Jaime Caruana: Contemporary issues in credit risk
Keynote address by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel
Committee on Banking Supervision, to the Credit Risk Summit USA 2003, sponsored by Risk
Magazine, New York, 27 October 2003.
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Introduction
I would like to thank Risk Magazine for inviting me to participate in this summit on contemporary
issues in credit risk. Looking at the agenda, it is clear that, while credit may constitute the oldest risk in
banking, it remains the most important and is still one where we have much to learn.
There is a Latin proverb that says 'Danger can never be overcome without taking risks'. As a
supervisor, I would tend to rephrase that by saying that managing risks properly is the best way to
overcome danger. I think this idea is at the core of any modern, innovative and dynamic economy. The
next two days will no doubt offer a sense of the rich abundance of research under way to identify risks,
to improve our measures for them, and to find better ways to address them.
On this front, a risk manager and a bank supervisor share similar interests. A risk manager seeks the
best risk measures and management techniques to protect a bank against losses, to hone its
competitiveness, and to enhance its profitability and long-term growth. Supervisors advocate sound
risk management practices to ensure the adequate capitalisation and prudent management of all
banks. This, in turn, strengthens the financial sector's resilience during periods of distress. I am
convinced that when banking systems are adequately capitalised and well-managed, and risks are
correctly assessed within the appropriate time horizon, the financial system becomes more stable, less
procyclical, more resilient during periods of distress and therefore better able to promote sustainable
growth.
In the light of our mutual interests, I am especially pleased to share with you some thoughts on the
landmark efforts under way to revise the Basel Capital Accord. The Basel Committee embarked on
this undertaking to promote the responsible pursuit of risk and rewards across the banking sector and,
hence, to promote greater financial stability. This reform builds on trends in many countries to
incorporate incentives into the regulatory framework encouraging banks to identify and understand the
risks they face today, to consider what risks may arise tomorrow, and to respond actively and
appropriately to both.
As you know, this has not been an easy task for supervisors or for bankers. Yet we have achieved
considerable goals over the past four to five years, and I would like to begin with a brief look back to
recall why bankers and supervisors decided that a New Basel Accord was needed. Then, I'd like to
share with you the latest news on consultations with the industry and the Committee's most recent
decisions on the way forward to finalise, and then to implement, the new rules.
There is still much to be done: I'll discuss as examples our efforts to reduce the complexity of the
rules; to ensure that they are sufficiently risk-sensitive without being overly conservative; and to
maintain a level playing field. Finally, I'll conclude with thoughts on some longer-term and future efforts
that the Committee may undertake to continue to align the system of supervision with the best
practices of leading institutions and practitioners worldwide.
A Look Back
As we resolve the final questions and complete the text of the New Accord, it's important to remember
why all of us put our best into its success. The existing Accord was already considered a milestone
achievement in banking, as it offered the first internationally accepted "yardstick" for capital adequacy
and a simple measure of risk. It had received praise for reversing a downward trend in bank capital
levels and for serving as a benchmark measure of a bank's financial health around the world.
But the 1988 Accord was a blunt instrument that quickly fell behind the times. Innovations in
technology, in banking products, and in risk management techniques changed the way that leading
banks measure and manage their risks. By the mid-1990's, bankers and supervisors agreed that the
original Accord no longer provided a meaningful measure of risk for the largest and most sophisticated
organisations.
As a result, by the late 1990's the Basel Committee and leading institutions worldwide began
discussions on ways for supervision to incorporate more sophisticated and sensitive measures of the
risks that banks face. The initiative for these discussions can be attributed above all to William
McDonough, who was until recently the President of the Federal Reserve Bank of New York and my
immediate predecessor as chairman of the Committee. Bill brought intellectual leadership, demanding
standards, and tireless energy to a project whose size and implications became apparent only after
bankers and supervisors had taken a long, hard look at how much the art of risk management had
advanced in the short years since 1988.
