Jaime Caruana: Basel II - back to the future
Speech by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, at the 7th HKMA Distinguished Lecture, "Basel II - Back to the Future",
Hong Kong, 4 February 2005.
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1. Introduction
Let me begin by expressing my gratitude for this invitation to participate in the "Hong Kong Monetary
Authority Distinguished Lecture". I am honoured to join the list of prestigious speakers who have
discussed critical issues in economics and finance in this forum, issues made especially prominent by
the important role that the Hong Kong Monetary Authority plays in promoting financial stability under
the leadership of Joseph Yam. From my perspective as Chairman of the Basel Committee on Banking
Supervision, I am indebted to Mr Yam for his support and initiative in contributing to the development,
and now the implementation, of the new bank capital framework, or "Basel II".
"Nothing endures but change," wrote the ancient Greek philosopher Heraclitus more than two
thousand years ago. In a world where change is the only constant, success depends on the depth of
our awareness of the risks and rewards on the horizon and on the quality of our preparations to
respond to them appropriately. That is true not just in the banking industry, but certainly also in the
formulation of public policies geared to promoting more sustainable economic growth through greater
financial stability.
Today I would like to address the importance of adopting a forward-looking approach in our framework
for financial stability. At the same time, following the advice of the Italian statesman and philosopher
Machiavelli that "whoever wishes to foresee the future might consult the past", I would like to make the
case that, to ensure a sound regulatory system for the future, we must look carefully back at the
lessons of the past.
It seems especially appropriate to discuss, here in Asia, the important relationship between financial
stability and sound growth. After enduring a period of regional financial distress in the late 1990s,
Asia's re-emerging dynamism and growing stature can be seen in many indicators: for example, in its
capacity as an importer of raw materials and foreign direct investment, and as an exporter of
manufactures, financial capital, etc. Asia is a central partner with the rest of the world through its roles
both in trade and finance.
Indeed, in a recent address at the Centre for Banking and Monetary Studies in Geneva, Mr Yam
offered an accurate overview of Asia's vibrant potential. He set out some impressive figures such as
the amount of foreign reserves held by Asian economies, the amount of portfolio and direct investment
going into and coming out of the region, and the high level of rates of private-sector saving, which is
increasingly institutionalised and professionally managed. Certainly, Hong Kong is a prime example of
the enormous potential that is being realised in Asia. Because of the openness of its economy and the
vitality of its business environment, Hong Kong serves as an important reference point for the world.
Hong Kong has captured the world's attention artistically as well, especially through the recent work of
the screenwriter and director Wong Kar-wai. His recent film, 2046, has rightly enjoyed acclaim, but it is
the film's unique perspective on time that might be interesting to contemplate today. In his film, as
many of you may know, an author writes a book about the future, but gradually we realise that he is
actually exploring his past. With apologies to Mr Wong and with deep respect for his beautiful film, I
might venture to say that we can draw some parallels with our discussion today. As I have just
suggested, I believe that in order to secure financial stability in the future, we must explore and
understand the risks that have endured since the past.
If I may draw on my own artistic license, I'd like to reinterpret the premise of Mr Wong's film slightly.
Let's consider an author, perhaps a central banker or a supervisor, who lives in the year 2046 and has
the benefit of the perspective provided by the passage of the first half of this century. What might such
an author write about the main determinants and evolution of financial stability during the first five
decades of the twenty-first century?
It is my hope that in that book of the future, the Basel II framework would be portrayed as a revolution
in our approach to financial regulation. It would represent the introduction of a new regulatory and
supervisory paradigm, one premised on the need to begin to depart from blunt requirements and
instead to develop rules that incorporate nuance, rules that align capital requirements more closely to
the actual degree of economic risk a bank faces. Our author might write that Basel II represented an
important step forward in continuing to replace static rules with rules that offer incentives for firms to
improve constantly their internal governance and management of risk. And that it marked a milestone
in the trend toward leveraging the power of the market place to exert discipline over firms' decisions
and strategies, such that other marketplace participants can better serve as effective allies of
regulation and supervision to achieve financial stability.
