Capital adequacy is the financial
barometer indicating the soundness
and stability of the international
banking system. In the early 1980s,
as concern about international banks’
financial health mounted and complaints
of unfair competition increased,
the Basel Committee on Banking Supervision
commenced considering proposals
to set capital standards for banks.
The efforts with regard to capital
regulation culminated into a capital
accord (Basel I) in July 1988 entitled
‘International Convergence
of Capital Measurement and Capital
Standards’ among G-10 countries
under the aegis of the Bank for
International Settlements.
The
Basel Committee on Banking Supervision
develops broad supervisory standards
and promotes best practices, in
the expectation that each country
will implement the standards in
ways most appropriate to its circumstances.
Agreements are developed by consensus
and decisions about implementation
aspects are left to each country’s
regulatory authorities. More than
100 countries have implemented the
Basel I in some form or the other.
Basel
I initially assessed capital mainly
in relation to credit risk (the
risk of loss due to the failure
of a counter party to meet its obligations)
and addressed other risks only implicitly.
In 1996 the Accord was amended to
take explicit account of market
risk (the risk of loss due to a
change in market prices, such as
equity prices or interest rates
or exchange rates) in trading accounts.
The accord requires international
banks from the G10 countries to
hold a minimum total capital equal
to 8% of their risk-weighted assets.
The total capital has two elements
namely, Tier I capital (equity capital
and disclosed reserves) and Tier
II capital, which include, among
others, subordinated debts and hybrid
debt capital instruments. The risk
weight for each class of asset ranges
from zero (for assets considered
to be very safe, such as government
securities) to 100% (for unsecured
loans). Risk-weighted assets are
defined as the sum of risk-weighted
assets on and off balance sheet.
On-balance sheet assets are assigned
to different risk buckets (as per
the Sri Lankan version there are
five buckets 0%, 10%, 20%, 50% and
100%). Off-balance sheet items,
such as letters of credit, guarantees
and derivative instruments need
to be first converted to a credit
equivalent and then multiplied by
the appropriate risk weight. In
practice, the rules vary slightly
across countries; in Japan, for
example, shares in other firms can
be counted as capital, and the minimum
capital ratio for banks that are
not internationally active is only
4%.
Basel
I is widely viewed as having achieved
its principal objectives of promoting
financial stability and providing
an equitable basis for competition
among internationally active banks.
However, over time the conceptual
limitations of the accord together
with financial innovation have created
incentives and opportunities for
regulatory capital arbitrage, and
have consequently led to a reduction
in its effectiveness especially
in the developed world. This has
prompted a debate and put pressure
on the regulatory authorities to
revise the Accord.
After
almost five years of negotiation,
in May 2004, the Basel Committee
of bank supervisors reached agreement
on a new Capital Accord (known as
Basel II). The Basel Committee plans
to implement this new Accord in
member countries by end 2006. Work
has already begun in a number of
countries on draft rules that would
integrate new Basel capital standards
with national capital regimes. The
ultimate objective of the new accord
is a safer and sounder banking system
through better risk management at
banking organizations.
The new Accord updates the capital
adequacy rules to address product
innovations such as credit derivatives.
It also aims to reduce regulatory
capital arbitrage by reducing the
gains from it. As a result, regulatory
risk weights are to be moved towards
bankers’ risk estimates, to
become more ‘risk-sensitive’.
The methodology of the new accord
is to incorporate within the regulatory
and supervisory processes some of
the risk management tools to evaluate
and manage risk positions of banks.
In the process, not only would the
banks be required to improve their
risk management, but also, in addition,
a system would be established that
could evolve naturally as risk management
practices themselves evolve. There
are three major components in the
new accord, namely the minimum capital
requirements (pillar I), the supervisory
review process (pillar II), and
disclosure of risks to enhance market
discipline (pillar III).