Throughout the five years of work on the New Accord, Bill McDonough convinced leaders in the
industry, in central banks, and in supervisory agencies that merely updating the rules would be
unsatisfactory. Instead, Bill sought to advance the state of the art in risk management across the
industry and thereby promote greater stability in the global financial system. This would benefit not just
bankers, but also businesses and consumers in all walks of life.
It was truly a privilege to work with Bill on an initiative that would represent not just good banking
policy, but most importantly good public policy, more broadly defined. Bill has since moved on to new
challenges as head of the Public Company Accounting Oversight Board in Washington, but the U.S.
delegation to the Basel Committee remains in excellent hands. Now I have the privilege of working
with leaders like Roger Ferguson, the Vice Chairman of the Federal Reserve, and Jerry Hawke, the
U.S. Comptroller of the Currency. Their hard work, and the hard work of the other supervisors
participating in the discussions, have strengthened the quality of the capital rules. They and others
have helped to ensure that the New Accord will be flexible, forward-looking, and fit for the service of
twenty-first century banking.
The process of revising the rules has involved formidable challenges. That should come as no
surprise. Capital requirements make up the foundation of the regulatory framework. Even more
importantly, capital is a key ingredient to the health of the banking sector. The changes we are
proposing to ensure that banks hold adequate capital will have broad implications not just for the
banking sector, but also for financial markets and the broader economy.
But the new Basel Accord is about more than just capital, it is also about keeping a level playing field
and about reinforcing incentives to foster sound risk management though three reinforcing pillars: risk
sensitive minimum capital requirements, coordinated supervisory review, and enhanced market
discipline through greater transparency. Supervisors and risk managers know that a bank's
management and controls make up its first and most important line of defence. The New Basel Accord
seeks to capture the relationship between capital adequacy and risk management.
Recent Developments: Status of Consultations and the October Press Release
In that vein, I'd like to discuss the status of our discussions and especially the proposals for managing
credit risk. By now you've no doubt read that the Basel Committee agreed two weeks ago on a
breakthrough plan to address the final issues raised in public consultations and to complete the new
rules. This was a difficult task, as the Committee received over 200 comment letters from the industry
and the broader public on the Third Consultative Paper, or "CP3". While we might have been
somewhat surprised by the number of responses that we received, we were not surprised by the hard
work that was evident in the letters. In addition, we will have further valuable information from national
consultative processes such as that under way in the United States.
The comment letters were positive and offered constructive suggestions on a wide range of issues.
Indeed, even among the most critical of respondents, one finds support for the introduction of the
"three pillars" of the New Accord and its aim to align capital more closely to risk; for the development
of greater consistency in the supervisory review of capital adequacy; and for strengthening the
effectiveness of market discipline through enhanced 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.
The depth and quality of the responses demonstrate that many banks and industry associations
understand the far-reaching significance of the New Accord. I would like to offer the Committee's
sincere thanks to the many organisations and banking associations here in the United States, Canada,
and elsewhere that invested considerable time and resources in the consultations. You shared
important views through comment letters, gathered data for impact studies, and engaged in
discussions such as those that will be held here over the coming days. If you've been following our
work since the first consultative paper was released in 1999, you will know that the proposals have
evolved and improved considerably thanks to the industry's candour, its creativity, and its drive to
innovate.
At the Committee's meeting in Madrid earlier this month, all members acknowledged our responsibility
to consider carefully your concerns and those of the broader industry. What is most important to the
Committee is the quality and consistency of the new Accord. At the same time, we recognised the
need to provide banks with as much certainty as possible while they plan and prepare for the adoption
of the new rules. The members of the Committee agreed on the importance of finalising the New
Accord expeditiously and in a manner that is technically and prudentially sound. We noted in a
statement to the press that we expect to take account of the remaining issues and complete the text of
the New Accord in the coming months and no later than mid-2004. This period of time will also allow
us to take careful note of domestic consultations under way in some jurisdictions, including the
process for the Advance Notice of Proposed Rulemaking in the United States.