Yet I must confess that, with the evolution in practices and technology that can reasonably be
expected by the year 2046, the Basel II capital framework released in June 2004 might well be judged
to be excessively simple. Still, its greatest virtues might be considered its forward-looking nature and
its flexibility, and its ability to adapt to new circumstances and to the emergence of better risk
management practices.
I was tempted by this flight of the imagination to frame my remarks today as the views of that author
looking back at the work we are undertaking in 2005. In truth, though, I thought it might depart too
much from the usual field of play of central bankers and supervisors. Instead, I'd like to share my
views on how the elements of Basel II take us "back to the future," not unlike the journey of Mr Wong's
author in 2046 from the future to the past. In many ways, Basel II brings us back to a traditional focus
on risk, but with the benefit of the most advanced techniques emerging today and into the future.
2. Overview
Specifically, I would like to try to address four key points.
Firstly, I would like to consider the current framework for promoting financial stability. I will argue that,
despite significant progress, our policy and decision-making framework for financial stability is still
incomplete, especially if we draw a comparison with the framework for monetary stability. That said,
there are a number of lessons we have learned in recent years that can be useful for the future, and
which we have taken into account in designing the new Basel II capital framework. One of the most
important of these is the very real and positive contribution that sound risk management practices can
make to promoting financial stability.
Therefore, in the second part of my intervention, I would like to explore in more detail some of the
most important recent trends and developments in risk management theory and practices, and also
the impact that these developments can have both on individual firms and on the economy as a whole.
I will cover three trends in particular: firm-wide assessment of risk, risk aggregation and risk transfer.
This will lead me to the third part of my intervention: the challenge of devising a supervisory response
which harnesses these developments for the benefit of financial stability. As I will argue, it is critical to
ensure that our supervisory and regulatory structures are compatible with the best practices in risk
management today. But I believe that our structures must go beyond that and actually encourage firms
to continue to improve their measures of risk exposures and their approaches to mitigating them in the
future. This forward-looking approach forms the basis of Basel II.
In the final part of my intervention, I will explore some of the implications of Basel II that received some
attention in recent times: namely, the potential impact of the new framework, both on capital flows and
on global competition.
My purpose today is not to describe Basel II in detail, but rather to highlight the dynamic processes
that it stimulates. I do not claim that Basel II covers all the areas and refinements needed to complete
the framework for financial stability, but it does make a landmark contribution by incorporating a new
forward-looking approach, to banking regulation and supervision, which is, at the same time,
consistent with the lessons of the past.
3. Framework for financial stability.
Beginning with my first topic - the framework for financial stability - allow me to make a final reference
to the hypothetical book that might be written in 2046. I would not be surprised if the author of that
future book noted an interesting contrast that existed at the beginning of the twenty first century.
Although we have a well-developed framework for debating and conducting monetary policy, our
thinking on financial stability is less advanced.
As an example, in the monetary field we have agreed on a definition of monetary stability - namely
price stability. We have a framework of analysis that allows the causes and consequences of price
instability to be studied. And, moreover, we have a highly developed decision-making framework for
pursuing monetary policy, which has almost universally adopted the principles of central bank
independence and primacy of price stability as the goal of monetary policy.
In comparison, and despite significant progress during the last decades, we are not nearly as far along
with financial stability, and there are areas where we still have something to learn. We don't have a
clear and measurable definition of the term financial stability and, in most cases, nor do we have a
clear policy or decision-making structure for pursuing financial stability, unlike in the field of monetary
policy, in which many central banks follow well-defined strategies which in one form or another respect
the principle of "constrained discretion".
Achieving a coherent approach to financial stability may be challenging, if only because it requires a
consistent combination of macro and micro elements and because of the large number of interested
and participating parties. Also, it should foster financial innovation, and ensure a level playing field.
