Basel Committee on B?nking Supervision

Risk Management

The Basel Committee on B?nking Supervision is ? "st?nding committee of the central b?nk governors of the Group of Ten ("G-10") countries" that convenes at the B?nk for International Settlements ("BIS") in B?sle, Switzerl?nd. The B?sle Committee's objective is to er?dic?te the worrisome disjunction between the intern?tion?l b?nking system ?nd the plethor? of n?tion?l b?nking regul?tions th?t h?ve f?iled to restr?in it. To this end, the Committee, ?long with its perm?nent st?ff ?t the BIS, eng?ges in the rese?rch ?nd study of intern?tion?l b?nking ?nd m?kes recommend?tions to the governors of the G-10 centr?l b?nks on how to better supervise ?nd regul?te b?nking ?ctivities with cross-border repercussions. Since its founding, the Committee h?s published numerous p?pers ?nd held conferences ?ttended by "b?nk supervisors from over 100 countries." During its first ten ye?rs, the B?sle Committee simply coordin?ted m?tters of regul?tory ?nd supervisory procedure. Since c?pit?l ?dequ?cy rules are subst?ntive, they were beyond the initial scope of the Committee's activities. This would soon ch?nge.

Basel I

Regulators from the G-10 countries developed the 1988 Basel Capital Accord after several notable b?nk failures in Europe, Jap?n, ?nd the United States. Before the accord, m?ny b?nks were woefully undercapitalized, ?nd capital levels varied signific?ntly among countries. In response, the G-10 formed the Basel Committee on B?nking Supervision, which operates under the auspices of the B?nk for International Settlements, ?nd in 1988 introduced uniform minimum-capital requirements for all internationally active b?nks. The 1988 accord requires b?nks to hold capital to 8 percent of their risk-weighted assets,?nd half of it ("Tier 1" capital) must be common equity or disclosed reserves. Although the Basel has no supr?national authority more th?n 100 countries (including the United States, Jap?n ?nd most Europe?n countries) have adopted the st?ndards set forth in the 1988 accord.

The main shortcoming of Basel I is that its risk-weighting of b?nk assets is very crude: ? lo?n to ? top-rated corporation such as GE, for inst?nce, carries the same 100 percent risk weight (requiring b?nks to hold 8 cent of capital for each dollar lent) as ? lo?n to ? risky start-up or the purchase of high-yield bonds. Lo?ns to governments in the Org?nisation for Economic Co-operations to sovereign states, such as Turkey, whose bonds are rated at less th?n investment grade.

Since 1988, adv?nces in the b?nks' own risk-m?nagement systems have underscored the large discrep?ncy between the capital required by the Basel accord (regulatory capital) ?nd the capital prudent b?nk m?nagers would choose to hold (economic capital). Exploiting this discrep?ncy, b?nks have engaqed in "regulatory arbitrage" to boost their bottom lines by shifting origination toward low-grade lo?ns (which have higher yields ?nd require no more regulatory capital th?n higher-rated lo?ns), by trading secondary lo?ns (selling high-grade lo?ns to nonb?nks ?nd then purchasing riskier lo?ns), ?nd by securitizing assets ?nd retaining the riskiest securities, which are the first to absorb ?ny losses. On occasion, regulators have admitted that the economically distorting capital requirements of Basel I have made such regulatory arbitrage almost inevitable.

New in Base II

Although certain details remain to be worked out by the committee, the goals of the new Capital Accord are clear: to resolve the main shortcomings of Basel I by more closely aligning the regulatory-capital requirements of internationally active b?nks with their actual risk exposure ?nd to establish more rigorous b?nk supervision ?nd broader disclosure. Taken together, these ch?nges are me?nt to encourage more adv?nced risk-m?nagement practices ?nd to make the risks that b?nks choose to make more tr?nsparent to the investment community.

The biggest departure from Base I is the way credit risk is assessed. When the new accord takes effect, b?nks will be able to choose among three methods for determining the risk weights on credit assets: ? st?ndardized approach suitable for less sophisticated b?nks as well as two approaches based on other b?nks' credit-rating systems. Under the new st?ndardized approach, risk weights will better reflect ? b?nk's true risk exposure,depending on the type of borrower (for inst?nce, corporations ?nd sovereign governments) ?nd the credit rating it is given by independent agencies such as Moody's Investor Service ?nd St?ndard & Poor's Ratings Services. Under the new framework, ? lo?n to ?n AAA-rated corporate borrower, for example, would receive ? 20 percent risk weight ?nd require only 1.6 cents of capital for each dollar lent, not the 100 percent risk weight ?nd 8 cents of capital required today. ? lo?n to ? BBB-rated sovereign government, such as Pol?nd, would receive ? 50 percent risk weight, not the 0 percent weight it receives today.

Basel II will also allow b?nks that successfully complete ? comprehensive qualification process to adopt one of two internal ratings-based (IRB) approaches, based in part on the b?nks' own risk models.4 The more sophisticated IRB approaches are intended to cut the capital requirement, giving b?nks ?n incentive to adopt these more adv?nced approaches to credit risk.

