Zeti Akhtar Aziz: Basel II implementation and the development of Asia's
financial system - experiences, challenges and regional cooperation
Keynote address by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the 4th
SEACEN/ABAC/ABA/PECC Public-Private Dialogue for the Asia Pacific Region, Kuala
Lumpur, 18 August 2008.
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It is my pleasure to be here today, to speak on the occasion of this Public-Private Dialogue
organised by the SEACEN Centre in collaboration with the APEC Business Advisory Council
(ABAC), the Asian Bankers Association (ABA) and the Pacific Economic Cooperation
Council (PECC) on the development of Asia's financial systems and the implementation of
Basel II.
The implementation of Basel II across the Asia Pacific region is occurring at a time of
heightened risks, during a time in which our economies and financial systems are confronted
with significant challenges and increased uncertainties. As the underpinnings of Basel II are
concerned with enhancing the responsiveness to risk by banking institutions, there are
enormous expectations that Basel II will stand up to the test of capturing the complexities
and the more uncertain direction of risk in the current environment. There is also enormous
interest in assessing the pre-emptive capabilities of the framework to anticipate the direction
of risk and thus ensure the provision of adequate capital buffers for such risk. The sharing of
experience on the implementation of Basel II in this region and the greater engagement
between the supervisory and financial communities will provide further insights to these
issues. The ultimate objective of Basel II is to achieve more resilient banks, and thus
preserve the broader financial stability.
In the Asia Pacific region, thirteen countries have adopted the standardized approaches
under Basel II for credit and operational risks. A number of countries have also either already
adopted or announced plans to adopt the more advanced approaches by 2010 or earlier.
Malaysia adopted the standardised approach this year and has recently issued a concept
paper detailing the parameters for the implementation of the more advanced approach to be
adopted in 2010.
The global economy has entered a period of greater uncertainty, with a number of
developments that are taking place in some of the developed economies having destabilising
implications on the global economy. The international financial markets continue to be in
turmoil, triggered by the developments in the subprime market in the United States and
resulting in the tightening of liquidity in the credit markets. The impact of these developments
on the financial position of financial institutions has affected the functioning of the financial
markets and the financial intermediation process. This has required interventionist policies to
contain its systemic implication. In addition, the global economy has been through a period of
high commodity and energy prices which has not only translated into higher inflation but has
also contributed to dampening economic growth.
While the Asian region has experienced robust growth in the first half of 2008, the regional
economies will be affected by these developments. Although growth is expected to
moderate, most economies will continue to see a reasonable growth performance. The
region will, however, continue to face inflationary pressures arising from high commodity and
energy prices. This is however, expected to recede with the substantial correction that has
recently taken place following the slower pace of global growth.
The Asian region is expected to weather this challenging period with the growing
intraregional trade and the expansion of its economic links with Eastern Europe and Russia, the
Middle East and Latin America. At the same time, increased infrastructure spending in
several of the large economies will provide further support to domestic demand. In addition,
the strengthened economic fundamentals of the Asian economies, including the high level of
reserves, low external debt, strengthened financial systems and improved fiscal position, will
allow the flexibility to better manage the risks to the economy and the financial systems.
In this environment, the implementation of Basel II presents a powerful lever for banks to
significantly enhance both their long term resilience and their competitive advantage. It
promises greater financial stability through the closer alignment of risk with capital. To realise
the full benefits from the implementation of Basel II, its multi-faceted dimensions need to be
well understood and well integrated with the financial structures, institutional practices, and
supervisory systems. Emerging markets in particular will need to ensure that supervisory
interpretations of the framework are contextualised to the local conditions, and the
preconditions for its effective implementation are adequately developed to avoid the potential
market distortions.
At the institutional level, Basel II provides a unique opportunity for banks to integrate risk
considerations with their business strategies. Indeed, several leading financial institutions
have successfully taken Basel II beyond the narrow and mechanistic risk applications to a
more strategic implementation of the framework across the organisation. Such institutions
have leveraged on the upgraded risk infrastructures that have been established for Basel II
to create competitive advantages through the application of new business and management
tools. This enables the risk function to have a central role in forming strategic moves into new
markets or products. In the process, this will ensure that the strategies are aligned with the
bank's risk appetite and policies.
The benefits of Basel II cannot be achieved with just a strict regulatory compliance approach.
While Basel II serves as a powerful catalyst to reposition the role of, and the attention to, risk
management in banking institutions, significant efforts need to be directed at strengthening
the financial structure, corporate governance, risk management and data capabilities within
the banking institutions. The approach adopted by Bank Negara Malaysia has been for these
efforts to complement and reinforce the positive outcomes of Basel II. These are important
preconditions for, and not automatic outcomes from the adoption of Basel II.
In the wake of the sub-prime mortgage crisis in the United States, several aspects of Basel II
have attracted attention. Among them has been the use of ratings in the regulatory
framework and whether this has unintentionally discouraged investors from performing their
own due diligence. The underestimation of risk for structured credit securitisations has now
come under greater scrutiny. There has also been increased debate over the cyclicality
impact of Basel II. The effectiveness of the supervisory review process in ensuring that
additional capital buffers are provided by banks for risks not fully captured under Pillar 1 of
the framework has also been the subject of this review by authorities.
