Jaime Caruana: Basel II - a review of ongoing work
Keynote address by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel
Committee on Banking Supervision, at the 20th Annual General Meeting of the ISDA (International
Swaps and Derivatives Association), Barcelona, 16 March 2005.
* * *
Mr Moulds, Mr Pickel, Ms. Sebton, distinguished guests,
It is an honour for me to be invited to join your meetings today and it is furthermore my pleasure to
welcome you and the International Swaps and Derivatives Association to Spain.
It appears to me that you have all of the ingredients for a stimulating and memorable conference. The
agenda is ambitious and addresses the latest topics in the ever-evolving derivatives markets. The
speakers are distinguished, deeply experienced, and represent a wide range of perspectives and
institutions at the forefront of financial services.
And, of course, I must commend you on your selection of a marvellous location for your annual
meeting. Barcelona has undergone a fantastic transformation, is a gateway for the world and a city
that celebrates the ancient and the innovative.
I hope that you take some time outside of your sessions to explore its blending of the old and the new.
A walk through the "Gothic" quarter serves as a window into our past. A visit to any of the creations of
Antoni Gaudì - after whom this conference hall was named - offers a vision of Catalan modernism
through architecture.
Selecting Barcelona as the venue for ISDA's discussions offers us a chance as well to celebrate the
ancient and the innovative, the old and the new, in financial services. This conference, for example,
will address some of the most sophisticated products in banking and finance and the risk management
practices, legal developments, and technological advances that are emerging to support these new
businesses. At the same time, our discussions here in Barcelona will remind us that we must all
always monitor and control the fundamental - and traditional - risks involved in our activities.
Credit risk, market risk, and operational risk have always been with us in various forms, although they
have increased in complexity over recent years. What has changed dramatically, however, is our
ability to measure and monitor those risks more comprehensively than our predecessors ever could.
We have, moreover, improved our ability to manage or transfer those risks, and I would like to share
with you today some thoughts on work underway in the financial community in this regard.
There are three topics that I would like to address in my intervention. I will begin by sharing first, in my
personal capacity, some thoughts regarding the need for standards to evolve and keep pace with the
times, whilst ensuring that new standards are not unduly burdensome and do not hinder firms' abilities
to innovate.
In this respect, I'd like to look forward and address some of the work we are doing to ensure that the
new international capital standard - Basel II - remains flexible and able to adapt to emerging practices
and risks. Many of you have a very strong interest in the efforts the Committee is undertaking to
consider how best to apply Basel II to certain trading-related exposures using the latest tools being
developed by the industry. While this work is still ongoing, I would like to share a status report with you
on that effort.
Finally, I will highlight some of the work that we are undertaking to promote a smooth and consistent
transition to Basel II, including our plans to conduct a review of the calibration of the framework, as
well as our efforts in the field of supervisory co-operation and validation, and the key messages that
are coming out of these initiatives.
The evolution of standards and regulatory burden
Allow me to begin by sharing some personal thoughts on a topic that has captured some attention
recently: The view, held by at least some in the financial services sector, that the tide of regulation has
risen to a high water mark. In my own conversations around the world, I have heard similar concerns
from some bankers. Some point to the long debates that have taken place in the accounting
profession. Others point to regulatory reforms underway, such as those to transpose and implement
the Committee's own work on Basel II, the new capital framework.
It should be said that the industry itself recognises that there is work to be done in these areas.
However, I do have sympathy for the sense that much is changing today. I understand that keeping
pace with these changes can absorb resources and require attention. In this sense, and especially in
relation to our work on Basel II, I see some merit in concentrating, at least for a while, on completing
current regulatory work, and on ensuring the quality and consistency of its implementation.
Let me expand a little on this point. Financial service providers often compete on their ability to create
value by offering new products and services to customers. As just one example, ISDA represents
institutions that are among the most active in the private negotiation of derivative instruments. These
instruments are initially tailored to unique sets of circumstances and may involve novel features of
risktaking or risk mitigation.