However, I think that our future author might take some comfort from the fact that supervisors, central
bankers, policymakers and others learned valuable lessons in the late 20th and early 21st centuries,
which will remain valid for the rest of the century. Let me outline four of those lessons.
First, we have learned of the need for businesses and consumers to have access to credit on fair and
reasonable terms, through all stages of the business cycle, so that the economy can grow through the
financing of the best opportunities.
We have learned that we need an efficient and resilient payments system to maintain the flow of funds
through the economy at all times. We need financial markets to remain active, liquid and trusted,
regardless of events in the economy. And we know that, for all these things to occur, our financial
institutions must be led by responsible individuals, must operate transparently, and must serve the
interests of depositors and shareholders alike.
Second, we have identified some characteristics of financial instability. For example, financial
instability may reveal itself via excessive volatility in asset prices, which can move substantially away
from the value which, in principle, their fundamentals would warrant. To be sure, a certain degree of
volatility in asset prices is simply the reflection of the normal workings of markets. Likewise, poor
results posted by a specific financial institution, even its bankruptcy, may not have systemic
implications. However, financial instability may be very costly if it is on such a scale as to cause harm
in the real economy.
These considerations allow us to draw a relevant conclusion: the pursuit of financial stability calls for
increased attention to a combination of micro and macro factors and must be based on a broad range
of tools which we should all seek to strengthen.
Third, we have learned the importance of sound macroeconomic policies and an appropriate
institutional framework, as well as of prudential regulation and supervision, and consumer awareness
and understanding. This is an extremely important point and even though it is not my main subject
today, I would like to briefly underline two elements.
Firstly, there is a broad consensus about the importance of promoting the implementation of
appropriate macroeconomic policies. Nobody has any doubts today about the need to promote price
stability. However, this is not a sufficient condition for ensuring financial stability, which demands other
additional measures.
These include, for instance, fiscal discipline, and the design of exchange rate policies that ensure the
consistency of the exchange rate system chosen with domestic policies, and that contain
vulnerabilities associated with exchange rate instability in the different sectors of the economy.
Macroeconomic policies must also be consistent and sustainable over time. Indeed, unstable
macroeconomic settings are one of the main causes of excessive volatility on financial markets.
Secondly, an appropriate institutional framework is also needed. In particular, a set of mercantile and
civil laws must be in place, including the treatment of bankruptcy situations; accounting obligations that
ensure the uniform representation of economic events; external auditing requirements; guarantee
funds providing appropriate safeguards; independent supervisors with operational capacity, etc. The
legal structure and its application by the judiciary should ensure the respect of property rights and
equality before the law; in sum, legal security.
The need for this set of minimum prerequisites is reinforced by the "Core Principles for Effective
Banking Supervision", which are invaluable as a tool for the evaluation of supervisory systems. In this
respect, let me mention also the excellent work of the Financial Stability Forum over the last years in
bringing together various standards issued by a number of bodies.
In summary, even though the framework for financial stability is not as comprehensive as in the case
of price stability, significant progress has been made in all of these areas in recent years.
There is a fourth lesson that is particularly relevant for this presentation, and it is a lesson that we have
learned from periods of bank resilience in times of stress. During the past few years, financial markets
have experienced a series of significant shocks. However, the banking system has been able to cope
with them successfully. Financial innovation, the existence of deeper financial markets with a great
variety and availability of instruments to transfer risks, and the improvement of the capacity of financial
institutions to understand and manage their risks are key ingredients in explaining the resilience of the
financial system during the period of shocks. And that leads me to my next point: important trends in
risk management.
4. Recent trends in risk management
Financial stability is a key precondition for sustained growth. It is crucial, therefore, to find reliable
ways of identifying risks to financial stability and, in particular, to banking stability, and to try to manage
these risks in the most effective way. Indeed, as experience has repeatedly shown, both inside Asia
and elsewhere, having a solid and well-run banking system not only greatly reduces the likelihood of
shocks originating inside the banking system but also makes it less likely that shocks arising
elsewhere in the economy are amplified through the banking system.
