Shamshad Akhtar: Demystifying Basel II
Keynote address by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the FICCI-IBA
Conference on "Global Banking: Paradigm Shift", Mumbai, 26 September 2006.
* * *
After years of research supported by several theoretical and empirical studies including rounds of
country specific quantitative impact surveys and long drawn consultation with the industry, the Basle
Committee on Banking Supervision (BCBS) issued an elaborate framework of
International
Convergence of Capital Measurement and Capital Standards - A Revised Framework (called
Basel II Accord) in November 2005. Basel I served banking industry well since its introduction in 1988
but it lagged behind the financial market developments and innovation. It increasingly became
outdated and flawed as it relies on a relatively crude method of assigning risk weights to assets,
emphasized mostly balance sheet risks relative to multiple risks facing financial firms today.
Furthermore, it offered a regulatory approach to capital determination and standard setting which did
not capture fully the range of large and complex banking operations and the accompanying range of
diverse set of economic risks.
Addressing the perceived shortcomings and structural weaknesses of Basel I, the Basel II Accord - a
landmark regulatory framework - offers a newer and comprehensive approach and methodology for
financial sector regulatory capital calculation which recognizes well the advancements and innovations
in banks' businesses, policies and structures and the accompanying financial engineering and
innovation.
The relevance and significance of Basel II stems from its ability to recognize effectively the different
types of risks facing industry and the new products as well as off balance sheet transactions. Some
distinct characteristics of Basel II are noteworthy:
•
aligns capital of banks with their basic risk profiles,
•
it is elaborate and far superior in terms of its coverage and details,
•
it has the ability to exploit effectively new frontiers of risk management and gives impetus to
the development of sound risk-management systems, which in turn are expected to promote
efficiency and more prudent allocation of resources,
•
It is perceived to be the harbinger of the future disposition of bank supervision and the
evolutionary path on which the banking industry would tread, and
Finally, it is designed to promote financial stability by making the risk-management systems more
robust and responsive to tackle the complexities arising out of a host of new risks. Given its
complexities, Basel II has been subject of intense debate. The industry has been gripped with
complexities of different dimensions of risk and capital calculation methods, data requirements, and
costs related to upgrading IT systems and business processes. Meanwhile, regulators are forewarned
to facilitate a proper and sequenced adoption of Basle II, while ensuring effective alignment of risk
weights and capital requirements in line with Basel II Accord. The debate has brought to forefront
some issues and inconsistencies which unless addressed would adversely impact the incentive
framework. The final draft of the Basel II incorporated several of industry concerns.
The paper aims to highlight the importance and challenges of introduction of Basel II. Basel II in itself
has the ability to meaningfully capture and suggest probable solutions for virtually all dimensions and
segments of banking risks. Diversity of approaches and methodology has brought with it criticism and
challenges since it may encourage and incentivize some intended and unintended behaviors and
practices, while adding to the cost of doing business. The challenges, however, bring new
opportunities for global banking systems to adopt more robust risk management approaches which
should serve industry well for capital leveraging and taking higher but still manageable risks.
Basel II - superior and all-encompassing architecture
It is widely recognized that Basel II is a major breakthrough in theoretical and practical world of
banking industry and a dynamic framework which will be able to adapt to ongoing innovation and
change. Some of the main features (see annexure) of Basel II are noteworthy:
First, while the new Accord maintains the level of capital adequacy requirements at 8% (Tier 2
capital is restricted to 100% of Tier 1 capital) consistent with Basel I, it has shifted emphasis
from regulatory to economic capital framework, while giving recognition to new risk mitigation
techniques (default protection etc.) and clarifying new trading book capital questions. Careful
evaluation of these elements suggests that Basel II is not ideologically about raising as per se capital
requirement but focuses on efficient and effective capital allocation. Appropriate and sharpened risk
articulation and assessment and safeguards would result in reduced capital requirements. Conversely,
ill-conceived financial structures with risky counterparties will attract punitive capital requirements.
Basel II in some senses "serves as a more intelligent solvency capital redeployment."
Second, the new Accord has depth and breadth in its architecture and it blends and integrates
well, with an element of mathematical rigor, all key prudential and supervision norms, however
the rules based approach allows substantive national discretion which has its pros and cons.
