Christian Noyer: Basel II - new challenges
Speech by Mr Christian Noyer, Governor of the Bank of France, before the Bank of Algeria
and the Algerian financial community, Algiers, 16 December 2007.
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I am very pleased and honoured to be here and I wish to wholeheartedly thank my friend
Mohamed Laksaci for inviting me to speak on the subject of Basel II. This subject is topical
for two reasons: first, we have already entered into (or, in some countries, are about to enter
into) the operational implementation of the new capital adequacy framework, which requires
a greater-than-ever involvement of banks and supervisors; second, the current financial
market turmoil raises questions as to the best way to implement this framework. In view of its
topical nature, I will present a few thoughts on "Basel II: New challenges", while attempting to
focus on the practical aspects of the implementation of the new capital requirements.
In this respect, and before moving on, I would like to thank the Bank of Algeria for its
participation in the Group of French-Speaking supervisors, created at the meeting of
Governors of central banks of French-speaking countries in June 2004 in Paris, which
coincided with the Basel Committee on Banking Supervision's publication of the New Basel
Capital Accord. I know that this Group is appreciated by many of its members as it enables
them to exchange experiences and information and promotes best banking supervisory
practices. It has already carried out useful work, in co-operation in particular with the
Financial Stability Institute (FSI) of the BIS, on the theoretical aspects and practical
application of Basel II.
Today, I will start by discussing the practical challenges arising from the effective
implementation of Basel II. I will then stress the need to pursue efforts to implement the
new Basel II framework in the context of the current financial market turmoil. Lastly, I will try
to draw some initial lessons from this turmoil with a view to ensuring that implementation is
optimal.
1. The effective implementation of Basel II is demanding and requires on the part
of credit institutions and supervisors considerable efforts and significant
resources.
The first challenge regarding Basel II is indeed of a practical nature, i.e. successfully moving
from the planning stage of this capital adequacy reform to that of its implementation. This will
be particularly challenging since Basel II is a much more ambitious supervisory framework
than Basel I, based on three complementary pillars:
- minimum capital requirements (Pillar I), which can be calculated in accordance with
various approaches, from standardised approaches to internal ratings-based
approaches (IRB), specifically developed by each credit institution. The approach
must be chosen by each institution under the control of the supervisor, in relation to
size and level of sophistication;
- the supervisory review process (Pillar II), which gives supervisors a key role in
assessing the risk profile and the quality of risk management of each institution as
well as the corresponding minimum regulatory capital ratios;
- market discipline (Pillar III), which enhances public disclosure requirements.
These three pillars, whose technical aspects I shall not discuss today, constitute an
ensemble aiming mainly to: i) improve banks' risk management, ii) align regulatory
capital more closely with the actual risks incurred by banks, iii) enhance the role of
supervisors, as well as iv) that of market discipline and therefore, ultimately, v) strengthen
financial stability.
The implementation of such a framework, embracing a broad spectrum of possible
approaches for banks and covering a large array of risks, is no simple matter and
accounts for the current variety of national situations, including within the G10: Japan for
example implemented Basel II in 2007, EU Member States are set to do so in 2008 and the
United States in 2009. The magnitude of this task is particularly vast since Basel II, in view of
the very nature of its objectives that I have just recalled, will be applied in a very large
number of countries. The latest study by the FSI on the application of Basel II, published in
September 2006 and conducted among 115 countries, shows that 82 Non-Basel Committee
Member Countries intend to implement the new framework, in most cases as of 2008 or
2009, and in some cases at a later date.
Fully aware of the practical aspects of implementing a more modern, complete and
risk-sensitive prudential framework, the Basel Committee published, in July 2004, i.e.
directly in the wake of the New Capital Accord, a document entitled "Implementation
of Basel II: practical considerations". Recognising that the adoption and application of
Basel II may not be a short-term priority for a certain number of supervisory authorities of
non-G10 Countries, the Committee encouraged the latter to develop their own approaches
and implementation timetables. Given that the necessary legislative and regulatory changes
and human resource requirements have to be identified, the application of Basel II will
necessarily be a gradual process throughout the world. This is especially the case since
technical decisions often have to be taken on the exact choice regarding the scope of
application of Basel II or the possibility of a staggered implementation of the three pillars.
In this respect, I welcome the choice made by Algeria to adopt and implement Basel II in the
near future. This choice should not be seen by banks as a regulatory constraint but
rather as a great opportunity to converge towards best international practices.
