David Clementi: Risk sensitivity and the New Basel Accord
Speech by David Clementi, Deputy Governor of the Bank of England, at a Financial Services Authority
Conference: "Reforming Capital Adequacy for Banks, Building Societies and Investment Banks",
London, 10 April 2001.
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Introduction
It is a great pleasure for me to be adding my remarks today to those of Bill McDonough and Howard
Davies. I would first like to congratulate Bill, as chairman of the Basel Committee, on the very real
achievement that this new capital framework represents. Products that are 'designed by committee'
normally come in for some fairly trenchant criticism, but this one represents a new milestone in
financial regulation, one which I believe will strongly influence how all financial firms, not just banks,
come to be regulated in the future. I know it has been a lot of hard work, and I don't just mean the
shoulder-strain involved in carrying the document onto airplanes! Unfortunately the hard work is not
over yet, both for the authorities and for the banking community - even looking beyond finalisation of
these proposals, supervisors and banks will of course have to see through a long and complex
implementation process. But this is not to underestimate the progress that has been made and it is
certainly a good moment to take stock of the proposals as they stand.
Although underpinned by the straightforward proposition that capital requirements should be more
sensitive to risk, the new Basel proposals are frequently referred to as a 'package'. I would describe
the components as, first, some very difficult technical thinking, which has addressed questions
regarding the purpose of capital that were barely even thought of back in 1988. The second
component is, unsurprisingly, pragmatic compromise. The result is, I think, a reasonably coherent
whole; I know that those involved have tried to think about the sum of the parts as well as the
individual parts. And it is this question of the overall, long-term impact of the new Accord that I would
like to focus on today. The Bank of England has as two of its three core purposes maintaining the
stability of the financial system and seeking to ensure the effectiveness of UK financial services. Both
are relevant to the discussion of capital adequacy. The Bank, participating in the discussion of the
New Accord as a member of the Basel Supervisors Committee, has looked at the proposals, not only
from the perspective of financial stability but also with regard to the efficiency of the banking system.
My intention this morning is to start by discussing how the principle of risk sensitivity has been
translated into the New Accord. I want then to consider the question of whether the proposals have in
some cases achieved too little risk sensitivity and the implications of this for the level of risk capital in
the system. I would then like to turn to the opposite question: whether in some circumstances the new
proposals will achieve too much risk sensitivity, and to discuss this question in the context of the
debate about whether internal ratings will amplify procyclicality. I shall also say something about the
implications of this for lending to small and medium-sized companies. Finally I would like to end by
saying a few words about forward-looking provisioning and liquidity. These are, to my mind, important
adjuncts to the regulation of capital and it is important that they are not overlooked in the current focus
on capital adequacy.
Risk sensitivity in the new Accord
The common theme behind the revisions to the Basel Accord is greater risk sensitivity. This is a move
we strongly support; risk insensitive capital requirements lead to some very perverse incentives and
have contributed to a number of real-world problems. This has been less the case in this country,
where of course the FSA supplements the crude minimum Basel requirement with tailored capital
ratios, than in some other countries, but we have not been immune even in the UK. Certainly I wonder
if over-investment in highly-speculative real estate development, a common precursor to a number of
banking crises, would have been quite so prevalent if capital requirements had better reflected the
often-volatile nature of such lending. And many commentators have expressed worry about the
possible role that the current, uniformly rather low, capital requirements for short-term interbank
lending played in the massive build up of capital flows to Asian countries prior to the 1997/98 crisis.
In several developed countries, of course, the risk insensitivity of the capital requirements has led to a
whole industry of capital arbitrage, which has swelled to enormous proportions over the past 10 years
or so. It has been estimated that by March 1998, non-mortgage securitisations by the 10 largest US
bank holding companies amounted to around $200bn, or more than 25% of these banks' risk-weighted
loans. A combination of conscientious supervisors, market discipline and relatively benign economic
conditions for much of the past decade has, of course, meant that such arbitrage has not so far led to
any major problems in developed countries, but the issue is not one that the authorities can afford to
ignore. Ultimately, capital arbitrage and capital requirements that do not capture accurately the risks
that banks are actually running mean that we risk tolerating unsound banks and jeopardising financial
stability.
