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Banks need to step up their preparations as the deadline for Basel edges closer Back  
With the publication of the third and final Basel consultative paper, the architecture of the new Accord is becoming clearer write Alan Merriman and P?draic Walsh. Key to a successful implementation from the viewpoint of Irish banks will be liaison with, and lobbying of, IFSRA to ensure that Basel is implemented in the most appropriate manner for them.
After four years of effort, the third and final Basel consultative paper has been issued (CP3). While its contents will come as little surprise to those that have been following the long debate, this is the first time that we have seen a full package of proposals, and it will fundamentally reshape the regulation of capital adequacy - and with it the markets in which firms operate.

Decisions by individual firms on what approach to adopt - if they have not been taken already - are now urgent. They are also fundamental. As the Quantitative Impact Study (QIS 3) results show, the capital benefits and costs are potentially substantial. There is a lot to do for firms that want to use an IRB approach for credit risk from the end of 2006.

On the operational risk side, there is also much to do. For example, firms that had been planning on applying the Standardised Approach may find that compliance with the qualitative requirements has been made substantially more difficult by the tougher requirements set out in CP3.

The consultation runs to July 31, and although there are a number of open issues, it is clear that the basic structure of the new Accord is set. Indeed, for many firms the focus of attention will shift to the EU consultative document expected in June/July, as it is the EU regime that will have legal effect and that will apply the Basel framework to all banks and credit institutions within the EU, and also to all investment firms authorised under the ISD.

Basel - the key changes

Pillar 1 - Credit risk
• Significant reduction to 35 per cent in the charge for residential mortgages - 10 per cent LGD floor introduced.
• More generous allowance in the use of credit provisions.
• Greater national discretion on specialised lending.
• New lenient treatment of rating systems ‘use’ tests.
• Additional acceptance of credit derivative banking practice.

Pillar 2 - Securitisation
• Pillar 2 focuses more on securitisation/transfer of risk.
• Liquidity facilities for securitisation are recognised.
• Operational risk
• New volume based metric for OR.
• More formal and onerous qualitative criteria for OR.
• Partial use of AMA permitted if robust migration plans exist.
• Mitigation via insurance permitted subject to certain conditions.
• Market risk
• While not changing the market risk rules, the capital floor is widened to incorporate market risk.

Pillar 2
• P2 may claw back gains obtained in P1 if proper documentation of policies & procedures are not in place.

Pillar 3
• P3 will align disclosure with accounting standards, but despite refinements disclosure is still very onerous.

On the credit risk side, most of the changes are technical, although the reduction of risk weighting for mortgages to 35 per cent in the Standardised Approach may mean that the cost/benefit case for moving to an IRB approach for some firms is rather weaker than it was.

On the IRB criteria, the weakening of the use test for ratings systems is significant, and potentially makes adoption easier in terms of the overall business impact. Basel accepts that firms do not need to use the same PDs for each application - for example the PDs used for pricing applications can be estimates over the life of the loan rather than a one-year PD estimate as required for the capital calculation.

On the operational risk side, the changes are potentially more significant. The inclusion of an Alternative Standardised Approach based on a measure of business volumes rather than income is an important step.

It is intended to apply where the bank can convince the regulator that ASA is more appropriate. It is intended for use only in the commercial and retail banking business lines, and requires the consent of national supervisors. Firms must consider whether this approach could be helpful.

Investment firms such as asset managers that argue that they are unjustly treated by an income based charge, should be considering how they could use the introduction of a volume based charge as a precedent to support an alternative volume based charge being developed for use by them in the context of the EU Capital Directive.

Firms should also note the significant hardening of the qualitative criteria for the Standardised Approach. In particular, firms will be required to have a dedicated operational risk function independent of internal audit, and to track relevant operational risk data (including losses) by business line. This information is expected to play a prominent role in both risk reporting and in the management of the firm.