Under the foundation IRB approach-the less adv?nced of the two-b?nks will calculate their capital requirements using internal estimates of default probabilities together with regulator-assigned values for other valuables. Under the adv?nced IRB approach, b?nks (perhaps fewer th?n ten) that meet even more rigorous criteria will be able to calculate capital charges by using their own estimates for several additional variables, such as loss given default, exposure at default, ?nd lo?n maturity.5

B?sel II ?lso proposes c?pit?l requirements for the b?nks' oper?tion?l risks, defined ?s those le?ding to losses resulting from "in?dequ?te or f?iled intern?l processes, people, ?nd systems, or from extern?l events." ?g?in, the ?ppro?ches ?re threefold; the B?sel committee is still revising them.

To improve tr?nsp?rency, B?sel II will require b?nks to disclose the composition of their credit portfolios by risk r?ting; in ?ddition, b?nks using either IRB ?ppro?ch will h?ve to publish their individu?l risk p?r?meters for e?ch risk-r?ting c?tegory.

Four shortcomings

The basic ch?nges proposed for Basel II are undoubtedly positive. Nonetheless, we see four major shortcomings that regulators should address while revising the accord if they are to meet their goals of aligning capital requirements with risk ?nd encouraging b?nks to adopt better internal risk-m?nagement practices.

Shielding the riskiest borrowers:

Under the risk weight calibration last proposed for Basel II, the least sophisticated b?nks will have the greatest incentive to undertake the riskiest types of lending because of ? discrep?ncy between the st?ndardized ?nd the IRB methodologies in the treatment of low-grade lo?ns, particularly to borrowers with BB ?nd lower credit ratings (Exhibit 1). The st?ndardized approach, for example, currently requires ? risk weight of 150 percent for B-rated borrowers, while the foundation IRB approach produces ? risk weight of around 440 percent. B?nks using the st?ndardized approach are thus required to hold less capital when lending to the riskiest comp?nies. Lo?ns to this category of borrower will therefore be made predomin?ntly by small ?nd regional b?nks with less sophisticated credit-risk-assessment skills ?nd fewer resources to withst?nd default.

To compound the problem, the current draft, despite the committee's stated intentions, gives only the largest b?nks ?ny incentive to upgrade their risk-m?nagement capabilities ?nd to qualify for the IRB approaches. For small ?nd regional US b?nks, which on average have ? higher proportion of noninvestment-grade assets, both the foundation ?nd adv?nced IRB approaches now result in capital charges higher th?n those under the st?ndardized approach (Exhibit 2). This ?nomaly isn't likely to be eliminated by the recalibration of the foundation IRB approach now being contemplated by the Basel committee.

If the risk weights are not sufficiently recalibrated, Basel II may create ? two-tier b?nking system, with small ?nd regional b?nks adopting the st?ndardized approach, which is less sensitive to riskier credit portfolios, ?nd with larger, stronger b?nks adopting the IRB approaches. The unfortunate result will be ? b?nking system in which smaller, weaker b?nks have ?n incentive to maintain riskier portfolios th?n larger, stronger ones. To solve the problem, the committee should more closely align the st?ndardized ?nd IRB approaches by sharply increasing the risk weights for the riskiest lo?n classes under the st?ndardized approach. Indeed, to spur b?nks to adopt more sophisticated risk-m?nagement systems, risk weights under it should generally be set somewhat higher th?n those under the IRB approaches.

? related problem is the proposed treatment of unrated borrowers. The st?ndardized approach, as currently envisioned, assigns them ? flat risk weight of 100 percent ?nd the lowest-rated borrowers (B+ ?nd below) ? risk weight of 150 percent. Comp?nies that fear getting ? low credit rating may thus choose to forgo obtaining ? rating altogether to avoid increasing their borrowing costs.

But this outcome runs contrary to the goal of improving tr?nsparency ?nd capital adequacy. By setting the minimum risk weight for unrated borrowers at ? level equal to the highest weight for rated borrowers (currently 150 percent), the committee would encourage comp?nies to get rated ?nd b?nks to adopt ?n IRB approach, which would let them escape high minimum-capital requirements. Such risk weights could be phased in over several years to avoid unduly penalizing b?nks outside of the United States ?nd the United Kingdom, for it is these non-US ?nd non-UK b?nks that have the greatest number of unrated borrowers.

Penalizing retail credit

The current Basel II proposal would greatly--?nd we believe unnecessarily--increase the capital requirements for unsecured retail lo?ns extended by b?nks using the IRB approach. Regulatory-capital requirements for credit card assets, for example, would increase three fold or more under the current proposal (Exhibit 3, on the previous page), needlessly penalizing credit card comp?nies, increasing costs to consumers, ?nd potentially deriving such lending from b?nks to nonb?nks that are outside the jurisdiction of b?nking regulation.

How? Basel II as currently written would require b?nks to hold capital for both expected losses (EL), reflecting the average number ?nd size of defaults over time, ?nd unexpected losses (UL), which might be due, for example, to higher rates of default in recessions. This so-called EL-plus-UL definition of capital isn't necessary. Economic theory holds that ? b?nk should hold capital only to withst?nd unexpected losses, since expected losses are factored into ? lo?n's pricing ?nd covered by ? combination of the b?nk's expected cash flows ?nd the reserves it sets aside for lo?n losses. Basel regulators respond that lo?n-loss reserves c?n cont toward ? b?nk's capital requirement. The catch is that under the proposed accord, only ? portion of the loss provisions c?n do so.

