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Author: | Published: 30 Sep 2004
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In the five years since it was introduced by the Basel Committee for Banking Supervision, the Basel II Capital Accord has evolved as a complex set of recommendations that will create a variety of regulatory compliance challenges for banks around the globe.

More important, however, are the wide range of business implications and risk-management challenges that the revised framework for International Convergence of Capital Measurement and Capital Standards (the New Accord) will trigger for banks, their non-bank competitors, customers, rating agencies, regulators, and, ultimately, the global capital markets. For example:

  • Banks will be asked to implement an enterprise-wide risk-management framework that ties regulatory capital to economic capital.
  • Non-banks outside the scope of Basel II will not face its compliance challenges but might be pushed to use it as a competitive benchmark.
  • Banks will need to collect and disclose new information and face the implications of increased transparency.
  • Rating agencies have new prominence as a result of the Basel II framework and could experience new competition.
  • Regulators are challenged to provide a level playing field in their jurisdictions and internationally as the Basel Committee's recommendations are implemented by legislatures in various countries.
  • The global banks could experience extended trends toward increased securitization as financial institutions adapt to Basel II requirements.

The complexity of the New Accord, as well as its interdependencies with International Financial Reporting Standards and local regulation worldwide, makes implementation of Basel II a highly complicated undertaking (now scheduled to be completed at the latest by January 1 2008). For a bank, implementing Basel will be driven by the structure of its business - beginning with its strategy and encompassing its risk measurement and capital calculation methods, business processes, data requirements, and information technology systems. The data requirements of Basel II are substantial, the New Accord is not simply a data and information systems exercise. Ultimately, Basel II's capital requirements have wide-ranging implications for risk management and, thus, corporate governance.

Why a New Accord?

With the New Accord, the Basel Committee moves closer to its goal of correlating banking risks and their management with capital requirements. By redefining how banks worldwide calculate regulatory capital and report compliance to regulators and the public, Basel II is intended to improve safety and soundness in the financial system by placing increased emphasis on banks' own internal control and risk-management processes and models, the supervisory review process, and market discipline.

The 1988 Capital Accord (Basel I) addressed market and credit risks, but Basel II changes the treatment of credit risk and requires that banks have enough capital to cover operational risks. It also imposes qualitative requirements on the management of all risks as well as new disclosures.

To be able to implement Basel II well, most banks will need to rethink their business strategies in relation to the risks that underlie them. Calculating capital requirements under the New Accord requires a bank to implement a comprehensive risk management framework across the institution. The risk management improvements that are the intended result may be rewarded by lower capital requirements. However, these large implementation projects also will have wide-ranging effects on a bank's IT systems, processes, people, and business.

Basel II also encourages ongoing improvements in risk measurement, assessment, and mitigation. It presents banks with an opportunity to gain competitive advantage by allocating capital to those processes, segments, and markets that show a strong risk/return ratio. Developing a better understanding of the risk/reward trade-off for capital supporting specific businesses, customers, products, and processes is one of the most important potential business benefits banks may derive from Basel II.

Since the first consultative paper on the New Accord was issued in July 1999, some banks have tended to treat compliance as a technical issue. In fact, for institutions worldwide, Basel II compliance is a risk management challenge with strategic business implications. Even those institutions that are not required to comply with the New Accord will likely tend to use its advanced requirements as risk management and economic capital benchmarks so they may remain competitive with those that must comply.

Basel II overview: the three pillars

With Basel II, the Basel Committee abandons the 1988 Capital Accord's one-size-fits-all method of calculating minimum regulatory capital requirements and introduces a three-pillar concept that seeks to align regulatory requirements with economic principles of risk management.

Pillar I sets out minimum regulatory capital requirements - the amount of capital banks must hold against risks. It retains Basel I's minimum requirement of 8% of capital-to-risk-weighted-assets.

The Basel Committee notes that "The new framework provides a continuum of approaches from basic to advanced methodologies for the measurement of both credit risk and operational risk in determining capital levels. It provides a flexible structure in which banks, subject to supervisory review, will adopt approaches that best fit their level of sophistication and their risk profile. The framework also deliberately builds in rewards for stronger and more accurate risk measurement."

Basel II will limit banks' savings on capital requirements initially until the potential effects of Basel II are better known. In 2008, for those banks making use of either one of the internal ratings based (IRB) approaches for credit risk or an advanced measurement approach (AMA) for operational risk, minimum capital requirements must equal at least 90% of what they were under Basel I. In 2009, minimum capital requirements must be at least 80% of the Basel I figure. The Basel Committee has not yet decided on future limitations but is considering keeping them in place when necessary.

