Nicholas C Garganas: On the practice of financial stability in Greece - the
implications of Basel II
Speech by Mr Nicholas C Garganas, Governor of the Bank of Greece, at the Conference on Financial
Stability and Implications of Basel II, Central Bank of the Republic of Turkey, Istanbul, 16 May 2005.
* * *
Ladies and Gentlemen,
I thank the organizers of this conference for inviting me to be here today. I am especially pleased to be
speaking on such an important issue. The concept of financial stability, considered from different
perspectives, which is the main focus of the Conference, is appropriately receiving considerable
attention in the light of the variety of risks confronting financial systems. My presentation will deal with
the practice of financial stability assessment in Greece, key aspects of the Basel II implementation
process in Greece, and some implications of Basel II for financial stability.
It is generally agreed that the objective of financial stability assessment is to review the main sources
of risks and vulnerabilities likely to affect the stability of the financial sector and to evaluate its capacity
to absorb the impact of adverse disturbances.
The Bank of Greece's assessment of the stability of the Greek financial sector is contained in a section
devoted to that issue of its semi-annual report to the Greek Parliament. Moreover, the Bank's Annual
Report to the General Meeting of its shareholders also contains a section on the stability and the
supervision of the Greek banking sector.
Before presenting the Bank's approach to financial stability assessment, let me provide some key
aspects of the Greek supervisory framework and of the Greek financial sector.
Effectively there are three bodies responsible for supervision of the financial system as a whole.
• The Bank of Greece regulates and supervises credit institutions and some special
institutions such as credit companies, financial leasing and factoring companies, etc. It also
has a mandate to contribute to the overall stability of the financial sector.
•
The Hellenic Capital Market Commission regulates the capital markets and supervises
investment firms and collective investment funds.
•
Finally, the recently-established Commission for the Supervision of Private Insurance is
responsible for insurance companies.
Cooperation between the three domestic supervisory authorities is crucial to the pursuit of financial
stability. To this end, a Memorandum of Understanding has been signed between the Bank and the
Capital Markets Commission which lays down the practical arrangements for cooperation; in addition a
representative of the Bank sits on the Commission's Board. Cooperation with the new supervisory
body for the insurance industry is expected to be organized along similar lines once the authority is
fully operational.
Banks dominate the Greek financial sector, accounting in terms of assets for approximately 85% of the
entire financial sector. The banking sector itself is characterized by relatively high concentration with
the 5 largest banks controlling 65% of the total assets of the banking sector. The Bank of Greece's
regulatory framework is essentially based on the relevant EU Directives which are closely aligned to
the Basel I framework. In the Greek context, credit risk is the main component of banking risks. Overall
the profitability and capital adequacy of Greek banking groups is satisfactory. On a consolidated basis,
the rate of return on equity and the rate of return on assets before taxes were respectively 16,1% and
1% for 2004 and the capital adequacy ratio reached 12,8% at the end of 2004.
In view of the dominance of the banking sector in the Greek financial system, I will focus on this
sector.
First, let me outline the approach followed by the Bank to assess the stability of the Greek banking
sector. On the one hand, this approach involves an evaluation of the information provided by a
number of indicators relating to the risk profile of banks and the economic condition of households and
firms, and an assessment from a stability perspective, of developments in key macroeconomic
variables and markets. On the other hand, the Bank seeks to determine the banking sector's capacity
to absorb negative shocks. For this purpose, it utilizes data on bank profitability and capital adequacy
and also takes account of the results obtained from stress tests.
To derive the main indicators, the Bank makes use of information submitted by banks in their
supervisory reports on exposures in default, provisions, concentration ratios and credit migrations of
individual exposures. Alongside ratios calculated from this source, data from household and firm
surveys on both debt and income/profit levels provide information on the debt-bearing capacity of the
household and business sectors.
Data from supervisory returns also provide information on market and liquidity risks. In its evaluation of
the information provided by all these indicators, the Bank takes into account the corresponding EU
and Eurozone average values of these indicators where available.
As regards macroeconomic variables and markets that may affect the stability of the banking sector,
the Bank focuses on developments in the GDP growth rate, interest rates and exchange rates, and in
the stock and real-estate markets. The direct impact on the financial condition of the banking sector of
adverse developments in interest rates and exchange rates and in share and real-estate prices can be
quantified using data on bank exposures to each of these risk factors. The indirect impact on banks of
adverse developments in GDP growth and the aforementioned risk factors on banks mainly consists of
an increase in credit risk arising from the effect of such developments on the financial condition of
households and enterprises and thus on their debt-servicing ability. At present, the Bank makes only a
broad qualitative assessment of this indirect impact in its published stability analysis.