The relative importance of these issues will be different for different countries, depending on
the stage of development of the financial markets and the banking system, as well as the
supervisory structure that is in place. Among Asia Pacific countries, experiences with the
implementation of Basel II have been varied.
For emerging economies, Basel II has arguably a more far reaching impact. This is on
account of several factors. Firstly, many emerging economies continue to depend heavily on
the banking system to finance economic activity. With a few exceptions, commercial banks
are the main providers of credit in most emerging economies, accounting for an average of
90% of total credit. This produces a higher correlation to the economic sectors where the
implications on the banking system could result in significant disruptions to credit supply
which could in turn affect economic activity.
Secondly, the more advanced approaches of Basel II are calibrated to the environment of the
G10 countries, with significant acceleration of capital charges as the probability of default
ratings deteriorate. To the extent that this inappropriately amplifies economic cycles by
inducing the systemic misperception of risk in emerging economies, this can exacerbate a
credit crunch during periods of weak economic performance.
Thirdly, the anticipation of lower regulatory capital requirements and hence, a competitive
cost advantage, provides a strong incentive for banks especially in the developed countries
to move towards the more advanced approach under Basel II. This could result in an uneven
competition between the domestic and international foreign banks operating in the domestic
financial system. Capability gaps in the adoption of the more onerous approaches under
Basel II may place domestic banks at a competitive disadvantage in such countries.
These considerations have meant that for many emerging economies, the translation of the
Basel II framework to suit the local environment needs to be approached carefully. The Basel
II text provides a range of options which can be considered by national supervisors to
rebalance the calibration of Basel II to reflect the local environment. It is also important that
Basel II is implemented as part, and not in isolation of, the overall financial sector
development programme. This has been Malaysia's approach.
The highly fragmented banking system and relatively weak risk management systems within
the domestic financial institutions which prevailed in Malaysia prior to the financial
restructuring and reforms that were undertaken from 2001 would have rendered the
implementation of Basel II extremely difficult, if not impossible to achieve without risking
disruptions to the intermediation process. The financial reforms that were undertaken to
strengthen the underpinnings of our banking system are therefore instrumental in facilitating
the smooth transition to the adoption of Basel II in Malaysia without adverse market
outcomes.
In the more recent period, the Asian region as a whole has made significant strides towards
strengthening market structures and institutional arrangements for financial stability. Two
developments deserve mention, in view of their important contributions towards mitigating
some of the concerns surrounding Basel II for emerging economies.
First, in the decade following the Asian crisis, the emerging economies in Asia have
extensively developed their bond and equity markets. Measured in terms of market
capitalisation, East Asia's equity markets have more than trebled since 1997. The bond
markets in the East Asian region have also seen significant growth during this period with
significantly improved liquidity conditions in these markets. There is therefore now a more
diversified structure in the financial system.
Second, within Asia, the regional cooperative framework has been substantially strengthened
to support financial sector development, surveillance, crisis management and capacity
building. An important achievement within the EMEAP process has been the establishment
of a Monetary and Financial Stability Committee, or MFSC, which is charged with the
mandate of facilitating greater regional collaboration in preserving monetary and financial
stability as well as in the development of regional financial markets. Since its establishment,
the MFSC has exceeded expectations in terms of the commitment towards supporting
regional monetary and financial surveillance, and in advancing efforts to institutionalize
cross-border crisis management and resolution arrangements.
These developments will contribute towards reducing any procyclical impact of Basel II and
facilitating over time, refinements to the risk parameters that are more appropriate to local
and regional experiences. The continuation of such efforts at the national and regional levels
will reduce the prospects for potential disruptions in the regional financial systems.
One of the most important consequences of Basel II lies in the effect that it will have in
sharpening the focus on corporate governance in banking institutions. While there has been
considerable attention focused on the quantitative implications and operational aspects of the
Basel II framework, there has been less attention given to the corporate governance
dimensions associated with its implementation.
The expectations on the board and senior management oversight are significantly higher
under Basel II. The board of directors is expected to ensure that a sufficiently strong risk
control framework is in place before banks can adopt the more advanced approach. Boards
and senior management must have a sound understanding of the risk profile of the
respective banking institution and ensure that it holds sufficient capital that is commensurate
with that profile. This is reinforced by the greater attention being accorded by supervisors to
the risk management control functions within the banking institutions and how they are
effectively governed. Improved market disclosures under the third pillar of the framework
further subjects the banking institutions governance practices to closer market scrutiny.
These developments have challenged governance practices that may have been tolerated in
the past, but which would be grossly inadequate to provide the oversight that is demanded in
today's far more complex business environment. Such practices have included vague
reporting of risks to the board, boards that are disengaged, and boards that have no or little
expertise in risk and financial matters. Boards and supervisors need to confront these issues
with firm resolve. This will entail the more rigorous scrutiny of board members and senior
management, both prior to their appointments and on an ongoing basis. Boards need to also
assert themselves more actively in advocating and driving risk reforms, and demanding the
appropriate level and amount of information from management that would enable the
oversight responsibility to be discharged effectively.
In many respects, Basel II remains a work in progress. As we continue to ponder its broad
and complex dimensions, platforms such as this for open and active dialogue between public
and private interest groups are important to provide further insights on the many issues that
will provide the direction forward for the wider and effective global implementation of Basel II.
On that note, I wish you all productive and successful discussions. Thank you.