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New Basel Capital Accord - start planning now! Back  
The implications of the new Basel Capital Accord are so great that banks and investment firms need to take virtually immediate action to be prepared says Alan Merriman.
Don’t be fooled by the proposed 2004 headline implementation date of the new Accord, the implications of the reform are so major that banks and investment firms, both at the coal face and in the boardroom need to start analysing, planning and investing now.

This is particularly so, because even if accepting that the overall industry effect on total regulatory capital is expected to be neutral there will without doubt be individual winners and losers, both between banks and within banks. And in what is already a very competitive market, any further competitive erosion, particularly for smaller players, has to be seen as critical.

Taking advantage of the expected benefits of the Accord will also certainly necessitate, inter alia, early investment in better risk management, financial reporting, supervisor relationship management and perhaps even some accelerated capital planning.

The new proposals have been the subject of much interest and debate since their publication, however given that the documentation runs to some 550 pages I suspect not many bankers would pass an exam on it. For similar reasons, considered industry opinion and analysis is just now beginning to materialise.

This article seeks to give an overview of the contents of the proposed new Accord, highlight some of the emerging controversial issues, and suggest some practical steps to take now.

Overview of New Accord
In summary, the proposals represent a wide-ranging and ambitious reform which seeks to better align regulatory capital with economic risk and in that context is very welcome and represents a real advance on the 1988 Accord. Put simply, rather than imposing a single method for calculating capital requirements to succeed the 8 per cent minimum ratio, under the new proposals, institutions will be able to select from a range of approaches for more accurately capturing, measuring and controlling credit and operational risks. It is envisaged that the more sophisticated control structures will be rewarded by lower capital charges.

Whilst the new proposals are not intended to raise the overall levels of risk capital within the system but rather to result in its more efficient allocation, initial industry assessment is questioning whether this will indeed be the ultimate result. The sentiment is that commercial and investment banks may lose heavily in terms of increased capital requirements whereas retail banks should do better. Moreover, it is argued that the resulting lack of equilibrium may lead to overall capital requirements actually being raised, and there is a fear that some national regulators may be overly cautious when resetting the required ratios for individual entities.

Three pillars
The new proposals confirm the ‘three pillar’ approach introduced in the 1999 consultative document:
• Pillar 1 - covering minimum capital requirements, specifically new rules for credit and operational risk;
• Pillar 2 - covering supervisory review; and
• Pillar 3 - covering market discipline (including greater disclosure and transparency)

Emerging industry reaction across Europe is particularly negative regarding the Pillar 3 proposals, which are far more onerous than previously flagged. Whilst there is sympathy for the overall objective, the prescriptiveness, volume and detail of the proposed disclosures is eliciting strong criticism. There is some feeling that the proposals are not consistent with IAS and may indeed be at the limits of legality in some countries. It is likely that this area will be the subject of much debate going forward.

A further issue likely to be debated heatedly over coming months concerns the Committee’s proposals on securitisation. Industry reaction has been especially negative regarding the proposed weighting of liquidity lines to securitisations, the treatment of banks investing in securitisations and retrospective penalties with time limits.

Two of the key features of the new Accord are the introduction of a tiered approach to supervision with a strong emphasis on allowing banks to make their own assessments of risk through use of internal ratings and secondly, the introduction of a capital charge for operational risk.

Tiered approach to supervision
The three-strand approach to supervision is aimed at engendering a stronger incentive for banks to improve their risk management procedures, thereby benefiting from lower capital requirements.
• Standardised approach - use of external credit assessment institutions for risk weightings
• Internal Ratings Based (IRB) Approach ‘Foundation’ - some use of internal models requiring at least 2 years of data
• Internal Ratings Based Approach ‘Advanced’ - use of sophisticated risk assessment models, extensive data required

The Basel Committee has stated that it expects that the majority of internationally active banks will move to adopt the IRB approach relatively quickly. However, initial industry assessments have indicated some strong concerns over the robustness of the calibration used by Basel for the IRB.

Basel’s ‘all or nothing approach’ to adoption of the IRB approach is also eliciting industry criticism. The Committee has stated it requires IRB to be rolled out across all business lines and to all significant business units according to ‘an aggressive timetable’. This attitude has raised concerns that banks will have to roll out the IRB approach in units where it might not be justified on risk management grounds even though the unit may be significant.

