William J McDonough: Implementing the New Basel Accord
Remarks by Mr William J McDonough, President and Chief Executive Officer of the Federal Reserve
Bank of New York, before the Global Association of Risk Professionals, New York, 11 February 2003.
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1. Introduction
Thank you for that kind introduction. It's a pleasure for me to be here today in my capacity as
Chairman of the Basel Committee on Banking Supervision and President of the Federal Reserve Bank
of New York.
The topics to be discussed at this conference certainly are timely. One need not look any further than
recent news headlines to understand why the work of a risk management professional matters so
much. Current events remind us that when companies lack the commitment to manage their risks
prudently, they will quickly fail to uphold their responsibilities to their shareholders, to their employees,
and, ultimately, to the public at large. Those failures are felt not just as a loss of jobs, or investments,
or savings, but also as the loss of public confidence in the soundness of our economy.
Sound corporate governance only comes about when there is a genuine commitment to do the right
thing and to manage risks in whatever form they arise. Risk managers must provide timely, objective
and accurate information to their senior management. In turn, senior management and a bank's board
of directors need to ensure that there is an atmosphere of transparency within the firm - one that
promotes healthy, disciplined risk taking.
The challenge of managing risks in the financial sector is made greater by the tremendous spirit of
innovation that fuels growth and healthy competition among banks and other firms. Bankers have long
competed on their abilities to tailor products and services to each client's unique needs. New
opportunities for profit often change the nature of the known risks a bank may face - they may also
expose an institution to unknown pitfalls.
As a former commercial banker, I know that responsibility for understanding and managing risks and
potential pitfalls rests with senior management and its board of directors. As a supervisor, I believe
that we should create incentives to help motivate responsible behavior within firms. Further, as
Chairman of the Basel Committee, I see the work of the Committee as helping to foster safe and
sound banking systems by creating incentives for banks to improve their understanding and
management of risk, and, in turn, to contribute to greater stability within the financial sector.
Encouraging the improvement of risk management in banks, is, indeed, the overarching goal of the
Committee's efforts to revise the Basel Capital Accord. In my remarks today, I'd like to focus on the
challenges associated with implementation of the new framework now that the revision process is
coming to an end. First, I'll spend a few moments discussing the evolution and structure of the New
Accord. Then, I would like to provide some insights into the preparations banks and supervisors are
making to implement the new framework - both internationally and here in the U.S. I'll end my remarks
with some thoughts on where we are in the Capital Accord revision process.
2. Objectives for revising the Capital Accord
As you may know, the Committee's process to revise the Capital Accord began in the late 1990s. It
became clear at that time that the original Accord was becoming outdated. Its broad-brush nature -
where required capital generally does not differ by degree of risk - has had a tendency to discourage
certain types of bank lending. It has also tended to encourage transactions whose sole benefit is
regulatory capital relief.
Further, banks have been developing new methods for monitoring and managing risk in a manner that
the 1988 Accord did not anticipate or address. It is due to the hard work of risk professionals and the
ideas advanced through organizations like GARP that banks today have an ever improving tool box for
identifying, measuring, and controlling risk. In light of those new tools, it is quite clear that the current
Accord provides internationally active banks, for which it was originally intended, with less meaningful
measures of the risks they face and of the capital they should hold against them.
To respond to these challenges, the Committee has sought to develop a more flexible and
forwardlooking capital adequacy framework - one that better reflects the risks facing banks and encourages
them to make ongoing improvements in their risk assessment capabilities. The Committee believes
that all banks should be subject to a capital adequacy framework comprising minimum capital
requirements, supervisory review, and market discipline. As you know, these are the three "pillars" of
the New Accord. Each is an essential element for ensuring the safety and soundness of banks
worldwide. In contrast, the current Accord only has one pillar - minimum capital requirements.
As we all agree, risk management is a dynamic process and one that will continue to evolve.
Consequently, the New Accord is designed to accommodate future changes in the way banks
measure and manage their risks by giving banks a range of options for calculating capital charges and
incentives for using best practices. Banks will be expected to apply the option most appropriate to the
complexity of their own operations and risk management capabilities.
