RegionsNorth AmericaThe New Basel Accord and US Implementation

The New Basel Accord and US Implementation

Basel policy process

The Basel Committee is quite close to finalizing the new capital framework
after a number of years of work recently publishing the Third Consultative Paper
(CP3), a fully-specified draft of the new framework.

During this last consultative stage, the Committee is again seeking public
comment on the proposals, which will feed into the finalization of the Accord,
targeted for year-end. Throughout this revision process, such transparency has
been an integral objective of the Committee. Indeed, the open and candid dialogue
with the industry and the thorough and detailed feedback received during the
prior two consultative periods have been instrumental in shaping the new capital
framework.

CP3 reflects the Committee’s extensive work on the proposals since the
release of the previous consultative paper in January 2001 and the recently
completed third quantitative impact study (or QIS 3), which evaluated the impact
of the New Accord on the current portfolios of a range of banks.

The current proposals in CP3 incorporate a number of refinements designed to
enhance the risk-sensitivity of the capital measures and to reduce complexity
where possible. These modifications reflect the continuing development of the
New Accord and not a fundamental change to the overall (three-pillared) framework.

There are a number of areas in the credit risk proposals where the Committee
has provided more differentiated capital treatment. One example is the internal
ratings-based approach (IRB) to retail exposures. In light of the fact that
retail exposures include a broad range of products each with unique loss characteristics,
Basel II provides separate risk weight curves for (1) residential mortgage lending,
(2) certain revolving exposures, and (3) all other non-mortgage exposures. Another
area where greater differentiation has been introduced is the treatment of specialized
forms of corporate lending, that is, lending whose primary source of repayment
is based on the performance of an underlying pool of assets or collateral. The
Committee also has agreed to provide a separate treatment for lending to small
and medium sized enterprises, recognizing that these exposures pose different
risks than lending to larger corporate borrowers.

There have been other important modifications to the proposals. In the area
of operational risk, the Committee has fleshed out the advanced measurement
approach (or AMA), giving banks unprecedented flexibility in basing their capital
requirements on internal measures of risk. The operational requirements underlying
the AMA, including the removal of an explicit capital floor are intended to
be sufficiently flexible so as to accommodate the rapid evolution in operational
risk management practices we expect to see over the coming years. The Committee
has also introduced greater flexibility in the minimum standards for entry and
on-going use of the IRB approach to allow for innovation and differences in
the way banks operate while still ensuring a high degree of credibility and
consistency in their risk assessments.

An important focus of the revision process has been to refine the calibration
of the credit risk capital requirements. To this end, the Committee has conducted
extensive data analysis in designing the risk-weights and setting quantitative
inputs and parameters for calculating the capital charges. The goal of the calibration
effort has been to ensure that the capital framework meets its primary objectives,
that is, not to introduce large changes in the aggregate amount of capital currently
held, while providing tangible incentives for banks to adopt the most advanced
and sophisticated approaches to capital adequacy.

Based on the results from the QIS 3 exercise, in which more than 350 banks
from more than 40 countries participated, it looks as if the New Accord is on
track in meeting these objectives. To illustrate this, we can compare the results
obtained using the Basel II approaches with the current requirements under the
1988 Accord. For example, the large, internationally-active banks in the G-10
experienced a projected increase of 11% in overall capital requirements under
the revised standardized approach, an increase in 3% under the foundation IRB,
and a decrease of 2% under the advanced IRB. The increase in capital requirements
under the revised standardized approach was a more modest 3% for the smaller
G-10 organizations, the ones more likely to adopt this approach. All of these
results take into account the impact of the operational risk charge as well.

The QIS results have also been helpful in making some additional refinements
to the proposals in CP3, such as modifying the IRB risk weight curve for revolving
retail exposures and setting a transitional floor on the Loss Given Default
(LGD) estimates for residential mortgages.

Application in the United States and Preparations for Implementation

As the Committee moves closer to finalizing the new capital framework, many
banks and supervisors around the world are giving serious thought to what they
need to do to get ready for the next critical stage in the Basel process – implementation.

