Jaime Caruana: The practical implementation of Basel II - current challenges
and the way forward
Speech by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, at the "Basel II & Banking Regulation Forum" organised by GARP (Global
Association of Risk Professionals), Barcelona, 16 May 2006.
* * *
Introduction and overview
It is an honour to be invited to join you for what looks to be a very timely and interesting conference,
and it is also my great pleasure to welcome you to Spain.
I hope that you will have the opportunity to explore the great city of Barcelona during your time here. It
is one of the most innovative cities in the world for art, architecture, cuisine, and even...football.
You may be aware that Barcelona underwent a major transformation when it hosted the Summer
Olympics in 1992. What you may not know is that the history of Barcelona is filled with similar
transformations. It is a city that risk professionals should be able to appreciate, as it has not only
survived countless "tail events" over the years, but has managed to thrive and continually reinvent
itself in response. With that in mind, I would like to talk today about how supervisors and the industry
have been responding to risk and positioning ourselves to continue to grow and evolve.
My talk today is likely to be one of my last public addresses as Chairman of the Basel Committee.
Therefore, while the focus of my comments will be on the current situation and looking forward to the
future, I hope you will allow me also to reflect on some of the things I have learned over the past
years.
In the first part of my intervention today, I will discuss the current state of the new framework for bank
capital adequacy, or Basel II, as well as how supervisors are carrying out work related to Basel II and
sound risk management practices.
Second, I would like to discuss some of the key lessons that I've learned in the development of Basel
II, which are factors that I believe will contribute not only to its successful implementation and
longevity, but also more generally to financial stability and effective banking supervision.
And I will close with some more detailed comments on a lesson we have learned during this process
that I think has broader implications for risk management in general - that is, the importance of taking
account of the macroeconomic perspective and the effects of the cycle.
Basel II update
One of Barcelona's greatest claims to fame is its modernista architecture, exemplified by the work of
Antoni Gaudí. The modernistas looked to the past for inspiration, but applied modern tools and
techniques to create something new with a focus on intricate details. Of course, the Basel II
Framework does not have the beauty of Gaudí's Sagrada Família, but I nevertheless think that both
supervisors and the industry have accomplished something similar. Basel II builds on long-standing
principles of bank safety and soundness, but with greater emphasis on modern tools of financial risk
management and differentiation of drivers of risk. And, like the Sagrada Família, the framework for
Basel II is firmly in place but much work still remains until the plans are finally executed.
As I'm sure you're aware, with the publication of documents on trading book/double-default and
downturn LGDs last year, the Basel Committee has completed its work on Basel II policy
development. Our efforts are now firmly focused on the challenging task of implementing the
Framework as efficiently and effectively as possible. With that in mind, I would like to now touch on
some issues relating to the calibration and implementation of Basel II, as well as work in both the
Committee and the industry on complex financial products and risk management
Calibration
One of the Committee's objectives throughout the development of Basel II has been to maintain the
overall level of capital in the banking system. To meet this objective, the Committee introduced a
socalled "scaling factor" of 1.06 into the Framework, with the agreement that this would be reviewed prior
to final implementation.
The Committee has just completed its fifth Quantitative Impact Study, or QIS 5, and I would like to
express my gratitude to those of you here today whose banks submitted data as part of this exercise.
The Basel Committee will be meeting in Berlin next week, and one of the main items on our agenda
will be to discuss the results. We hope to be able to say more about calibration shortly thereafter.
What I can say at this moment is that I have not seen anything that would call into question the
framework, or which cannot be addressed through implementation. . We are carefully reviewing any
dispersion of results to better understand the underlying reasons. Some dispersion is to be expected
within a risk-based system, but it is important that material dispersions are driven by actual differences
in risk. In addition, while there is still a need for better data quality in the future, it appears that the
quality of data submitted in QIS 5 was greatly improved over the data submitted in the previous QIS
exercises. This is certainly a positive development, and I hope banks continue to make strides in this
area.
What is important to keep in mind about QIS 5 is that it represents a point-in-time view. We know that
models and validations processes are still under development, just as banks are working to take into
account the recent updates to the trading book regime and the guidance on incorporating economic
downturn effects in LGD estimates. We cannot know the true impact of Basel II until it has actually
been implemented, which is why we have built safeguards such as transitional floors into the
Framework. That is one reason the Committee is placing so much importance on an effective Basel II
implementation process, which brings me to my next point.