Getting the level of capital requirements right
So the move to introduce greater risk sensitivity is right. But determining the optimum level of risk
sensitivity for a common set of rules intended to apply to banks in a wide range of different markets,
countries and businesses is more difficult. And so there are two questions I want to go on to explore.
First, have the proposals achieved enough risk sensitivity? And second, do they achieve too much risk
sensitivity, particularly in the context of the debate about whether ratings amplify procyclicality?
As I said earlier, the new Accord has been designed to incorporate some real-world pragmatism. A
major achievement of the existing 1988 Accord, and one that we would like to see preserved, has
been its near-universal worldwide acceptance as the minimum standard for banking stability. So, if this
huge advantage is not to be lost, it means that the new Accord has to be adaptable to a wide range of
situations, to accommodate not only differing levels of sophistication amongst banks but also differing
levels of expertise amongst supervisors. The answer, unsurprisingly, is a menu approach. For credit
risk, alongside the greatly more risk sensitive internal ratings based approach, we have the option of a
revised standard approach. This is certainly a step forward from the existing approach, but it remains
a relatively simple framework. In its implementation, for many banks it may prove very simple indeed,
since the large bulk of their loans are likely to have no ratings and so fall into the unrated bucket. The
result will be little change on the existing Accord.
I think this is inevitable. Whilst I would hope that all banks have some form of internal ratings system,
and whilst the Committee's proposals are intended to offer incentives to banks to upgrade their
systems to the Committee's standard for recognition, banks cannot be forced to adopt loan ratings
systems that conform to the Committee's criteria, and nor is there an unlimited global supply of
supervisors capable of monitoring such systems. In the absence of external ratings - which the
Committee is not in the business of promoting - there has to be a simple uniform weighting on unrated
credits.
While this outcome may be inevitable, we do need to think carefully about the possible consequences.
First, given that we have to have a simple alternative to the internal ratings approach, it is important
that the new Accord provides the right degree of capital incentive for banks to progress over time to
using internal ratings. It is the Committee's firm intention to ensure that the final Accord provides
modest incentives for banks to adopt the internal ratings approach. There is a conservative bias in the
standard approach; and internal ratings in measuring risks more accurately should, for lower risk
business, result on balance in lower capital requirements.
The objective of ensuring some capital incentive for banks to progress to risk sensitive measurement
does, of course, have to be balanced against the objective of roughly maintaining the overall amount
of capital in the financial system. It would be dangerous to financial stability if we gave so large a
capital carrot to banks to use the internal ratings based approach that many of the world's most
important financial institutions, which account for the vast bulk of global and G10 domestic banking
activity, saw a significant reduction of their regulatory capital requirement. It is the need to balance
incentives with the maintenance of overall capital levels which makes this issue a difficult one. This,
along with a large number of other questions about the impact of the proposals, will be further
examined by the Committee in the course of a quantitative impact study to be carried out before
finalising the proposals. The Bank of England has been asked to co-ordinate this work calibrating the
impact of the new Accord on individual institutions and on the system as a whole. I recognise that the
time allowed for this exercise is short, but I hope very much that we can count on the contribution and
co-operation of the banking community.
Turning to the second possible consequence of maintaining a risk insensitive alternative approach, we
may find that the combination of having some banks on the IRB approach and some on the standard
approach will, perversely, introduce a financial stability risk that is not present with all banks on the
standard approach. This is that the more sophisticated institutions would have to hold more regulatory
capital against weak loans than banks that remain on the standard approach. Over time, therefore, we
could find that the worst-quality credits could gravitate to those banks which are the least able to
assess, price or monitor them. However, I do not wish to suggest such a scenario without also
highlighting how we may guard against it.
First, of course, the role of Pillar 2 - individual assessment of banks by supervisors with appropriate
action to follow - will be extremely important in ensuring that all banks, not just those on the internal
ratings approach, have a level of capital appropriate to their risks. Secondly, the Committee has
clearly emphasised that the standard 100% risk weight for unrated credits represents a floor.
