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Saturday, 13th April 2024
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Implications of the new Basel Capital Accord for investors Back  
Len Riddell examines the stock market implications of Basel II and says that the bigger Irish banks such as Bank of Ireland are likely to benefit from the proposed new regulations but that it could prove challenging for smaller operations.
For bank investors, the Basel Committee’s proposed changes to regulatory capital requirement rules represent some of the most significant developments in the global banking industry in recent years. Capital allocation represents the most crucial aspect of bank management and the stock market is likely to review the new regulations in detail, as they are likely to be a significant future driver behind both strategic planning and, most importantly, bank valuation over the next few years.
With the proposed new framework still under consultation, finalised regulations remain as yet undetermined. The full impact of implementation on valuation and strategy therefore, remains difficult to calculate with any degree of accuracy.
However, the new BIS II Capital Accord is likely to be a net positive for Irish bank stocks due to their favourable business mix, defensive profile, diversified portfolios and robust asset quality. Within the Irish universe Irish Life & Permanent, Bank of Ireland and First Active are likely to be the most significant potential beneficiaries from the proposed new regulations.
In general, overall Tier 1 capital levels for the Irish banks are likely to decline following the implementation of the new framework as an increased focus on risk management practices and systems permits lower regulatory capital levels. This could be a strong driver behind improved RoE performance going forward that in turn is likely to be positive for Irish bank share prices. If the banks can punch above their weight in a European context in terms of driving efficiency gains, the historic valuation differential between Irish and other Eurobanks could narrow considerably as the Irish banks are re-rated to reflect their more defensive profile.
Within the market as a whole, over •700m of capital could be liberated under the proposed new rules, equating to 4.1 per cent of the total capital held by the major Irish banks.

BIS I - The old world
The incumbent capital accord was instigated in 1988 in order to establish a common minimum framework for calculating banks’ capital adequacy requirements. Its two main objectives remain:
• to strengthen the stability of the global banking system as a whole, and
• to diminish a source of competitive inequality within international banking.

Despite its rather ‘crude’ nature the principal successes of this original accord have been twofold. Firstly, it has established a level playing field for all banks in terms of capital requirements. Also, it has forced all banks to direct more resources towards monitoring and controlling their capital adequacy and efficiency levels, and thus should have increased management understanding and control of both the risks and returns inherent in their various business models.
However, it is now largely recognised by the market that the current accord is overly simplistic and needs to be superseded by a more risk-sensitive framework.
BIS II - Brave new world
The proposed new BIS Accord intends to replace the one-size-fits-all approach of the 1988 Accord with a number of risk-sensitive approaches to calculating regulatory capital requirements for credit risk. The approach adopted by different banks will most probably depend on their risk profile, their size, the expected outcome of the various approaches and, most importantly, the complexity of the business and sophistication of their risk management systems and processes.

Objectives
The Committee has stated that the primary objectives of the new framework of rules are twofold:
• to promote best practice in risk management by encouraging banks to use their own detailed knowledge of their own inherent credit risk tendencies when setting capital targets; and,
• to achieve a better alignment between economic and regulatory capital.
These are welcome developments from a bank investor’s point of view as they go some way to ensuring that the regulatory capital required to be held by banks will more accurately reflect the risks inherent within a given portfolio of assets.

Operational risk
The introduction of an operational risk (OR) element in calculating regulatory capital requirements is perhaps the most controversial change between the BIS I and II frameworks. An OR charge is proposed in order to cover ‘the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events’.
The losses incurred by Barings and AIB would be examples of events expected to be covered by an OR capital requirement. Arguably one of the major reasons behind the proposal for an OR charge is also the elimination of regulatory arbitrage (avoiding business with high regulatory capital requirements) in bank strategic planning.
Various computation methods for an OR charge have been proposed, but as yet no specific method has been finalised. It is likely that, when finally implemented, OR will be a flexible charge, based on more qualitative factors than just a simple percentage of required capital. Importantly, the calculation of an OR charge is likely to focus more on the sophistication of internal controls and the process and reporting structure of banking businesses, rather than simply their scale.

BIS II - Where could the positives come from?
If the current proposed framework for credit risk capital requirements was to be implemented, Irish banks’ regulatory capital levels are likely to be lowered in two principal areas: wholesale lending and residential mortgages.
Given the current status of the consultation process concerning the operational risk charge it is difficult to come to a conclusion on the overall impact of BIS II. However, the credit risk calculation approaches are likely to remain at levels similar to those currently proposed.
If Irish banks manage to increase their focus on improving the sophistication of their internal capital adequacy systems and processes over the next few years, the new Accord is likely to be a net positive.
This is primarily due to Irish banks’ favourable business mix and robust asset quality. If margins remain robust and efficiency gains can be driven from lower regulatory capital requirements, PE expansion across the sector is likely going forward. Although the new Accord is unlikely to change the total amount of capital held on a systemic level within the industry as a whole, there is likely to be a redistribution of regulatory capital towards higher risk banking models.
Irish banks could therefore benefit as their more defensive positioning allows lower regulatory capital levels and, if capital is allocated successfully, higher RoE’s going forward.
AIB and Bank of Ireland are likely to be suitably sophisticated and are of an ideal size for adapting to the challenges presented by the new Accord - both are large enough to swallow the sizeable capital investment required and neither have extensive, sprawling global franchises that would require significant standard and process harmonisation.
The smaller Irish franchises could find the capital spend and increased risk analysis disclosures more of a burden, but their more simple business models should render implementation a relatively painless exercise.
Implementation of the new framework is now unlikely before 2007. However, banks will have to align their strategies and balance sheets with the new rules long before implementation.
Capital allocation systems and process changes will need to be implemented long before 2007 and, thus, the new rules could be a strong determinant both of bank strategic positioning (ie regulatory arbitrage) and profitability in the near term future.

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