Most of the comment letters that the Committee received focused on credit risk and the minimum
standards in the first pillar. Respondents identified as one of the most important issues the proposed
treatment of credit-related losses. As you know, with respect to the internal ratings-based treatment of
credit losses, the CP3 calibrated regulatory capital on the basis of both unexpected and expected
credit losses - or "UL" and "EL" in Basel terminology. This was intended as a practical compromise to
account for differences in national accounting practices and supervisory authority regarding
provisioning.
Many respondents - including quite a few here in the U.S. - cautioned against this approach, as they
believed that it departed from the traditional view that unexpected losses should be absorbed by
capital, while expected losses are best managed through provisioning. Based on those comments,
and following additional research, the Committee now intends to align regulatory capital more closely
to economic capital by calibrating it on the basis of unexpected credit losses alone. A supplementary
mechanism will help to encourage banks to provide sufficiently for expected credit losses.
Details on our proposal can be found on the website of the Bank for International Settlements, and the
Committee has invited public comment on the approach through the end of this year. In
recommending this revision, the Committee seeks to ensure that risk management systems
distinguish between losses that can be anticipated versus those that cannot. Moreover, the new
framework would include explicit incentives for banks to address each kind of loss appropriately
ensuring strong incentives for banks to provision properly against expected losses.
Since the proposal would require only modest revisions to the text of CP3 and would not alter the
underlying system and data requirements for banks wishing to adopt an advanced approach to credit
risk, we expect that the revised treatment will conform closely to the work that banks have already
completed to prepare for implementation. The work plan to improve the framework discussed during
our last meeting identified several areas in addition to this important EL-UL issue. We think that this
work plan is perfectly compatible with the original time schedule to implement the New Accord by
yearend 2006.
Other issues ahead: complexity
Beyond the "EL/UL" issue, the Committee has put at the top of its work plan for the next few months
several other credit-risk related issues that emerged in consultations. Of these matters, I'd especially
like to highlight three, namely complexity, conservatism, and competition.
Certainly, the complexity of the proposals continues to draw the public's attention. It is no secret: the
New Accord offers a far more sophisticated view of risk than the far simpler 1988 Accord does. But
that is indeed the point. The Committee is adopting the best measures of credit and operational risk
being developed by leading institutions worldwide. Today's conference offers a good picture of just
how sophisticated - and sometimes complex - the measures of credit risk are becoming. Loan officers
and risk managers now have at their disposal a constantly evolving array of databases, software,
credit risk models, and risk rating systems, all of which provide supplemental empirical insight into a
risk previously not readily quantified. And all of these new tools were initially developed or refined to
promote a bank's competitiveness and protect it against loss - and not just to respond to a regulatory
mandate.
We seek a balance between complexity and risk-sensitivity, between complexity and the necessary
room for diversity and between complexity and comparability. Where complexity in the rules fails to
add much to the sensitivity of the New Accord's measures of risk, the Committee has worked to
remove it. In the past, this has included eliminating the so-called "W" factor for credit risk mitigation
and even shortening and simplifying the disclosure requirements of Pillar 3. Just two weeks ago, the
Committee announced in our Madrid press release that we will simplify the proposals for securitisation
exposures and replace the "Supervisory Formula" approach to unrated tranches with a simpler rule.
At the same time, the industry has asked the Committee not to sacrifice risk sensitivity where it makes
sense, even if it means that the rules may become somewhat complicated. Indeed, the complexity of
the New Accord stems partly from the options the industry requested to ensure that a blanket rule
would not unfairly disadvantage a particular business or exposure. You need only read a few of the
comment letters on our website to see that many of the latest suggestions would tend to increase the
complexity of the New Accord even further. Nonetheless, the Committee is aware that it is easier to
enforce a simpler rule than a complicated one. As we complete the text of the new rules, we will
continue to simplify and streamline the framework.
Conservatism
A second important theme addressed in comment letters suggested that the Committee may have
adopted an overly conservative approach to some aspects of the framework, resulting in much higher
capital charges than banks feel are necessary. Respondents attribute what they view as excessive
levels of conservatism to different sections of the New Accord, including, as I mentioned earlier, the
calibration of capital requirements to both EL and UL. We have heard similar concerns about
conservatism in the securitisation proposals, in the treatment of certain credit risk-related hedges, and
in the recognition of insurance products within the operational risk proposals.