Scope of Application/Range of Options

Throughout the Basel process, the US supervisory agencies have carefully contemplated
how to apply the New Accord to US banks. The focus of the Basel Committee’s
revision process has been to align the capital requirements of international
banks that compete in the global capital markets and thereby promote a more
level playing field for these institutions. Consider also that the need for
Basel II arises because our current capital framework – Basel I – is deficient
for larger US banks, particularly for the most complex banking organizations.
Consequently, the Basel II implementation efforts in the United States have
focused on these large, complex, internationally active institutions.

US supervisors have given considerable thought to the criteria that could be
used to identify the institutions best suited to adopt Basel II. These criteria,
which will be clarified publicly in a forthcoming rulemaking notice, focus on
a bank’s asset size, foreign exposure and activity, and its participation
in other critical activities, such as global payments and settlements. Based
on these proposed criteria, approximately ten banks will be required to adopt
Basel II. Banks outside this “core” list will of course have the
option of adopting Basel II. Another ten or so will probably voluntarily choose
to do so at or near the Committee’s formal implementation date of December
2006. It is worthwhile to note that the twenty banks projected to adopt Basel
II account for about 99 percent of the foreign assets held among the top fifty
US banks and approximately two-thirds of all assets in the US banking system.
As you can judge by these statistics, the US implementation strategy is designed
to encompass the population of large, internationally active banking organizations
– in other words, those banks for whom a level international playing field is
most critical.

Given the nature of their operations and risk management systems, the US banks
adopting Basel II will be expected to use the approaches to capital adequacy
that rely on their internal risk assessments, namely, the advanced internal
ratings-based approach (AIRB) to credit risk and the advanced measurement approaches
(AMA) to operational risk. US supervisors believe that these approaches provide
the greatest potential benefit in achieving more risk-sensitive capital requirements
and promoting stronger risk management practices. We also believe that the large,
sophisticated banks are capable of meeting the requirements of these most advanced
approaches, such as the ability to calculate robust LGD estimates for use of
the AIRB. This said, we anticipate that most institutions adopting Basel II
will need to enhance some aspect of their risk management infrastructure to
fully meet these requirements. Banks not adopting Basel II will continue to
be subject to the existing US capital rules.

Many of the organizations not included in the mandatory set have relatively
straightforward operations. In light of their less complex risk profile, these
organizations may find that the benefits of using the advanced approaches for
capital adequacy purposes are outweighed by the potential costs involved in
meeting the rigorous minimum IRB standards. Nevertheless, we anticipate that
banks will continue to develop their risk assessment capabilities, and some
may choose to do so along the broad risk management principles embodied in the
new framework, even if they do not adopt the Accord formally for calculation
of regulatory capital. Indeed, this movement toward more sophisticated risk
management is a market trend reflective of evolving technology, growing complexity,
and the understanding of modern finance.

As a further consideration, we are confident that less complex banks which
do not adopt Basel II will remain prudently capitalized under our current capital
adequacy regime. US capital adequacy requirements are bolstered by the “prompt
corrective action” features, such as the leverage ratio and the use of
“well-capitalized” thresholds above the minimum ratios prescribed
by Basel. All banks in the United States are also already subject to comprehensive
and thorough supervision. These features of our capital adequacy regime therefore
meet the spirit of Pillars 1 and 2 of the New Accord, that is, that banks are
expected to maintain a prudential level of capital and that supervisors will
take preventive measures to ensure that this is the case. Moreover, such banks
already provide significant disclosures to the public – consistent with the
third element of the three-pillared Basel II framework.

Some concerns have been expressed that banks not required to apply Basel II
will potentially face a competitive disadvantage against a rival on Basel II
that may face lower capital requirements. It is not clear, however, that regulatory
capital levels are the dominant factors in the pricing and profitability of
banks, first, banks are already operating well above minimum regulatory levels;
secondly, economic capital (not regulatory capital) tends to be the binding
constraint for large, complex banking organizations; and third, local market
competition from banks and other lenders and the cost of funds are more important
competitive factors.

Enhancements in risk measurement and management will enable banks to price
new extensions of credit more accurately. Thus, it would follow that exposures
with lower underlying risk, and in turn lower capital charges, may be priced
at a rate below that of riskier exposures with higher capital charges. This,
of course, does not mean that higher capital requirements result in higher credit
spreads. Rather, the pricing of credit and the size of the capital charge under
Basel II will reflect the same common driver, the level of underlying risk.