For credit risk, the range of options begins with the standardized approach and extends to the internal
ratings based (IRB) approach. The standardized approach, as you know, is structurally similar to the
1988 Accord, where banks are required to differentiate their exposures into broad categories, such as
loans they have made to corporate and sovereign borrowers or banks. It improves on the 1988 Accord
by aligning risk weights with a borrower's creditworthiness as indicated by an external credit rating.
The IRB approach goes further and is one of the most innovative features of the New Accord. It has
been constructed to build upon and further encourage investments banks are already making in their
internal risk management systems. As you know, these systems have been developed and further
refined to promote a bank's competitiveness and to protect it against loss - and not just to respond to a
regulatory mandate.
Banks using the IRB approach will be permitted to quantify key measures of a borrower's
creditworthiness in determining the corresponding capital requirement. This will include estimating the
likelihood that the borrower will default. Many banks will also be able to provide internal estimates of
other key variables, such as the recovery rate if a borrower were to default and the likelihood of a
credit line being drawn upon. While banks adopting the IRB approach will have the flexibility to rely on
their own estimates of key risk parameters, those estimates will be subject to a set of minimum
operational requirements. The aim of these standards is to ensure that these critical inputs have
integrity and are the product of a system the bank relies upon to perform its day-to-day operations.
Further, through pillars two and three, the new framework builds in additional checks and balances to
ensure that banks' systems will generate accurate and timely credit assessments.
The Committee believes it critical to complement the more risk reflective capital requirements with the
added incentives of supervisory review and market discipline. The second pillar of the new framework
focuses on the need for banks to conduct their own assessments of the amount of capital they should
hold relative to their risk. Supervisors will be expected to review and respond to these assessments. I
believe that discussions between bankers and their supervisors will create added incentives for
management to assess its risks carefully. No longer will the emphasis solely be on whether a bank
complies with regulatory minimums. Rather, banks will be expected to manage their economic needs
and operate with a capital buffer at levels above the regulatory minima. Accordingly, there will be a
need for strong capabilities by banks and supervisors alike to evaluate banks' level of risk
appropriately.
Market participants also will play an important role in evaluating the adequacy of bank capital. Greater
disclosure of key risk elements and capital by banks will provide important information to
counterparties and investors, who need these data to develop an informed view of a bank's risk profile.
By bringing greater market discipline to bear through enhanced disclosures, I believe the third pillar of
the New Accord, the market discipline component, can produce significant benefits. It will help to
encourage banks to manage their risks prudently and, by supplementing official supervision, thereby
also improve financial stability.
3. Implementation of the New Accord
(a) Overview
Today, the Committee is close to finalizing the new capital framework, and I know that many banks
and supervisors in different countries have already begun to think about the practical implications
surrounding implementation. This second stage of the Basel II effort is close on the horizon, and both
banks and supervisors must give serious thought to what they need to do to get ready. I'd like to
spend a few moments describing some of the efforts currently underway.
It is no secret that implementation of the New Accord will require a substantial resource commitment
on the part of banks and supervisors alike. I think it is important to emphasize that the efforts banks
will need to undertake to comply with Basel II build on the efforts that some large and well-managed
banks already had in train before the new framework was contemplated. I know that many banks are
devoting more attention to enhance tracking and assessment of the quality of the loans they make.
Further, banks have been looking to strengthen their credit assessments by employing experts who do
not stand to gain from overly favorable reviews. Time and effort has also been invested in working to
pull all of this together in a management information and control system that produces timely and
accurate reports for senior management review. I expect that much of the cost to banks of adopting
the advanced approaches of Basel II will come from precisely these types of initiatives.
While it will not be inexpensive to achieve these capabilities, particularly for a very large and diverse
organization, I believe that it is essential for the largest and most complex U.S. banking organizations
to continue down this path. We know all too well the costs to society of bank weakness and ultimately
bank failures. As our largest banks continue to grow, to prosper and to pursue new opportunities, they
must simultaneously make the investments required to manage themselves appropriately.
Likewise, the new framework is providing supervisors with an opportunity to enhance their ability to
identify and respond to sources of banking risk, and to share this knowledge within the supervisory
community. The Basel Committee was established precisely to maintain an open and constructive
dialogue among banking supervisors. This spirit of communication will be more crucial than ever as
the new framework is adopted across national jurisdictions. To help ensure that market competition is
driven by each bank's strengths, rather than by differences in each country's regulatory capital rules,
the Committee established the Accord Implementation Group. This group, comprised of senior line
supervisors, is responsible for promoting the consistency and quality of implementation of the New
Accord. Further, the group has been established to facilitate the exchange of information among
national supervisors about bank and supervisory practices. This is something that I view as being
critical to successful implementation of the New Accord.