Basel II at the very basic level consists of the Standardized Approach (SA) which recognizes and
defines various asset buckets and assigns them risk weights in accordance with the type and nature of
corporate issue and other transactions and delegating its qualitative assessment to external raters.
The matrix of risk buckets and weights is considered to have added excessive complexity for less
sophisticated banks. The linkage and delegation of quality assessment to external ratings, while
understandable, lends excessive confidence on the objectivity and soundness of rating agencies
which, in at least developing countries has only thus far rated a small proportion of corporates and
issues.
Notwithstanding, the Pillar 1 offers a choice to resort to either a Standardized Approach (SA) which
has pre-specified weights or to turn to Internal Rating Based (IRB) approach which involves a
foundation and advanced IRB option. These approaches are differentiated on the basis of (i) the
available in-house risk assessment expertise, (ii) the size and product mix of the bank, and (iii) overall
financial sophistication. There is considerable national discretion for regulators to decide, within the
parameters defined under Basel II, on risk weights for different types of finances, treatment of
collateral and risk mitigation, etc.
The core pillar is bedecked by two other pillars; and all three pillars are interlinked and intertwined and
mutually reinforce each other. Pillar 2 (Supervisory Review) underscores need for strengthening the
financial institutions' internal capital assessment processes to capture risks which remained uncovered
under Pillar 1 and thus set aside capital in line with the banks' risk profile and control environment. The
supervisory review process validates the bank's internal assessments by ensuring that the whole array
of risks has been taken care of. Pillar 3 (Market Discipline) complements the other two pillars by
requiring disclosures and transparency in financial reporting to promote market discipline.
Third, the Accord encourages banks to recognize all types of risk and take appropriate steps to
mitigate these risks, while providing for adequate capital. Besides the credit risk, the Accord for
the first time recognizes the operational risk, however, the degree of guidance and complexity in
measurement provided within the framework for these risks varies. The Credit Risk (the risk of default
by the counterparty) is dealt with most comprehensively in the Basel II in line with legacy of the first
Accord as well as the banks traditional edge and competence in credit risk assessments.
The inclusion of Operational Risk, a fundamental improvement over Basel I, captures risks
associated with bank's internal control processes and systems and corporate governance policies and
practices. Operational risk calculation explicitly requires capital for "the risk of loss resulting from
inadequate or failed internal processes, people and systems or from external events"
risk. This
definition includes legal risk, but excludes strategic and reputational risk. Three approaches underlie
measurement of capital against operational risk:
(i) Basic Indicator Approach (BIA) - capital for operational risk should be equal to the average
over the previous three years of a fixed percentage (denoted alpha=15%) of positive annual
gross income,
(ii) Standardized Approach capital charge for each business line is calculated by multiplying
gross income by a factor (denoted beta) assigned to that business line. Beta (ranging
between 12-18%) serves as a proxy for the industry-wide relationship between the
operational risk loss experience for a given business line and the aggregate level of gross
income for that business line; and
(iii) Advanced Measurement Approach - the regulatory capital requirement will equal the risk
measure generated by the bank's internal operational risk measurement system using the
quantitative and qualitative criteria for the AMA.
Overall the approaches for operational risk assessment are not as nuanced as for credit risk, however
the AMA approach does allow for more fine tuning. Once again the banks with better risk assessment
would opt for the advance approaches.
Market Discipline pillar underscores need for transparency and disclosure of data and technicalities.
The evaluation of banks' risks and its systems and capital adequacy by the market will help ensure
integrity and validation of other pillars. For this pillar to work, it needs to be supported by proper
accounting rules and more elaborate disclosure of bank's strategies and approaches adopted, risk
profile and capital strategy through economic and credit cycle, information of the stress tests, and
PD/LGD data.
Fourth, within the pillars, the Accord offers a range of options and incentivizes banks to move
from vanilla SA which assigns high risk weights and capital standards to adopting IRB and
within it further having the option to choose either the Foundation versus Advanced IRB. These
options have clear trade offs but most importantly, IRB offers greater capital relief relative to SA.