Implementation issues
From the outset, one of the key objectives of both Basel II and, indeed, the current Accord, has been
to maintain a level playing field across jurisdictions. Since experience has shown that this was difficult
to achieve even under the fairly rigid Basel I rules, the challenge will be even greater in the more
flexible Basel II regime. One of the key lessons we have learned in this whole process is that having
similar national rules, which are based on common international agreements, does not of itself create
a level playing field.
What is essential is how the rules will be applied. The success of Basel II will depend to a large extent
on our ability to achieve greater convergence in our supervisory practices in implementing these rules.
This will require a much higher level of cooperation among supervisors than hitherto. Home country
and host country supervisors will need to work closely with each other and with banks to provide
effective supervision while minimising burden and duplication of effort. Although changes in financial
markets mean that these efforts would in any case be necessary, Basel II has raised the stakes.
To promote convergence, the Committee has established an Accord Implementation Group, or AIG,
which is chaired by Nick Le Pan, Superintendent of Financial Institutions in Canada and
ViceChairman of the Basel Committee.
When the AIG began its work, it quickly became clear that there was no "one-size-fits-all" approach to
implementing Basel II. Rather, implementation should be tailored to the specific circumstances of a
bank and the jurisdictions it operates in. In this regard, one of the primary methods the AIG uses to
promote convergence is to encourage home supervisors of the 50 or 60 largest internationally active
banks in Basel Committee member countries to engage in practical outreach to host supervisors and
the banks to open clear lines of communication and cooperation in based on banks' own
implementation plans. Each home supervisor coordinates the work in a way that is most practical in
light of the particular bank circumstances and its own supervisory approach. It is clear that successful
implementation rests on adequate flows of information, as well as trust among supervisors.
As we go forward, we need to strike an appropriate balance between top-down and bottom-up
consistency. That is, the top-down rules and the bottom-up convergence of supervisory practices
should work together to reinforce a level playing field. This balance will naturally be dynamic. Early on,
the scales were tipped toward developing a common set of rules. Now that these rules are in place,
the scale is tipping the other way toward enhancing communication and convergence among
supervisors in the implementation of these rules. I expect that this dynamic process will accelerate
through work within the AIG, with supervisors outside of the Committee, and by banks in the months
and years ahead.
Risk management and complex products
Our response to changes in risks must also be dynamic, and it is to this aspect that I would like to turn
now. In recent years, we have seen tremendous growth in the derivative markets, which include a
range of quite complex products. In addition, these markets have attracted new participants, in
particular hedge funds, whose risk profiles and exposures may not be transparent to regulators or to
other market participants. While these developments have had the beneficial effect of diversifying and
spreading credit risk, they have also posed new risks. I would like to briefly discuss steps that both
supervisors and the industry are taking to promote better management of these risks, and to ensure
that supervision keeps track with market developments.
Supervisory efforts
One important area where we are working within the Basel Committee to promote sound risk
management practices is through a review and, if necessary, update of the Committee's 1999 paper
on sound practices for banks' interactions with highly leveraged institutions. As part of this review, we
are looking at emerging best practices related to banks' interactions with credit derivatives markets
and hedge funds. In addition, we have had informal discussions regarding the potential impact on
bank safety and soundness of prime brokerage activities.
We are also looking into how to better capture risks associated with banks' trading book positions in
credit derivatives and highly structured and complex products. The AIG has established a working
group that is following up on the Committee's July 2005 trading book guidance. This working group, in
consultation with the industry, is in the process of identifying possible principles for the implementation
of so-called incremental default risk charge for trading book capital, and will be exploring other issues
related to the measurement and modelling of risk in the trading book.
And work is also going on outside the auspices of the Basel Committee. Many of you are probably
aware that the Federal Reserve Bank of New York and the UK Financial Services Authority, in
conjunction with other supervisors of major credit derivative dealers, have encouraged the industry to
focus greater attention on sound risk management practices and the infrastructure of the credit
derivatives markets by improving controls around assignments, reducing confirmation backlogs and
increasing the use of electronic matching platforms. Other supervisors are reviewing bank stress
testing practices and potential risks arising from banks' private equity activities and exposures to
hedge funds. The Basel Committee supports these efforts, and members will continue to keep each
other informed on the results of their reviews.
Private sector initiatives
The public good of financial stability is not just of interest to supervisors and public authorities, but also
to the financial sector. The industry has therefore undertaken a number of valuable initiatives aimed at
responding to financial risks in the marketplace. One key example is the Report of the Counterparty
Risk Management Policy Group II, better known as the "Corrigan report."