In order to assess the banking sector's capacity to absorb the impact of adverse disturbances, the
Bank focuses on a number of developments in banks' financial condition and makes use of stress
testing. The latter involves the Bank asking banks to quantify the impact on their own funds and capital
adequacy ratios of pre-specified adverse changes in the values of certain basic risk factors. The risk
factors considered are the probability of default and the loss given default, interest rates, share prices
and exchange rates. In addition, the Bank is working towards developing a macro stress-testing
framework, especially for credit risk.
Let me now move on to discuss issues related to Basel II, which represents a major change in the
supervisory framework and a challenge to both supervisors and banks. Before considering some
implications of Basel II for the stability of the banking sector, I would like to refer to the preparations for
Basel II implementation in Greece and to the choices Greek banks are expected to make between the
alternative approaches for calculating capital requirements.
A large majority of Greek banks are expected to adopt the standardized approach in determining
capital requirements for credit risk. However, a number of banks, comprising a share of around 50% of
the total assets of the banking sector, are reasonably expected to adopt the foundation IRB approach
for a significant part of their total portfolio. The Bank of Greece is encouraging banks to move to the
IRB approach because this approach will require an improvement in their risk measurement and
management systems. Thus, it will strengthen their competitive position and their capacity to
successfully adapt to changes in the economic environment.
For operational risk, although the majority of Greek banks are expected to adopt the basic indicator
approach to determine capital requirements, most of the large banks plan to adopt the more refined
standardized approach.
The Bank of Greece is working closely with the banks to help them prepare for the implementation of
the new rules. In this connection, it has already put out 5 consultation documents dealing with issues
where there is national discretion. These documents discuss measures which the Bank intends to
adopt as well as other matters requiring clarification and supervisory guidance. Detailed consultations
with each bank planning to use the IRB approach have begun so that problems can be identified and
resolved, while the preparations of banks intending to use the standardized approach will be reviewed
at a later stage - sometime before the end of 2006. An important issue for the Bank of Greece is to
evaluate not only the technical aspects of the banks' internal systems and the methodologies used to
validate their output, but also to ascertain whether the output of these systems is utilized in managerial
decision-making in such areas as loan approval and pricing, provisioning, and capital allocation.
At this stage it is difficult to determine the overall impact of Basel II on the total capital requirements of
the Greek banking sector. The impact will depend not only on the alternative approaches adopted by
the banks, but also on the composition and quality of their assets, both of which are affected by
economic conditions. However, one limited preliminary indication was provided by the result of the
2003 quantitative impact study. For the 6 Greek banks that participated using only the standardized
approach at that time, there was a 7.5% net increase in the combined capital requirement for credit
and operating risk compared to the corresponding requirement under the existing framework (a 2.5%
decrease of the requirement for credit risk and a 10% increase for operating risk).
Pillar II on supervisory review requires the conduct of risk-based supervision and the existence of
detailed systems and policies at each bank to determine, maintain and allocate economic capital in
accordance with its risk profile. This increases the pressure on supervisory resources as well as
banks. In Greece, supervision has traditionally focused more on examining the accuracy of
supervisory returns submitted by the banks, on a point-in-time evaluation of the quality of loan
portfolios, and on the technical calculation of capital requirements to cover credit and market risk. In
recent years, however, increasing emphasis has been placed on the assessment of internal control
and risk-management systems, taking into account the risk profile of each bank. In this respect, the
Bank of Greece found it necessary to impose a minimum capital adequacy ratio above the statutory
minimum of 8% on some banks. To enhance its ability to conduct risk-based supervision, the Bank
has taken steps to improve the skills of existing supervisory staff through specialized training and has
also recruited personnel with skills in quantitative risk analysis. The banks have also strengthened
their risk management units, but, in order to successfully implement Pillar II further efforts will be
required.
Pillar III enhances market discipline by requiring credit institutions to disclose appropriate risk
information, allowing the market to reward well-managed and well-capitalized credit institutions.
Let me now turn to some implications of Basel II for the stability of the banking sector.
To successfully implement Basel II, Greek banks will need to further improve their risk measurement
and management systems and to develop their contingency planning. This will enable them to react
more promptly and effectively to disturbances affecting their risk profile. In addition, the Bank of
Greece, in its stability assessment, will utilize the output of the banks' improved internal systems to
undertake more timely and accurate estimates of the total impact of alternative stress scenarios on the
risk exposures and capital adequacy of the banking sector. Therefore, it will be in a better position to
evaluate the sector's overall resilience.