Financial service providers have long competed on their ability to provide products and services
tailored to each customer's needs and profile. Traditionally, a bank's balance sheet and earnings
offered insight into the quality and results of its transactions with customers, but those historical
measures reflect only the outcome of past decisions. A bank's ability to thrive in the future - and the
ability of the banking sector to act as a source of credit to businesses and consumers alike - depends
instead more on the kinds and levels of risk that its transactions entail. For most of the history of
banking, banks could assess those risks only in a highly subjective manner and without significant
confidence in the quality of such assessments.
However, financial innovation and advances in the measurement and management of risk have
fundamentally changed how banks and other financial service providers approach their businesses.
Three trends are particularly prominent and have been analysed by the Joint Forum.
First, one of the most notable advances in risk management is the growing emphasis on developing a
firm-wide assessment of risk.
Firm-wide risk assessment
Improvements in technology and telecommunications have made it easier for firms to gather, collect
and analyse large amounts of data on their exposures and business activities efficiently and
increasingly in near "real time." To make the best use of firm-wide data, many organisations have
established a dedicated risk management function to foster more highly integrated and systematic
approaches to risk measurement and management. The risk management function typically promotes
the use of common risk measures across business lines. It can then report the firm-wide risk data to
senior management.
Even though no single model for organising an integrated risk management function has become
dominant, all firms that establish integrated risk management units are highly dependent on the quality
of their information technology to collect, analyse and report firm-wide data efficiently and effectively.
Some participants have found that the greatest challenge in developing a centralised risk
management structure lies in constructing compatible and efficient management information systems
across all of their businesses. As a result, they devote substantial resources in terms of personnel and
expenditures to the maintenance and enhancement of their management information systems.
This trend is important for two reasons.
For one thing, comprehensive firm-wide assessment of risk and consistent reporting helps to ensure
that the firm is aware of the wide range of risks to which it is exposed, that it understands the relative
importance of various risks and how they may interact, and that the firm is less likely to ignore material
sources of risk. This facilitates early detection and resolution of problems.
For another, this integrated risk management function requires a balance between the centralisation of
some functions within the group as a whole, and the need to be close to local markets to incorporate
better knowledge of local needs, risks, sensitivities and regulations. This, in turn, raises issues of
co-ordination and communication for both internationally active banks and also supervisors, about
which I will say more later.
Risk aggregation and quantification
Collecting risk data across many business lines has catalysed further efforts to aggregate those
measures of risk by quantifying them in a more rigorous and more consistent fashion. This
quantification of risk is the second major risk management trend identified in the Joint Forum report. It
is not a new concept. In the insurance industry, for instance, actuaries have long sought to estimate
the likelihood of various events taking place. What is new is that, in recent years, financial risk
managers and researchers apply mathematics, statistics and modelling to many risk exposures that
were previously not thought to be readily quantifiable.
In the banking industry, for example, statistical and computational analyses developed for evaluating
exposures to market risk led, over the past decade or so, to the application of similar techniques to
credit risk. The introduction of increasingly reliable estimates of the drivers of credit risk, such as the
probability of default, led to many of the proposals that form the basis for the new Basel II bank capital
framework.
The Joint Forum found that the "ultimate expression" of risk aggregation is the summation of many
types of risk into a single risk measure. This measure, often called "economic capital," estimates the
amount of capital a firm requires to protect itself against all risks with a certain degree of confidence.
The benefits of developing more aggregated measures of risk across diverse business lines are
especially appealing to complex financial organisations whose activities span many kinds of activities.
As a result, it is not surprising that large, mixed financial conglomerates have tended to invest most in
the development of economic capital estimates.