Nevertheless, IRB systems will only be feasible if they are supported by databases and history on
credit losses, rating models and risk management systems etc. and their soundness and integrity has
been validated by supervisors.
Banks operating in less developed countries, having limited in-house expertise, and small to medium
size are in general opting for SA. The advantage of SA is its relative ease of implementation by even
small and mid-sized banks. The main problem, however, is that it would usually result in much higher
capital requirements as compared to IRB. There is much less fine tuning of the risk weights, and
banks have to rely on external rating agencies. The banks adopting this approach would thus be at a
disadvantage against their competitors. Jurisdictions that will stick to the SA for too long may find that
their domestic banks are losing ground to the foreign banks operating globally who are more likely to
adopt IRB.
Fifth, the IRB approach is being preferred by large global banks, which already competitively
price credit risk. The key parameters under IRB approach are PD (probability of Default), LGD (loss
given default), M (Maturity) and EAD (Exposure At default). Under the FIRB, the banks calculate PD of
their portfolio, while the other parameters i.e. LGD and EAD are prescribed by the regulator. Minimum
PD is 0.03% for banks and corporates; no floor has been prescribed for sovereigns. The LGD for
senior exposure is 45% and the subordinated exposure attracts a lower recovery of 75%. These rates
should be re-examined by the regulators taking into account the ground realities of their respective
jurisdictions.1
The Advanced IRB provides discretion to banks, and as such there is an incentive to move too quickly
to AIRB without adequate preparation. The balancing act has to be performed by the regulator, on one
hand it has to promote the efficiency of banking capital and pursue more fine tuned risk assessment,
and on the other it has to ensure that banks have sufficient resources and expertise to undertake this
complex task. The AIRB approach has very high sensitivity to the changes in LGD and M given
the differences in PDs. In a paper by ING Bank2, it is shown that at higher LGD levels e.g. 75% there
is a particularly strong impact on the risk weights of bonds of lower rated issuers. On a similar note the
variations in maturity M, have greater impact on low rated borrowers as compared to high rated
borrowers. It implies that in case of a BBB- rated borrower, the risk weights will be highest for
subordinated loans (LGD 75%) having long maturity (e.g. 5 years). At the same time for short term
secured loans (i.e. with low LGD) the difference in risk weights will not vary a great deal with the
quality of borrowers. The use of AIRB would thus produce winners and losers in the banking sector.
The low rated borrowers and users of long term funds would face much higher costs of funds, whereas
public sector and other high quality borrowers would gain. Regulators have to ensure that instead
of marginalizing the low rated borrowers any further, policies are in place to enhance the
overall credit profile of the business sector in the country.
The choice of the approach will also impact sovereign borrowers. Some countries like Hong Kong
and China will gain, because the risk weights associated with their sovereign loans will be lower,
whereas Turkey and Indonesia will face higher risk weights. According to ING report, the risk weights
of OECD and Non-OECD countries would vary depending on the approach applied by the banks. The
table below will give some RW of selected countries:
The Accord clearly discourages certain exposures as banks earn more pejorative capital treatment for
equity style risks which were under-capitalized in Basel I. An ING study has observed that a number of
European banking groups have unwound their industrial and non-strategic financial equity holdings as
a part of preparation for Basel II.
Given the objectives and scope of Basel II and its architecture, the Mckinsey study (2004) highlights
that there is a as the accord could impact profits and generate gains
"Business Case for Basel II"3
from reduced capital charges which of course need to be netted from funding costs. For some banks,
given the risk sensitive nature of Basel II, the regulatory capital could be substantially reduced by up to
50 percent in segments such as residential mortgages, which would translate in to savings on funding
costs. However, such savings would be subject to conditions: such as requirement that regulatory
capital should be higher than economic capital4 and presence of regulations such as leverage ratios
which may prevent banks from reducing their regulatory capital significantly.
The McKinsey's research identifies four important Basel II-related risk-management efficiencies which
could together raise pretax earnings by 3 to 6 percent. These include:
(i) Reduced charge-offs through better default-prediction and collection processes
(ii) Improved pricing discipline on loans and risk selection through risk-based pricing to and
reduced risk from new business opportunities.