According
to the Chairman of the Basel Committee
and Governor of the Bank of Spain
Jaime Caruana,“Basel II introduces
a far more comprehensive framework
for regulatory capital and risk
management than we have ever known,”
The Basel I has serious shortcomings
as it applies to the large international
banks, major one being the possibility
of regulatory capital arbitrage.
The methodology of Basel I is too
simple to address the activities
of the most complex banking organizations.
The calculation of risk-weighted
assets is crude. For example, in
the assessment of risk countries
that are members of the Organisation
for Economic Co-operation and Development
(OECD) are considered to be much
less risky debtors than non-OECD
countries, which is true on average
but not in all cases.
As
far as risk mitigation is concerned
while some collateral is recognized
in Basel I, other collateral of
equivalent quality is not. Even
though loans assigned the same risk
weight (for example, 100 per cent)
can vary greatly in credit quality.
The limited differentiation among
degrees of risk means that calculated
capital ratios are often uninformative
and may provide misleading information
about a bank’s capital adequacy
relative to its risks. The limited
differentiation among degrees of
risk creates incentives for banks
to “manipulate” the
system through regulatory capital
arbitrage by selling, securitizing,
or otherwise avoiding exposures.
So banks indulged in “regulatory
arbitrage”: they disposed
of risks for which Basel 1 required
more capital than the market did,
such as credit card loans or residential
mortgages; and they retained assets
for which the market demanded more
capital than the regulators did.
Banks
have incentives to collect risks
that they consider under priced
by the Basel accord (eg: investment
in low rated entities) and to repackage
and sell risks that they consider
overpriced (eg: lending to a blue
chip company). Many new products
are created precisely because the
Accord required them to be treated
in ways that do not reflect the
economic risk. Basel 1 had an unintended
consequence: its weights did not
match the market assessment of the
risks that banks faced.
Further,
the art of risk management has evolved
at the largest banks significantly
since the introduction of Basel
I. Banks themselves have developed
new techniques to improve their
risk management and internal capital
measures in order to be more effective
competitors and to control and manage
their credit losses. A revised accord
that is carefully crafted could
speed the adoption of still better
techniques and promote the further
evolution of risk measurement and
management by spurring increased
investment in the process.
The new capital accord is more complex
than its predecessor, for several
reasons. According to Roger Ferguson
of the Federal Reserve Board, one
reason for its complexity is the
assessment of risk in an environment
of a growing number of financial
instruments and strategies having
subtle differences in risk reward
characteristics being inevitably
complicated. The multiple objectives
of the new accord also make it more
complex. The major objectives of
Basel II are:
• Improvement of risk measurement
and management in banks
• Linking to the extent possible,
the amount of required capital to
the amount of risk taken by banks
((pillar I of the new accord attempts
to achieve this objective)
• Further focusing the supervisor-bank
dialogue on the measurement and
management of risk and the connection
between risk and regulatory capital
(pillar II has been introduced with
this objective in mind)
• Increasing the transparency
of bank risk-taking to the customers
and counter parties that ultimately
fund – and hence share –
these risk positions (pillar III
attempts to meet this objective)
As stated earlier the new Accord
is built on three mutually reinforcing
elements, or “pillars”.
Pillar I of the new accord sets
capital requirements against three
risk categories: credit risk (introduced
in 1988); market risk (introduced
in 1996), and operational risk (a
new category). Each of the risk
categories will offer a menu of
approaches varying from the crude
but penal to the sophisticated and
more generous. The concept of the
capital ratio would remain unchanged.
As under Basel 1, the numerator
of the ratio would be its regulatory
capital and the denominator would
be its risk-weighted assets. The
minimum required capital ratio (8%)
and the definition of regulatory
capital (equity, reserves, subordinated
debt etc.) would not change from
Basel I. What would change is the
definition of risk-weighted assets
– the method used to measure
the riskiness of the loans and investments
held by the bank. Specifically,
Basel II would make substantive
changes in the treatment of credit
risk and would provide for specific
treatment of securitization, a risk
management tool not fully contemplated
by Basel I. The Pillar I would explicitly
take account of operational risk
– the risk of loss resulting
from inadequate or failed internal
processes, people, or systems or
from external events. The major
changes in the new accord is summarized
in diagram I:
 |
In
contrast to Basel I, which applies
the same framework to all banks,
Basel II, offers three options for
measuring credit risk and three
for measuring operational risk.