Using the concept of economic capital and its elements, banks can develop sound policies for
monitoring exposure limits, risk-adjusted pricing policies and sound provisioning practices based on
the inherent risks of the portfolios. They can also measure returns and assign capital on a
riskadjusted basis.
Let me add a word of caution. Despite the significant progress made in the banking industry in the use
of models and new technologies, banks still depend largely on risk managers' expert judgement.
Quantifying risk involves making assumptions and judgements. And no model, and no software
package, no matter how sophisticated, can ever replace the skills of a trained, experienced and
conscientious risk manager. That is why we have made sure that the Basel II framework is much more
than numbers and models. Such judgement should be reinforced, however, with the best possible
information, techniques and tools for processing that information. To the extent that risk assessment
and control methods become more formalised and rigorous, this will lessen the likelihood of making
bad decisions. It will also contribute to the prompt detection of errors and deviations from targets,
allowing banks to implement corrective measures at an early stage.
The first two trends that I have cited relate to the internal efforts firms undertake to identify and
measure their risks. The third trend I'd like to highlight concerns the dramatic increase in the use of
transactions designed to transfer exposures to risk, especially to credit risk, to outside counterparties
and even to investors.
Credit risk transfer
This past autumn, the Joint Forum released for public comment a study on the current use of credit
risk transfer activities among financial service providers, along with a series of recommendations on
how to promote sound risk management practices in this area. In recent years, the markets for credit
derivatives, credit default swaps, collateralised debt obligations and other products have grown
tremendously, providing financial service providers with new mechanisms through which they can
reduce their direct exposure to credit risk. Such tools may also help to reduce concentrations of risks
in particular firms.
I think that the emergence of these new channels for re-packaging and selling off credit risk serves as
another means of looking forward to the future to manage risk. In this sense, the rapidly expanding
secondary market for new credit-risk related instruments bears witness to the innovation and the
search for new ways of managing risk that is so vital to the continued evolution of the financial sector.
However, we must remember to look back at the fundamental risks involved in these practices. The
sale to outside parties of credit risk packaged into new instruments helps, of course, to transfer the
risk, but the credit risk still exists.
While the transfer of risks to institutions or households that are better able to withstand them is a
positive factor, and one of the structural explanations for the resilience of the banking sector during
recent periods of stress, we should be conscious that this development may introduce some new risks
into the system, such as operational risks, which require adequate treatment. Sellers of credit-related
instruments face some degree of legal risk, for example, when new instruments are issued and their
enforceability in courts has not yet been tested. Likewise, the creation and management of the new
products can put strains on legacy risk measurement and management systems that were not
intended to handle them, creating new possibilities for operations to fall short or even to fail in some
way, creating losses.
These advances in the technology and practice of risk management introduce unique opportunities for
public authorities to promote greater stability. I'd like now to turn to the efforts that banking supervisors
are undertaking to respond to these recent trends. This represents the next topic I'd like to address
today.
5. The supervisory response: Basel II
Against this background of increasingly sophisticated risk management practices, heightened
complexity in the financial markets and stronger interaction between the real and the financial
economy, the Basel II process started more than 5 years ago. Rather than simply resetting the
quantitative standards, we sought to develop a new forward-looking approach that would be more
sensitive to the actual risks that banks take on, one that would ensure a level playing field for banks
that compete globally, one that would be better able to evolve with, and indeed encourage, future
improvements in the measurement and management of risk, and one that would be well-anchored on
a solid corporate governance structure and a sound risk culture.
If you allow me, I will draw one more parallel between monetary stability and financial stability. I would
say that Basel II incorporates some of the key basic principles that are also built in modern
approaches to monetary policy and which have successfully resolved the debate between rules and
discretion: a flexible and forward-looking approach, anticipatory rather than reactive behaviour to risk,
and the need to take into account market views.