Some concern has also been expressed that the new Accord could result in smaller banks being indirectly penalised in that they will not be able to benefit from lower capital charges because they do not have the appropriate systems in place. It is likely that many small banks will choose to remain on the standardised approach because it will almost certainly be too expensive to develop, verify and implement their own models necessary for the IRB approach.

Operational risk
The new Accord sets out a three-strand approach for assessing operational risk;
• Basic indicator approach
• Standardised approach
• Internal measurement approach

A key element to note in this regard is that banks can move up from the standardised approach to the internal measurement approach on an individual business line basis - i.e. don’t have to upgrade the entire institution. Much of the detail of how this will work in practice remains to be defined. The disclosure requirements get more onerous as an entity moves upwards towards the internal measurement approach.

It is considered likely that very few of even the most sophisticated internationally active banks will aim to adopt the advanced internal measurement approach (level 3) in the medium term. It is most likely that the majority of larger banks will rather aim to adopt the standardised approach (level 2), whilst recognising that a significant amount of investment in internal systems will be required to enable them to meet the necessary standards. Over the longer term it is likely that larger banks will aim to move to level 3 for their more high capital business lines.

The debate on the operational risk proposals is currently focusing on the suggested timetable and definitions. US and Japanese supervisors are apparently considering making agreement conditional that the level 3 approach (most sophisticated) must be achievable by 2004. Whereas, EU supervisors are more focused on adoption of the standardised method as a first stage. Furthermore, there are some concerns that Basel will rush calibration and therefore rush key definitions such as distinctions between credit and operational risk and business lines on the one hand and data determination on the other. There are fears that this could result in institutions being locked into sub-optimal results.

European Union
Following publication of the Basel document, the EU published its second consultation document on the new capital adequacy framework on the 5th of February. The Commission’s consultation document confirms that the EU will largely follow the Basel approach, with some modifications. The EU will amend existing Directives so that the new capital regime will apply to all EU credit institutions and to investment firms authorised under the Investment Services Directive.

The EU document focuses on the need for EU institutions to be able to compete with the rest of the world. Some modifications to the internal ratings based (IRB) method are proposed with the aim of facilitating internal ratings for smaller banks. Pillar 2 looks likely to be watered down - almost to the point of being voluntary, and there may be some easing of pillar 3 disclosures for smaller banks, with the prospect of only annual disclosures for some firms. The EU is aiming to have legislation in place in time to meet the Basel implementation schedule of 2004.

EU investment firms
As outlined above, EU incorporated investment firms (particularly securities firms and fund managers) will be subject to the new operational risk charges. Given that these institutions have not been subject to this type of charge before, they generally do not have well developed systems for tracking purposes. Therefore, the majority of these institutions are likely to adopt the basic indicator approach (level 1), at least initially. However, it is likely that investor confidence will require them (at least the larger institutions) to move to level 2 sooner rather than later. Furthermore, their non-EU competitors will not be subject to operational risk capital charges, raising international competition concerns.

Much of the detail in the revised Accord remains to be filled in before the end of the year; and lobbying efforts may result in certain aspects of the proposals being amended and/or removed. Moreover, there is general industry dissatisfaction that it is Basel’s current intention that the next document it produces will be the final text. The general feeling is that there needs to be more discussion with the entire industry, and not just with selected working groups.

All entities affected should begin to assess now the potential impact of the proposals on their business. An immediate ‘to do’ should be getting a high level self-assessment of the likely impact of the proposals. Amongst other things, this will help identify the most critical issues to be lobbying on via industry groups such as the IBF, or sharing with the Central Bank, albeit there is growing concern that the proposals are near final.

In a similar fashion to Euro and Y2K concerns, putting in place a robust project plan and a steering committee will be important. Promoting awareness, and assisting in co-ordinating group or bank wide plans and implementation of needed risk management and system changes, will be key. The capital and potential commercial impact on each business unit will need to be assessed together with the business case for adopting a specific approach to capital calculations and investment in risk management systems.

Other areas will also warrant special attention, particularly those that may influence strategy, for example the impact of these changes on securitisation programmes. Finally, don’t be misled by the 2004 date; requirements for 2, 3, and 5 years of historic data creates a range of more immediate deadlines for compliance, and in the market, certain instruments have already priced-in the expected capital changes.

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