Rasheed M Al-Maraj: Basel II and risk management
Address by His Excellency Rasheed M Al-Maraj, Governor of the Bahrain Monetary Agency, to the
Institute of International Finance: Basel II & Risk Management - Meeting International Standards,
Manama, 30 November 2005.
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Mr. Chairman, Excellencies, Ladies and Gentlemen:
It is a pleasure to be with you here today, and to have this opportunity to contribute to this topical
symposium. My own personal thanks go to the organisers, the Institute for International Finance, and
to the sponsors, Gulf International Bank and Arab Banking Corporation, for making this event possible.
I should also like to welcome those of you who have taken time out from busy year-end diaries to
attend today's event - especially those who have travelled from overseas.
Basel II, as you need no reminding, constitutes the most significant change to banking regulation in
nearly twenty years. Its impact so far, however, has probably been less felt in the Gulf region than in
the G10 countries, where extensive implementation efforts have been taking place for some time. The
situation in the Gulf, however, is now rapidly changing, as the strong turnout today I think
demonstrates.
I should like, therefore, to use today's opportunity to set out in high-level terms the BMA's approach to
Basel II implementation and how it relates to the BMA's other regulatory initiatives. I will also touch on
what I see as some of the key challenges posed by Basel II, not only for GCC regulators, but also for
the regional banking industry. In doing so, I will avoid touching on some of the more detailed
implementation issues, which will be covered later this morning.
The BMA has endorsed the implementation of Basel II and is now working closely with the industry to
apply it to the whole of Bahrain's banking sector. We are aiming to implement Pillars 2 and 3 first,
during 2007; Pillar 1 will be implemented at a later stage, from 2008 onwards. We currently expect that
most locally incorporated banks will use the standardised approach for credit risk - only a handful have
expressed an interest in using the IRB approach. For our part, we have said that we will only offer the
foundation IRB approach, to start with at least.
The above approach reflects our view that Basel II represents a significant improvement over Basel I,
in terms of its better alignment of regulatory capital with risk, its emphasis on risk management and
supervisory review, and its requirements on disclosure. It also reflects the fact that Bahrain hosts a
large and dynamic banking industry, comprising international as well as local and regional players, and
that their expectations are that Bahrain should move towards Basel II.
Finally, the above approach also reflects our view that a realistic and measured implementation of
Basel II is essential, if it is to succeed without creating additional risks to the banking system. Basel II
is clearly a much more complex and sophisticated framework than the original Capital Accord, and its
successful implementation will require not only a strong supervisory infrastructure to be in place, but -
for many banks - more sophisticated risk management and comprehensive data capture to be
developed. For this reason, we remain sceptical at this stage that the necessary preconditions for
implementing the advanced IRB and operational risk measurement approaches will exist by 2008.
Many of the BMA's recent enhancements in supervision will help prepare the groundwork for effective
implementation of Basel II. For instance, our development of a risk-profiling methodology for bank
licensees, to help better focus our supervisory efforts and provide for a more systematic assessment
of key risks in an institution, is essential in my view to the successful implementation of Pillar 2. As part
of our Basel II preparations, we will be developing this system further to incorporate assessments of
banks' capital assessment processes and to ensure more effective implementation across both on-site
and off-site supervisory directorates.
Our on-going efforts at strengthening corporate governance in banks, and our support for the recent
development of a credit reference bureau in Bahrain, will similarly help underpin the implementation of
Basel II.
Nevertheless, the fact remains that Basel II represents for the Gulf region as a whole a major
implementation challenge. Even where risk-based supervision has already been introduced, moving to
a system of individual capital requirements, set by regulators through the Pillar 2 review process, will
require significant improvements in internal processes, staff training and resources, if the whole
system is to work effectively and in a manner that carries credibility with the industry, the rating
agencies and other supervisors.
Supervision, in short, will have to become even more pro-active and risk-focused, and will become
more resource-intensive.
Equally, significant challenges exist for banks. Boards will be required to demonstrate that they have in
place effective processes for capital adequacy assessment and management. Many GCC banks,
particularly the smaller entities, have much work to do in this area to ensure that such frameworks are
properly embedded in their organisation. Further efforts need to be made to link capital planning to risk
management in a comprehensive manner. And many boards need to engage in such issues in much
more detail; some will need to revisit their mix of skills and experience.
Furthermore, banks will also be required to implement a comprehensive range of disclosures under
Pillar 3. Although banks in Bahrain are already subject to fairly extensive disclosure requirements, the
Basel II requirements are even more detailed. For many banks, this will pose challenges in terms of
reporting systems; for some, it may also require a shift in corporate culture.
In short, Basel II represents more than simply a technical compliance exercise. It will require major
changes in the way that we operate as supervisors, and in the way that banks and their boards
manage their business. Without such changes, the benefits of Basel II will not be realised.
I should like to turn now to some of the wider implications of Basel II for the Gulf region. Many of the
concerns voiced over its competitive and macro-economic impact are based on the assumption that
there is a direct relationship between regulatory capital requirements and the pricing and supply of
bank lending - in other words, that regulatory capital requirements determine banks' behaviour.
In fact, the evidence suggests that although there is some impact, that regulatory capital is not usually
the key determinant. Actual capital held by banks, for instance, is often significantly in excess of
regulatory minima: in Bahrain, commercial banks on average maintain a capital adequacy ratio of over
25%, significantly in excess of the BMA-imposed minimum of 12%.
Some banks also assume that the more sophisticated credit risk approaches offered under Basel II
inevitably lead to lower regulatory capital requirements. In reality, of course, the impact of the different
possible approaches is dependent on the quality of the loan portfolio concerned. The more
sophisticated approaches, because they measure more accurately the underlying economic risks
involved, in fact impose higher capital requirements for poorer quality loans than the standardised
approach. Even where they offer regulatory capital savings, banks often overlook the systems and
data costs involved in implementing the more sophisticated approaches.
And finally, some comments are based on the assumption that the current Basel I regime, the status
quo, is the valid yardstick by which to measure these changes. Thus, the move away from the simple
risk weighting of bank exposures at 20% may indeed lead to higher cost of funds for some banks - but
to the extent that the existing approach does not adequately discriminate between the different risk
profiles of borrowers, the change in regulatory treatment is clearly an improvement.
Bearing these points in mind, I believe that many of the concerns expressed over the competitive
impact of Basel II are somewhat over-done. At the very least, the issues involved - and the impact of
any changes to regulatory capital requirements - are not always as straightforward as they may first
appear.
In short, therefore, the main impact of Basel II is more likely to be to move regulatory capital
requirements closer to banks' actual risk assessments when lending to emerging markets, rather than
lead to material changes in pricing or availability of funds.
Similarly, Basel II will not necessarily favour foreign banks over domestic ones. Banks operating
mainly in lower-rated markets will, it is true, on average be required to hold under Basel II more
regulatory capital relative to banks operating in higher rated markets, including a higher capital buffer
to match the higher volatility inherent in their business. But the regional experience here is that local
banks already are relatively well capitalised - again indicating that actual risk assessments, rather
than regulatory capital, are the key driver.
These comments, of course, only touch on the surface of what is a complex subject. But the message
that I wish to leave today is simple. It is that Basel II has the potential to bring about significant
improvements in both the quality of supervision and banks' risk management. For that reason, it is
important to the financial services industry in this region that we implement it wholeheartedly, in a
manner that brings about these improvements.
Ladies and gentlemen, thank you for your patience.