Pillar II defines the process for supervisory review of an institution's risk management framework and, ultimately, its capital adequacy. It sets out specific oversight responsibilities for the board and senior management, reinforcing principles of internal control and other corporate governance practices established by regulatory bodies in various countries worldwide. According to the Basel Committee: "The New Accord stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's particular risk profile and control environment. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to supervisory review and intervention, where appropriate." As a consequence, the supervisor may require, for example, restrictions on dividend payments or the immediate raising of additional capital.

Pillar III aims to bolster market discipline through enhanced disclosure by banks. It "sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods." Enhanced comparability and transparency are the intended results.

Effects of Basel II: challenges for banks

Depending on its risk-management processes, size, customers, portfolio, and market, a particular bank is likely to experience varying effects of Basel II.

Figure 2: The environment of Basel II
Source: KPMG International, 2004.

Internal impact: data needs

The New Accord drives banks to measure their performance against risk factors other than market share or expected return. Once banks can attribute risk to a potential transaction, product, or process, they can ascribe a portion of economic capital to it, define an expected return on it, consider how best to price and to mitigate it, and thereby decide whether to enter a transaction, engage in a business, or pursue an activity or process.

Using quantitative methods to manage risk requires high-quality data. Better information will help enable banks to improve overall risk management, which in turn is expected to prompt improvements in corporate governance, transparency, and the value of disclosures.

Business and customer impact: changing relationships

Improved risk management and data flows should enable banks to identify target clients, evaluate their customers in a more thorough way, and determine whether to retain certain customers. Banks will need to request better information from borrowers to perform the internal rating assessments and the collateral evaluation that are essential to Basel II's risk-calculation process.

The standardized credit risk approaches require external rating of most borrowers to be taken into account. External ratings agencies acquire new importance under the New Accord. Certain markets will remain accessible to unrated borrowers, but they are likely to face premium pricing, as lenders would have to set aside additional capital to cover the risks they pose. Moreover, unrated borrowers will find that banks are required to rate them internally.

These developments will affect existing relationships between banks and their customers. An external rating can open doors in the capital markets; the more information a borrower can provide, the less it needs a bank. By contrast, those customers unable to provide appropriate, timely information could be deemed higher risk than others and consequently face tightened credit lines or tighter credit conditions and increased funding costs.

Figure 1: The three pillars
Pillar I Pillar II Pillar III

Minimum capital requirements

Market risk

  • Slight changes from Basel I

Credit risk

  • Significant change from Basel I
  • Three different approaches to the calculation of minimum capital requirements
  • Capital incentives for banks to move to more sophisticated credit risk-management approaches based on internal ratings
  • Sophisticated approaches have systems/controls and data collection requirements as well as qualitative requirements for risk management

Operational risk

  • Not explicitly covered in Basel I
  • Three different approaches to the calculation of minimum capital requirements
  • Adoption of each approach subject to compliance with defined qualifying criteria

Supervisory review

  • Banks should have a process for assessing their overall capital adequacy and strategy for maintaining capital levels
  • Supervisors should review and evaluate banks' internal capital adequacy assessment and strategies
  • Supervisors should expect banks to operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum (that is, trigger/target ratios in the UK; prompt corrective action in the US)
  • Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum levels

Market discipline

  • Market discipline reinforces efforts to promote safety and soundness in banks
  • Core disclosures (basic information) and supplementary disclosures to make market discipline more effective
Source: KPMG International, 2004


Global impact: financial market stability

The banking industry's improved risk management, enhanced information flows, and related disclosures could drive parallel improvements in the stability of the financial markets. New disclosures will provide regulators with early warnings that banks or rating agencies could pass on to the public and investors, potentially enhancing trust in the financial markets.

For the individual institution, the challenge will be to determine how to translate internal risk management into external disclosures. Scenario analysis of both credit and operational risk - and to what extent to disclose such analysis - becomes increasingly important for banks. Basel II's disclosure requirements are intended to "allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution."

In addition, the growing importance of rating agencies and the dependency on their services and conclusions has to be considered. Potential clients could be affected, and the bank's rating itself could be subject to increased scrutiny.

Basel II also affects financial institutions that do not have to comply with it. Such non-banks or near banks (that is, certain credit card companies, leasing companies, auto makers, or retailers' financing arms) may not have to fulfil Basel II's potentially extensive disclosure requirements or make investments in managing operational risk. However, Basel II will raise the standard for risk management across the global market, and such institutions will likely seek to enhance their risk management techniques by adopting those the New Accord describes. The end result could be improvements in global market stability.

Regional implementation issues

EU

After publishing Basel II, the European Commission issued a draft for a revised directive on new capital adequacy rules based on the New Accord. That effort is intended to bring the directive in line with Basel II and its deadlines, taking EU specificities into account.

Basel II will be received as a recommendation in the EU, which will convert it into EU legislation applicable to all EU credit institutions and securities firms in the member states. Each member state would then convert the EU legislation to locally appropriate laws, subject to local regulator interpretation and ongoing supervision. Deviations between Basel II regulations and EU regulations will occur, as will national choices: some member states will adopt Basel II for partial use, for example.

