Jaime Caruana: Basel II - a new approach to banking supervision
Remarks of Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, at the Fourth Annual International Seminar on Policy Challenges for the
Financial Sector: "Basel II - the international banking system at the crossroads", Washington DC,
1 June 2004.
* * *
It is an honour to be invited to join you, the members of the global supervisory community, at this
seminar on the future of banking supervision. I would like to thank our host, Chairman Greenspan, for
his warm welcome into the hallowed halls of the Federal Reserve. Likewise, all of us express our
gratitude to the World Bank, the International Monetary Fund, and the Federal Reserve for organising
this seminar. To ensure rich, lively, and informed discussions, our sponsors have assembled an
impressive array of speakers and participants, including senior supervisors, central bankers, and
others from over 50 countries, an achievement that demonstrates, for the fourth time, excellence in
international and inter-organisational cooperation.
Overview of remarks
The new capital adequacy framework, or "Basel II," figures into virtually every discussion today on the
outlook for international banking tomorrow. This seminar will tackle its policy implications. They include
the new framework's potential effects on risk management within an individual firm; on competition
between firms; on the stability of the financial sector and the future of supervision; and, most broadly,
on the long-term growth of the economy.
What makes this seminar unique is its focus on the perspectives of countries that are not members of
the Basel Committee and particularly those of emerging market countries. Consequently, I will try to
focus most of my remarks from this very relevant perspective.
I would like to discuss three of the most sensitive policy questions that national banking authorities in
those markets - but also elsewhere - have raised about Basel II. First, will Basel II harm the flow of
capital to emerging and developing markets? Second, is Basel II appropriate for banks in those
markets? And third, will Basel II lead to a deterioration in the level playing field?
In my answers to these three questions, I will also highlight other related issues in the new capital
framework, such as complexity and procyclicality.
In some of the discussions that I have heard or read about these important issues, I have had the
impression that perhaps too much attention is placed on the constraints of regulatory capital. While
regulatory capital forms one of the overall constraints on banks' activities, it is not usually the most
binding constraint for the majority of individual banking decisions taken by leading institutions, which
are much more affected by factors such as economic capital, the level of competition and general
costs. At the same time, too little attention seems to be placed on another channel of influence of
Basel II: the improvement of risk management practices fostered by the incentives and transparency
enhancements contained in the new framework. In fact, this is one of the key innovations of Basel II
compared to Basel I. Basel II is about much more than just setting quantitative minimum capital
requirements. It is about establishing incentive-based approaches to risk and capital adequacy
management, within a framework of three mutually-supporting pillars: minimum capital requirements,
supervisory review and transparency.
I think that Basel II represents an unparalleled opportunity for banks to improve their business
strategies and risk management systems. In my view, the combination of better risk management, a
stronger capital structure and improved transparency standards in the banking system could
significantly improve the access of emerging economies to financial markets.
This raises two additional groups of relevant questions that I will also address later in my presentation:
the first group relates to the transition by different jurisdictions to the new framework, and the second
to the necessary cooperation between home and host countries to make its implementation more
effective and consistent.
Our discussions on all of these topics will bear on the very well chosen title for this event: "the
international banking system at the crossroads." That wonderful image of a "crossroads" suggests two
metaphors that we should keep in mind.
The most immediate image that the term "crossroads" calls to mind is, of course, a place where four
roads meet. It is where a traveller, having followed one road to this point, must reflect to select one of
the next three roads to continue a journey. That is an appropriate metaphor for us today. We must
evaluate the environment we and our banks are entering and choose a way forward that enhances
supervision and that contributes to the safety and soundness of our banks. At the same time, we
should not invent new roads. There are already 'roads' of good practices used by leading banks that
we can follow and support.
We might discover a second relevant metaphor if we allow ourselves to be inspired by the beauty of
the Federal Reserve's Eccles Building and its architectural references to antiquity. In classical times,
scholars divided the liberal arts into seven subjects. The first three related to language and formed the
"Trivium," "Quadrivium"
which in Latin means "three roads." In contrast, the - which is the Latin term
for "four roads," but also for "crossroads" - represented the study of four subjects related to numbers -
namely, arithmetic and geometry, but also music and astronomy.