The challenge, therefore, is to ensure that the rules support and encourage firms in their efforts to
improve their ability to manage their businesses while pursuing new opportunities. That is a constant
responsibility for legislators, for standards-setters, and for supervisors, but also for the industry. We
must all review and ensure that our rules are implemented fairly and in line with our intentions.
Some reforms underway represent efforts to ensure that our rules keep pace with the achievements
that the industry has already made. On this note, I would argue that Basel II is just as much about
aligning supervisory practices more closely with the industry's latest advances as it is about promoting
improvements in the management of risk within the industry itself.
But I sympathise with the sense that the wide range of standards that are evolving in parallel
represents a drain on the limited resources that firms have to keep pace with those changes. I agree
that we must find a way to balance the dangers we are trying to ward off against the time and
resources it takes to adapt to new circumstances and new rules. And I want to work with you to make
sure that the labours you undertake are not merely exercises in compliance with new rules, but rather
will represent honest efforts to strengthen your practices and your long-term prospects for growth and
innovation.
From my perspective as chairman of the Basel Committee, I can say that the Committee's main focus
in the near future will be on completing the current work and on implementing Basel II in a sound,
consistent, and effective manner. This will allow us all a period to digest the framework we have
designed.
At the same time, we have always said that Basel II should be an evolutionary approach. This does
not mean a moving target. We have designed a stable framework that we believe will stand the test of
time. But we have always been clear that some of the details may need to change over time to ensure
that they remain relevant to the ongoing evolution in banking markets and risk management practices.
Indeed, in the text of the Basel II framework that was published in June 2004, the Committee
reiterated its intention to maintain an active dialogue with the industry to ensure that the new framework
keeps pace with, and can be applied to, ongoing developments in the financial services sector. The
framework itself already provides banks with a great degree of latitude in developing new measures of
exposures to risk and new means for addressing them. But supervisors - and banks - are still
responsible for evaluating whether the framework addresses risk exposures in a sensible manner and
in line with our sense of sound and best practices that are being developed.
Status of work on the trading book
There are two areas where both banks and supervisors recognised that this work could already
commence. One was to find a prudentially sound treatment under Basel II for exposures to "double
default," where the risk of both a borrower and a guarantor defaulting on the same obligation may be
substantially lower than the risk of only one of the parties defaulting. The other area concerns the
applying Basel II to certain exposures arising from trading activities. This brings me on to my second
topic.
As you know, we have already spent close to three-quarters of a year studying both sets of issues in
depth. Because both banks and securities firms have a great interest in the potential solutions to these
particular issues, the Basel Committee has worked jointly with the International Organization of
Securities Commissions (IOSCO) to consult with industry representatives and other supervisors on
these matters. I must say that this co-operation with IOSCO in areas of mutual interest has been a
very fruitful and beneficial experience, and the work has been conducted in a very positive and
collaborative spirit. Also in this regard, I must extend my thanks to ISDA and its members for being
faithful and active participants in these discussions. ISDA and its members have volunteered again
considerable data, time, and energy to the work at hand.
As you may already know, there are five specific areas of focus, namely
First, the treatment of counterparty credit risk for over-the-counter derivatives, repo-style and
securities financing transactions;
Second, the treatment of double-default effects for hedged transactions, in relation with trading book,
but also banking book, exposures;
Third, the short-term maturity adjustment, under the internal ratings-based approach, for some trading
book-related items;
Fourth, a limited number of improvements to the current trading book regime, especially with respect
to the treatment of specific risk; and
Fifth, the design of a specific capital treatment for unsettled and failed transactions.