(iii) Reduced operating expenses by streamlining loans and underwriting processes
(iv) Reduced operational loss expenses through the use of proper mitigation techniques.
Substantial savings can also be achieved through freeing up of regulatory capital, depending on the
risk characteristics of loan portfolio. For example, a bank carrying substantial mortgage loan portfolio
would free up regulatory capital when it moves to Basel II. In case of operational risk, for big banks
that must adhere to Basel II, moving to a proposed advanced measurement standard might generate
savings from 20 to 25 percent of the capital requirements for operational risk if regulatory capital
exceeds economic capital.
Realizing these savings, however, would require substantial investment. For large, diversified global
banks, the cost of implementation is estimated at $100 million but can be as high as $250 million, and
the process could well take up to three years. For diversified regional banks, the cost is estimated at
$25 million to $50 million.5 It is important to remember that many banks would incur much of this cost
even without Basel II, since they must upgrade their risk-management capabilities to keep pace with
changing markets and remain competitive.
Basel II implementation - opportunities and challenges
Globally there is a deep interest in Basel II. World wide there is a strong commitment for it but the
pace of implementation would vary from economy to economy and bank to bank. Presently, on one
hand there are differences in economy and institutions' risk management processes, state of tech
know how, customers portfolio, and on the other hand, the state of development of rating agencies,
external auditors, and above all, regulators varies across economies. By virtue of their better
infrastructure, resources, and size of operations, the large internationally active banks particularly in
Australia, Japan, Singapore, Hong Kong and Korea are expected to adapt to the new regime in
relatively shorter span of time. Meanwhile, economies with less sophisticated, small and fragmented
financial structure would be implementing Basel II gradually and remain confined to adoption of SA.
Notwithstanding, in next few years, Basel II will drive and shape the bank's business strategies,
policies and structure, its risk measurement and capital calculation methods, its internal controls and
processes, data requirements, and IT systems. Although the ultimate aim is to achieve the intended
benefits by way of enhanced risk management and lower capital requirements, the actual Basel II
implementation is turning out to be complex and challenging involving substantial funds outlay for
changes in IT, internal controls and processes and human resources. These challenges offer
opportunities to the banks as well, to strengthen and transform themselves to better compete both
within and outside domestic markets.
Banking industry worldwide today faces several issues and challenges which unless effectively
addressed would impact the pace of adoption and implementation of Basel II. These include
1) Good and Reliable Data and Information
2) Development of sound risk-management system
3) Asymmetry in supervision
4) Imperfect Markets
5) Pro-cyclicality
6) Access to finance for disadvantaged
7) Operational costs
8) Cross-border challenges.
9) Challenges for the corporate Sector
10) Cost and volume of capital
11) Relevance of Basel II assumptions in the Asian context
12) The Problem of Adverse Selection
Good and reliable data and information is critical to proper risk assessment. In absence of this,
Asia's banks by and large are initially adopting SA for measuring their credit risk. Under SA, the role of
the External Credit Assessment Institutions (ECAIs) and external auditors magnifies but coverage and
penetration of both is limited. In the absence of reliable ratings for different assets, banking industry
will not be able to fully exploit the flexibility of Basel II and most credit risks will tend to end up in the
unrated 100% category and as a result there will be little change in capital requirements relative to
Basel I. Furthermore, the erratic behavior of loss data due to frequent volatility of economic cycles
would deter the proper assessment of risks under IRB and hence the actual capital allocated might not
be truly reflective of economic capital. In view of these, national regulators are striving to encourage
both further development of national rating and scoring mechanism and encouraging banks planning
to adopt IRB to collate reliable and longer trail of data on its basic inputs. The application of more
advanced approaches also depends on business continuity planning and sophistication of the IT
resources among banks as well as regulators.