The classical metaphor of the Quadrivium, or of the "crossroads" of subjects related to numbers,
seems equally well suited to a discussion of contemporary banking and supervision. Leading banks in
recent years have sought to augment subjective assessments of risk with more objective and
formalised, more rigorous, and more numerically oriented analytical techniques. After all, good
numbers are the best friend of good judgement.
Credit scoring, advanced statistical analysis, and financial modelling are among the ever expanding
range of tools that credit officers and others use to lend more rigorous insight into risks that were once
thought not readily quantifiable. The businesses of banking and risk management will always be more
art than science. Still, the metaphor of the crossroads of subjects related to numbers reminds us that,
for our system of supervision to remain relevant in the twenty-first century, it must reflect the industry's
advances in quantifying risk and in developing other tools to measure and manage risk.
At the conclusion of this seminar, I hope that all of us will return to our home countries with deeper
insight into Basel II and into our own readiness for a new approach to banking supervision. A Spanish
proverb reminds us to "drink nothing without seeing it; sign nothing without reading it." It is in that spirit
that I would like to begin the substance of my remarks with my thoughts on why we need Basel II.
Do we need Basel II?
As you know, Basel II has attracted much more attention, from more segments of society, than
probably any other reform of bank supervision. Mainstream newspapers have reported extensively on
it. Politicians of all views have addressed it. Even non-financial business owners have discussed it
extensively. The level of public debate reminds us that banks are charged with a special public trust
and that capital requirements are intended to safeguard their ability to discharge that trust. Banks
serve as custodians for the public's wealth and as intermediaries of credit to consumers and
businesses alike. No bank can discharge those duties for long if it lacks sufficient capital. When capital
is exhausted, the bank fails, leaving public authorities - and taxpayers - responsible for making
depositors whole again.
The 1988 Basel Accord established the the first internationally accepted definition and measure of
bank capital. In many ways, the 1988 Basel Accord was a tremendous success story. Perhaps
because it was simple to apply, it was adopted in over 100 countries, including most of the countries
represented here today. As a result, it became acknowledged as one of the benchmark measures of a
bank's financial health.
While the simplicity of the 1988 Accord was an asset in promoting its acceptance, today its simplicity is
quickly becoming a liability for some bankers and supervisors alike. Over the past 16 years, the
methodologies for measuring and managing risk have evolved in ways that the architects of the 1988
Accord could not have anticipated.
For one, advances in technology, telecommunications, and markets have changed the way that banks
collect, measure, and manage their risks. Having gained experience in quantifying exposures to
market risk, leading banks today are quantifying and using increasingly reliable estimates of the credit
risk associated with particular borrowers. Likewise, banks seek to quantify in a more reliable manner
their exposures to operational risk, or the risk of losses stemming from failures in internal processes or
systems or from damage caused by an external disruption. Evolution in markets has likewise provided
banks with more tools for managing and transferring credit risk, such as through securitisation
transactions and credit derivatives.
As risk management becomes more sophisticated, the simple and static rules of the 1988 Accord are
becoming less relevant. Leading banks increasingly view the old rules as a burden, constraining their
abilities to administer their businesses relative to the best information and practices available today.
Supervisors, for our part, have less confidence in the 1988 Accord's measures of risk for banks that
engage in the most sophisticated forms of risk taking and risk mitigation.
By the late 1990s, it became clear to banks and supervisors that we needed a new capital framework.
But one person in particular knew that we should do more than merely revise the minimum
requirements. Bill McDonough, the previous chairman of the Committee, and the former president of
the Federal Reserve Bank of New York, convinced leaders in the industry, in central banks, and in
supervisory agencies that we should provide incentives to advance the state of the art in risk
management across the industry. He did not seek to reduce the amount of capital held by the banking
system but rather sought to increase the stability of the global financial system - a goal that would
benefit not just banks, but more broadly businesses and consumers.
