Ardian Fullani: Basel II, its implications, opportunities and challenges ahead
for Albania and Southeastern Europe
Speech by Mr Ardian Fullani, Governor of the Bank of Albania, at the Southeastern European
Financial Forum, the Second Edition, Bucharest, Romania, 11 November 2005.
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Ladies and Gentleman,
The topic to be discussed at this forum is certainly timely. You need not look any further than news
headlines to understand why risk management matters so much. Several events remind us that when
banks lack the commitment to manage their risk prudently, they will fail to uphold their responsibilities
to their shareholders and public at large. Consequently, the cost to society can be high and the impact
on the economy devastating.
Sound corporate governance comes about only when there is a genuine commitment to do the right
thing and to manage risks in whatever form they may arise. Risk managers must provide timely,
objective and accurate information to their management. In turn, senior management and board of
directors need to make sure that there is an atmosphere of transparency within the firm, one that
promotes healthy and disciplined risk taking.
In order to improve understanding and management of risk, the Basel Committee has been
formulating regulatory approaches to foster a safe and sound banking system and greater stability
within financial sector. It has become clear, though, that the 1988 Accord and many of its amendments
have become outdated and overtaken by advances in the banking and the financial sector, and other
economic developments. As a consequence, the Basel Committee has come up with a new proposal
known as Basel II. This proposal is intended to be more risk sensitive than the 1988 Accord, in order
to provide a better alignment and calibration of regulatory capital and capital adequacy with the
underlying economic risks that banks face. Categorizing debtors into a fewer risk 'buckets' was
certainly a progress in 1988, but it open the gap between the regulatory risk measurement of any
given transaction and its actual economic risk. This favours high risk loans over the low risk ones,
given the 100% risk weight charged, irrespective of the risk profile of firms receiving the loan.
Consequently, it adversely affects the accuracy of assessing capital requirements and allocation. The
most concerning side-effect has been the distortion of financial decision-making which is, loans and
investments made on basis of regulatory constraints rather than genuine economic opportunities.
The new Basle II accord tries to improve on these issues by encouraging banks to become more
sophisticated in their risk assessment and aligning more rigorously regulatory requirements with
internal risk measurement methodologies. It is important to recognize that the application of the New
Accord is principally intended for large international banks, which are complex institutions usually
operating in developed countries. Therefore, Basel II has often been questioned about its implications
and appropriateness for banking in emerging market economies, and it is on this point that I would like
to focus my remarks.
In principle, the three-pillar structure of the New Accord provides more precise directions to regulators
to strengthen bank supervision and incentives to banks to become more sophisticated in risk
management. Implementation of Basel II eliminates "one size fits all" methodology to assess risks and
offers instead a wide range of methods to evaluate risks based more on failure likelihood. But the
supervisory authorities in several emerging markets and many developing economies are concerned
that Basel II puts a challenge they cannot meet.
Probably our greatest concern relates to the need of the standardized approach to rely on external
rating agencies for calculating minimum capital requirements. Currently domestic rating agencies are
totally absent in Albania and not well developed as in many other non-OECD countries. On the other
hand, in most of our economies many small enterprises cannot afford to be clients of international
rating agencies. Since borrowers unrated from rating agencies will be assigned a 100% risk according
to Basel II, initially most domestic credits may end up under this 100% category. This could reduce risk
sensitivity of the new system brining it close or similar to that of Basel I.
On the other hand, Albanian banks hold a significant share of government treasury bills and notes.
Actually, under Basel I to this exposure of the banking system denominated in local currency is
assigned 0% risk independently whether credit risk of the sovereign debt is rated or not. Under Basel
II, standardized approach, it is possible that sovereign debt is assigned a risk weight between 0% to
150%, most likely 100% since it falls under unrated category. This means that banking system in
Albania may have to increase capital allocation to comply with the minimum level of the capital
adequacy ratio.
An important intention of Basel II is to strengthen market discipline by developing a set of information
disclosure requirements. In our countries there is plenty of room for improvement in this respect to
allow market participants to assess key information on risk exposure, risk assessment process, and
hence capital adequacy. This is important since it increases public pressure on banks to have a better
performance in assessing and monitoring risk. However, in short run information disclosure might also
have some adverse implication, say in Albania. Let me explain myself better on this issue. Public is
usually more sensitive to bad news than positive developments. In countries like Albania, reactions
between good or bad news are even more asymmetric than in mature market economies. Public in
Albania is particularly over-reactive toward grim news on banking sector or on a certain bank while
tend to ignore what falls in the positive side. This could be due to both historical factors, e.g. the crisis
of financial system in 1997, and culture factors e.g. low level of bank business understanding, e.g. the
overreaction of public to the introduction of the Deposit Insurance Law in 2002. This means that
enhanced information disclosure required by Basle II, could be problematic if not supported by a
proper public understanding.
