The general overview of the New Capital Accord Basel II and its implications

Mariana Cucu PhD Student, Finances Department Academy of Economic Studies, Republic of Moldova

By December 2006, banks all over the world
will be expected to comply with the new
Capital Accord, Basel II and, given it’s complexity, countries that hope to successfully adopt the new capital framework, have already begun preparations.

As banking has become globalized, the New Capital Framework is designed to establish minimum levels of capital for internationally active banks, according to which, national authorities will be free to adopt arrangements that set higher levels of minimum capital, as well as to introduce supplementary measures of capital adequacy for the banking organizations. Moreover, as the largest banks continue to grow and to pursue new opportunities, they must simultaneously make investments required to manage and understand their existing risks more fully, and to appropriately address the new risks. Thus, the necessity of changes introduced by the New Accord are determined by our day-to-day developing environment, continuing technological advances, complex activities and the growing necessity for risks management, and as a result, the necessity for improvement of prudent capital regulation, supervision and market discipline. The New Accord is significantly more risk-sensitive, comprising sound capital requirements that pay due regard to particular features of the present supervisory and accounting systems, leading to stabilization of the international banking sector. It aims to safeguard safety and stability of the financial system as a whole by increased alignment of capital requirements with the risks taken by individual banks.
Basel II encourages the development of sound internal systems for risk evaluation since only banks complying with strict methodological and disclosure standards will be allowed to use these ratings as a basis for determining the regulatory capital requirement. In comparison to 1988 Capital Accord, which mostly dealt with the credit risk and was not well suited to deal with the other types of risks (market, interest rate, and operational risks) Basel II increases the risk sensitivity of capital requirements, creates incentives for banks to improve their risk measurement and management systems, strengthens the role of banking supervisors with supervisory review processes and the role of market discipline, as well as takes into account all the risks banks may face.
Diversity in financial systems worldwide makes it difficult to determine a single rule applicable to various banking systems in different countries, that is why Basel II represents the range of rules and options available to various organizations in countries that face different economic circumstances, encompassing additional risks, in particular operational risks, widening the recognition of credit risk mitigation techniques and setting out a thorough framework for securitization transactions. The new prudential framework is flexible, and can be implemented in any country, as well as evolve along with financial industry changes.
Investments in Basel II implementation enable banks to realize more consistent profits and reduced volatility of credit losses, risk differentiation adding transparency to the credit decision-making process and empowering better economic decision-making.
Basel II consists of three Pillars which are intended to be mutually reinforcing: capital requirements, supervisory review and market discipline. It is obvious that capital requirements are the foundation of the regulatory framework, because Capital is the key ingredient of the healthy banking sector. Risk-based capital requirements however require the major focus, hence the first pillar deals with the minimum regulatory capital requirements and contains new rules for calculating more refined risk weights for different kinds of loans, suggesting that capital should be held against operational risk and at the same time, allowing banks to rely on their own measurements of those risks. The growing importance of operational risk has become largely evident in recent years, as the bank losses attributable to operational risk during the period 1980-2000 are generally estimated at more than 200 billon Euro. However, benefits of Basel II consist in the fact that measurement of the banking risks became the tool of commercial banks and not the supervisory authority, the latter being in charge for control of the banks methodology and assessment procedures of the market risks. Expanding the rules introduced by the Capital Accord of 1988, it imposes on banks the obligation to have capital at least equal to level calculated according to three increasingly sophisticated and risk-sensitive options for the computation of credit risk (standardized approach, foundation internal ratings-based approach, advanced internal rating-based approach) and operational risk (basic indicator approach, standardized approach and advanced measurement approach).
According to the second pillar the banks capital is consistent with its risk profile and banks should hold additional capital against risks not covered by Pillar 1, having the power to require the supervisory action if necessary. It implies the monitoring of all risks (overall interest rate risk, liquidity risk, strategic risk, economic downturn risk on the basis of crisis simulations or “stress tests”), requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks and enables supervisory authorities to impose higher individual requirements, according to each institution’s risk profile. It requires banks to enter into the dialog with their supervisors on the methods of internal estimates, that they develop in order to determine how best to manage all the risks. This pillar determines the necessity of risk evaluation, as well as the role of supervisory authorities in this field as well as basic principles of effective supervision.