Supervisors are encouraged to increase this risk weight when warranted by the overall default
experience in their jurisdiction and for the particular bank concerned for their unrated exposures. And I
hope, taking a prudent approach, that the supervisors will do this. Even with the current Accord, there
are a number of countries, the UK included, that have applied capital requirements in excess of the
minimum risk weights in the Accord and this does not appear to have made their banking systems
uncompetitive internationally.
Where supervisors do not currently have the types of data that would enable them to form a
judgement on the appropriate risk weight for unrated credits, I hope that the disclosure requirements in
Pillar 3 of the new Accord will help them. Corporate bankruptcy rates, bank provisioning and write off
experience, bond yields and default experience, together with data from any banks that are on internal
ratings, could all be used to help the authorities form a view of typical or average credit risk for bank
portfolios in their countries. This sort of overall, aggregate monitoring of the adequacy of the standard
risk weights will be particularly important for developing countries who may initially face some resource
constraints in implementing Pillar 2. It should result in an overall adjustment of the weight on unrated
exposures, if risks appear to be higher than the capital set aside to back them. This would need to be
reinforced by supervisors assessing for all their standard-approach banks individually whether their
write-off rate is compatible with the 'standard' 100% capital weight, or whether a higher figure is
needed.
Credit risk mitigation
So there may be elements in the new Accord that achieve too little risk sensitivity but I think this was
unavoidable and, with Pillars 2 and 3 of the Accord, supervisors have the scope to see that they do
not give rise to problems. However, I do not want to leave this question before touching on one more
issue. This is the extent of the recognition of credit risk mitigation techniques. The new risk sensitive
framework goes much further than the introduction of internal ratings - another area of greatly
increased risk sensitivity is the new regime for credit risk mitigation. Again, the Committee's proposals
here represent a considered and careful balance. On the one hand, the objective has been to provide
in the new Accord a significant expansion, within a menu approach, to the recognition of collateral,
credit derivatives and guarantees. But this is balanced on the other hand by specifying legal and
operational standards that must be met before relief is granted and setting capital requirements
against residual risks. This may - indeed is intended to - lead to much greater incentives to acquire
good quality collateral and other credit insurance. This will be positive, provided the necessary
operational standards including legal robustness are observed, and provided, as I said on another
recent occasion, that the processes, volumes, and end results of transfers of credit risk are reasonably
transparent.
I am aware, however, that some initial comment from the banking industry is that the Committee has
not afforded enough recognition to physical collateral, particularly under the standard and 'foundation
IRB' approaches. In this respect they think the Committee achieved too little risk sensitivity. The idea
of a consultation paper is to elicit comment, but there are problems with the recognition of physical
collateral that need to be considered. One is the difficulty of pinpointing accurate valuations for such
collateral - much of it does not have anything by way of a valuation history. And values for physical
collateral are also likely to be cyclical. When manufacturing companies are in recession, the values of
related assets - plant and machinery or inventories - are likely to suffer too. Before regulators
recognise more physical collateral, the banking industry needs to come forward with ideas on how to
solve this problem.
Procyclicality of capital requirements
I want now to turn to my second question; whether we might in some sense be introducing too much
risk sensitivity. Under this heading the issue I want to discuss is the danger of 'procyclicality', that is
the possibility that regulatory capital requirements will reinforce cyclical movements in the
macroeconomy. There was some element of that in the original Accord - because in a downturn
specific provisions and write-offs increase, which reduces banks' capital, and may diminish their
appetite to make new loans. However, under the new Accord this will be reinforced by the possibility
that, as the condition of borrowers deteriorates during an economic downturn, they will be downgraded
by banks with the consequence that extra capital has to be set aside. On some estimates, bank capital
requirements could as much as double during a cyclical downturn.