That's why I feel a bit concerned about the effectiveness and appropriateness of an immediate
implementation of Basle II. Therefore a more gradual approach may be necessary. This approach
could take the form of an interim standard between Basel I and Basel II that could offer banks in
emerging market economies some of the benefits of Basel II without having to face a prohibitive cost.
This means that Basel II adoption should not be made mandatory in financial assessments (of WB,
IMF for example) and countries should be left with the option to keep Basel I.
EU banking directives are mandatory for our countries that opt to join EU. As Basel II elements are
embedded in EU Directives, and as our countries are making progress toward integration in the EU,
we shall be faced with the challenges of Basle II implementation. I'd like to point out three challenges
in particular.
Albania as many other East European Countries host a considerable number of foreign banks. These
consist mostly of branches or subsidiaries of banks from EU countries which eventually may have to
implement the new system including its most advanced elements if their head offices decide to adopt it
throughout the network for consistency and competitiveness reasons. Bearing in mind there is a high
degree of standardization in the risk management practices of a banking group - which is, same risk
management techniques being applied uniformly throughout the group - the host country banking
supervision might choose to rely entirely on the validation conducted by the home country supervision,
provided that the adequacy of the model fits local conditions. If this is not the case, the host country
supervision will probably have to rely on its own assessment of Internal Ratings Based (IRB) models.
However, the latter raises two other sensitive issues. First, the feasibility of IRB application is
complicated by the lack of reliable data on at least a full business cycle. Second, it requires training
and preparation of banking supervisors with new rules, and thereby to improve their ability to examine
and evaluate IRB approaches for consistency, integrity and accuracy in order to properly measure risk,
otherwise, the whole capital allocation system could become faulty. On the other hand, this new
environment calls for better cooperation and coordination across countries' banking supervision in
order to avoid over regulating banks and to save resources.
The second challenge relates to the need of developing our own domestic rating industry for
assessing borrowers. This is indispensable to gain the potential cost reduction of intermediation out of
the implementation of the new system. It will make possible for some borrowers to obtain better ratings
and consequently better risk weights compared to the actual 100% unrated system. However, this is
not an easy task by any mean. Rating agencies should satisfy several criteria in order to be eligible.
These criteria, as you might already be aware of comprise experience, freedom from external
influence, publicly available assessments, requirements to disclose assessment models and
approaches, sufficient resources and finally validation or recognition by supervisory authorities in our
countries.
Third but certainly not the least, the new system poses a challenge to all banks to improve their
capacities in order to comply with the new framework to successfully compete and survive. Banks
should start adopting a more dynamic and forward looking approach to the evaluation of risk and
provisions since under a risk sensitive approach there is always the risk of pro-cyclicality1, which
means bank capital ratios are likely to fluctuate more over the course of business cycles.
In spite of the above challenges, in Albania we have already started addressing some of these issues.
First, by making sure that we have consolidated the achievements of our supervisory
function by completing the requirements of Basel I. We are glad that the good progress has
been confirmed also by the FSAP assessment during their mission in February-March, this
year. Certain recommendations related with requirements about consolidated supervision,
will be followed very attentively;
Second, we have been pushing already our supervisory process and the banks, toward a
more risk oriented attitude. At the same time we intend to keep a higher minimum level of
capital adequacy ratio than the European standards, in order to provide for some cushion for
other forms of risk like operational risk;
Third, we try to gain as much as possible out of the experience and knowledge of other
countries in the region, which are in a more advanced stage in their efforts of adopting Basel
II requirements either partly or fully. We have also the privilege of being close to the euro
area member countries, like Italy and Greece, with their banks playing an important role in
our financial system. This gives us the possibility to benefit out of expertise of the
supervisory authorities of these countries, in the process of adopting new requirements;
Fourth, we have expanded our cooperation with other "peer" countries in the region, as the
variety of problems found in our countries is very similar and the experience sharing in this
respect, is very practical;
Fifth, we are trying to promote an environment where issues of Basel II are being discussed
in a professional level. We are not focusing only on directly involved parties (including
government, other supervisory authorities of the financial market) but also on relevant clients
of the banking and the financial sector.
Concluding, I would like to stress that Basel II represents a logical and appropriate successor to Basel
I. It embeds recent and past lessons and gives excellent directions to financial system and supervision
authorities how to move ahead. On the other hand, its implementation may be a bit too ambitious and
a difficult task for our countries. Therefore it is in our interest to find ways to make it more suitable to
our needs by following a gradual approach rather than jeopardising its success through an uninformed
adoption.