The third pillar aims to increase market discipline through enhanced disclosure by banks. Banks will have to publish detailed qualitative and quantitative information concerning their risks, capital and risks management. Pillar 3 recognizes that market discipline has the potential to reinforce and support minimum capital standards determined by the first Pillar and supervisory review process, provided by the second Pillar, and in such a way, it contributes to maintenance by banks of the appropriate levels of capital as a tool against potential future losses arising from risk exposures. At the same time the realization of the third pillar will be difficult, as when banks are required to ensure the transparency of the banking sector, the same requirements will have to be addressed to the banks’ clients. In such a way, banks will have to determine internal standards, which would ensure the transparency of clients information.
However, the application by banks of specific risk measurement systems under the Pillar 1 will result in specific capital adequacy requirements, which shifts towards more increased and more sophisticated supervision (Pillar 2) and a market discipline (Pillar 3) is encountering considerable difficulties in developed countries. That is why banks have to gradually introduce the “internal rating based” or IRB models, when the new framework will be introduced in order be able to reduce the credit risk charges. The internal ratings-based approach to credit risk is one of the most innovative elements of the new Accord, under which banks are going to supply their estimates of the probability of default exposure, loss given default, and maturity to come up with the risk weight associated with the particular assets. It has become obvious that the events in which separate capital charge for operational risk would be necessary, are those being of a low probability of occurrence, although in case these occur, this is going to imply high costs. At the same time IRB approach gives too much autonomy to banks.
Banks have much to gain from investments in Basel II Internal Ratings Based compliance as those investments are adopted with an understanding of the economic trade-offs between risk and return, are distributed consistently throughout the organization, are imbedded in day-to-day business practices, and are adopted with an understanding of the economics of credit portfolio management. For emerging countries the foundation IRB level of capital requirement is likely to give higher capital requirements than the existing 8% minimum of the accord. If the bank actually holds 12 percent capital it would be deemed to be well capitalized in a regulatory sense, even though it might be undercapitalised in the economic sense. Anyway, this approach is more likely to be used by smaller and less sophisticated banks that lack the expertise to develop their own technical models to evaluate credit risk.
For the most sophisticated institutions, the “advanced measurement approach” – or AMA, which is the method having the goal to incorporate banks own sense of risk into the capital framework should be used. AMA would permit banks to use their internal methodologies to assess their exposure to the operational risk – subject to the series of the quantitative and qualitative supervisory parameters that are intended to ensure that approach used is comprehensive and implemented with integrity. AMA approach should be sufficiently flexible, so as to accommodate to the rapid evolution in operational risk management practices. It will contribute to development of strong corporate operational risk governance and management structures, incorporation of qualitative factors and loss data quantification.
Although Basel II, alike to it’s predecessor, is consistent with achieving safety and soundness in a market economy, each bank’s Basel II strategy must include a thorough analysis of the costs and benefits. It entails efficiency costs, although it will have evident advantages for the banking stability.
The benefits of the New Capital Accord application include the risk transparency, greater cost efficiency and fewer exposures to large losses. It is to be mentioned that Basel II represents the basis for the changes in the EU legislation, the new capital framework being introduced into EU legislation, and mainly the two existing directives (Codified Banking Directive 2000/12/EC, and the Capital Adequacy Directive 93/6/EC). Basel II will have the considerable changes in the activity of financial institutions of the European Union as well as will influence the activity of emerging countries banking organizations.
It will contribute to consolidation by banking supervisors of all banking group members, although the recent programs, determining the compliance of various countries with the Basel Core Principles, have demonstrated a number of emerging countries fail to comply with the 20th principle.
The New Accord will also have potential effects on the stress testing, Basel II advanced approaches requiring the assessment in the context of supervision and Basel Core Principles assessments, the quality of stress testing practices of banks and its monitoring by supervisors.
Moreover, the envisioned close co-operation between banks and supervisors is intended to reduce the information asymmetry between banks and supervisors.