I can report informally that I personally am highly satisfied with the progress that the joint Basel
Committee and IOSCO working groups have achieved to date, which reflects in no small way the
cooperation of the industry in preparing data and responses for the discussions. I expect that the
Committee will release a proposal for a six-week period of public comment next month such that the
proposals can be released in final form this summer. However, intensive work will continue prior to the
discussions at the meetings of the Basel Committee and IOSCO's Technical Steering Committee
toward the end of March and the beginning of April.
So I cannot yet comment on the solutions that may be proposed or approved by the Committee and
IOSCO. I can tell you that we set, as a guiding principle, a goal to apply Basel II to these exposures in
a manner that reflects as best as possible sound practices already in use when those practices
appeared to be both prudent and broadly acceptable to many kinds of banks and markets.
Some industry representatives have raised concerns that finding ways to apply Basel II to trading book
exposures might lead to a revision of the existing "Market Risk Amendment" to the capital framework
that was approved in 1995. Understandably, those industry representatives expressed concern that
this might disrupt banks' efforts to prepare for Basel II, which addresses mainly credit and operational
risk. The members of the Committee shared this concern when we decided to undertake work on the
prudential treatment of certain trading-related exposures under Basel II. We do not intend to overhaul
the capital rules for trading book exposures, but rather seek to address narrowly a handful of concerns
that relate either to potential inconsistencies that could arise with the new treatment for banking book
assets or that relate to a limited number of issues that have arisen since the adoption of the Market
Risk Amendment.
The implementation of Basel II
With that, I would like to turn now to my third topic and report on our efforts to smooth the path from
the existing capital standards to the new Basel II framework.
On the regulatory side, supervisors are working with national authorities to transform the framework
into enforceable rules and regulations, within the context of each jurisdiction's process. This work is
well underway in all of the Basel Committee member jurisdictions, but also in many other countries as
well.
On the supervisory side, let me mention three areas in particular where we are devoting resources to
promote a seamless transition to the new framework.
Calibration
First, we are verifying that Basel II has been calibrated appropriately. The Committee has long stated
its intention to conduct work to re-confirm that the new framework meets our objective to broadly
maintain the aggregate level of capital requirements, while keeping incentives to adopt the more
advanced approaches that are offered.
In order to establish a common data set on which to base this review, the Committee has decided to
begin a recalibration exercise in autumn this year. In addition, national field tests are already underway
in some jurisdictions, while there will be a period of time during which banks will calculate their capital
requirements in parallel under the 1988 Accord and under Basel II.
We recognise that these tests and reviews will demand resources from both banks and supervisors.
Yet I must emphasise that neither banks nor supervisors will be able to evaluate the calibration of the
new framework - and hence its effectiveness - if banks do not participate fully and seriously in these
initiatives. Only you can provide the data that all of us will need to ensure that Basel II functions as we
intend and that it does not create unintended side effects.
Consistent and co-ordinated implementation
Second, supervisors are working to avoid unexpected outcomes by developing, in advance, a better
understanding of how various jurisdictions will apply Basel II. This is also helpful to developing a more
consistent set of expectations across countries. In a world where the business of banking is
increasingly international, the need for supervisors to cooperate and to strive for more consistent
principles would exist even if Basel II did not. But under Basel II, this need is even more pronounced,
especially for internationally active banks that wish to adopt one of the advanced approaches to credit
or operational risk provided under Basel II. In fact, in many ways, Basel II is acting as a catalyst for
enhanced co-operation.
The Committee is finding ways to avoid the need for those firms to endure redundant or uncoordinated
reviews of the systems and processes they develop to benefit from Basel II. The Accord
Implementation Group, which is chaired by Nick Le Pan, the Canadian Superintendent of Financial
Institutions and Vice-Chair of the Committee, has already undertaken a number of practical exercises
to encourage supervisors from many countries inside and outside the Committee's membership to
consider how they will review those systems and processes for firms that operate across borders.