One key issue in the EU is the potential scope of the application of Basel II. The European Commission proposes to require all banks and certain investment firms to comply with Basel II rather than limiting the scope to only the largest internationally active banks. Some have asked whether the EU legislation should apply to European subsidiaries of non-EU banks as well as whether a country could adopt the EU legislation but not Basel II. Whether Basel II is ultimately a recommendation or a set of binding regulations is also a topic generating considerable interest.

US

The presence of both federal and state bank regulators has brought almost all US banks under the regulatory authority of more than one agency. The three primary federal agencies that will be responsible for overseeing commercial banks affected by Basel II are:

  • Office of the Comptroller of the Currency (OCC) is responsible for chartering national banks and their supervision and examination.
  • The board of governors of the Federal Reserve System (the Fed) directly supervises and examines state-chartered banks that choose to become members. The Fed is also the supervisor and primary regulator of bank holding companies and the umbrella regulator for financial holding companies; it is responsible for supervising the overall banking organization. As a result of supervising holding companies, the Fed gains an insight into the operations of many banks not directly under its supervision.
  • The Federal Deposit Insurance Corporation (FDIC) directly supervises and examines state-chartered banks that are not members of the Federal Reserve System.

The Federal Deposit Insurance Corporate Improvement Act of 1991 created a supervisory framework linking enforcement actions to the level of regulatory capital held by a bank. This system of supervision, known as prompt corrective action, represents an attempt to provide a timely and non-discretionary triggering mechanism for supervisory action.

All US banking regulators have been supportive of Basel II. They have indicated that Basel II implementation will be required for a small number of internationally active banks (about eight banks representing about two-thirds of US banking assets and 99% of the foreign assets held by the top 50 domestic US banking organizations), and voluntary for about a similar number of banks that may or may not be internationally active but wish to opt-in to the Basel II framework. In addition, the stated intention is to allow only the Advanced IRB approach to credit risk for those banks; the Foundation IRB and Standardized approaches will not be permitted to be used in the US. Similarly, only the Advanced Measurement Approaches to operational risk will be permitted.

Asia/Pacific

The attitude of local regulators in this heterogeneous region differs with the maturity of their financial systems. Countries such as Australia, Hong Kong, and Singapore have already expressed their intention to comply with Basel II, even to varying extents in terms of scope and timeline. Other countries, however, see value in the general idea but are still struggling with Basel I. It would be fair to assume that those banks and the respective financial systems in which they are based will take a more proactive approach to implementing Basel II requirements than others in financial markets that continue to lag in the wake of the Asia crisis or where international business is minimal.

An opportunity, but with issues

Basel II represents a long-term opportunity but with budget issues and operating profits under pressure worldwide. The initial investments banks must make to comply with the New Accord also represent a short-term challenge. But the improvements in risk management Basel II is intended to drive might enhance risk culture, reduce volatility of all risks, lower provision for bad debts, reduce operational losses, improve the institutions' external ratings, and help ensure access to capital markets and enhanced organizational efficiency.

The New Accord's risk management requirements are likely to prompt big changes in the core business of an individual bank as well as in its organizational structure. Under Basel II, the outputs of better management of credit and operational risk will be the inputs of an economic capital model by which banks can allocate capital to various functions and transactions depending on risk.

Aside from new or altered methods that must be employed, the new capital requirements will also drive change in resource needs, processes, and IT system architecture. These changes could ultimately pose broad challenges for a bank's board of directors and its senior management, who are charged with new risk management and reporting responsibilities under the New Accord. They will need to consider how Basel II compliance could (or should) integrate with other efforts they are making to improve corporate governance.

To avoid the potential for higher capital reserve requirements that could jeopardize market position, banks need to ensure that they have a comprehensive implementation approach in place. They also need to consider how Basel II's challenges and opportunities could affect their business and their customer relationships.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG. The information contained is of a general nature and is not intended to address the circumstances of any particular individual or entity. 

KPMG is the global network of professional services firms of KPMG International. Its member firms provide audit, tax, and advisory services through industry-focused, talented professionals who deliver value for the benefit of their clients and communities. With nearly 100,000 people worldwide, KPMG member firms provide audit, tax, and advisory services from 715 cities in 148 countries.

Author biography

Jörg Hashagen

KPMG

Jörg Hashagen is Partner-in-Charge Business Services – Financial Sector at KPMG Germany and Global Head of Risk Advisory Services Financial Sector – KPMG International. His expertise is focused on developing and implementing Financial Risk Management frameworks and concepts in business sectors such as Investment Banking, Insurance, Asset Management, Corporate Treasury and Public Debt Management, as well as on the transformation of the Basel II Accord. A further field of concentration is the impact of the Basel II Accord on the non-financial sector.


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