In order to address these and any other potential concerns, the US supervisory
agencies are conducting and will continue to pursue extensive public discussion
on Basel II implementation. The feedback and comments that we receive during
these consultations will be critical in shaping our approach to implementation.

Outreach/communications strategy

Communication is a critical ingredient in preparing for Basel II. Our frequent
and in-depth interactions with banks have been essential to providing both banks
and supervisors with a clearer sense of the preparations that need to be made
for meaningful and timely implementation of the new framework. As part of this
interagency effort, US supervisors have begun to engage banks in extensive dialogue
to convey our expectations about how the New Accord will be applied in practice.

An important element in our communications strategy is the publication of an
advanced notice of proposed rulemaking (ANPR), which we will be releasing for
public comment shortly. The ANPR will outline how the supervisory agencies currently
envision applying Basel II in the United States. It will also solicit comment
on whether changes should be made to the US capital adequacy regulations for
those banks that will not be adopting Basel II. The feedback and public comment
we receive on the ANPR will provide critical input for the US agencies in negotiating
the final modifications to Basel II later this year. Banks are encouraged to
pay close attention to the direction that the ANPR takes, to participate in
a dialogue with their supervisors about the proposals, and for those preparing
to adopt Basel II to start evaluating, in a general sense, their own state of
readiness vis-à-vis the general principles expressed in the draft guidance.

Another critical element in our Basel II outreach efforts is the one-on-one
dialogue we are pursuing with several banks. The supervisory agencies have already
been conducting individual discussions with the banks currently identified as
mandatory Basel II banks. A key aspect of these discussions is to emphasize
that banks implementing Basel II are expected to conduct in-depth self-assessments
of their credit and operational risk management systems and to develop comprehensive
plans for enhancing those systems to meet the requirements of the advanced approaches
to calculating minimum capital requirements.

In addition, US supervisors have been conducting outreach meetings with the
largest regional banking organizations which may wish to adopt Basel II on a
voluntary basis, including some US subsidiaries of foreign banks. These meetings
have served as a forum for supervisors to convey that any banking organization
that wishes to adopt the New Accord may do so, provided that it can meet the
same rigorous supervisory standards that will be applied to the mandatory Basel
II banks. The outreach meetings also provide an opportunity for banks to learn
more about the Basel II framework and how it will be implemented domestically.

US Supervisory Preparations

Another key element of our interactions with banks has been to raise awareness
of where banks’ internal ratings systems stand in meeting the robust operational
requirements for use of the advanced approaches. We’ve also focused on how Basel
II might impact the US approach to supervision.

As part of our preparations, the US supervisory agencies have conducted exploratory
reviews of banks’ internal credit rating systems. The purpose of the reviews
was both to determine where banks stand in meeting the Basel requirements and
to raise awareness by both banks and supervisors of what the new requirements
will mean in practice. The findings of the reviews have helped to shape the
supervisory guidance we are developing to provide additional detail on the range
of acceptable practices for meeting the Basel operational requirements for use
of the advanced IRB approach. In this regard, US guidance on applying the IRB
approach to corporate exposures is forthcoming.

In terms of process, these reviews were conducted on site by supervisory teams
that included both relationship staff and risk specialists. The reviews focused
on learning more about the range of practices in internal ratings across institutions,
and thus were designed to be separate from the formal examinations process.
The institutions selected to participate were ones that seemed likely candidates
to use the advanced IRB approach.

The results of the reviews generally indicate that banks have been making strong
progress in developing robust internal ratings systems and also reveal some
key areas where banks might need to focus more energy.

In terms of rating systems design, we found that banks’ systems are generally
oriented to capturing the essential components in estimating credit risk. But
banks need to work further on defining their ratings categories more clearly
and objectively in order to provide a meaningful differentiation of credit risk.
The clarity and transparency of the ratings criteria will be critical to ensuring
that ratings are assigned in a disciplined and reliable manner.

Another area where banks face important challenges is the collection of robust
loss data, an essential element for designing and validating credit ratings
system. It is important that banks implementing Basel II consider their data
needs very seriously and comprehend fully the techniques they will need to use
to derive appropriate estimates of loss based on those data. Critical to this
process is the need for banks to understand how the estimates produced by their
internal ratings systems compare with the actual performance of a borrower.
In practical terms, banks will need to invest time and effort in developing
a data “warehouse”, that is, a process that enables a bank to collect,
to store, and to draw upon loss statistics in an efficient manner over time.