Moreover, this choice should preserve and strengthen the stability of the Algerian banking
system, which has been achieved in particular by strong economic and financial performance
since 2001 and the enhanced supervision capacities. The strengthening of these capacities
over the past years constitutes a major asset for the Bank of Algeria and should make it
possible not only to successfully ensure that Algerian banking regulation and supervision
complies with international standards (such as the Basel Committee's Core Principles for
Effective Banking Supervision), but also to efficiently prepare the implementation of Basel II
with a good take up of the Accord by Algerian banks.
As Governor of the Banque de France and Chairman of the Commission bancaire, I am
aware of the extent to which the preparation of the implementation of Basel II requires efforts
and resources on the part of both institutions and supervisors. Allow me to illustrate this by
briefly presenting initiatives carried out by the and its General
Commission bancaire
Secretariat for effectively implementing Basel II in France. By 31 December 2007, over
30 on-site inspections will have been conducted in 20 institutions, involving at times up to
100 inspectors at a time. These on-site inspections examined IRB systems for credit risk and
advanced operational risk measurement approaches.
This choice to carry out on-site inspections of internal risk measurement systems and
approaches and the importance attached by the Commission bancaire to such checks
is mainly due to the fact that, in 2008, 17 institutions (accounting for almost 95% of the total
assets in the French banking system) are set to use an IRB approach to measure their credit
risk and 5 institutions (accounting for almost 60% of the total assets in the French banking
system) are expected to adopt an advanced operational risk measurement approach. As
institutions have the possibility under Basel II of using their IRB approaches to calculate
regulatory capital requirements, supervisors must ensure that these approaches are reliable.
Following these on-site inspections and the examination by the Commission bancaire of the
corresponding inspection reports, 26
Memoranda of Understanding (MoU) were signed
with the institutions concerned. Improvements were requested mainly in the following
areas i) the different classes of risk held by the institutions, sometimes also ii) the definition
of default used by them, iii) the estimate of certain parameters such as Loss Given Default
(LGD), iv) the operational integration of the approaches implemented in the daily
management of risks and v) the governance principles applicable to these approaches.
Until the end of 2007, the Commission bancaire will monitor the implementation of the
corrective measures requested of the institutions. Following this process, the
Commission bancaire will take a formal decision as to whether or not to authorise the
institutions in question to adopt the advanced approaches of Basel II on 1 January 2008. For
institutions with foreign entities, this authorisation is granted, where appropriate, following an
exchange of information with the host supervisors, i.e. where the institutions' subsidiaries are
established.
While many counties, such as France, have entered into the effective implementation phase
of Basel II, the recent financial turmoil has once again drawn attention to this framework,
leading some observers to call into question its overall rationale.
This turmoil has new
characteristics as it is a credit crisis in a market environment with particular
implications concerning contagion channels. Risk transfer operations, in particular
securitisation, and the
interaction between funding liquidity and market liquidity risks
have played new or at any rate greater roles than before. I am nevertheless convinced that
the reform of the capital adequacy ratio rightly remains a crucial element in the regulatory
response to the problems facing us today. I would now like to explain why I am convinced of
this.
2. The current financial turmoil confirms the need to concretely implement
Basel II.
This turmoil may very legitimately raise questions about several of the major
provisions of Basel II, such as the use of rating agencies or the internal approaches
developed by banks to assess credit risk. The risk associated with a regulatory capital ratio
that is more sensitive to risk, and therefore potentially pro-cyclical, has also been advanced
in some quarters. I shall, however, give five main reasons showing that these questions
do not cast doubt on the benefits provided by the implementation of Basel II.
Firstly, unlike the present solvency ratio, the Pillar 1 of Basel II stipulates down a
specific calculation of regulatory capital to set against credit risk transfer transactions
(such as securitisations and credit derivatives). This is essential in the framework of the
"originate and distribute" model currently used by many financial institutions and that consists
in transferring as quickly as possible the risks associated with the loans extended and not
retaining them as in the past. The treatment set out in Basel II thus aims to ensure that
securitisation transactions now have their own economic reality, rather than seeking
regulatory arbitrage as was sometimes the case under Basel I. Based on two fundamental
principles - first, the actual nature of risk transfer and second, the significant nature of these
transfers - the treatment of securitisation in Basel II applies not only to banks acting as
originators and investors but also as sponsors. This treatment also takes account of the
many specific mechanisms in this type of transaction, such as early amortisation clauses and
credit enhancement. Lastly, it introduces a requirement for regulatory capital to be tailored for
certain off-balance sheet exposures, particularly liquidity facilities associated with these
transactions, which under Basel I were generally exempted of any capital charge.