To work toward greater financial stability, the Basel Committee is blending several policy approaches
to replace the existing capital framework. As I have mentioned, Basel II consists of three mutually
reinforcing pillars. The first pillar aligns the minimum capital requirements more closely to banks'
actual underlying risks. Qualifying banks will rely partly on their own measures of those risks, a rule
that helps to create economic incentives for banks to improve those measures. The second pillar -
supervisory review - allows supervisors to evaluate each bank's assessments of its own risks and to
determine whether those assessments seem reasonable. The third pillar, market discipline,
strengthens external incentives for prudent management. It strengthens the ability of marketplace
participants to reward well managed banks and to penalise poorly managed ones by enhancing
transparency in banks' financial reporting.
One might say that Basel II seeks an "efficient frontier" of policy objectives through the three pillars.
Each pillar provides something that the other two cannot. Each is essential to achieving our overall
objective of financial stability.
The three pillars represent a far more sophisticated view of risk and a far more comprehensive
approach to supervising bank capital than the "one-pillar" approach contained in the 1988 Basel
Accord. As a result, the Committee has engaged in an exhaustive - and sometimes exhausting -
public dialogue with bankers, supervisors, and other observers on Basel II's structure and merits. That
dialogue was critical to improving the quality of the new framework, and I would like to express my
gratitude to all who took great pains to share their views and concerns. You provided us with the
perspective of other markets and countries. You shared detailed comments on the proposals. You
encouraged your banks to participate in our consultations. The improvements that the Committee
made to Basel II would have been impossible without your contributions.
Indeed, it was during those public discussions that policymakers in emerging market countries raised
three sensitive questions. I would like to turn now to address those questions and help explain my
belief that Basel II represents an opportunity for banks and supervisors in many countries.
1. Will Basel II harm the international flow of capital?
The first key question in the discussion about the new framework and emerging markets is whether
Basel II will harm the flow of capital across borders and especially to emerging markets. In this
context, some observers suggest that the new capital framework's heightened sensitivity to risk may
reduce the flow of foreign investment in developing economies, since exposures to those economies
might typically be considered of higher risk. As I will explain, I believe that Basel II will not have a
material effect on the flow of capital. Basel II seeks to align capital regulations more closely to banks'
current practices - it will not change the way that banks actually evaluate risk to decide whether to
invest in emerging market economies.
To understand this answer, we must first understand the issue that may have triggered this debate.
One of the valid criticisms of the 1988 Accord concerns its rather arbitrary treatment of country risk.
The 1988 Accord assigns risk weights, and hence capital charges, to sovereign governments and
related borrowers, as well as to banking organisations, based on whether the country in question is a
member of the Organisation for Economic Cooperation and Development. The "OECD Club Rule," as
it has become known, assigned a zero percent risk weight to exposures to sovereign government
borrowers that were members of the OECD, which means that no capital had to be held against such
sovereign exposures. In contrast, exposures to all other countries were assigned the standard 100%
risk weight, which is equivalent to an 8% capital charge.
The Club Rule was meant to help distinguish between higher and lower risk sovereign borrowers and
their banks. In retrospect, it seems to be an unfair way to divide the world. Indeed, some OECD
member governments have experienced serious economic shocks that threatened their repayment
abilities, while several non-OECD member governments have performed extremely well in the
international debt markets.
When the Committee set out to revise the 1988 Accord, we wanted to resolve the arbitrary treatment
of country risk that the Club Rule introduced. Our solution in Basel II was to assign risk weights, and
hence capital charges, to exposures to sovereign borrowers and to banks that reflected a measure of
their credit risk. Banks on the standardised approach to credit risk will determine the risk weights on
their exposures to sovereigns and to banks based on those borrowers' external credit ratings. Banks
adopting the internal ratings-based approach to credit risk will rely on their own sense of the credit risk
involved.
Basel II eliminates the arbitrary distinctions imposed by the Club Rule and sets capital requirements
based on external or internal measures of credit risk. Yet some observers have assumed that a more
risk-sensitive approach might drive up not just capital requirements, but also the pricing of credit for
loans to emerging market countries and banks.