The purpose of offering options
is to allow each bank and its supervisors
to select approaches that are most
appropriate to the bank’s
operations and its ability to measure
risk. Diagram II illustrates the
major components of the new accord:
As indicated in the above diagram,
the options for calculating credit
risk are the standardized approach
and two internal-ratings-based (IRB)
approaches – the foundation
approach and the advanced approach.
The
simplest approach to credit risk
is called the ‘standardised’
approach. Instead of basing the
risk weight on the category of borrower
(bank, sovereign, public sector
entity, others), this approach would
use borrower’s rating for
the computation of capital charge.
The ratings are to be provided by
External Credit Assessment Institutions
(ECAIs) such as rating agencies,
national credit registers and export
credit guarantee agencies.
The
more sophisticated ‘IRB’
approach relies on banks’
estimates of key determinants of
credit risk. The foundation IRB
approach uses banks’ estimates
of a borrower’s probability
of default (PD), while the regulator
sets other inputs. Under the foundation
version, rigid supervisory rules
would establish many of the credit
risk parameters that would determine
bank capital requirements. That
is because the foundation approach
is designed to address either the
bank in the early stages of developing
its risk management systems or those
operating in a supervisory environment
that is not yet prepared to validate
and enforce the sound practice standards
applicable to banks under the Advanced
IRB approach. In such countries,
the foundation version may be useful
as a transition for banks that have
not yet developed the ability to
estimate all of the necessary credit
parameters or have not convinced
their supervisors that they can
both do so and use those parameters
in making credit decisions. The
foundation version may also be useful
for large organizations that have
relatively limited business lines.
In
the advanced IRB approach, the bank
may estimate other inputs, such
as Loss Given Default (LGD), but
the mapping from input to risk weight
is still set by the Basel Committee.
In the IRB approach, the risk weight
is a function of four variables.
The function is concave in probability
of default (PD); linear in effective
maturity (M); and proportional to
loss given default (LGD) and to
exposure at default (EAD). Estimating
the impact on funding costs requires
assumptions about M, LGD and EAD,
and on banks’ internal ratings.
| LGD:-
|
Measures
the proportion of the exposure
that will be lost if a default
occurs. |
| PD:- |
Measures the
likelihood that the borrower
will default over a given time
horizon. |
| EAD:- |
Measures the
amount of the facility that
is likely to be drawn out if
default occurs. |
The
details for calculating capital
charges would vary somewhat according
to the type of exposure (corporate
or retail, for example). The difference
between the two IRB approaches is
that the foundation approach would
require the bank to determine only
each loan’s probability of
default, and the supervisor would
provide the other risk inputs, under
the advanced approach, the bank
would determine all the risk inputs,
under procedures validated by the
supervisor. Banks choosing to operate
under either of the two IRB approaches
would be required to meet minimum
qualifying criteria pertaining to
the comprehensiveness and integrity
of their internal capabilities for
assessing the risk inputs relevant
for its approach.
Banks
use a number of techniques to mitigate
the credit risks to which they are
exposed. Exposure may be collateralised
in whole or in part with cash or
securities, a loan exposure may
be guaranteed by a third party,
or a bank may buy a credit derivative
to offset various forms of credit
risk. Additionally banks may agree
to net loans owed to them against
deposits from the same counter party.
Where these various techniques meet
the requirements for legal certainty
as prescribed in the new accord,
the revised approach to credit risk
mitigation allows a wider range
of credit risk mitigants to be recognised
for regulatory capital purposes
than is permitted under the 1988
Capital Accord.
