Basel II: New Wine in an Old Bottle

Sabyasachi Bardoloi, former manager of Pinnacle Research Group, Pinnacle Systems, Inc. (now Accurum), a technology consultant and solutions provider to capital markets firms, regularly contributes financial technology-related articles to various news portals. The premiere publication of his article below also marks his first publication in RiskWorld. He retains the copyrights.

Basel II: New Wine in an Old Bottle

By Sabyasachi Bardoloi

This article gives an overview of Basel II, charting from the birth of the Basel Committee on Bank Supervision, which initially provided guidelines to central banks in the G10 countries and gradually expanded its wings to cover more than 100 countries. The article tries to make a comparative analysis of the first Basel Accord and the current Basel II proposed accord. It moreover points out the wide-angle scope that Basel II provides and spells out the key drivers.

Introduction

The year 1974 witnessed the governors of the central banks of the G10 (Group of 10) countries joining hands, and it culminated in the establishment of the Basel Committee on Bank Supervision. The Committee's members hail from Switzerland, the United States, the United Kingdom, Japan, France, Germany, Sweden, Belgium, Canada, Italy, Spain, Luxembourg, and the Netherlands.

The Basel Committee does not possess any formal supranational supervisory authority and its conclusions do not have any legal or binding force. It merely formulates broad-based supervisory principles or strategies. However, it recommends statements of best practice, keeping in mind that individual authorities will undertake steps to implement them through detailed arrangements in a way that suits them best.

Thus the Basel Committee encourages convergence towards common approaches and common standards without attempting the detailed harmonization of member countries' supervisory techniques.

Basel II - Forward March

The Basel Committee in the year 1988 decided to introduce a new capital measurement system that came to be popularly known as the Basel Capital Accord. This forced banks of the G10 countries to implement a credit risk measurement framework with a minimum capital standard of 8% by end-1992. This framework has been progressively introduced not only in member countries but also in more than 100 other countries that have active international banks.

In June 1999, the Basel Committee issued a proposal for a New Capital Adequacy Framework to replace the 1988 accord. This framework, which is currently under development, is known as the second Basel Accord or, more commonly, as Basel II.

Further to the proposal, the Basel Committee has from time to time been submitting consultative papers. On April 29, 2003, it submitted the third consultative paper (CP3), which has set July 31, 2003, as the cutoff date to get feedback on the same. The Basel Committee intends to finalize Basel II in the fourth quarter of 2003, allowing for implementation of the new framework in each G10 country by the end of 2006.

Basel II is designed to be more flexible and risk-sensitive than its predecessor. It affects all banks and other financial institutions, including bankers, custodians, fund managers, and brokers, to name just a few. The accord provides a draft set of regulations that is set to modify notably the way that banks are capitalized.

The new framework is set to improve the trustworthiness of the financial system by aligning capital adequacy assessment more closely with the fundamental risks in the banking industry. Moreover, it will also provide incentives for banks to enhance their risk measurement and management capabilities. It will thereby augment market discipline.

An improved capital adequacy framework is aimed to foster a strong emphasis on risk management and to encourage ongoing improvement in risk assessment capabilities of banks. It further seeks to maintain the current overall level of capital in the system and boost competitive equality.

In the final form, Basel II will establish the basic capital frameworks for committee member countries and will enforce that banks have a risk management strategy. For example, a commercial bank’s greatest risk 15 years ago was its loan portfolio; but, due to innovative financial instruments today such as derivatives, a bank's capital is exposed to credit risk, interest and market risk, as well as operational risk. Once Basel II is implemented, operational risk will feature directly in the assessment of capital adequacy for the first time.

Basel II defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.”

Though this will include legal risk, it is worth noting that strategic and reputation risks are currently out of the scope. International banks will be required by regulators to set aside capital against operational risk for the first time. Banks are being asked to set aside approximately 20 per cent of their regulatory funds against unexpected disasters.

The next 3 years will be strenuous for finance organizations, since they will not only have to implement changes for the Basel II accord but also will be faced with large-scale programs such as the Euro, STP/ T+1, and other regulatory changes.

Existing Capital Accord	Proposed New Capital Accord
Focus on single risk measure	More emphasis on bank’s own internal risk management methodologies, supervisory review, and market discipline
One size fits all	Flexibility; menu of approaches; capital incentives for better risk management; granularity in the valuation of assets and type of businesses and in the risk profiles of their systems and operations
Broad brush structure	More risk sensitivity by business class and asset class; multi-dimensional; focus on all operational components of a bank

Source: “The New Basel Capital Accord: an explanatory note,” BIS

Basel II - The Three “Pillars”

Basel II provides for a framework based on three “mutually reinforcing pillars,” implying that each of the three pillars, or areas, described in Basel II is of equal importance. The three pillars are:

1. Minimum capital requirements. The minimum capital requirement is still set at 8 per cent of risk-weighted assets. A revised credit risk measurement has been proposed and a measure for operational risk is also included in Basel II. However, market risk remains unchanged.