This assumption is where the debate breaks down. Indeed, the arguments suggesting that Basel II will
reduce flows of capital into emerging markets requires us to accept the view that regulatory capital
drives loan pricing - something that has not been proven in any research.
In fact, research and the Committee's own discussions with banks suggest that something else drives
loan pricing. When determining the price of a loan, banks consider all of the economic risks associated
with a particular borrower. It is factors such as "economic capital" and the level of competition that
drive loan pricing, rather than regulatory capital.
Research on the pricing of international syndicated loans has confirmed that "pricing clearly varies
positively with credit risk." That finding should be no surprise to any banker or supervisor - banks that
do not price their loans based on a borrower's credit risk probably will not be in business very long.
When applied in the context of sovereign or bank borrowers, this finding suggests that loan pricing
already takes into account the credit quality of the borrowers.
Studies such as this one have concluded that, consequently, even those countries that have the
lowest credit quality will not likely experience a marked contraction in capital flows. Why would that be
true? It is because banks that are managing their risks appropriately are already considering all of the
risks that they face when they lend to higher risk borrowers - and thus a country's lower credit quality
is already priced into a loan, even under the existing capital rules today.
Furthermore, there are additional elements in Basel II that can contribute to alleviate concerns about
the impact on capital flows. Let me mention the reduction in capital charges for retail lending,
residential mortgages, small and medium enterprises (exposures below € 1 million) and
well-provisioned past-due loans.1 Also, the recognition of credit risk mitigants such as collateral and
guarantees is significantly better in the new framework of Basel II.
In a similar vein, I would like to address a related comment that I have often heard. Some observers
argue that Basel II will have a detrimental effect on capital flows to emerging market economies
because the new framework does not recognise the diversification benefits that characterise
investments in such markets.
It is true that Basel II falls short of recognising the diversification benefits of full credit risk models,
although the internal-ratings based approach recognises the benefits of diversification to some degree
by assuming that a bank's assets benefit from the same degree of diversification as that of an
average, internationally active bank. Under the evolutionary approach of Basel II, the Committee
recognises the importance of continued active dialogue with the industry regarding both the
performance of this models and their comparability across banks, and we have included this issue in
our agenda for future work.
Nevertheless, the main reason that we have not fully recognised diversification effects at this stage is
because first we need to see clear evidence from many banks that they have robust systems in place
themselves to assess and quantify such effects and that they rely on their measures of diversification
in their daily risk management. Of course, as systems improve in the future, we would be happy to
discuss them, and once there is a "best practice" in this field we will be better able to recognise it in the
capital framework. In the meantime experience with internal credit models will provide us with highly
valuable information.
In addition, since loan pricing is not predominantly driven by regulatory requirements, banks are free to
recognise diversification benefits in their own pricing calculations. Consequently, they can indeed
capture their sense of the benefit of diversification in their credit decisions and loan pricing for every
borrower, whether in an emerging market country or not.
From a different perspective, I think that what should be of concern to emerging market is not just the
level of capital flowing into a country, but also the volatility of the level of capital that is flowing inwards.
Abrupt changes in capital flows can be just as harmful as contractions in flows. Volatility erodes the
confidence that businesses and governments have in the future supply of credit, rendering long-term
planning meaningless.
I believe that banks adopting especially the advanced approaches to credit risk will increasingly take
longer-term views of their international investments, as stress testing and other requirements will
ensure that they consider how their risks would react to certain changes in the market environment.
When banking systems are adequately capitalised, well-managed and risks are correctly assessed
within the appropriate time horizon, the financial system becomes more stable, less procyclical, better
able to promote sustainable growth, and more resilient during periods of distress. Risk assessment
process that are more formalised and disciplined may facilitate early detections of deviations or
mistakes, and that may facilitate making smoother corrections at an early stage, reducing the
probability of sudden changes in investment decisions. This, in turn, should benefit emerging market
economies by improving the degree of confidence that they can have in the future level of capital
inflows.
Procyclicality
This is very much related to the discussion about procyclicality, an important issue that we at the
Committee have taken up and addressed seriously.
In particular, some have suggested that the internal ratings-based approaches will drive up the cost of
credit for borrowers precisely at times when its supply is falling, namely during downturns in the
business cycle. This has led to concerns that Basel II may exacerbate fragility in emerging markets.