While
the use of risk mitigation techniques
reduces or transfers credit risk,
it simultaneously may increase other
risks to the bank, such as legal,
operational, liquidity and market
risks. Therefore, it is imperative
that banks employ robust procedures
and processes to control these risks.
One of the complexities of unbundling
risk related capital charges is
the need for an explicit capital
charge for operational risk. Devising
such a charge has proved extremely
difficult because of a lack of both
an agreed upon methodology and credible
industry data. This has required
the adoption of a strategy to permit
banks to use their own internal
measurement approaches – subject
to quantitative and qualitative
criteria and, on a transitional
basis, to a minimum or floor capital
charge.
The
three proposed options for calculating
operational risk are the basic indicator
approach, the standardized approach,
and the Advanced Measurement Approaches
(AMA). The basic indicator and standardized
approaches are intended for banks
having relatively less significant
exposure to operational risk. They
require that banks hold capital
against operational risk in an amount
equal to a specified percentage
of the bank’s average annual
gross income over the preceding
three years. Under the basic indicator
approach, the capital requirement
would be calculated at the firm
level; under the standardized approach,
a separate capital requirement would
have to be calculated for each of
eight designated business lines.
Banks using these two approaches
would not be allowed to take into
account the risk mitigating effect
of insurance.
The
AMA option is designed to be more
sensitive to operational risk and
is intended for internationally
active banks having significant
exposure to operational risk. It
seeks to build on the banks’
rapidly developing internal assessment
techniques and would allow banks
to use their own methods for assessing
their exposure, so long as the methods
are judged by supervisors to be
sufficiently comprehensive and systematic.
No specific criteria for using the
basic indicator approach would be
set forth, but banks using that
approach would be encouraged to
comply with supervisory guidance
on sound practices for managing
and supervising operational risk.
Banks using either the standardized
approach or the AMA approach would
be required to have operational
risk systems meeting certain criteria,
with the criteria for the AMA being
more rigorous.
Pillar 2 says that banks must increase
their capital cushions if national
supervisors consider them too low,
even if they are above the minimum.
It also promotes the notion that
supervisors, on the basis of their
knowledge of industry practices,
should provide constructive feedback
to bank management on their internal
assessments. Three main areas that
might be considered for treatment
under Pillar 2 are as follows:
| 1.
|
Risks
considered under Pillar 1 that
are not fully captured by Pillar
1 process. E.g. Credit concentration
risk |
| 2. |
Risk areas not
taken into account by Pillar
1. E.g. Interest Rate Risk in
the banking book, Liquidity
Risk and business and strategic
risks |
| 3. |
Factors external
to the bank. E.g. Impact of
Business cycles |
The
supervisors are supposed to review
and evaluate banks’ internal
capital adequacy assessment and
strategies as well as their ability
to monitor and ensure their compliance
with regulatory capital ratios.
The supervisors should take appropriate
supervisory action if they are not
satisfied with the results of this
process and they should expect banks
to operate above the minimum regulatory
capital ratios and should have the
ability to require banks to hold
capital in excess of the minimum.
The risks to which banks are exposed
and the techniques that banks use
to identify, measure, monitor and
control those risks are important
factors market participants should
consider in their assessment of
a bank. Pillar 3 stresses the importance
of market discipline, and says that
banks should become more open about
risks to their capital positions
and profitability. This pillar is
seen as particularly important because
some banks under Basel II would
be allowed to rely more heavily
on internal methods for determining
risk, giving them greater discretion
in determining their capital needs.
