Basel II - The Pitfalls of Delaying Compliance
Throughout 2004, Basel II Accord implementation is likely to remain a major issue for credit managers. The new Accord, which banks will need to comply with by 2007, is intended to ensure capital charges more precisely represent the inherent risks banks undertake. The ability to more accurately assess risk will allow many financial institutions to reduce the amount of capital charges they currently set aside. This is likely to become a competitive issue with many lenders placing a considerable emphasis on installing the most accurate credit risk assessment solution.
But whilst a large number of lenders have been quick to herald the opportunities presented by the Accord, others have been more reticent. There have been criticisms that the capital calculations aren’t always appropriate for the types of products and risks they will be applied to, although modelling techniques are proving popular for achieving optimum value within the Accord’s restraints. There are also doubts whether the Accord will be implemented consistently throughout the globe and others have voiced concerns regarding adjustments for pro-cyclicality. But the cost of implementing Basel requirements is commonly viewed as the biggest barrier. Some larger lenders are facing costs running into the hundreds of millions of pounds and have suggested that the capital savings are insufficient for the amount they need to spend in order to get them.
Encouraged by American banks, who are dragging their heels, a number of UK lenders are falling behind on their projects to implement Basel requirements. According to KPMG’s recent survey around half of the 294 financial institutions that they spoke to are still only in the pre-study phase. Some corners of the lending industry are even advocating delaying implementation, recommending lenders set their own timetable for advanced compliance. It has been suggested that lenders won’t see a return on the investment for up to ten years, and some argue that delaying implementation will allow lenders to take advantage of reduced implementation costs. Whilst it’s clearly up to every individual lender to choose its own path to compliance, such a strategy could be risky. By planning to meet just basic requirements now, and aim to obtain IRB Advanced status at a later date, lenders are basing implementation on two assumptions.
Firstly, this strategy assumes that the savings (risk management improvements and capital charges) will not be greater than the cost of implementation over the initial period. This would also assume that lenders gaining IRB Advanced status from 2007 will not be able to use the benefits to market and price their products to the point where those without IRB Advanced approval struggle to compete. Those lenders that are at the front of the queue will also gain an immediate edge in terms of experience and modelling, which will be valuable going forward. Obviously, where possible these benefits need to be compared with the implementation cost, but this is a cost that every lender will have to face to some extent. The second assumption is that implementation costs will go down significantly. The suggestion is, the amount of money banks need to spend on implementing changes has attracted a number of outsourcing technology suppliers to the market. However a considerable amount of the cost of implementation is spent on man-hours for skilled analysts, and this amount of time needed to implement changes will not go down. Allied with the fact that most IT systems suppliers can’t afford to overcharge because of market competition, it’s unlikely that implementation costs are currently overly inflated, or that costs will come down significantly.
But whilst it’s unlikely that lenders will benefit from a cost reduction from delaying Basel implementation, neither is it prudent to rush in. There is still a lot of uncertainty surrounding many of the final requirements for the Accord, and a clear picture of how banks will need to calculate capital is yet to materialise. As a result, a number of IT systems suppliers are now offering software support and analysis on a step-by-step basis to help meet IRB Advanced status by assessing their data history, the first component of the Accord.
To attain advanced IRB status, lenders will need to have started using models for credit approval, limit management, provisioning and reporting to ensure they satisfy ‘experience test’ requirements by 2007. The required data history needed for achieving IRB status was thought to be a major stumbling block for smaller mortgage lenders. Concerns arose that the Accord would deliver an unfair bias, as lenders wanting to achieve IRB status need to have large volumes of customer data in order to properly validate models to predict defaults and losses. Some smaller mortgage lenders simply haven’t had enough clients to complete this requirement. However, more and more smaller mortgage lenders are looking to share customer data on which to base their model development, and this willingness to share data is likely to become a growing trend throughout the year.
A number of smaller mortgage lenders have grouped together and have contacted IT systems suppliers to provide a data audit, which will highlight any gaps in a lender’s data capture and retention processes and determine what data items will need to be captured under a compliant regime. Once complete, the data audit provides an independent opinion whether each lender needs to pool mortgage data in order to accurately calculate capital adequacy. The audit involves an analysis of the application and customer performance data, so that a profile can be developed of different customer groups and their typical behaviour. IT systems suppliers can then provide an estimation of the volumes of data each lender will need in order to achieve IRB status.
By supporting lenders to meet compliance stage by stage it is possible to take a pragmatic approach. For instance, once the data audit is complete, lenders can decide if they need to pool data. This approach, whereby lenders implement the stages as the Basel Committee confirms them, ensures money is not wasted re-defining requirements as the Accord is finalised. It also ensures that lenders do not get left behind.