Development of sound risk-management systems
The foremost challenge facing the banks in implementation of Basel II is to develop well-functioning,
efficient and integrated risk-management systems. While the treatment of market risk remains the
same under Basel II, banks need to strengthen their risk-management systems to properly define and
assess credit and operational risks and to recognize the inherent interdependence of such risk. To
capture credit risk under IRB, banks will have to generate exposure data and calibrate it properly to
differentiate between borrowers' default risks - a complex task in developing countries given the level
of industry expertise, lack of historical data and absence of adequate technology. Most challenging is
estimation of operational risks since most banks do not have required systems and technology to
calculate operational risk or determination of capital standards. By increasing the sophistication of the
operational risk assessment and management processes, banks can save on capital charge for
operational risk. To strengthen risk-management systems, banks and supervisors invariably require
capacity building both in terms of human and technology resources to enable them to properly assess
the risk-profile and associated capital requirements. Supervisors and banks will have to achieve
synergies in their operations to meet the high demands of Pillar II.
Asymmetry in supervision
When different market participants are regulated by separate supervisors, it is difficult to maintain
comparable quality of policy formulation and vigilance. The asymmetry of regulatory regime can arise
within one country e.g. between banks and securities firms, as well as on cross-border level. The
Basel Accord provides an opportunity for developing common standards; yet it requires a much closer
cooperation, information sharing and coordination of policies. In many developing countries, only the
banks are coming under the ambit of Basel II and not other financial services providers, thus creating
some scope of regulatory arbitrage.6 The presence of a large number of internationally active banks in
the region requires close cooperation among supervisors across the globe to resolve the home-host
issues. It would become all the more important for the jurisdictions where the approaches for Basel II
would differ.
Imperfect markets
The functioning of risk assessments system of banks is affected by distortions in markets namely
dominance of large players, high asymmetry of information, and lack of market depth. The price
manipulation by significant market players can distort the true market value of securities' portfolio. To
make any meaningful assessment of market risk and encourage market discipline, the imperfections
have to be removed from the financial markets. The regulator should have the capability to assess the
price risk, and identify situations in which market values of portfolios have been over/ under stated by
the regulated institution through price manipulation.
Pro-cyclicality
One of the initial criticisms on the Basel II Accord was related to pro-cyclicality. The new accord could
generate more pronounced business cycles in an economy particularly in recessionary period when
the borrower's credit risk increases, as measured by IRB, and the banks will curtail lending, while in
boom time they will expand lending. However, under the new accord the deterioration of a portfolio
should begin to be reflected in the bank's capital adequacy ratio at a much earlier stage, and no
further deterioration should occur in the capital adequacy ratio at the moment it is recognized as an
accounting loss.7 Pro-cyclicality can be addressed by several ways. For example supervisors have
discretionary powers under Pillar 2 to demand additional capital during a business cycle expansion or
banks can adjust the value of probability of default (PD) in IRB system based on the historical trend in
business cycle. However, the adjusting of the IRB parameters has to be consistent and transparent.
Access to finance for the disadvantaged
Keeping in view that the new accord would require banks to hold higher capital allocation for assuming
higher credit risk, there is a concern that small businesses and poor segments of the society would
receive no or very costly credit. Even under the old framework, the problem of access to finance for
low income segments is quite significant for developing countries. Given the wider prevalence of
poverty, particularly in the South Asian region, the governments' efforts to combat poverty might
receive serious blow and hence cannot be addressed in isolation. However policies should be made to
bring more segments in the ambit of financial services, without seriously compromising the banks' risk
profile.
Operational costs
The installation of risk assessment systems would obviously carry massive initial costs. Some of these
costs would be explicit e.g. cost of IT systems, hiring of new staff, trainings etc. There will be,
however, several implicit costs e.g. adjustments in historical processes, and frequent adjustments of
the new systems in the beginning of the learning curve. Moreover, compliance failures can result in
incurrence of legal costs. In order to contain the costs of implementations for the banking sector, the
banks should aim to8 (i) devise simpler work flows to keep processes easy to understand, (ii) have
frequent proactive interaction with the regulator to ensure that compliance systems are developed
correctly the first time, (iii) ensure that legal department works closely with compliance and risk
management, and (iv) create swift corrective procedures for any compliance failures.