Questions about conservatism are important, as we are trying to align capital more closely to risk. This
means that where the Accord treats exposures too harshly relative to their inherent risks, we expect to
reduce the capital requirements. A good example would be the treatment of retail exposures, where
the Committee found good economic evidence supporting a significantly lower requirement compared
to earlier drafts of the new rules. But where the risk is greater, and where the existing rules fail to
assign adequate capital, it should not be surprising that capital requirements are raised. We will
continue to evaluate the assumptions in the New Accord and their relative degrees of conservatism in
the final months ahead.
Competition and consistency of application
Conservatism in the framework raises concern in the industry partly because banks welcome the great
flexibility they will enjoy in other areas of the New Accord. A key example would be the ability to
develop their own risk measurement tools and use their own models to estimate the drivers of credit -
or operational - risk. Yet the great flexibility banks will enjoy raises the concern among some that too
much flexibility might allow competitors at home or abroad to employ methods subject to less rigorous
supervision. This brings us to the final theme we noted in our consultations, namely the need to
maintain a level playing field and promote competition.
Ensuring the consistent application of the New Accord in its entirety is a critical concern for the
Committee. The minimum standards were developed to help ensure that global competition in banking
markets will be driven by each bank's strengths, rather than by differences in each country's rules.
Moreover, Pillars Two and Three were largely created to promote a more level playing field for banks.
For example, incorporating supervisory review - or Pillar Two - into the international guidelines
represents a seminal achievement for all of us. By developing guidelines for supervisors' evaluation of
a bank's internal capital allocation process, the Committee believes that supervisors and banks will
engage in more focused, more consistent, and less burdensome discussions of the risks that banks
face and the responses they adopt. National laws and regulations provide different avenues through
which supervisors may conduct such reviews, and consequently Pillar 2 affords each jurisdiction the
flexibility to accommodate those differences.
To advocate more consistent standards, the Committee created the Accord Implementation Group, or
"AIG," precisely to share experiences and encourage shared approaches. This group, which is chaired
by Nick Le Pan, the Canadian Superintendent of Financial Institutions, has already been long at work
comparing notes on practical matters. We expect these discussions to help supervisors apply the New
Accord more consistently at home, thereby providing a more level playing field across countries as
well.
Based on the AIG's work to date, the Committee published a paper last August on the "high level
principles for the cross-border implementation of the New Accord." In this paper, we reiterate our view
that the traditional allocation of responsibilities to home and host supervisors will continue.
Cooperation will be critical for effective supervision under the New Accord, especially considering the
need for an internationally active bank to receive the approval to adopt, and then validate, advanced
approaches to credit and operational risk at home and in host jurisdictions. Similarly, supervisors will
need to find practical ways to cooperate in the evaluations of capital adequacy under pillar 2 and
ongoing reviews of compliance with the minimum operational requirements of the New Accord.
At the same time, Pillar 3 - market discipline - draws on the power of markets to help ensure that
banks do not hold unrealistically low amounts of capital for credit or operational risk. More generally,
by emphasising principles in the rules - that internal measurement tools must be credible, that they
must adequately capture risk, that they must be used by banks in the daily management of their
operations and not just for regulatory capital purposes - enhanced disclosure and transparency may
actually result in more consistency in the application of advanced approaches than detailed
quantitative criteria.
Future Work: Full Credit Risk Modelling
The Committee will spend the next few months considering these and other themes carefully and
finding ways to balance the complexity of the New Accord against the need for appropriate sensitivity
to risk; to ensure that the assumptions supporting the rules are appropriately conservative, but not
excessively so; and to apply the rules consistently to protect and promote competition in the global
banking market.
But when the ink dries on the New Accord, rest assured that the Basel Committee will not be
adjourning. Just from the comment letters we received, we can already identify a wide range of issues
ahead to continue to find new ways to advance risk management, to promote greater transparency,
and to strengthen the stability of the financial sector. I'd like to conclude by mentioning just two of the
potential items on our agenda for future work once the New Accord is implemented.