The AIG, as this group is known, identified two key lessons for banks to consider that may help to
ease the transition to Basel II. One lesson is that the more detailed, comprehensive, and clear a firm's
plans are for moving to one of the more advanced approaches to risk management, the better able
supervisors will be to assess and evaluate those plans in a less intrusive manner. But a second lesson
takes this one step further: it is also important for banks to share those plans broadly with their
branches and subsidiaries worldwide. Already some host supervisors have found that local managers
may be unfamiliar with the parent organisation's plans for Basel II: this understandably tends to make
host supervisors less confident about the quality of an organisation's planning and its readiness to
move to Basel II. Moreover, it increases their need to ask more questions, some of which may
duplicate the questions that the home supervisor or other host supervisors are asking.
If a bank has already developed sufficiently detailed and transparent plans for its application of Basel
II, a substantial portion of the hard work has already been done. Sharing those plans with home and
host supervisors, and with managers throughout the bank's operations and locations, should not
require too much more effort. Instead, the bank should be in an even better position to focus on
running its business confidently while still implementing its plans carefully for the future.
Validation
One of the greatest challenges - for both banks and supervisors - of the Basel II framework is the
need to validate the systems and processes used to generate the parameters that serve as inputs into
the IRB approach to credit risk. Although validation is foremost the responsibility of banks, supervisors
must have a thorough understanding of validation in order to ensure overall integrity of bank's
activities in this area.
In recognition of the importance of validation the Committee recently published six principles on
validation that will guide our future work. We also published a working paper called: "Studies on the
Validation of Internal Rating Systems" Let me mention these principles briefly.
Firstly, we set out our understanding that validation is fundamentally about assessing the predictive
ability of risk estimates and the use of ratings in credit processes. Secondly, we stress that the
primary responsibility for validation lies with the bank itself, while the supervisor's responsibility is to
review the bank's processes and outcomes - a point which I think we all agree is very important.
The remaining principles relate more to the process itself. We note that validation is a likely to be an
ongoing, iterative process which will require an ongoing, iterative dialogue between banks and
supervisors. Then our fourth principle reflects that there is no single validation method, or universal
tool for validation, even though techniques may converge over time. We also highlight, in our fifth
principle, that validation should encompass both quantitative and qualitative elements - validation is
not a purely technical or mathematical exercise, but should also include an assessment of controls
and other qualitative factors. Finally, we stress our view that validation processes and outcomes
should be subject to review within the bank, by parties which are independent of those who are
responsible for the design and implementation of the processes.
I think these principles set out clearly what supervisory expectations are, and should provide a useful
steer to the industry. Our work on validation will accelerate over the coming months, although our
focus will be more on sharing and cataloguing information and approaches, and not on trying to
develop a prescriptive method. As we have stated in our principles, the primary responsibility for
validation lies with the banks themselves. Close dialogue with the industry in our work will, of course,
be of great importance.
In turning to my conclusions, I would like to use this opportunity to make a brief comment from my
perspective as Governor of the Banco de España. Although I have talked about the work underway in
the AIG on implementation, you are probably also aware of similar work being conducted in Europe,
by the Committee of European Banking Supervisors, which is seeking to promote consistency and
convergence in the application of Basel II in the EU. As I have said on other occasions, I believe that
Basel II represents a great opportunity for the EU - as a single market - to lead the way on
international convergence, and I hope that we can seize this opportunity. Certainly, the progress
made by CEBS so far is encouraging in this respect.
Conclusion
Coming back to the points I made earlier, even considering the ongoing work on trading activities
under Basel II, I believe that the vast majority of efforts being undertaken by banks and supervisors
alike today related to Basel II are focused on implementing the very good rules that have already been
developed. I believe that this should be the Committee's main focus for the near term.
It is important as well to remember that Basel II is not meant to be an exercise in compliance. Its goals
are to improve the quality of risk management across the banking sector; to strengthen the resilience
of the financial system; and to promote more sustainable economic growth for the good of both
consumers and businesses alike.
I look forward to continuing to work with you as we all enhance our efforts to make those goals a
reality.