Momentum in Plans for Introducing Basel 2 standards but Countries face implementation problems

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TWN Info Service on Finance and Development (Feb07/04)

22 February 2007

MOMENTUM IN PLANS FOR INTRODUCING BASEL 2 STANDARDS BUT COUNTRIES FACE IMPLEMENTATION PROBLEMS

Plans for the introduction of Basel 2 appear to have acquired widespread momentum, as indicated by the Basel-based Financial Stability Institute (FSI), based on a new survey of the state of play in major regions and by other specifically national information.

The definitive text of Basel 2 (short for the official title – International Convergence of Capital Measurement and Capital Standards, A Revised Framework Comprehensive Version), was published in June 2006 by the Basel Committee on Banking Supervision (BCBS), a body of banking regulators from major industrialised countries. The final text was the culmination of a drafting process lasting the better part of a decade, and is designed to replace the 1988 Basel Capital Accord (Basel 1).

The Basel Committee on Banking Supervision is the body of banking regulators of the countries of the G10 and selected other developed countries, originally established in 1974 and linked geographically and organisationally to the Bank for International Settlements (BIS) in Basel. The BIS itself dates from 1930, and was set up primarily to serve the functions of bank and meeting-place for national central banks.

Basel 2 conjures up a vision of complex new prudential rules for banks worldwide, and these have been a subject of contention even in countries with advanced banking sectors and financial regulation and supervision. Contributing to this vision (and contention) have been the highly public disagreements in the United States among supervisors, politicians and banks as to how Basel 2 should be implemented. Plans for the introduction of Basel 2 have nonetheless acquired widespread momentum as indicated by a new survey of the Basel-based Financial Stability Institute (FSI) of the state of play in major regions and by other specifically national information.

Below is an analysis of Basel 2, including its implications for developing countries, many of which face problems in implementing the Basel 2 standards. It is written by Andrew Cornford, formerly a senior UNCTAD economist and currently Research Fellow at the Financial Markets Centre based in Geneva.

It was published in SUNS #6193 Monday 19 February 2007.

With best wishes
Martin Khor

Momentum in Plans for Introducing Basel 2 standards but Countries face implementation problems

By Andrew Cornford

Basel 1 set rules for the capital of banks, i.e. amounts available to banks as a buffer against future, unidentified losses. Capital under Basel 1 was to serve as a buffer against credit risk, i.e. that of the failure of borrowers or parties to the other banking transactions to meet their obligations, and market risk, i.e. that of adverse changes in interest and exchange rates and of the prices of stocks and other financial instruments. The calibration of credit risk under Basel 1 was crude. For example, the same regulatory capital charges applied to the great majority of private enterprises with the oft-cited consequence that these would be the same for a loan to a big enterprise like General Electric and an overdraft to a corner newsagent.

Moreover, the rules discriminated in important cases unjustifiably in favour of borrowers from OECD countries in comparison with borrowers not belonging to this group. By the second half of the 1990s the view had gained currency among both supervisors and banks that the gap between Basel 1 and actual practices for the management and supervision of banking risks was becoming unacceptably wide, opening the way for the revision which was to become Basel 2 and which is designed to provide a calibration of risks more sensitive than that of Basel 1.

The FSI was created by the BIS and the BCBS in 1999 to assist financial supervisors through the provision of the latest information on financial products, practices and techniques and through the organisation of seminars and workshops. The FSI in a publication in September 2006, “Implementation of the New Capital Adequacy Framework in non-Basel Committee Member Countries”, provided a summary of the Responses to the 2006 Follow-Up Questionnaire on Basel II Implementation (FSI Occasional Paper No. 6.)

Schedules for introduction have been extended. But this was to be expected as authorities confronted the concrete problems posed by Basel 2, but it seems unlikely to derail the process. Nevertheless, the flexibility and multiple options built into Basel 2 during the consultations since the publication of the first full set of proposals in 2001 are proving a challenge for the supervisory cooperation required for cross-border implementation. Moreover, the goal of regulatory uniformity and thus of “a more level playing field” for banking competition (the objective of Basel 2) is likely to be at best partially achieved.