The good risk management will permit to protect banks against losses, to enhance their profitability and competitiveness, and will insure the long-term growth and ability of financial sector to withstand the periods of distress.
The realization by banks of the third, transparency component would permit market participants to obtain the full information on the methods used by banks in risk measurement and capital sufficiency.
The New Accord will contribute to development of cross-border cooperation in application of capital standards to international banking groups, which is an essential element of the Basel II successful implementation. In this context, the need to develop the more robust information-sharing arrangements between home and host supervisors is obvious.
It is considered that the Basel II application constitutes the premises for the stability and effectiveness of the banking system. At the same time, the New Capital framework’s heightened sensitivity to risk may reduce the flow of foreign investment in emerging countries and may pose the banks of emerging countries in the uncompetitive position with the foreign banks, as these have much more possibilities to confirm to the international standards. It is obvious, that banks that will not follow Basel II recommendations (these being time and money-consuming), will have the low ratings and possibilities to integrate the international capital markets, as well as will have lower possibilities to attract the foreign investments.
Another major problem of the countries in transition is that for an adequate implementation of Basel II the creation of credit bureaus is necessary. These unfortunately lack in most countries as such a statistics even lacks, the great number of firms acting on the market no more than 5-10 years, which is too little for the necessary statistics. That is why, the elaboration of relevant legislation on credit bureaus is necessary for a successful Basel implementation and risk management in these countries.
The weak facet of Basel II is that it fails to create a supervisory regime embodying a credible and strong form of market discipline, which could mitigate the incentives of some banks to underestimate the credit risk profile when designing internal ratings systems and which could limit the extent of regulatory capture.
It is also obvious that the implementation of the Basel II is impossible without a relevant and effective system of corporate governance. The lack of the aforementioned system in most emerging countries constitutes the barrier for the banking system development, as well as creates additional risks for banks, because in case of adoption of the more advanced approaches to calculating regulatory capital appears the deeper need in understanding by the management of the operational mechanics of a banks internal rating systems and measures of banks derived from them, organization of rating process, methods of assigning and reviewing ratings, the approach to developing reliable quantitative estimates, and the consistency of the system with Basel standards. That is why, it will be important to devote necessary supervisory resources – in terms of skilled personnel, technical training, and targeted strategy – to these new supervisory efforts. As there is no model and software programs that could replace skills of the experienced and trained risk manager, the EU has already launched a major effort to improve it’s members corporate governance regimes.
Basel II realizes new issues and requires a lot of work to be implemented, but these efforts will surely help to promote safety and soundness of the international financial system. As many countries have benefited of foreign bank entry, internationally active banks are precisely the ones that will be implementing the more advanced approaches of Basel II on the worldwide, consolidated basis. Even though the framework is mandatory only for internationally active banks domiciled in G-10 countries and European Union members, it has effectively become a global standard. According to the recent FSI Survey, more than 88 non Basel Committee jurisdictions worldwide have declared their intention to adopt Basel II within the firs few years of its implementation.

References
1. BIS Review 15/2003, William L Rutledge: Implementing the New Basel Accord, 13 March 2003
2. IMF Working Paper “Emerging Issues in Banking Regulation” Ralph Chami, Mohsin S. Khan, Sunil Sharma, May 2003
3. WB Working Paper “Basel II and Developing Countries: Sailing through the Sea of Standards”, Andrew Powell, September 2004
4. BIS Review 32/2004, Jaime Caruana “Basel II – a new Approach to Banking Supervision”, June 2004
5. BIS Review 8/2005, Jaime Caruana “Basel II – back to future”, February 2005
6. Basel Committee on banking Supervision “Home-host information sharing for effective Basel II implementation”, Consultative document, November, 2005
7. Bank for International Settlements, Basel Committee on Banking Supervision “International Convergence of Capital Measurement and Capital Standards. A revised framework.”, November 2005
8. ECB Monthly Bulletin, January 2005, “The New Basel Capital Accord: Main Features and Implications”
9. Financial Stability Institute “Implementation of the new capital adequacy framework in non-Basel Committee member countries”, occasional paper, BIS, 2004