Major areas of required disclosures
are:
| i)
|
The
risk management objectives,
policies, strategies and processes
in each of the risk areas, including
qualitative disclosure. The
supervisors should ensure qualitative
disclosure accurately reflects
the position of a bank. Also
a bank should have a formal
disclosure policy approved by
its Board of Directors. |
| ii) |
Information to
assess how capital requirements
apply to the bank and how entities
within the banking group are
treated for capital purposes. |
| iii) |
The actual amount,
components and features of all
capital instruments especially
in the case of innovative, complex
and hybrid capital instruments.
|
| iv) |
Capital adequacy
ratio and the risk weighted
assets and a summary discussion
of the bank’s approach
to assessing the adequacy of
its capital to support current
and future activities. |
| v) |
Disclosures on
credit risk, credit risk management,
equities and interest rate risk
under the banking book, asset
securitization, market risk
and operational risk etc. |
There is a strong case for improving
disclosure standards in most countries.
Weak disclosure standards undermine
the effectiveness of all three pillars
of the new accord. However, the
production and the processing of
information are costly. The pillar
III seeks to complement the other
two pillars with stronger market
discipline.
The challenges of the new accord
are daunting, indeed, if the effort
does nothing but improve risk management
at banks and improve the risk focus
of supervisors, it will be worth
the time and resources that have
been expended.
The
new accord is expected to decrease
charges for many classes of credit
risk. This is expected to be offset
by a totally new charge for operational
risk. So the overall minimum regulatory
capital in the banking system is
expected to remain at the same level.
The expected reduction in the overall
capital requirements will allow
banks to plough more capital back
into banking business, as long as
the banks can show that they have
more stringent risk evaluation systems.
However, Banks that do not have
internal rating systems will need
to hold significantly higher levels
of capital, as a result of the operational
risk capital charge.
For
many activities, and thus for a
few banks, the new regime implies
big changes in capital requirements.
The new operational risk element,
for instance, will hit banks specializing
in areas - such as custody or asset
management – that involve
little lending and therefore in
the past have needed little capital
to meet the minimum regulatory capital.
Almost any bank with a lot of retail
business – except for sub-prime
lending and perhaps credit cards
– can expect its minimum capital
to fall as the risk weight for retail
exposures is to be reduced.
The
adoption of the new Accord requires
a significant improvement in supervisory
resources. The supervisory authorities
are expected to build up their expertise
substantially in both quantitative
and qualitative terms. The Pillar
2 requires supervisors to have tools
to evaluate the adequacy of banks’
internal risk management systems/internal
capital assessments and to have
means of requiring banks to hold
capital in excess of the Pillar
I minimum, where necessary. The
adoption of the IRB approach, even
under the foundation level requires
considerable investments in IT/human
resources and rigorous supervisory
oversights. The data management
capabilities of banks will be critical
for the adoption of IRB approaches
that require the banks to estimate
the credit quality of their borrowers
internally.
The
reliance on ECAIs under the standardised
approach for assigning risk weights
is another area of concern. The
rated entities, especially in developing
countries, which have exposure to
the banking system, are very few
in number. Further, the use of external
credit rating agencies in the regulatory
process may act as a disincentive
for the banks to improve their credit
risk management systems.
Jonathan Ward (2002) points out
that the new accord has not been
designed with developing countries
in mind, and it is likely to fail
in developing countries. The developing
countries experience greater macroeconomic
volatility, and greater volatility
of external flows and greater vulnerability
to external shocks. Further the
skills are scarce in developing
countries. Supervision and market
discipline require skilled supervisors
and market participants. Even the
more basic capital requirements
rely on the skill of bankers since
any capital adequacy rule relies
on the valuation of assets that
have no market price.
The
developing countries will be under
pressure to implement the new accord.
Though according to the official
view the implementation of the Accord
is voluntary, in reality it is not
entirely voluntary. Countries, that
do not implement, risk sanctions
in several ways. The lending programmes
of the international institutions
linked with conditions attached,
and these conditions may include
compliance with international regulatory
standards.
Given
their resources and capacity the
option of implementing Basel II
in full is not a viable option for
developing countries in the near
future. Implementing a restricted
form of Basel II, using only the
simple capital adequacy options
and relying only to a limited extent
on supervision and market discipline,
would economise on scare resources.