The proposals on Supervisory Review (Pillar 2) continue to leave a huge amount of discretion to individual regulators. In general, the proposals on developing the firm’s internal view of adequate capital are little developed from CP 2, although firms that adopt an IRB approach to credit risk will be required to test that the capital they hold is sufficient to protect them in adverse economic conditions by ‘performing meaningfully conservative stress tests of their own design’. This will feed into an analysis of whether the regulator should set additional capital requirements or require some reduction in risk taking. The proposals on Pillar 2 now include specific consideration of a range of issues that were once part of Pillar 1, including some aspects of Securitisation. Regulators will consider under Pillar 2 whether securitisation has produced a significant transfer of risk, and may increase capital requirements if they deem that this has not occurred.
PricewaterhouseCoopers has recently completed a pan-European survey (including Ireland) of banks’ views on Pillar 2 (Supervisory Review of Capital Adequacy), to be published shortly.

Key concerns raised by institutions included the competitive implications of different approaches to Pillar 2 by different national supervisors, the ability and resources of supervisors to implement Pillar 2, and the potential unravelling of Pillar 1 (Minimum Capital) capital gains through additional capital charges under Pillar 2. CP3 adds to the issues to be considered under Pillar 2 - e.g. adding aspects of securitisation risk and credit concentration risk - without harmonising the approach that supervisors will take to these issues.

The proposals on Market Discipline/Disclosure have been further refined, but are similar to the proposals of the working paper of September 2001. Regulators have, however, acknowledged that the debate on disclosure standards is still taking place, and they do hold out the prospect of modifying their requirements to reflect the outcome of that debate.

QIS 3 - the capital savings at stake
QIS 3 confirms the calibration of the new Accord. The results also highlight the critical importance of the strategic decision about the approach to credit and operational risk. There are substantial gains to be had (and potentially substantial losses to mitigate). The QIS results show that the overall impact on banks will vary greatly, depending on activities and risk profile.

For example, the results for the overall change in capital requirements for so-called Group 2 banks (primarily domestically focused retail banks) using the Standardised approach, indicate an average capital increase of 3 per cent, whereas for those banks using the IRB Foundation approach an average capital saving of 19 per cent is indicated.

Thus, some firms could see substantial increases in overall capital requirements unless they are prepared to move towards more sophisticated approaches - although a sophisticated approach does not of itself guarantee a lower capital charge.

QIS 3 results indicate that Group 2 banks have the potential to benefit from very real capital savings depending on their choice of approach to credit risk. For example, an average reduction of 11 per cent in credit risk requirements was indicated for Group 2 institutions using the Standardised approach, whereas those using the Foundation IRB approach indicated a reduction of some 27 per cent.

QIS 3 highlights data issues
The QIS 3 results raise another key issue for firms, namely improving data quality. Unless they have data of sufficient quality, firms will not be able to derive all the benefits that may be available from the new approaches.

Analysing the results of QIS 3, Basel felt that the results were inflated by the inability of banks to provide all the information required to calculate the effects of the proposals. This is especially true in the area of credit risk mitigation and collateral.

Basel also highlights the failure of some institutions to meet the data standards set out for the calculation of probability of default (PD), loss given default (LGD) and exposure at default (EAD). This contributed to the wide variation in results across firms, and Basel expects the dispersion of results to reduce as firms come into line with Basel’s data standards.

In any event, the moral of the story is clear: firms need to improve their data quality quickly.
If the architecture of the new Accord is now set, it should be recognised that the impact of the proposals, particularly as regards implementation, will be powerfully influenced by national discretion, and firms should not ignore this angle. National regulators are left both very substantive options in determining key aspects of the new regime and a very large measure of freedom to assess the various approaches of individual firms. Liaison with, and lobbying of, IFSRA to ensure that appropriate decisions are taken at Irish level will be vital.

Overall, decisions by individual firms on what approach to adopt - if they have not been taken already - are now urgent. Firms who have not already made substantial progress on Basel 2 preparations will find it increasingly difficult and expensive to catch up as scarce resources become even scarcer as the deadline gets nearer.

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