Second, by reinforcing the link between the capital base and the risks actually
incurred, Basel II encourages banks to improve their systems for managing these
risks as well as their due diligence procedures. Beyond reminding banks of the basic
caution required when extending credit, this encouragement is all the more useful in that
banks now often play a role in securitisation transactions for which the underlying assets, for
example housing loans, may be initiated by unregulated entities, that are not always
accountable for their risk analysis and pricing. In other words, the weaker the discipline
surrounding the granting of a loan the stronger banks' diligence procedures needs to be.
Thirdly, Basel II gives banks and supervisors a vital tool, Pillar 2, with which to assess
the risk profile of institutions and in particular to take account of certain risks that are
sometimes difficult to quantify but whose impact can be great. By way of example, I
shall merely mention refinancing risk and reputational risk. Pillar 2 thus enables banks,
through the determination of the level of economic capital and supervisors, via for example
an increase in capital requirements, to ensure that all of the risks incurred are appropriately
covered.
Fourth, Basel II sets out to promote stress tests as one of the tools for managing and
assessing risks. This is very important in dealing with the turmoil like that we are currently
experiencing. Basel II stipulates that the stress tests conducted by banks must incorporate
the effects of a large increase in credit and market risks as well as those of a rise in liquidity
risk. The aim is to ensure that banks hold sufficient capital to absorb severe shocks.
Fifth and last, Basel II aims to substantially reinforce transparency and market
discipline. Pillar 3 of the framework lays down numerous requirements regarding the
disclosure of qualitative and quantitative information about capital and risk, including in
respect of risk transfer transactions. The importance of this information was thrown into
sharp relief by the financial turmoil this summer, during which greater transparency,
particularly regarding the nature and quality of assets recorded by credit institutions in
securitisation vehicles, proved necessary.
To sum up, and before trying to draw any preliminary conclusions from this turmoil aimed at
optimal implementation of Basel II, I should like to emphasise that the new framework
encourages banks to better assess and manage risks linked to securitisation
transactions and to improve their financial reporting, two crucial areas in which the
current problems have highlighted that significant progress needs to be made.
3. The financial turmoil has shown that optimal implementation of Basel II
requires further progress in several areas.
While it is too early to draw definitive conclusions from the current episode, it is
nevertheless apparent that progress needs to be made by credit institutions, for
example in the management of credit risk, market risk, liquidity risk, the risks associated with
certain activities such as asset management and risks linked to the valuation methods used
for some financial instruments.
Regarding credit risk:
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It is important to check that banks' internal rating systems, along with the
estimation of the different risk parameters they use, are updated in order to
reflect the increase in default risk and losses in the wake of the current
turmoil. It is indeed vital that these systems do not lead to risk being
underestimated. This update appears all the more necessary at the present time
given that in the case of real estate loan portfolios, estimates of risk parameters
have perhaps not been sufficiently rigorously tailored by all banks to the specific
features of some risky forms of credit such as US subprime mortgages. The same
thing may have happened in other countries. In a more general way, it seems useful
that supervisors should continue their analysis of the ways in which banks take
account of the specific features of certain financial assets whose risk profile may be
higher than that of the regulatory asset classes defined in Basel II;
- We need also to deal better with the issue - crucial for some assets such as
housing loans and specialised financing - of the correlation between
probabilities of default (PD) and loss given default (LGD). This may be quite
variable depending on the characteristics of housing loans in different countries.
More generally, we need to analyse in greater depth the ways in which banks take
into account the guarantees and collateral used and especially the correlation
between the risk associated with the hedged instrument and that related to the
collateral. This is all the more important given that Basel II increases very
substantially the range of collateral eligible for prudential recognition.
- Lastly, it is important to improve the quality of stress tests relating to credit
risk - including concentration risk - by including in them possible chain
reactions and spillovers on different markets. The way in which the results of
these stress tests are factored into risk management and assessment
systems as well as, where appropriate, into the level of economic or
regulatory capital required must also be closely examined, both by banks and
the supervisory authorities. This should also be one of the aspects of Pillar 2,
which I have mentioned several times and which I will come back to a bit later, given
its importance.