There is no question that the global financial system has become more interlinked, which, when
combined with the introduction of new and complex products, raises the question of how well market
participants could absorb a potential major financial shock in the future. In response, a group of the
largest players in the global financial markets developed a series of recommendations and guiding
principles to strengthen the resiliency of the financial system.
Given the complexity of the subject, it is not surprising that the Corrigan report is a long and complex
document. We found the same challenge in developing Basel II, I might add. But I think that this is a
very valuable piece of work, and that the supervisory community can very much welcome its
recommendations and guiding principles. We are certainly taking it into account in our work on the
issues that I have mentioned.
In reflecting on the various strands of work that are underway in both the industry and in the
supervisory community, I am encouraged by the fact that many of the findings of industry projects
such as the Corrigan report are consistent with the lessons we have learned from the Basel II process
and from other strands of the Committee's work.
Lessons learned
That brings me to my second broad topic, which is the lessons we have learned over the years as we
have developed Basel II. I am not looking back simply for the sake of nostalgia. Rather, in looking to
the past, I would like to share some thoughts on how the things we have learned and reflected in the
process of developing Basel II will help to make Basel II successful in the future, to stand the test of
time and to have the impact that we intended.
Focus on risk management
First, Basel II is fundamentally about establishing incentive-based approaches to risk and capital within
the three-pillar framework. We should never lose sight of the fact that Basel II is built around both
qualitative and quantitative risk management elements.
Why is this so important? As a bank supervisor and central banker, what most concerns me is
financial stability. When I review the various reports on this subject that cross my desk, one thing they
almost always have in common is an emphasis on the link between sound risk management and
financial stability. It is my hope-indeed, it is my belief-that the incentives for risk management in
Basel II will therefore promote greater financial stability in the future.
Improved and more formalised risk management, as fostered by Basel II, will bring more awareness of
risks and better quantification of these risks. To the extent that risk assessment and control methods
become more formalised and rigorous, this will lessen the likelihood of making bad decisions. It will
also contribute to the prompt detection of errors and deviations from targets, allowing banks to
implement corrective measures and develop buffers as appropriate at an early stage. Banks should be
encouraged to develop systems that allow managers to identify and understand the risks they are
facing, consider the risks that may arise in the future, and respond promptly and actively to both. This
will maximise the likelihood that they can continue to operate, even in the most difficult of conditions.
Continued outreach and dialogue
A second lesson I have learned through the development of Basel II is that communication with
interested parties is absolutely essential. One reason we were able to incorporate leading practices
into Basel II is because of the open and transparent process by which the Framework was developed.
There has been a steady dialogue with the industry since the Committee began discussing revisions to
the capital Accord back in 1999. Many of the firms represented here today contributed extensive and
valuable feedback to the Committee on its proposals over the years.
The Committee has tried to explain to the industry as clearly as possible its objectives and methods
during this process, and in turn firms and industry associations have shown a willingness to engage in
a serious dialogue to find practical, prudent solutions. This has helped supervisors to better
understand the state of industry practice. Where we have found these practices to be reasonable and
appropriate we have tried to incorporate them into the revised Framework in a sound manner. Looking
ahead, one of the benefits of this transparent process is that it has set the tone for discussions
between banks and supervisors as industry practices evolve going forward.
We have also greatly benefited from the dialogue we have maintained with our supervisory colleagues
outside of the Basel Committee. I believe that it is in many countries' best interest to adopt the new
Framework when they are ready, so it is critical that supervisors in these countries be part of the Basel
II conversations. The Basel Committee has established several mechanisms for heightened dialogue
with our fellow supervisors, and we are fully committed to further enhancing this dialogue.
Principles versus rules
A third lesson I have learned is that it is important to strike the right balance between principles and
rules. Of course, we want to ensure that banks apply principles in the same manner and that
supervisors interpret them in the same way even in different jurisdictions.
But while the temptation is to do this through ever more detailed rules, I am reminded of the words of
the famous Surrealist painter Salvador Dalí, who said: "Have no fear of perfection-you'll never reach
it." We have learned from the Basel II process that adding detail to the rules does not guarantee a
level playing field or equal application. The marginal utility of adding detail falls rapidly as you move
ahead in a process such as Basel II, so we need more than detail and prescriptiveness. We need a
bottom-up, cooperative approach that maintains a focus on principles of effective risk measurement
and management.