It has been argued that Basel II is likely to produce a procyclical effect. According to this line of
reasoning, for banks using the IRB approach, capital requirements for credit risk will increase during
cyclical downturns because of a deterioration in the quality of loan portfolios and, conversely,
decrease during cyclical upturns. As a result, bank capital adequacy will deteriorate during downturns,
given the difficulty of raising new capital in such conditions. Consequently, Banks will be under
pressure to restrict their lending during downturns, while during upturns they will tend to unduly
expand it. It should be kept in mind, however, that bank lending is likely to be pro-cyclical to some
degree, irrespective of the supervisory framework. Yet, the possible additional pro-cyclical effect
arising from the IRB approach can be mitigated. In the context of Pillar II, supervisors should insist that
banks hold capital comfortably above minimum requirements under normal conditions and also require
banks to conduct rigorous stress tests in order to assess the adequacy of capital buffers. In addition, it
would be advisable to encourage banks to adopt a more forward-looking through-the-cycle approach
in their credit quality assessments and in their provisioning policy. At present, even the more
sophisticated Greek banks tend to employ only a point-in-time approach to determine the values of the
main credit risk parameters.
In its consultation document regarding the minimum requirements for the Internal Rating Systems, the
Bank of Greece has announced that, although it will accept Point in Time systems, it encourages
banks to incorporate the effects of the economic cycle in their assessments.
During the various consultation phases preceding the finalization of Basel II, concerns were also
expressed with respect to the impact of Basel II on small and medium enterprises (SMEs). It was
argued that capital requirements applicable to loans to these firms, especially under the IRB approach,
would increase compared to the existing framework, leading to an increase in their financing costs or,
possibly, to a decrease in the amount of credit supplied to them. Both these factors would adversely
affect their financial condition. This, in turn, would have negative consequences for economic growth
and employment and would impact on financial stability, particularly in countries such as Greece,
where SMEs account for a large share of total output and employment. I believe, however, that the
final version of Basel II substantially alleviates these concerns. In Greece, the majority of banks will
adopt the standardized approach. For the significant part of their total exposures to SMEs, which will
qualify as retail exposures, the applicable risk weight will actually decrease compared to the existing
framework. For most of the remainder, the risk weight will remain unchanged. Even in the case of
banks adopting the IRB approach, most of their SME customers are expected to derive some benefit
either from the firm-size adjustment for corporate exposures or from the generally lower risk-weight
function for retail exposures.
Increased disclosure under Pillar III is expected to strengthen market discipline by increasing
transparency. This will have a positive effect on stability to the extent that anticipated market reaction
dampens banks' incentives to assume excessive risks. However, the influence on bank behavior of the
direct market discipline exercised by depositors, other creditors, and shareholders, is often limited
either because these stakeholders lack sufficiently strong incentives or because, in some cases, the
interests of the different stakeholders do not coincide. In particular, the actual or presumed existence
of public safety nets may dampen the incentives of depositors to exercise discipline. Wider and more
pertinent public disclosure is expected to enhance the information content of listed banks' share prices
and of interest spreads on subordinated bank debt. This will increase the accuracy and predictive
power of fragility indicators based on market data, such as the distance to default, an indicator derived
from market prices of bank shares. At this point, I may mention that the 10 banks whose shares are
listed in the Athens Stock Exchange account for over 75% of the total assets of all credit institutions
operating in Greece. Based on empirical evidence, changes in the distance to default represent a
useful forward-looking indicator for stability assessment purposes, especially if based on weighted
average values for the entire banking sector rather than for each individual bank. In general,
marketbased fragility indicators are a useful supplement to supervisory data, which are derived as a rule from
accounting records.
In concluding, I would like to stress the increasing importance of maintaining financial stability in the
increasingly competitive environment of recent years, following the deregulation of the Greek financial
system and the liberalization of capital movements. These changes have made the Greek banking
system more sensitive to international capital flows, which can sometimes be volatile and
unpredictable. The internationalization of the activities of Greek banking groups, Greece's entry into
the eurozone, and the integration of European financial markets, although generating significant
benefits, have also increased the exposure of the Greek financial system to contagion risks. In the
light of these developments, the Bank of Greece has instituted - and continues to institute - changes
that improve the quality of its financial stability analysis, so that timely and accurate assessment of
risks be made and, where necessary, appropriate policy responses can be formulated. I believe that
the implementation of Basel II in Greece will yield significant benefits because of its effects on the risk
profile and the risk management systems of banks in the evaluation of their capital adequacy. This,
after all, is a key determinant of their capacity to absorb adverse shocks. Therefore, both from a
supervisory and a financial stability perspective, the difficult task of implementing Basel II in Greece
will be well worth the effort.
Thank you for your attention.