Corporate governance and internal controls are other key areas for banks to
address. Since a bank’s internal estimates will be used to produce its
capital charge, supervisors need to be assured that the process for producing
inputs to the capital calculation has viable controls and is not subject to
undue influence. In the same vein, there will be a need for a bank’s board
of directors and senior management to gain a deeper understanding of their bank’s
internal rating systems. Thus, it is crucial that board and senior management
think more actively about the conceptual underpinnings of the ratings process
and incorporate this into their risk strategies.

Communication between supervisors

Communication between national supervisors has also been critical in preparing
for implementation, particularly for the cross-border supervision of complex
international banking groups. An important consideration of the Basel Committee
is that wherever possible supervisors should avoid redundant approval and validation
work. The goal is to promote consistent application of the proposals to banks
that compete globally in a manner that limits the burden for banks and conserves
supervisory resources. To this end, the Committee has established a group comprised
of senior line supervisors to promote the consistency and quality of implementation
across countries. The Accord Implementation Group (or AIG for short) will help
to facilitate the exchange of information among national supervisors about bank
and supervisory practices. The AIG is developing principles to promote coordination
and information sharing between national supervisors.

Impact on US approach to supervision

The New Accord will present supervisors with an opportunity to re-evaluate
dynamically and further develop their current approaches to monitoring banks.

Basel II’s emphasis on risk management strongly supports our current
efforts in the US to make evaluations of banks’ internal processes the
heart of a more forward-looking supervisory approach. Particularly for our large
sophisticated banking organizations, US examinations have already been moving
towards and in many cases already incorporate the supervisory principles embodied
in Pillar 2 of the new framework.

That is, we are increasingly focused on evaluating banks’ internal capital
management processes to judge whether they meaningfully tie the identification,
monitoring and evaluation of risk to the determination of institutions’
capital needs. In turn, we are moving away from static, point-in-time assessments
of a bank’s asset quality and simple compliance with minimum capital adequacy
ratios. To this end, the Federal Reserve has published examinations guidance
in SR Letter 99-18 for assessing capital adequacy in relation to banks’
internal risk assessment processes and has also conducted targeted examinations
of economic capital methodologies at a number of large, complex institutions.

Thus, US supervisory processes themselves are not expected to change fundamentally
with Basel II rather, we expect that they will continue to evolve and focus
more on the quality of banks’ internal risk management processes and controls.
Going forward, consistent with the spirit of Pillar 2, even more emphasis will
be placed on ensuring that a bank’s capital buffer and capital planning
process consider those risks not fully captured in the minimum capital requirements
such as concentrations or lack of diversification. More formally, banks are
expected under Pillar 2 to have capital adequacy assessment processes that supervisors,
in turn, will review. The bank’s assessment processes should take a holistic
approach that reflects all of the bank’s material risks (e.g., credit,
market, interest rate, liquidity, legal, etc.) and should be overseen by the
board and senior management.

We recognize that the capital adequacy assessment process should be tailored
to the nature and complexity of a bank’s operations. Therefore, we do
not expect that the internal risk assessment processes of the less complex US
banking organizations not adopting Basel II will be as sophisticated or grounded
in complex mathematics. However, we will continue our supervisory efforts to
encourage all institutions to have a thoughtful process to conduct and review
their capital planning. For smaller organizations, this may take a more strategic,
scenario-based approach such as an assessment of how the capital needs of the
bank may change in the event of a shift in management’s business strategy
or scenario analyses of future business conditions on asset quality and loan
growth.

Ultimately, we envision that the supervisory review of these processes will
promote dialogue with banks on this issue and will motivate banks to think further
about how they can refine their internal capital adequacy processes, as consistent
with their size, operations, and risk profile.

Preparing examiners

To monitor banks that use the advanced approaches, there is clearly a need
for ensuring that people working in the examinations process have the requisite
skills including the appropriate quantitative expertise and skills to understand
and critically evaluate complex models.

US supervisors have already been shifting their emphasis towards the quality
of a bank’s risk management process and ability to assess risk exposures
properly. This evolution in our supervisory framework has helped prepare our
examiners to evaluate a bank’s internal processes and how this ties into
assessments of capital adequacy. An accompanying shift in our supervisory approach
has been to increasingly emphasize specialization, so that we have dedicated
staff focusing on particular risk areas. Within this structure, we have been
able to train and develop people to have state-of-the-art knowledge in their
discipline – including teams dedicated to analyzing credit risk and operational
risk.