There is some degree of procyclicality inherent in banking behaviour. The question that we should
consider is whether Basel II will unduly exacerbate this behaviour. In response, I believe that concerns
in this respect may reflect the perception that I have already challenged - that regulatory capital
charges directly drive credit pricing decisions. As I noted, research suggests that it is economic capital
that drives credit pricing, not regulatory capital. Consequently, Basel II will simply align regulatory
capital rules more closely to banks' actual practices; it will not change how they price credit facilities.
Nonetheless, the Committee recognises that any risk-sensitive capital framework will cause the capital
requirement to fluctuate for the same exposure if a borrower's creditworthiness strengthens or
weakens. To mitigate excessively wide swings in capital requirements, the Committee has flattened
the risk weight curves that apply under the "internal ratings-based approach" to credit risk so that a
small change in credit risk does not lead to a large change in capital requirements. At the same time,
the Committee will require banks adopting the more advanced approaches to credit risk to adopt a
more forward-looking approach to credit risk management by requiring meaningful stress testing of
their credit portfolios. Stress testing is intended to help banks understand how their exposures to credit
risk may change in the future should sudden shocks affect the market in some way.
2. Is Basel II appropriate for banks in emerging market countries?
The first key question addressed Basel II's potential impact on investment and capital flows between
countries. The second key question is whether Basel II is even appropriate for banking systems in
emerging markets, which I would like to address now.
In my view, the principles and vision of supervision in Basel II are valuable for supervisors and banks
in all markets. I must acknowledge that its advanced approaches to risk measurement are mainly
intended for those internationally active banks that have the greatest potential to increase systemic
risk, and are very demanding in terms of the investments that they pre-suppose in the banks' own
systems, and the qualitative requirements that they set. The 1988 Accord itself was created initially to
apply a more consistent set of rules to globally competitive banks, and the shortcomings of the existing
rules today are especially evident in the context of these highly sophisticated organisations. However,
many supervisors apply the 1988 Accord to less complex organisations that may be active mainly or
even only in domestic markets. Is Basel II appropriate for those banks as well?
I think that the great level of diversity in markets and in financial systems worldwide makes it difficult -
and perhaps even counterproductive - to try to specify a single rule that could be applied to all banks
in all countries. Fortunately, Basel II is moving away from a "one-size-fits-all" rule. In fact, Basel II's
menu approach provides supervisors and banks with a range of options that make its basic standards
more readily available to many kinds of organisations in countries that face different economic
circumstances. It also makes greater supervisory cooperation essential, in order to ensure consistent
implementation.
One concern which has been expressed many times is that excessive reliance is placed on External
Credit Agencies for those banks that do not have sufficiently robust internal rating systems. The
Committee has been mindful of this concern and if supervisors are uncomfortable with external ratings
in their countries, there is an option whereby all corporate claims are weighted at 100% and
sovereigns and banks can be risk weighted according to the risk scores of export credit agencies, in
which case there need not be any reliance on external credit agencies at all.
Indeed, our discussions with colleagues and counterparts from countries outside the Committee have
been instrumental in revising the capital framework. Thanks to our consultations, we have
endeavoured to address several broad issues in the new framework, which I will set out now.
Complexity
One inevitable by-product of designing a comprehensive three-pillar framework with built-in options to
suit different circumstances is increased complexity. The members of the Basel Committee certainly
recognise that complexity is not a virtue for supervisory guidelines. It is far easier to enforce a simple
rule than a complicated one. However, achieving a balance between simplicity and comparability, and
also between simplicity and risk sensitivity is particularly difficult in an industry like banking, where a
culture of constant innovation makes it a tall order for regulators to develop simple rules that fit all
banking products and services in all their permutations. Paraphrasing Einstein 'a good framework
should be as simple as possible, but not simpler'
Much of the complexity in Basel II actually stems from the diversity existing in real world and from the
many options that the rules provide. Many of those options reflect banks' own requests to address the
rich variety of risks and practices in existence today; some banking organisations thought that a
"blanket rule" would unfairly burden them. By providing a range of options, we are better able to fit the
regulatory framework to each bank's profile, rather than the other way around.