Regarding market risk, it is important:
- to ensure that banks only book their transactions in the trading book if they
are carried out on sufficiently liquid markets;
- and to better capture all of the risks within the trading book, especially default
risk the weight of which has increased over the past few years, notably due to
growing trade in structured credit products and products including stakes in hedge
funds. The publication by the Basel Committee on 12 October of guidelines for
computing the capital charge for incremental default risk in the trading book
constitutes an important step forward in this regard.
Regarding liquidity risk, the recent financial turmoil has highlighted the need
- for banks, to reassess the way in which refinancing risk can materialise and
analyse its impact on other risks such as credit risk and concentration risk, in the
event of liquidity facilities extended to securitisation vehicles being drawn on;
- for supervisors, to ensure that banks have set in place, within the framework
of their business continuity and "back-to-normal" plans, robust mechanisms
and procedures for liquidity management, taking account both of their own
refinancing risk, the risk of markets drying up and the potential interaction
between these two risks. This is all the more important in the context of the
"originate and distribute" model given that the effectiveness of the risk transfer
instruments on the basis of which the latter has developed requires sufficient
liquidity both on the part of agents and markets.
It is, incidentally, worth noting that the Committee of European Banking Supervisors (CEBS)
and the Basel Committee are working on a revision of the current regulations regarding
liquidity.
Moreover, concerning risks incurred by some activities such as asset management, it
appears necessary to gain a better insight into the transmission channels of these
risks between activities carried out for banks' own account and for third parties as well
as the liquidity requirements generated by the latter. More generally, the methods used to
assess and capture some risks such as reputational risk and strategic risk, notably in the
context of Pillar 2, need to be developed.
I would like to stress the very important role that Pillar 2 must play in improving
banks' management practices i) regarding new risks not covered by Pillar 1 and ii) in
areas that supervisors deem, specifically, liable to become new sources of
vulnerability. In practice, for some activities, there are still no universally accepted
standards for risk management. This does not mean, however, that banks' risk management
processes in these activities are always sufficiently stringent, but rather that there is a wide
range of instruments available for this purpose, each with its advantages and disadvantages.
This also means that supervisors should not carry out a mechanical assessment of these
risks and their management by banks such as would result for example from the simple
observation of a statistical confidence interval. The assessment must be more refined. In
addition, Pillar 2 should ultimately serve to improve risk management in the areas that
supervisors, at a given moment, deem to be crucial for financial stability, using a
forwardlooking approach.
Lastly, the recent financial turmoil has highlighted the difficulties and risks associated
with the valuation methods used for certain financial instruments, particularly complex
structured products but also some products regarded as more straightforward. Indeed, a
sometimes very great disparity has been observed between the theoretical valuations
derived from models and market values. However, the issue of the accurate estimation of the
price of complex transactions has taken on particular importance with the gradual adoption
across the board of fair value assessments since the entry into force of the new accounting
standards (IFRS).
In this respect, it seems necessary to include in risk assessments assumptions of an
erosion of liquidity and a rise in volatility as well as, more generally, to ensure that
processes for monitoring valuations within banks are strengthened. In particular, it is
vital to reinforce critical, independent and regular analysis of valuations obtained for
certain complex positions, which appear to have relied too often on external data supplied
by external rating agencies or service providers, without real analysis of the characteristics of
the underlying and collateral. It is also important to increase the banks' transparency
with regard to information on fair value valuation methods and how they are used to produce
income statements.
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As you can see, the challenges related to the implementation of Basel II are numerous.
Whether these are long-recognised or recent, such as those that have appeared since the
financial turmoil this summer, they must be addressed. To use what is I believe Governor
Laksaci's expression, the "challenge is a feasible one" and over the coming period, banking
supervisors will have to continue to work towards the robust and sound implementation of the
new framework. This implementation will bring about significant improvements with regard to
risk assessment and management, as has been confirmed by the initial feedback by
authorities that have already switched to Basel II.
I will conclude my contribution by citing a formulation used by the General Secretariat of the
Basel Committee, which, it seems to me, sums up perfectly the spirit in which the reform
should be introduced in each country: "Basel II is not a destination but a journey".
Thank you for your attention.