Zeti Akhtar Aziz: Enhancing the soundness of the banking sector -
The New Capital Accord
Keynote address by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the Risk
Management Seminar on the New Capital Accord (Basel II), Kuala Lumpur, 15 April 2004.
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Distinguished guests,
Ladies and Gentlemen,
It is my pleasure to welcome you to the Risk Management seminar on Basel II organized for the
directors and senior management of banking institutions. The objective of this seminar is to promote
greater understanding of the impending changes to the international capital adequacy regulation.
Given the importance of the subject and its implications on the banking industry, it is important for the
industry to understand the intentions and the challenges arising from these changes so that the
necessary action may be taken in a manner in which the benefits to be derived from it can be
maximised. While there has been global acceptance of the broad principles of the new accord,
differing implementation approaches are being adopted by different countries. I will take the
opportunity to discuss the new Accord from our perspective and the approach that will be adopted for
Malaysia. This seminar will provide you with the opportunity to engage in discussions on the issues
concerning the new Accord.
Philosophy and objective of capital regulation
A well functioning and efficient banking sector is vital to the economic growth process. The banking
institutions perform the important intermediation function of mobilizing funds to finance productive
activities. This intermediation process needs to be performed in an environment of financial stability.
Therein lies the importance of confidence and soundness of the financial system. Banking business
inherently involves risks and these risks need to be rigorously managed. In an environment of
heightened uncertainty and increased volatility, this needs to be reinforced with the development of a
more robust and resilient banking system. Hence the importance of prudential regulations to ensure
the soundness and stability of the financial system.
An important component of prudential regulation is having a sound capital framework that measures
risks accurately and allocates adequate capital to the risks. The current capital accord issued in 1988
has served as the international benchmark for capital adequacy assessment for banking institutions.
While it has achieved the desired results in terms of developing more well-capitalized banking
institutions globally, the rapid developments in the financial markets over the years, including the
growth of off-balance sheet financing such as asset securitisation have rendered the broad-brush
measurement of the existing accord to be less effective.
Risk and risk management - the need for new accord
New institutional structures and evolving market practices have reduced the effectiveness of the
existing accord. While the basic categorization of risks have not changed significantly, the ways in
which risks present themselves have changed quite substantially. With the introduction of new
products and more complex financial transactions enabled by technological innovations, risks can be
disaggregated and rebundled in new ways. Similarly, the advances in financial engineering and
improved expertise have allowed the introduction of new hedging instruments to facilitate risk
management. Significant enhancements have been achieved in the measurement of market risk
where the use of internal value-at-risk models is fast becoming the industry standard.
The advances in the quantitative approach to the management of market risks have also expanded to
the areas of credit as well as operational risks. Despite the significant data constraints, new research
has strengthened the theoretical foundation for internal credit and operational risk modeling. The
development of new hedging instruments such as credit derivatives has also increased the use of
credit risk transfer mechanisms within the financial system, thus promoting more active credit portfolio
risk management. Key developments have also taken place in the area of operational risk. The
experience of large corporate failures due to fraud and lapses in internal controls has focused greater
attention on improving operational risk management in banking institutions. This has prompted the
need for banking institutions to provide capital for operational risk and to put in place a more
integrated risk management framework on an enterprise-wide basis.
The essence of the new accord
Ladies and Gentlemen,
The efforts of the BIS to introduce an enhanced framework for capital adequacy regulation through
Basel II is in the context of these developments. The accord seeks to bring into greater alignment the
more advanced concept of capital management into the regulatory equation. The assessment of
capital adequacy needs to look beyond the computed capital ratio. The new Basel Accord therefore
comprises three pillars. The first pillar provides a minimum capital measurement framework for credit
and operational risks. In essence, the regulatory capital requirement is aligned more closely with the
actual degree of underlying risk that the banking institution faces. It provides the capital measurement
that has three options with different levels of complexities for both credit and operational risks to better
reflect actual risk. The second pillar focuses on strengthening the supervisory process, particularly in
assessing the quality of risk management in the banking institutions. The supervisory process aims to
provide the mechanism to ensure that other risks such as concentration risks and market risks in the
banking books being managed. Under such an environment, prudent lending such as that
characterized by a high degree of portfolio diversification, could justify lower capital requirements. The
third pillar specifies minimum disclosure requirements on capital adequacy to enhance market
discipline.
Despite its relatively more complex architecture, the implementation of the new framework provides a
number of options and flexibility to banking institutions. This is to ensure that the approach adopted
reflects and is commensurate with the nature of risk-taking activities and the level of sophistication of
individual institutions. In adopting the standardized approach for credit risks, the credit exposures are
weighted based on recognized external credit ratings. However, for large banking institutions with
businesses which are highly complex, the more advanced approaches, that is, the foundation or
advanced internal rating based (IRB) approach may be more appropriate to reflect their actual risk
profile. Similarly, there are three alternative approaches that may be adopted in allocating capital for
operational risks, that is the basic indicator approach, the standardised approach and the advanced
measurement approach.