Basel 2 consists of three so-called pillars. Under Pillar 1, regulatory capital requirements for credit risk are calculated according to two alternative approaches, the Standardized and the Internal Ratings-Based. Under the Standardized Approach (SA), the measurement of credit risk is based on external credit assessments provided by external credit assessment institutions (ECAIs) such as credit rating agencies or export credit agencies. Under the Internal Ratings-Based approach (IRBA), subject to supervisory approval as to the satisfaction of certain conditions, banks use their rating systems to measure some or all of the determinants of credit risk. Under the foundation version (FIRBA), banks calculate the probability of default (PD) on the basis of their own ratings but rely on their supervisors for measures of the other determinants of credit risk. Under the advanced version (AIRBA), banks also estimate their own measures of all the determinants of credit risk, including loss given default (LGD) and exposure at default (EAD). Pillar 1 also contains rules for regulatory capital requirements for market risk which broadly follow those of Basel 1.

Unlike Basel 1, Basel 2 contains regulatory capital requirements for operational risk which covers losses due to events such as human errors or fraudulent behaviour, computer failures, or disruptions from external events such as earthquakes. Under the Basic Indicator Approach (BIA), the capital charge for operational risk is a percentage of banks’ gross income. Under the Standardized Approach (SAOR), the capital charge is the sum of specified percentages of banks’ gross income or loans for eight business lines. Under the Advanced Measurement Approach (AMA), subject to the satisfaction of more stringent supervisory criteria, banks estimate the required capital with their own internal measurement systems.

Pillars 2 and 3 of Basel 2 are concerned with supervisory review of capital adequacy and the achievement of market discipline through disclosure. Under Pillar 2 guidelines, supervisors are to prescribe additional regulatory capital not only for the credit, market and operational risks of Pillar 1, when they judge this to be necessary, but also for risks not covered here such as liquidity risk (which covers banks’ ability to obtain funding and the prices at which it can sell assets in financial markets) and interest-rate risks due to differences in the rates at which banks lend and borrow.

The 2006 FSI survey covers the plans of regulators in non-BCBS countries for the introduction of Basel 2 and follows a similar exercise in 2004. Major findings of the most recent survey were that 82 of the 98 countries which responded (but which are not named in the survey) planned to implement Basel 2, a proportion very close to that in 2004. This figure rises to 95 when the 13 member countries of the BCBS are added.

Of the different regions, only for the Caribbean was the proportion of responding countries planning introduction of Basel 2 less than 70 per cent. In a picture marked nonetheless by considerable variation among the six regions, the proportions were a little more than 70 per cent for respondents from Africa, 100 per cent for Asia, 57 per cent for the Caribbean, 86 per cent for Latin America, 100 per cent for the Middle East, and 83 per cent for non-BCBS Europe.

Unsurprisingly in comparison with the 2004 survey, the planned schedule for introduction is now less ambitious in many countries for different options under Pillar 1 for minimum capital requirements for credit and operational risk, especially of the more complex ones, and for achieving the obligations regarding Pillar 2 and Pillar 3. Nonetheless, at least half of respondents expected to introduce the SA for credit risk by 2009 in each region except Latin America and the BIA for operational risk in each region except Africa and Latin America by the same date. Fifty per cent of Asian and Middle Eastern respondents and 73 per cent of those in non-BCBS Europe also intend to introduce the more advanced FIRBA for credit risk by 2009.

Except for Latin America, there have been marked increases in comparison with the 2004 survey in the proportions of respondents planning to meet the obligations of Pillar 2 (supervisory review) and Pillar 3 (transparency) by 2009. Indeed, the data on Pillars 2 and 3 suggest a widespread tendency to give first priority in plans for the introduction of Basel 2 to strengthening supervisory capacity and disclosure standards.