The option of incorporating certain
provisions of the new accord in
to their current version, which
has been proposed by a group of
non-G10 regulators, may be a better
option; however, inclusion of Pillars
2 and 3, would require significant
improvements both in supervisory
resources and disclosure standards.
Alternatively, developing countries
could take the Basel framework as
a starting point and, using the
guiding principles, simplify the
regime and adapt it to local circumstances.
Most
of the banks in Sri Lanka are in
the early stages of developing their
risk management systems and the
supervisory environment also is
not yet prepared to validate and
enforce the sound practice standards
applicable to banks under the advanced
internal risk measurement approaches.
The new accord contains incentives
to improve internal risk management
systems of banks. Banks in Sri Lanka
are not sophisticated enough to
adopt the new accord in the near
future, in whatever the form. However,
few foreign banks operate in Sri
Lanka will be in a position to adhere
to internal rating based capital
measurement systems.
The
Sri Lankan version of capital adequacy
takes into account only the credit
risk and there is no explicit charge
for market risk. The 1996 amendment
to the capital accord with regard
to market risk has not been incorporated
yet in Sri Lanka.The market risk
component of the existing accord
is to be retained even in the new
accord. In this background it seems
the viable option for Sri Lanka
would be, while taking steps to
implement the amendment with regard
to market risk, to introduce specific
measures to enhance the risk management
capabilities of banks. This would
lay the foundation for the adoption
of a more risk sensitive approach
for capital measurement at least
at a future date.
The
quality and content of market information
disseminated by banks in Sri Lanka
also need mprovement in order to
enhance market discipline. The supervisory
resources need to be improved with
a view to equipping the bank examiners
to perform the additional tasks
they are supposed to undertake under
the Basel II methodology.
The critics point out that the new
accord, in which several options
to credit and operational risks
are available, replaces one form
of regulatory arbitrage with another.
The IRB approach generates higher
capital requirements than the standardized
approach on lower-quality assets,
but lower requirements on higher-quality
assets. Banks on the IRB approach
will tend to acquire all the high-quality
assets and banks on the standardized
approach all the low-quality assets
– the assets for which the
standardised approach undercharges.
Banking groups will be tempted to
‘cherry-pick’ between
the two regimes, but even if they
do not, the banking system will
do it automatically.
Unless suitably modified, the adoption
of the new accord in its present
format would result in a significant
increase in the capital charge for
banks, especially in the emerging
markets. The benefit of risk mitigation
techniques also may not be available
as most of the banks in emerging
markets are not in a position to
comply with the preconditions stipulated
by the Basel Committee.
| 1.
|
The
New Basel Accord and Developing
countries: Problems and alternatives,
Jonathan Ward 2002 |
| 2. |
Basel II: Vintage
2003,Andrew Cornford, Journal
of Financial regulation and
Compliance, Volume 12 Number
1 |
| 3. |
The New Basel
Capital Accord: Consultative
document of the Basel Committee
on Banking Supervision, Bank
for International Settlements,
April 2003 |
| 4. |
Comments made
by various supervisory authorities
on the New Capital Accord |
| 5 |
Judging the effects
of new rules on bank capital,
The Economist, May 8,2003 |
| 6. |
Journal of International
Banking Regulation, Vol 4.No
2, 2002 |
| 7. |
Bothersome Basel:
The new capital adequacy rules
have proved tricky to draw up,
The Economist, April 17 2004 |
| 8. |
Now for the hard
part, The Economist, May 13,
2004 |
| 9. |
Capital Standards
for Banks: The Evolving Basel
Accord, Roger W.Ferguson, June
2003. |
| 10. |
New Capital Accord
and its Implementation Challenges,
V.Sivanesan, News Survey, Central
Bank of Sri Lanka, January/February
2003 |
| 11. |
New Basel Capital
Accord and Credit Ratings, V.Sivanesan,
News Survey, Central Bank of
Sri Lanka, March/December 2003 |
| |
|