The first would be to consider the benefits of full credit risk models in the calculation of minimal capital
requirements. In theory, a bank's capital requirements would then reflect to the greatest degree the
economic benefits of diversification in its balance sheet. In fact, the Committee did at one point
evaluate whether advanced banks should be permitted to estimate the degree to which their assets
might behave similarly or default together in the New Basel Accord.
As you know, we decided that we are not quite there yet. 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 and the consequent difficulties third parties would
have to validate any estimates at this stage.
Likewise, we have not yet seen evidence that there is a critical mass of banks that today would
consistently meet the "use" test spelled out in the New Accord. For example, we are not certain
whether banks today consistently take into account in their valuations each asset's contribution to
diversification as part of their daily monitoring and risk management practices, or use diversification
estimates as part of their credit approval and review process.
Many members of the industry have accepted our decision as prudent for now. But you have also
stressed the need to develop a treatment for credit risk that is more consistent with the existing
treatment of market risk and the emerging practices for operational risk. That's why the work that so
many of you do is so important to the future of banking: by finding ways to capture and measure risk in
a manner that is increasingly comprehensive, accurate, and elegant in form, you are laying out a map
for us to consider as we all traverse the landscape of risk management. In the coming years, and we
can start very soon, we look forward to continuing this dialogue with banks, banking associations, and
researchers to find ways to move Basel in the direction of full credit risk models.
Consistency of Accounting Standards and the New Basel Accord
A second area, where work has started and will continue, is the need to align the regulatory framework
more closely with the converging standards in accounting worldwide. Many industry representatives
have noted quite correctly that 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. Likewise, the Basel Committee's treatment of provisions and the valuation of
financial instruments must keep pace with changes in the relevant accounting standards.
The members of the Committee believe that market discipline, and hence financial stability, is
strengthened when accounting and disclosure requirements reflect sound risk management principles
and are consistent with the control practices that banks adopt. Consequently, we recognise our
responsibility to participate actively in the development of national and international accounting
standards. Where the development of international standards is concerned, the Committee and its
member organisations devote considerable resources and staff time to sharing our perspectives as
supervisors with those who make the rules.
But the discussions between supervisors and accountants cannot be a one-way street. As supervisors
on the Basel Committee have developed standards for the disclosure of components of capital, for
loans, and for other topics of mutual concern, we have sought out the views of representatives of the
accounting profession. This dialogue will continue. I should add that we are currently seeking new
opportunities for discussion on issues of mutual concern with accounting standards-setting bodies and
private sector accounting professionals.
Conclusion
By the end of this conference, I think that we will all have a better sense of our many worthy
accomplishments to date in refining the measures and management of credit exposures. At the same
time, we will no doubt develop a better understanding of the significant work ahead - in terms of
developing more sensitive capital requirements, but also in terms of advancing our ability to control the
risks we face.
With regard to the New Accord itself, the issues and themes you will discuss at this conference
suggest that we've moved beyond a discussion of the principles behind the rules to a focus on
preparing for their implementation. This seems appropriate, since we expect that, given the very good
progress that we have noted in banks preparing to adopt the New Accord, supervisors and the
industry will be ready to implement the new rules by the end of 2006. Indeed, banks that wish to be
among the first to adopt an advanced approach to credit risk should already have begun to gather and
process the data that is key to the IRB approach.
Adopting a more risk-sensitive treatment of credit risk will require significant work by all of us. What we
learn about the factors driving losses from default, and how we can better measure and reduce our
exposure to losses, means much more to all of us than simply a more favourable capital requirement.
Instead, our efforts on credit risk, combined with advances on the operational and market risk fronts,
will advance our understanding of the many risks banks face and improve our ability to navigate them
successfully. For all of us, that offers the reward of a more stable banking system less susceptible to
systemic risks and the business cycle and one better able to ensure the circulation of credit, the
lifeblood of the economy, to businesses and consumers alike.