create explicit incentives for banks to strive to adopt the most advanced approaches.
The New Accord still has its limits, however. Members of the IIF and others have cited as an example
the failure to recognise use of full credit risk models, which would adjust a bank's capital requirements
in accordance with the benefits of diversification in its balance sheet. As you know, the Committee
evaluated proposals that would have allowed advanced banks to estimate the degree to which their
assets might behave similarly or default together.
For the time being, we have decided instead to establish standard estimates of diversification that
banks would apply. I know that many members of the IIF have accepted that choice as prudent for
now, but you have also cautioned us that this decision is incompatible with the existing treatment of
market risk and the emerging practices in operational risk management.
We know that some banks are making commendable progress in thinking about ways to estimate the
value of diversification. Nonetheless, we remain concerned about the degree of confidence one might
have in those estimates, given the relative lack of data available on which to base them. Furthermore,
we are concerned that it would be difficult for third parties to validate any estimates at this time.
Finally, we are not convinced about the consistency of application of these diversification effects. For
example we are not certain that any leading bank today consistently adjusts the value of all of its
assets based on each asset's contribution to diversification.
Portfolio theory suggests that an obvious next step to further enhance the risk-sensitivity of the capital
framework would be to incorporate calculations of diversification benefits into the framework. In the
coming years, and we can start very soon, we look forward to working with banks, with banking
associations such as the IIF, and with academics and researchers to find ways to move Basel in the
direction of full credit risk models, and to harness other improvements in risk measurement and
management practices.
As we consider the long-term view, we should not lose sight of the fact that we are just at the
beginning. The New Accord represents another important milestone in the adoption of more advanced
risk measurement and management practices. But to remain robust and relevant to the demands of
twenty-first century banking, our capital regulations must keep pace with changes in the market
environment and with the state of the art in risk management.
On that note, I would like to emphasise the importance of research and debate in promoting the safety
and soundness of the financial system. The Basel Committee owes a debt of gratitude to the studies
and efforts undertaken by economists, risk management professionals, and researchers in both the
public and private sectors as we have sought ways to refine the proposals. We know that your work
has helped to inform ours. The future evolution of the Accord will be dependent on input and
contribution from the industry, and I look forward to continuing our healthy and fruitful exchange of
views.
In closing my remarks today, I would like to stress again the Committee's commitment to having a
balanced Accord of the highest quality. Although we are encouraged by the general support for the
proposals shown through the CP3 process, we recognise that there are some high-level issues still to
be addressed and we are working hard to find the best ways to resolve them. I should also stress that
no formal decisions have yet been taken in this respect. As you probably know, the Committee will
meet next month for the first time since the comment period closed. I can assure you that we will
continue to do our utmost to ensure that you - the industry - can take advantage of the benefits of the
new Accord at the earliest possible opportunity.
Thank you for your attention.