For retail unsecured lo?ns with high expected losses but relatively low unexpected losses, b?nks will have to hold signific?nt amounts of additional capital, with no measurable gain in stability or soundness. the draft accord's overly broad definition of capital is exacerbated by its miscalibration of the level of expected ?nd unexpected losses. Citigroup, for example, estimates that unexpected losses in its credit card portfolio will be no more th?n 0.82 times the level of expected losses, calculated at ? 99.97 percent confidence interval. The proposed accord, by contrast, assumes that unexpected losses among retail assets will be more th?n four times the expected losses. This me?ns that even under ? UI-only approach, the capital requirements for unsecured retail assets for b?nks are far too high.

To avoid these unwarr?nted penalties, we suggest that capital requirements for retail credit risk be based only on unexpected losses ?nd that the accord's ratio of UL to EL for retail assets be subst?ntially recalibrated. Alternatively, if the Basel committee insists on the EL-plus-UL definition, lo?n-loss reserves should be allowed to count toward regulatory capital without limit.

Measuring operational risk

Few people would argue that operational risk is irrelev?nt to b?nks--witness the meltdown of Barings at the h?nds of one rogue trader. The problem is how to measure operational risk. Basel II proposes ? new capital charge for it, but the existing measurement methodologies are too simplistic to be useful or require extensive data that do not yet exist in reliable form.

The proposed operational-risk charge would be based on gross income (under the basic indicator approach) or on business-specific fin?ncial indicators (under the st?ndardized approach). Either of these approaches would perversely penalize the b?nks with the highest income or the largest revenue, regardless of the operational risks actually being taken. Import?nt qualitative factors, such as m?nagement ability ?nd internal risk controls, are ignored. So too are portfolio effects, in which different lines of business help diversify or exacerbate risk.

Under ? third approach suggested for measuring operational risk, b?nks could estimate the probability of default ?nd the severity of the resulting losses for specific kinds of events, such as information technology systems failures. This third approach is sounder in theory but harder to implement, since it requires creating multiyear, detailed loss databases most b?nks don't yet have.

We estimate that under the Basel committee's current proposal, the capital requirements for US b?nks would increase by roughly 20 percent, since there is no net ch?nge in credit-risk capital ?nd the newly introduced operational-risk capital requirement calls for ?nother 20 percent. Unless the credit-risk capital requirements are recalibrated quite sharply downward, ?ny sizable operational-risk charge will in all probability impose ? new capital burden on b?nks, despite the Basel construction's stated intention of not raising overall capital requirements.

We heartily welcome the Basel committee's suggestion that it is considering m?ny other ideas about operational risk. Until ? generally accepted approach for measuring it is developed, we suggest that Basel II's operational-risk framework serve only as ? guideline for b?nks, not as ?n additional capital requirement. Operational risk should instead be monitored in the supervisory-review process, ?n approach that ought to promote ? better assessment of operational risk ?nd prevent unwarr?nted increases in capital charges.

Getting the timing right

As Basel II now st?nds, m?ny b?nks won't have adequate time to qualify for the IRB approaches, thereby frustrating the committee's intention of promoting better risk m?nagement. The current proposal would require b?nks to have no less th?n two years of experience using ?nd collecting detailed data on internal ratings categories ?nd related credited processes to qualify for these approaches. Given the recent decision to defer the implementation of Basel II to 2005, b?nks will now have until J?nuary 2003 to make their own internal risk-m?nagement practices conform to the Basel II requirements. The truth is even the most sophisticated b?nks will need this time to revise their information technology ?nd risk-m?nagement systems so that they match the IRB criteria.

But m?ny b?nks won't be ready by 2003. After that point, the draft accord states, every additional year's delay will entail the accumulation of ?n extra year of experience, in part to provide ?n incentive for b?nks to get on board early. Consequently, b?nks that w?nt to use ?n IRB approach in 2006, for example, would need three years of data, which they would have to start collecting in 2003. This rising bar will create ? virtual moratorium on b?nks qualifying for IRB from 2006 until 2009, when the experience requirement is capped at five years. We suggest that the committee instead keep the experience requirement at two years until the accord takes effect, in 2005, ?nd then raise the requirement more gradually over time--for inst?nce, by six months each year, to ? maximum of five years. This would allow even those b?nks that miss the initial window to upgrade their risk-m?nagement systems ?nd to qualify more rapidly for the IRB approaches, as intended.

Although the final details of Basel II are still being determined, its broad outlines are already quite clear. The proposed accord is ?n import?nt step forward, but given the far-reaching ?nd long-lasting impact it is sure to have, regulators should summon the energy to address the remaining shortcomings. B?nkers of every stripe are already pl?nning ways to exploit the inconsistencies in the proposed risk weights. Regulators should make the exercise as difficult as possible.


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