This is clearly an issue of major concern to central banks. The risk is not a theoretical one; there is
evidence that external ratings to some degree behave procyclically, while banks' internal ratings are
liable to be even more so. Clearly here again a balance has to be struck between our desire to have
the new framework incorporate and reflect current practice at banks, and ensuring that these current
practices do not lead to economic volatility. The Committee's statement that ratings should not be
'point in time' but 'must represent a conservative view of a long run average probability of default for
the borrower grades' attempts to introduce such a balance. Such ratings ought to be reasonably
robust to the normal ups and downs of economic activity. The Committee has backed this up with
requirements for minimum lengths of data histories to underlie the internal ratings, so helping to
ensure that they incorporate some experience of economic low points. Over-optimism by banks in
allocating ratings could also induce procyclicality. The Committee proposes several checks on this. In
particular, supervisors will look at the ratings allocated to some individual loans, and also compare the
distribution of loans across rating bands with those of different banks. Ultimately, of course, we will
have to rely on those charged with daily supervision of banks, backed up by the Pillar 3 disclosure
requirements, to ensure that ratings are not set in a way which risks undue procyclicality.
Impact of the Basel Accord on SMEs
Leaving aside the issue of how the risk sensitive capital requirements will behave over an economic
cycle, I would also like to touch on the question of how they may affect the supply and pricing of
finance to certain types of borrower. If risk sensitivity means a greater distinction between different
types of borrower, we need to consider carefully whether the right outcome has been achieved. A
specific concern, which I know has occupied a number of members of the Basel committee, is how
small and medium sized enterprises might be affected, given their importance to economic activity and
their reliance on bank finance. It is not yet clear how the proposed new Accord would affect the pricing
of finance for SMEs. Many factors are relevant, including whether banks are on the standard or IRB
approaches, what types of collateral or guarantees SMEs can offer, whether the borrowers are
classed as part of the retail portfolio (as very small enterprises will be), whether the regulator sets the
bank's overall target capital ratio (which in the UK is set individually for banks) and how much excess
capital the bank has over that. It seem likely that in the UK at least the overall result for many SMEs
will be 'no change', not least because banks' economic capital and pricing is often already
riskadjusted. But I know that a number of major British banks are concerned about the impact on SMEs,
and the Bank is working closely with them to understand the precise factors behind this, and to ensure
that there is no inadvertent increase in capital requirements for finance to smaller companies.
Ultimately the best guarantee of a stable and reasonably priced supply of credit to SMEs, as to other
borrowers, is a stable and competitive banking industry. In the UK, moves have recently been made to
improve the competitiveness of SME finance; I believe that the new Basel framework could in turn be
a positive contribution to banking stability but we stand ready to monitor developments.
Although this conference is essentially about the issue of banking capital, I would like to end by
emphasising that capital is only one component of banking stability; many other factors also come into
play. In the field of prudential regulation, I would like to highlight two: valuation and provisioning
frameworks, and liquidity management and regulation. There will be little point to all the Committee's
work on risk sensitive capital measures if this is not underpinned by adequate loan valuation and
provisioning practices - preferably ones which incorporate a forward-looking view of risk and
deterioration in loans. A lot of valuable work has been done on loan provisioning by the Basel
Committee and other bodies, and I welcome the debate that is currently being sponsored by the IASC
on valuation frameworks.
Secondly, adequate liquidity is a vital counterpoint to capital for banks; the regulation of capital
adequacy and liquidity are interrelated. Rationally, solvency ought to be a guarantee against funding
problems, with customers happy to roll over deposits where they are confident that a bank is soundly
capitalised. But reason does not always prevail, in part because solvency is sometimes hard to
ascertain, more often because, swept along by animal spirits, markets can behave emotionally and
perversely. Capital adequacy and liquidity regulation are thus two sides of the same coin. Just as it
would be impossible or uneconomic to require banks to operate without risk to provide total certainty
of solvency, so liquidity regulation is needed as a form of insurance. The issue is discussed in an
article in the December edition of the Bank's Financial Stability Review. The Basel Supervisors'
Committee has done valuable work in examining issues and techniques in liquidity management and
this work deserves to be carried forward further. For those of you who have already digested the 500
pages of the new Basel Accord we are discussing today and are looking for some more recreational
reading, over the Easter holiday, I thoroughly recommend a re-read of the update the Basel
Committee published last year of its sound practices for managing liquidity risk.
In the meantime, thank you for allowing me to address you this morning.