The objective of the new framework is to emphasise on the need for refined measurement of risks,
more efficient capital management and the adoption of sound risk management practices that will
ultimately contribute to greater financial stability. This will be complemented with efforts to enhance the
corporate governance framework, the robustness of the internal control systems, and to introduce
greater transparency and market discipline. Within the context of these developments is the
importance of the ability of the board members and top management of banking institutions to assess
risk from a broader perspective and its strategic impact on the institution.
In view of the significant implications of this new capital framework, Bank Negara Malaysia has been
directly involved in the consultative process through regional forums to ensure that issues and
concerns of the emerging markets are considered by the BIS in designing the new accord. We are
pleased to note that many of these issues have been taken into consideration.
Motivation for migration to the new accord
The adoption of the new accord is consistent with building strong risk management capability. The
enhanced risk management practices required by the new accord not only can result in greater capital
savings but becomes vital as the domestic banking system becomes increasingly competitive and
integrated with the global marketplace. Effective and efficient decision making is enhanced with
relevant and timely information supported by more quantitative analysis. This can be achieved through
having a more robust data architecture and information system, integrated processes and enhanced
information flow and reporting. Having a robust risk management framework would also allow banking
institutions to better assess the marginal contribution of existing as well as new business lines to the
institution's overall financial performance. This would allow for more-informed decision-making, thus
contributing towards greater competitive advantage.
Moving forward, there will be increased expectation for more efficient use of internal resources. A
more enhanced and integrated risk management framework, and the adoption of a risk adjusted
performance management model would serve to further facilitate shareholders' activism and drive
greater efficiency among banks.
Risk management however does not operate in a vacuum or in isolation and it should not be viewed
merely for the purpose of regulatory compliance. Priority should be given to ensure that the risk
management framework is well-aligned and well-integrated with the strategic business directions of
the banking institution. The benefits of refined risk quantification and more robust risk management
should be translated into improvements in business operations and more effective functioning of the
institutions. This will in turn ultimately bring benefits to the consumers and the economy at large.
Implementation challenges and considerations
Ladies and Gentlemen,
Given the complexity of Basel II, the ability to comply appears to be the main concern within the
banking community. This is truly a major undertaking with respect to the IRB approaches or the
internal rating based systems. The resources involved and data constraints are often cited as the two
main challenges in implementing the IRB approach, particularly for banks in the emerging markets. At
this stage, data on default and credit migration for certain market segments is too limited to facilitate
any meaningful analysis. It is therefore recognized that some lead time would be needed for banking
institutions to produce a robust and meaningful validation of internal estimates of probabilities of
default and loss given default. However, this does not mean that banks should wait until all the
requisite data is in place. Banks can initiate work to establish the framework for analytical functions.
While the industry survey conducted by Bank Negara Malaysia revealed a strong preference among
Malaysian banking institutions to adopt the IRB approach, many had indicated the need to further
strengthen their business case and undertake more comprehensive gap and impact analysis. This is
indeed a critical process. Of importance is to be able to extract the benefits out of the new accord. This
would however, take time even for large and internationally active banking institutions that have made
substantial enhancements over the years.
Standardised approach offers benefits with much less complexity
While capital savings from the adoption of the standardized approach may be relatively lower than the
IRB approach, the benefits to be gained under the standardized approach are still considerable
compared to the current accord. It includes the lower risk weights to be assigned to the mortgage
portfolio, which would be reduced from 50% currently to 35% under the standardized approach.
Similarly, substantial capital savings could be generated from lending to small and medium enterprises
(SME) that would qualify as retail exposures where the risk weights would be lowered from 100% to
75%. The potential impact of lower risk weight for this sector under the standardized approach could
result in greater participation by banking institutions in this market segment.
Bank Negara Malaysia's initial estimates on the impact of the standardized approach indicated that
benefits would be derived by individual institutions in terms of capital savings. However, improvements
in a number of areas such as loan identification systems as well as collateral management systems
would result in higher capital savings for credit risks under the standardized approach. Continuous
calibration would be required to ensure that banks under the standardized approach would continue to
maximize capital savings for credit risks in view of the requirement for an explicit capital charge for
operational risk under the new accord.
While the IRB approaches promise greater capital savings in the longer term, the adoption of the
standardized approach in the transition is considered a more pragmatic option even for some
internationally active banking groups. Under the IRB approaches, banks would need to reach an
agreement with the regulator in the countries they operate on the robustness of group internal
estimates and validation. The standardized approach is therefore seen to provide the breathing space
for a smooth transition to IRB approaches while at the same time allowing banking institutions to avail
themselves of the benefits of capital savings.