(b) Challenges for banks
Within the United States, supervisors have long considered how the new framework will apply to our
banks. Recently, our efforts have focused on the preparations and challenges ahead for some of the
largest U.S. banks as they look towards implementing the IRB approach to credit risk. Among other
important topics, the dialogue has focused on application of the minimum standards for entry and
ongoing use of the IRB approach.
Our sense from this interaction is that banks have both the desire and commitment to continue to
develop their internal ratings systems in a manner consistent with the ideals embodied in the IRB
framework. The discussions with the industry have also highlighted a number of areas where banks
may need to expand their efforts in preparing for implementation. These include the design and
structure of rating systems; the availability and quality of credit data; and the role of corporate
governance in evaluating bank assessments. I will touch on each of these in turn.
Rating system design
The design of a risk rating system is key to its effectiveness. The Basel Committee believes that
banks' internal rating systems should accurately and consistently differentiate between degrees of risk.
The minimum IRB standards in this area build on leading risk management practices observed in the
industry. For example, many organizations either already have, or are in the process of developing, a
ratings system that captures both the risk of borrower default, as well as transaction-specific factors
that shed light on the amount that could be collected if things were to go poorly. In other words, these
banks' systems are generally oriented to capturing the essential components in estimating credit risk.
As the methods for measuring credit risk improve, we expect that banks will incorporate these new
insights in their ratings practices. For example, banks may look to expand the number of ratings
categories to more finely distinguish between exposures of different credit quality. However, the
challenge is for banks to clearly and objectively define the criteria for these ratings categories in order
to provide more meaningful assessments of both individual credit exposures and, ultimately, their
overall risk profile. The clarity and transparency of the ratings criteria will be critical to ensuring that
ratings are assigned in a disciplined and reliable manner.
It is also important to note that it is not enough to have a well-designed internal risk rating system - it
must also be an integral part of a bank's day-to-day credit risk management processes. The
expectation is for banks to rely on their internal risk rating systems not just when making decisions
about whether to extend credit. We also encourage banks to incorporate ratings information into other
key processes, such as pricing and reserving determinations and when allocating economic capital
internally. The more a bank makes use of its risk rating system, the more confidence supervisors are
likely to have in the results of the banks' assessments of their capital needs.
Data requirements and validation
Clearly, a system is only as good as the inputs that go into it. Accordingly, banks using the IRB
approach will need to be able to measure the key statistical drivers of credit risk. The minimum Basel
operational standards provide banks with the flexibility to rely on data based either on internal
experience or generated by an external source, as long as the bank can demonstrate the relevance of
the external data to its own exposures. Regardless of source, sound data are critical for formulating
meaningful internal risk assessments. From a broader risk management perspective, access to high
quality data will enable a bank to evaluate the performance of its internal rating and risk estimation
systems in a consistent and meaningful manner.
The Basel standards outline the data history banks will need to use the IRB approach. The Committee
recognizes that banks may not currently have all of the required information on hand. For this reason
we have continued to engage market participants in a dialogue on this issue. As implementation of the
New Accord approaches, we encourage banks to consider their data needs very seriously and to
comprehend fully the techniques they will need to use to derive appropriate estimates of loss based on
those data. Critical to this process is the need for banks to understand how the estimates produced by
their internal ratings systems compare with the actual performance of a borrower. In practical terms,
banks will be expected to have in place - or be actively developing - a data "warehouse". By data
warehouse, I mean a process that enables a bank to collect, to store, and to draw upon loss statistics
in an efficient manner over time.
Corporate governance
I mentioned earlier that responsibility for managing risk lies squarely with senior management and its
board of directors, and I know that the involvement of senior management will be critical to the
successful implementation of the New Accord. This will be particularly true for those banks seeking to
adopt the more advanced approaches to calculating regulatory capital. As a bank's capital
requirements will more closely reflect the actual risk to which the bank is exposed, there will be a need
for its board of directors and senior management to gain a deeper understanding of their bank's
internal rating systems.