Cross-border challenges
The challenges discussed above become more pronounced in a cross-border environment. One of the
main benefits of Basel II is to provide a common language to banks and regulators to communicate
about risks embedded in an entity or transaction globally. However the difference in readiness across
countries would make this quite difficult to achieve. The differences in preparedness of banks would
hinder information sharing across sectors and across borders. Moreover, this may also create
restriction in credit flow from banks of developed countries into the emerging economies, because
these banks may be discouraged due to high capital allocation for such investment. The most basic
step is to ensure that whatever is the stage of development vis-à-vis the Basel II implementation, at
least adequate information disclosure rules (Pillar III) are in place. This would help in building the
confidence level of foreign donors and banks.
Challenges for the corporate sector
Since the risk-sensitivity is at the core of Basel II, the flow and cost of credit to firms is going to vary
depending upon their respective risk-profile. Those with high risk and low credit worthiness are going
to be loser whereas the other with low risk and high credit worthiness shall derive benefit, as banks
would have to allocate their capital accordingly.
This impact can be deduced from the emerging, peculiar clientele structures for the banks adopting SA
and those going for the IRB. The IRB bank would find little attraction in lending to low rated borrowers
because they would have to incur a capital charge which would be higher than 8%, while SA banks
might be indifferent regarding their lending to such borrowers because they anyhow would have to
incur the capital charge of 8%. By the same token, IRB banks will be forced to attract high rated
borrowers through more favorable pricing of products whereas the SA bank would not be able to
compete with the IRB bank on price to capture those high rated customers. Consequently, high rated
customers would tend to converge into IRB banks and the low rated customers with the SA banks.
This not only holds serious connotation for small, local banks of the developing economies because of
the higher risk of default and possible deterioration in their asset quality but also for the non-financial
firms on low rated spectrum as they might witness serious constraints in their access to credit at fair
terms.
Cost and volume of capital
Some studies have pointed out that Basel II would impact cross-border capital flows to developing
countries, particularly reducing access and raising the cost of commercial loans from developed
markets. This is largely because developing countries carry low sovereign ratings which attract higher
capital charge. Yet another possible implication is that international banks might find reduced incentive
to expand their operations into these countries, thus further exacerbating their problem of low capital.
However, the situation might favor those countries of the region, which are enjoying superior sovereign
ratings by virtue of their economic and financial strength. Under the SA, countries like China,
Singapore, Taiwan, Malaysia, etc. are going to benefit, as they will attract less than an 8% charge9.
Relevance of Basel II assumptions in the Asian context
The risk weights/ implied correlations for different exposures under standardized or IRB approaches
are based upon certain assumptions which may not be applicable in the Asian context. For example,
35% risk weight for mortgage lending is based upon PD estimates and LGD of rather developed
European/US markets and may not be adequate as the losses in secured real estate lending in
countries like Japan, Korea, Taiwan, Thailand and Indonesia have at times exceeded 35%.10
Therefore it highlights the need for the supervisors in Asia to assess whether these assumptions are
equally applicable to their jurisdictions as well or not.
The problem of adverse selection
Under IRB, high quality corporate lending attracts a lower capital charge, while low quality borrowers
require a higher charge than the 8% charge under Basel I. Under IRB therefore banks would prefer
high quality over low quality borrowers, while under SA banks will have relatively greater incentive to
lend to lower quality borrowers, particularly those that are not externally rated, given that these will
continue to attract an 8% capital charge irrespective of the underlying risk. The possibility that high risk
borrowers will migrate to banks following SA is a concern for Asia given the risk it poses for less
sophisticated banks.
Conclusion
Basel II is recognized to have "revolutionized" the risk assessment, management and mitigation
systems and offered financial industry innovative and sophisticated approaches to weighing these
risks. Concurrently, Basel II has catalyzed new supervisory approaches which have encouraged
regulators to start thinking of aligning their national regulations along the Basel II Accord. Most
countries have now defined a road map and timetable for adoption of Basel II by industry and to
position themselves to conduct the required due diligence for supervision of more advanced
approaches to regulatory framework. However, the progress on Basel II implementation varies among
the regions reflecting mainly differences in their financial and technological readiness. The speed of
adoption could be explained by a succinct analogy that one can travel a certain distance by taking the
high-speed autobahn while in Europe, however, the same distance would require a lot more time in
developing countries context given the quality of the roads.