More detailed information for 50 individual countries indicates that 70 per cent have set 2008 or earlier as the date for introduction of Basel 2, while the timing for the remainder is still uncertain (For more details, see ‘Basel 2 at Mid-2006: Prospects for Implementation and Other Recent Developments’, www.fmcenter.org)

A high proportion of those with introduction dates belong to the EU, of which the new Capital Requirements Directive (CRD), designed to translate Basel 2 into EU law, was ratified in October 2005. For banks using the simpler approaches of Basel 2, the CRD comes into force at the beginning of 2007; for those using the IRBA and AMA, it takes effect at the beginning of 2008. However, the complexity of CRD (which is nearly 500 pages long) is already leading to delays in implementation so that adherence to the timetable currently envisaged may not prove feasible throughout the EU, in particular in the newer Member States.

In view of the substantial worldwide variation in the development and sophistication of banking sectors and regulation, the global extent of plans to introduce Basel 2 is remarkable. In developing countries, the driving force appears to be emulation and the objective of installing internationally agreed best practices. Indeed, introduction of Basel 2 appears in many cases to be serving as a vehicle for overhauling banking supervision more generally and upgrading banks’ risk management.

South Africa provides an example of prompt and comprehensive action in a country with a relatively advanced financial system. Regulations covering Basel 2 were issued in 2004 and consultations with banks on use of the more advanced IRBA for credit risk were initiated at the same time. Economic impact studies were completed in 2005, and the parallel calculations required prior to adoption of the IRBA and the AMA (which enable regulatory capital calculated according to the rules of Basel 1 to be compared with that calculated for the advanced options of Basel 2) are to be conducted in 2007.

In Sri Lanka, initial efforts will focus on meeting the requirements of the SA for credit risk and the BIA and SAOR for operational risk by 2008. Considered particularly important by the authorities is the challenge of upgrading the infrastructure for credit rating since Basel 2’s more sensitive calibration of credit risk depends on such rating (see Dr R.Jayamaha, ‘Basel II – A Roadmap for Sri Lankan Banking System with International Comparisons’, opening remarks of the Deputy Governor of Sri Lanka as part of a lecture series organised by the Association of Professional Bankers, Colombo, 18 December 2006).

Pakistan’s problems in meeting its deadline for introducing the SA and SAOR by 2008 were outlined in a recent address of the Governor of the State Bank of Pakistan in Geneva. The country currently has only two credit rating agencies and objective of Pakistan is to accompany introduction of Basel 2 with an overhaul of the rating infrastructure (see Dr S.Akhtar, ‘Lessons from Pakistan’s Banking Sector’s Reforms’, public lecture for the International Centre for Monetary and Banking Studies, HEI, Geneva’ Switzerland, 1 February 2007).

India is planning to start introduction of Basel 2 in 2007. The options chosen under Pillar 1 will be SA for credit risk and BIA for operational risk. Basel 2 will apply to the 88 commercial banks which account for about 82 per cent of the assets of the financial sector. China is to phase in Basel 2 over a period of years. New capital rules introduced in March 2004 included an adjusted version of Basel 1 with the use of external credit ratings for international claims, implementation of the 1996 Amendment (of Basel 1) to Incorporate Market Risks, the introduction of Pillar 2 and Pillar 3 of Basel 2, and revised rules for provisions for loan losses.

In Japan, amendments to banking regulations to incorporate Basel 2 are to follow the publication of the definitive draft of Basel 2 of June 2006, and implementation of approaches other than the most advanced is expected to start in 2007. The amendments will address the definition of default (in a country where rescue operations for banks have recently been frequent) and the treatment of LGD in the IRBA for credit risk (taking account of the country’s exceptionally time-consuming procedures for loan recovery). Large banks are expected to adopt FIRBA owing to the difficulty of accumulating in the aftermath of the many recent mergers and restructurings in the country’s banking sector time series of bank-specific data on LGD sufficiently long to meet Basel 2’s conditions for adoption of the AIRBA.