The new capital framework is much more comprehensive than the 1988 Accord for many reasons: it
applies to a wider scope of entities within banking groups; it offers a menu of different alternatives to fit
different circumstances; it encompasses additional risks, in particular operational risk; it widens the
recognition of credit risk mitigation techniques; it sets out a thorough framework for securitisation
transactions; and, most importantly, it is based on 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, captures the view that capital supervision requires banks to
enter into a dialogue with their supervisors on the processes and internal estimates that they develop
to determine how best to navigate the risks and rewards that they encounter. That includes making
decisions on how much capital beyond the minimum requirement a firms should hold.
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
By relying on an "efficient frontier" of three very different policy approaches, Basel II is intended to help
supervisors to promote the adoption of sound practices today, to support efforts to improve those
practices tomorrow, and to nurture a stronger risk management culture overall. In many ways, Basel II
brings us back to a traditional focus on risk, but with the benefit of the most advanced techniques
emerging today and into the future.
As I noted at the beginning of my intervention, my purpose today is not to describe Basel II, but rather
to highlight those elements of the framework that set in motion dynamic processes that will enhance
banks' safety, efficiency and soundness, thereby strengthening the stability of the financial system as
a whole and ensuring that it can better serve as a source for credit and growth for the economy.
The comprehensive framework of Basel II provides four transmission channels for influencing financial
stability: first, by setting more risk-sensitive minimum regulatory capital requirements, so that
regulatory capital is both adequate and closer to economic capital; second, by providing incentives to
encourage improvements in banks' internal risk management processes; third, the enhanced
mechanisms to encourage the marketplace to exert external discipline on banks and the banking
sector; and fourth, the necessary greater co-operation among supervisors across jurisdictions.
Through these channels, Basel II should remove distortions potentially hindering capital flows, improve
the efficiency of the allocation process, and increase the stability and resilience of the financial system.
The way I see this improved dynamic "risk-based efficiency", as I would call it, is that, given the same
situation of an economy in terms of risk appetite and risk absorption capacity, the financial system will
be able to provide more and better allocated financing flows, something that may help to increase the
potential growth of the economy, without reducing the safety and soundness of the system.
All in all the potential impacts of this new regulatory approach may be profound and wide-ranging. I
would like to explore some of these implications that have received some attention.
6. How Basel II will affect the flow of capital across borders.
Let me start reflecting on how Basel II will affect the flow of capital across borders. Some observers
suggested 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.
I believe that, in the short run, Basel II will not have a material effect on the flow of capital, whereas in
the medium and long term Basel II's forward-looking elements will probably take over and higher risk
efficiency will improve the financing of all kinds of economies.
The first part of this comment, the lack of any short-term material effect on capital flows, is based on
the notion that Basel II seeks to align capital regulations more closely to banks' current practices,
which today are already risk-sensitive. Therefore, it will not change the way that banks actually
evaluate risk to decide whether to invest in emerging market economies.
Yet some observers have assumed that a more risk-sensitive approach might drive up not just capital
requirements, but also the pricing of credit to emerging market countries. This argument assumes that
regulatory capital drives individual loan pricing decisions. However, while regulatory capital is
important and may represent an overall constraint, research and discussions with banks actually
suggest that, when determining the price of a loan, banks consider all of the economic risks
associated with a particular borrower. It seems that factors such as "economic capital" and the level of
competition are much more influential in individual loan pricing than regulatory capital.
That finding should be no surprise to any banker or supervisor - banks that are managing their risks
appropriately are already considering the risks that they face when they lend to higher-risk borrowers,
and thus lower credit quality is already priced into a loan, even under the existing less risk-sensitive
capital rules today.
Furthermore, there are additional elements in Basel II that can contribute to alleviating concerns about
the impact on capital flows to emerging markets. 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. Also, the recognition of credit risk mitigants, such as collateral and
guarantees, is significantly better in the new framework of Basel II.
If we take a medium or longer-term perspective, the different channels that I mentioned before will
ensure better access to financi