As we have moved into implementation, the Committee has placed greater emphasis on
principlesbased guidance, for example through the use of so-called Basel Committee Newsletters. We have
found that these Newsletters, which clarify supervisory expectations rather than establishing more
rules and making the Framework more complicated, have been well-received. Examples include
recent Committee guidance on the use of vendor products in the IRB framework and the treatment of
expected losses in an operational risk AMA. In my view, such an approach to communication with the
industry allows for a range of sound practices and encourages further work by both banks and
supervisors, but does not "lower the bar" in terms of supervisory expectations for risk management
and capital adequacy.
The importance of the macroeconomic perspective
Let me close my intervention today by dedicating a little more time to something which has been
increasingly recognised over recent years, and which I think will become even more critical to risk
management in the future - the macroeconomic perspective.
It is clear to me that taking a point-in-time approach to transactions, or looking at them from a narrow
"micro" perspective, does not provide a sufficiently comprehensive picture of the underlying risks. It is
important to take a broader "macro" approach, and one that builds in the impact of possible changes in
the cycle.
This is a philosophy that we have built into Basel II. In fact, I would say that there is no other
international regulatory initiative that gives more attention to these questions. For the sake of brevity, I
will give you just three examples of how the new framework encourages banks to consider how risk
determinants change over the cycle and in stressed conditions.
First, banks are expected to use sufficiently long time series of historical data in designing their rating
systems. The aim is to capture as much data as possible about how relevant factors have behaved in
the past. Furthermore, when assigning ratings to borrowers, they should also consider how the
borrower's ability to meet contractual obligations may change in the future as a result of possible
changes in economic conditions over the course of the cycle.
Second, banks' LGD estimates should reflect economic downturn conditions. The potential for realised
losses to be higher than average during times of high default rates may be a material source of
unexpected credit losses for some exposures. The Committee has elaborated principles that banks
are expected to fulfil in this respect, and will continue to monitor industry practice and encourage the
development of appropriate approaches to this issue.
Third, Basel II places much emphasis on stress testing in the assessment of capital adequacy. Indeed,
the new framework sets specific stress test requirements for banks using the advanced approaches to
credit risk, but also encourages the use of these tests more generally. And the value of stress testing
and scenario analysis is even more important in those situations where risk measurement is based on
scarce or incomplete data or unproven quantitative tools.
The above mentioned examples demonstrate the clear view we have taken in the Committee that the
sound and stable functioning of credit institutions requires consideration not only of micro conditions,
but also, and very importantly, incorporating a macro, long-term and forward-looking perspective.
I think these principles also make good business sense. I believe that risk managers, should
incorporate macro perspectives into their risk management models and into the design of the bank's
capital strategy. That is, to analyse how risks may change through the cycle and in stressed economic
conditions, and incorporate these elements into the decision-making process.
It is often thought that risks increase during times of economic downturn. But this is only partly true.
Banks' risks increase as they take on more business and extend more credit during times of economic
expansion. The risks may not crystallise until times of difficulty, but the seeds are sown during the
good times. It seems to me to be both prudent policy and consistent with risk management objectives
to take a long term perspective, using the results to make decisions that gain room for manoeuvre in
the good times in order to face up to difficulties that arise in the bad times..
In the end, the most risky behaviour is one characterised by over-optimism, and lack of consideration
of all the relevant risks. This means that when shocks occur, entities are unprepared and tend to react
abruptly, causing problems for their institution and, sometimes, for the whole system. On the contrary,
adopting a forward-looking approach, which takes account of the possible impact of broader changes
in the cycle, should help institutions to avoid mistakes and bad decisions, and to detect and respond to
problems in a smoother fashion and at an earlier stage.
Conclusion
In closing, I would like to thank you as risk professionals for your inputs to the various Basel
Committee initiatives during my Chairmanship, especially Basel II. A unique element of Basel II is that
rather than imposing a purely regulatory approach, it incorporates what the Basel Committee views as
leading practices in bank risk management. In developing the revised Framework, the Committee
sought to incorporate rigorous and comprehensive risk management approaches into the regulatory
structure. We could not have come as far as we have without the advances in risk management that
you in the industry have developed. Moreover, as industry practices continue to evolve, I believe the
Framework is flexible enough that these advances can be incorporated on an ongoing basis.
These past several years have been among the most interesting and challenging in my career, and I
will always look back on the accomplishments of the Basel Committee over this period with a mixture
of pride and humility.
Thank you very much, and I would be happy to take any questions.