Similarly, some of the complexity in Basel II stems from the details we provide to clarify expectations
for banks and supervisors and to promote a more level playing field. Many bankers and supervisors
asked the Committee to provide greater details where they thought a danger existed for differences in
interpretation to arise across jurisdictions.
We have worked hard over the past years to clarify the rules, to simplify those thought to be the most
complex, and to provide options for those wishing to use a simpler approach. In fact, as the Basel
Committee demonstrated in an annex to the third consultative paper, supervisors can select options
that would result in a very simple set of rules that can be specified in just 12 pages of text. That is
approximately equal in length to the original 1988 Accord.
The "simplified standardised approach", as we call it, is intended to be useful for those countries that
do not wish to adopt all of the options available under the new framework. The trade-off, however,
reflects the fact that the policy balance at stake is between simplicity and risk-sensitivity; if one
chooses simpler rules, the cost is less sensitivity to risk and hence greater conservatism in capital
requirements.
3. Competition and consistency of application.
Another broad concern that the Committee has worked to address is Basel II's impact on global
competition. In particular, some have asked whether banks that choose Basel II's advanced
approaches will enjoy benefits over those that choose simpler approaches. Others have wondered
whether banks that remain on the 1988 Accord for some time will be disadvantaged.
To respond to these concerns, we should understand that adopting an advanced approach does not
automatically reduce a bank's capital requirements. In fact, a more risk sensitive capital framework is
intended to align capital requirements more closely to risk. This could mean that capital requirements
for an advanced bank may actually rise relative to the current rules if the bank's exposures are actually
riskier than the measures under the 1988 Accord would have suggested. Furthermore some national
supervisors may set higher capital requirements than implied by Basel I, perhaps even higher than
those implied by Basel II, depending on the risk environment.
For those banks that do experience reductions in capital as a result of Basel II, some observers have
questioned whether the lower requirements might provide certain advantages and make it easier for
those banks to acquire other banks that do not share in the same benefits. History suggests that this
particular concern may be unfounded. In a paper published this past February by the Federal Reserve,
researchers reported that they did not find convincing evidence that past changes in capital
requirements have had a substantial impact on mergers between banks.
The issue of competition between banks has also come up in the context of competition between
countries. Here, we should remember that Basel II is intended to help ensure that international
competition in banking markets is driven by the strengths of each bank, rather than by differences in
each country's rules.
One way that the Committee has sought to promote a consistent application of the new framework is
by providing banks and supervisors with detailed requirements where necessary. As I have already
mentioned, these details may add to the appearance of length and complexity in Basel II, but that is a
small price to pay for greater consistency and a more level playing field.
However, given the need to have a framework which can be adapted to a wide range of
circumstances, cooperation among supervisors is clearly the most important tool in achieving an
appropriate level of consistency. The Committee has established a working group of supervisors,
called the Accord Implementation Group, or "AIG," that shares information on implementation efforts
among Basel Committee member countries. The AIG works with other supervisors as well, including
through the Core Principles Liaison Group, a group of supervisors from many other countries that
shares views and exchanges information.
By promoting the sharing of information on practical issues, the AIG's discussions will help to foster
greater consistency in the implementation and application of the new framework across countries. For
example, thanks to the work of the AIG, the Committee has been able to publish its thinking on the
implementation of the supervisory review process - Pillar 2 - and on home-host co-operation in
implementation of the framework.
Let me just come back to this latter point. Given the internationalisation of banking groups and their
increased reliance on group-wide risk management, it is clear that the cross-border implementation of
the framework is more complex than it was in 1988. The AIG has been actively discussing this issue,
and in August 2003 the Committee published a set of principles to promote closer practical
cooperation and information exchange among supervisors. The principles re-emphasise the traditional
responsibilities of home and host supervisors, but also how those responsibilities will continue under
the new framework on the basis of enhanced co-operation. More recently, at the beginning of May, the
Committee published an elaboration of the principles.
Of course, w