Different approaches are adopted by regulators
Ladies and Gentlemen,
While there has been global acceptance of the broad principles of the new accord, differing
implementation approaches are being adopted by different countries. In some countries, regulators
have opted for the accord to be applied to all institutions while in others selected banks are being
mandated specific approaches. Some other regulators have given greater flexibility for banks or have
extended the timeline for the implementation of the new accord. These reflect the different
considerations and priorities accorded by the various regulators in their policy agenda. In essence, the
decision by national regulators are based on a number of common factors, namely, the stage of
industry development and market infrastructure, the size and types of institutions involved, the
regulatory philosophy and priorities, as well as the economic environment. Of importance is to ensure
that the implementation of the new accord is consistent with the overall agenda and objectives for the
financial sector to facilitate growth and economic expansion.
Implementation principles for Malaysia
In Malaysia the appropriateness of the new accord is being assessed in the context of our own
objective to develop a more effective and resilient banking system that is best able to serve the nation.
In view of the significant and special role of the banking sector in the economy, a well-capitalised
banking system has always been a priority in the regulatory framework. In this context, the principles
advocated by the new accord are consistent with our regulatory philosophy that encourages capacity
building and enhancing risk management.
Effective Basel II implementation strategies would be premised on the industry having the correct
understanding of the new framework. To implement the required changes, it is therefore vital that the
management of banking institutions understands the principles of the new accord. One common
misperception is that the recognition of financial collateral under the new framework will encourage
more collateral-based lending within the banking sector. This is a simplistic conclusion given the
stringent minimum standards for the recognition of such financial collaterals before banks can qualify
for the capital savings. Moreover, the potential capital savings under the new framework is not from
the recognition of financial collateral, but rather from the much lower risk weights attached to higher
rated loans.
Indeed, the real benefit to be gained under Basel II environment comes from improved standards of
loan underwriting and more accurate quantification of risks that can subsequently translate into
enhanced performance. Acceptance of collateral is only to mitigate loss severity should a default take
place. In an increasingly more competitive marketplace, the emphasis is on maximizing risk-adjusted
returns on capital and maintaining an optimal asset portfolio that reflects the risk tolerance level of the
institution. In such an environment, overemphasis on collateral is certainly not viable.
Ladies and Gentlemen,
Bank Negara Malaysia will adopt four key principles in the implementation of Basel II in Malaysia:
Firstly, the need to accommodate capacity building efforts, with strong emphasis on gradual
enhancement to risk management framework for all banking institutions;
Secondly, a more flexible timeframe that allows capacity building measures to be implemented;
Thirdly, an emphasis on strong business justification instead of regulatory mandate for the adoption of
IRB approaches; and
Finally, an enhanced supervisory methodology to assess internal models and advanced risk
management systems.
Malaysia will adopt a two-phased approach for Basel II
These principles would be implemented in a two-phased approach. The first phase will begin in
January 2008 where all banks will adopt the standardized approach for credit risks and basic indicator
approach for operational risks. Banking institutions would be required to submit to Bank Negara
Malaysia parallel calculation of capital adequacy on a monthly basis for one year prior to the
implementation of the standardized
approach.
In Phase I, Bank Negara Malaysia may also allow banking institutions to remain on the current accord
if they intend to adopt the Foundation Internal Rating Based (FIRB) approach, instead of the
standardized approach. However, Bank Negara Malaysia would require a submission of business
case justification as well as a blueprint for implementation that has been approved by the Board of
Directors of the banking institutions concerned. These banking institutions would be expected to have
undertaken a comprehensive gap and business impact studies to justify their roll-out plans. In this
regard, a broad guideline on the required processes and expectations will be issued to facilitate the
process.
Banking institutions intending to adopt the FIRB approach are expected to do so by January 2010.
This is when the second phase of implementation will commence. These institutions will be required to
submit to Bank Negara Malaysia parallel calculation of capital adequacy on a monthly basis for one
year prior to implementation. However, during the second phase, banks on the standardized approach
will not be mandated to migrate to the FIRB approach. For purposes of regulatory validation and
approval, Bank Negara Malaysia would expect that all parameters and assumptions used for the FIRB
approach will be based on local data inputs.
Conclusion - capital is key, but not the sole factor to ensure soundness
Ladies and Gentlemen,
Despite the increased sophistication of the regulatory capital framework and internal economic capital
model in banks, capital remains the last line of defence. Capital regulations will have to be
complemented with prudent banking that includes enhanced underwriting standards, effective internal
controls and risk management, as well as strong corporate governance. In achieving your future goals
and aspirations, significant benefits can be derived from Basel II provided that your institutions
undertake the necessary efforts to align your strategy and business orientation with the new
standards. Your interest, participation and decisive actions on the new accord are therefore important
in positioning your institution in this increasingly competitive and more dynamic environment.
Thank you.