At the time of writing, disagreements in the United States as to how regulatory capital requirements will be revised in the United States in response to Basel 2 are still unresolved.

Under the regulators’ initial plan, the introduction of Basel 2 would begin in 2008, and only banks with total assets or total cross-border assets above specified thresholds would be required to adopt the AIRBA and AMA, though some other large banks were also expected to follow suit.

The consultation process preceding definitive plans for introduction has been prolonged owing to regulators’ need for time to evaluate the results of the country’s study of Basel 2’s quantitative impact on banks’ regulatory capital, to continuing concerns about the potentially unfavourable competitive effects on small banks of a regime that limits Basel 2 to a minority of large banks, and to consideration of this summer’s request of some large banks to be allowed the option of adopting the less advanced approaches of Pillar 1.

Further delays may result from Public Law 109-173, which was adopted in February 2006 and mandates an evaluation of Basel 2 by the Government Accounting Office (GAO).

Under new rules proposed at the end of last year (whose implications for implementation of Basel 2 will be discussed at greater length in a subsequent article) a new option under Pillar 1 (Basel 1A) would be available to banks not adopting the AIRBA and the AMA. This option is designed to increase the risk sensitivity of the capital requirements of Basel 1, which, with or without the adjustments of Basel 1A, would continue to apply to the majority of the country’s banks not on Basel 2.

Other difficulties which are currently the subject of regulatory attention in many countries concern convergence in the cross-border implementation of Basel 2. As was also true of Basel 1, Basel 2 aims to ensure a degree of consistency in the regulation of the capital of international banks sufficient to prevent the rules from resulting in distortions of competition.

But this objective has to be achieved in ways that accommodate both the variety of approaches to capital requirements for credit and operational risk under Pillar 1 and supervisory latitude as to setting additional regulatory capital levels under Pillar 2.

Flexibility has been built into Basel 2 owing to the acknowledgement of the BCBS that the agreement will be applied to banks and supervisory regimes with different capacities and at different levels of sophistication i.e. to the acknowledgement that Basel 2 is a global standard.

For banks with cross-border operations, Basel 2 is to be applied through a framework of consolidated supervision for the banking group as a whole. This can be a source of difficulties if the supervisor of the group in its parent country and the supervisor of a subsidiary or branch in a host country employ different rules for minimum regulatory capital.

Such differences have been the subject of extensive consultations between national regulators and Accord Implementation Group (AIG) of the BCBS during the preparations for Basel 2, and in view of their importance to an understanding of the politics of the introduction of Basel 2 will be discussed at greater length in the second article.

To how successful an outcome for Basel 2 does the information above point? An attempt to answer the prudential part of this question, namely what will be the impact of Basel 2 on the control of risks by banks and their supervisors, and thus on the strengthening of “the soundness and stability of the international banking system” in the words of the text of the agreement, would clearly be premature.

The proof of the pudding must await the eating. Assessment should also include the extent to which the second major objective of Basel 2 is achieved, namely that of “maintaining sufficient consistency that capital adequacy will not be a significant source of competitive inequality among internationally active banks.”

The data above indicate that Basel 2 is likely to be implemented very widely. However, the data also highlight that schedules for implementation at national level are already the subject of widespread delays which will have implications during a substantial period for cross-country uniformity of regimes for capital regulation, or rather for the lack of it. Moreover, even the regulatory minima of Basel 2 may vary as a result of the prescription of additional capital by national supervisors under Pillar 2 at levels not internationally uniform for risks not covered, or not adequately covered, under Pillar 1.

Thus, global regulation of the capital of banks will remain something of a patchwork even after the introduction of Basel 2.

*Andrew Cornford, who contributed this article, was formerly a senior UNCTAD economist and is currently Research Fellow at the Financial Markets Centre based in Geneva.

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