2. Supervisory review process. The supervisors need to ensure that each financial institution adopts effective internal processes in order to assess the adequacy of its capital based on a comprehensive evaluation of its risks. Supervisors will intervene if the risk of a bank is greater than the capital it holds.

3. Effective use of market discipline. It aims to improve market discipline through enhanced disclosure by financial houses. This will include the method a bank adopts to calculate its capital adequacy and its risk assessment.

Basel II - A Wide-Angle Scope

The original Basel Accord only covered internationally active banks. Harmonization across all sectors in the financial industry is the focus of the Basel Committee on Bank Supervision, which aims to implement detailed disclosure requirements across all sectors. Basel II will affect most financial institutions in the following ways:

· All banks in the 110 countries that have signed Basel II will be affected.

· All banks, securities firms, asset managers, and insurance companies with any involvement in banking, fund/asset management, and capital markets in the G-20 (Group of 20) countries will be affected.

· All banks, securities firms, fund managers, and enterprises involved in securitization and with long-term equity holdings, such as private equity/venture capital, will be affected.

· Basel II will directly cover bank-owned or controlled insurance entities. Moreover, insurance companies that own or control banks/non-insurance financial services functions will be covered by the new rules.

· Though the primary focus is banks that are active internationally, the G-20 central banks and the regulatory authorities of most of the countries that are signatories to Basel II are applying the policies to all the financial service institutions in their specific jurisdiction and are expecting the other countries to follow suit.

· It should be noted that regulatory jurisdictions such as the United States, United Kingdom, and the rest of the European Union are moving quite aggressively to use the Basel II framework in their areas to harmonize the capital adequacy and regulatory oversight rules and regulations across all sectors of the financial industry. Similar efforts are also under way in Australia, Singapore, India, and Hong Kong. Many emerging market countries that are signatories to Basel II are also in the process of implementing this framework, using this as an opportunity to re-structure their financial industry.

Basel II - Key Drivers

1. Data and IT systems. The most significant issue facing banks in relation to Basel II is aligning and upgrading data and existing IT systems for consistency and integrity across the organization. Systems must be compatible with the existing IT architecture, must provide suitable reporting facilities, and must support internal credit risk ratings analysis. Banks, especially if they want to achieve the advanced IRB (Internal Ratings Based) and measurement approaches for credit and operational risk, must start implementing these systems.

2. Program governance. Executive-level Basel II champions must seize the initiative and remove all hurdles to a successful Basel II compliance. The role and responsibilities of each individual and department must be clearly defined to avoid confusion, especially with regard to operational risks, since many institutions are not yet convinced about the need to install operational risk systems.

3. Organization-wide scope. Basel II is set to influence all areas ranging from business processes and operations to organizational structure and strategy. As such, banks must establish a risk management methodology, a senior management audit and overview process, data collection and IT systems and disclosure processes, all of which are underpinned by the overall integration of risk into core business processes. To tackle operational risk management effectively, a proper integration of enterprise-wide risk management principles is of utmost necessity.

Conclusion

The positive points of implementing Basel II stand out loud and clear. Stakeholders of banks are increasing the pressure on them to do so. Regulators and analysts are clearly expecting banks to act on Basel II principles and are set to take this into account while issuing opinions and assessing the market. Credit rating agencies are also expecting banks to act on the accord. Despite the heavy odds placed before banks, Basel II should be not be seen as a tedious burden on resources but rather a commercially viable option that will provide an opportunity to consolidate their market position.

About Pinnacle Systems, Inc.

For over seven years, Pinnacle Systems, Inc., a technology consultant and solutions provider to capital markets firms, has applied its in-depth domain expertise and off-shore development capabilities to the capital markets. Pinnacle’s Capital Markets Excellence Center (CMEC) and its Efficient Delivery Model (EDM) successfully deliver cost-effective, project-based solutions for leading global banks and financial institutions.

The company is headquartered in Piscataway, New Jersey, with offices in New York City and development centers in Chennai, India. Contact Pinnacle's capital markets experts at 275 Madison Avenue, 6th Floor, New York, New York, 10016, USA; telephone (212) 880-3737.

For more information, visit www.pinnacle-sys.com.

Posted June 12, 2003.

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