To further prepare our examiners to evaluate banks’ internal processes,
the US supervisory agencies are collaborating on a training and development
strategy geared to enhancing the desired skills. A key element of the strategy
is that it recognizes that the level of expertise needed will depend on the
role and function of each staff member.

Risk specialists and quantitative experts will need to understand a bank’s
internal ratings systems and models well enough to conduct initial validation
and to monitor on-going compliance. This requires a high level of expertise
in areas such as statistics, modeling techniques, models evaluation, simulation
and stress testing.

Supervisory staff responsible for the overall supervision of large banking
organizations might not require the same level of expertise in technical areas
as the quantitative experts. Rather, their training will likely focus on developing
a solid understanding of the key concepts, methodologies and risks associated
with the advanced approaches; the ability to use quantitative data in their
analyses; and a basic understanding of capital allocation and measurement processes.

In the US, we envision that training will be geared to the needs of these different
audiences and will likely take several different forms including classroom training,
self-study programs, conferences bringing together regulators and industry practitioners,
and partnering examiners in the field with our internal experts.

Conclusion

Stepping back a little, one can argue that Basel II is a monumental step forward
in capital adequacy regulation – a more flexible and forward-looking framework
that better reflects the risks facing banks and encourages them to make ongoing
improvements in their risk assessment capabilities.

It is important to keep in mind that the New Accord reflects what banks themselves
have been doing to better understand and manage their risk exposure. The efforts
banks will need to undertake to comply with Basel II build on the efforts that
some large and well-managed banks already had in train before the new framework
was contemplated. As you know, a primary motivation for banks to develop and
further refine internal risk management systems is to promote a bank’s
competitiveness and to protect it against loss. Basel II is designed to encourage
banks to continue making investments in refining these systems.

Risk management is clearly a dynamic process and one that will continue to
evolve. The New Accord contains the promise of a capital framework that will
evolve with improvements and advancements in risk-management techniques. As
banks develop new methods and techniques, Basel II can and should embrace such
advances. The sooner we can gain practical experience with the framework, the
sooner we can begin to realize its full potential as a supervisory and risk
management tool.

Zahra El_Mekkawy is Vice President in the Bank Supervision Group of the Federal
Reserve Bank of New York. Her current responsibilities focus on US supervisory
efforts to prepare for implementation of the New Basel Accord. Prior to this,
she served on the Secretariat of the Basel Committee on Banking Supervision
and was a member of the Models Task Force, the group responsible for developing
the internal ratings-based (IRB) approach to credit risk.

Related Articles

Video: Supporting digital transformation in corporate treasury

Corporate to Bank Relationships Video: Supporting digital transformation in corporate treasury

4w Austin Clark
New LIBOR guidance gives providers transformation deadlines

Banking New LIBOR guidance gives providers transformation deadlines

1m Shannon Moyer
HSBC launches Treasury APIs for payments in 27 markets

Corporate to Bank Relationships HSBC launches Treasury APIs for payments in 27 markets

1m Jay Ashar
ING – bank or fintech?

Banking ING – bank or fintech?

2m Austin Clark
Corporate debt to default ratio falls as debt bubble fears rise

Banking Corporate debt to default ratio falls as debt bubble fears rise

2m Jeremy Chan
KYC registry of SWIFT now open to corporate customers

Corporate to Bank Relationships KYC registry of SWIFT now open to corporate customers

2m Jay Ashar
Deutsche Bank launches instant payments guide for corporates

Corporate to Bank Relationships Deutsche Bank launches instant payments guide for corporates

2m Jay Ashar
BigTech in financial services may require sweeping new laws

Big Data BigTech in financial services may require sweeping new laws

3m Jay Ashar

Whitepapers & Resources

Transaction Banking Survey 2019

Transaction Banking Survey 2019

5m
TIS Sanction Screening Survey Report

Payments TIS Sanction Screening Survey Report

8m
Enhancing your strategic position: Digitalization in Treasury

Payments Enhancing your strategic position: Digitalization in Treasury

9m
Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation

1y