How will this be put into practice? It will be the responsibility of bank management to expose its board
members to the key elements of the organization's ratings process. Members of the board will need to
be fully aware of whether the system complies with the Basel standards, makes use of the necessary
data and produces reliable quantitative estimates. Ensuring that everyone understands the nature and
level of risks facing a bank will depend on the timely delivery of the right information. We expect many
banks will need to make greater investments in their reporting systems with the aim of facilitating the
flow of information about a bank's ratings practices to senior management and directors.
(c) Challenges for supervisors
I've focused on the challenges banks may confront in implementing the new Accord. Let me now
spend a few moments discussing how our supervisory approach is also likely to evolve over time.
The New Accord will present supervisors with an opportunity to re-evaluate and further develop their
current approaches to looking at banks. Going forward, supervisors, like banks, will have to take a
more dynamic view of risk management. Change will occur in response to the new Basel framework. I
must add that change would also occur as part of the natural evolution of banking supervision. Basel
II's emphasis on risk management strongly supports our current effort to make evaluations of banks'
internal processes the heart of a more forward-looking supervisory approach.
In terms of credit risk, we will focus less on point-in-time assessments of financial condition, and much
more on internal processes and control structures that are intended to help safeguard the health of
banks. Some of the conventional, static metrics that we now use - such as those to judge asset quality
and to assess the adequacy of credit loss reserves - are likely to be supplanted by more quantitative
and more sophisticated measures. Supervisors will increasingly have to assess the bank's ability to
properly rate all exposures across the spectrum of its internal rating grades - not just its classified or
problem assets. In addition to ensuring the integrity of banks' internal rating assignments, supervisors
will also need to understand how these ratings feed into the models and tools used by banks to
manage credit risk. They will also need to understand the implications of using these new tools.
I also see a significant shift on the horizon in our examination approach to operational risk, as we bring
together operational risk management assessments with operational risk capital analyses. Examiners
will have to understand, and be able to evaluate critically - much more so than today - how banks
combine qualitative and quantitative techniques. Here I am thinking of the need to consider
selfassessments banks may make of their control environments, as well as their processes for data
collection and statistical analyses.
It clearly will be important to devote the necessary supervisory resources - in terms of skilled
personnel, technical training, and a targeted strategy - to these new supervisory efforts. As we prepare
to traverse this uncharted regulatory landscape, there is an opportunity for supervisors to take a fresh
look at how they do their work. In doing so, it is important that we not lose sight of one of the
longerterm goals of the New Capital Accord - that it will enhance the capabilities of banks and supervisors to
better understand and address risk.
4. Next steps in finalizing the New Accord
Most of my remarks today have been centered on implementation of the new framework. I'd like to
conclude by spending a few moments discussing where we are in the process to finalize the New
Accord.
As you may be aware, the Committee has just finished gathering data from the industry for its third
impact study. The aim of the study was to collect and to analyze information from banks worldwide
regarding the capital impact of the new proposals on their existing portfolios. The results are under
review and will help us to determine whether any adjustments will be needed prior to release of the
final consultative package this spring. This information, as well as feedback received through our
ongoing discussions with industry participants, will be critical in shaping the final document. It will also
help to ensure that the final framework meets the objectives the Committee has set out for itself in
developing the New Accord. I'm very pleased to say that the preliminary indications from all of our
efforts suggest that we look to be on track in meeting our primary goals. That is, not to introduce large
changes in the aggregate amount of capital currently held in the banking system while at the same
time to provide tangible incentives for banks to adopt the most advanced and sophisticated
approaches to capital adequacy.
As we near completion of the New Accord, I am reminded that the tremendous progress we have
made is a reflection of the steadfast commitment that so many have put forth to see the revision
process through to its completion. The success of the New Accord will be directly attributable to the
enormous support and assistance provided by both bankers and supervisors. Yet a Chinese proverb
reminds us that, "On a journey of one hundred miles, ninety is but halfway." I suppose the last miles of
any marathon are the toughest to finish. The wisdom of that proverb is borne out by the critical nature
of the tasks ahead of us to complete, and then to implement, the new capital framework.
Adopting the New Accord will be a challenging but also an exciting undertaking for us all. The potential
benefits are many - including improving the management of risk, enhancing transparency and
promoting greater financial stability. In short, this new framework will make all of us - bankers,
supervisors and others - better at what we do.
Thank you very much.