Building on the Wrong Pillars: Should Banks Delay Basel II Compliance?
In a recent paper, written with Tim Giles of the Charles River Associates, we analysed the costs and benefits of advanced Basel compliance i.e. qualifying for the Internal Ratings Based (or IRB) method for calculating capital for credit risk and the Advanced Management Approach for calculating capital requirements for operational risk.
This is relevant to UK banks because the FSA is allowing these banks to decide for themselves whether and when to adopt the advanced methods. They can apply to qualify for these advanced methods in 2007, when the new Basel accord is first implemented, or they can delay qualification until a later date.
We find that the benefits of advanced compliance are much smaller than has generally been assumed. Our calculations show that for a typical UK bank the annual benefits of advanced compliance are less than 0.4 basis points of total assets before tax. According to recent figures published by Mercer Oliver Whyman, the total cost of achieving advanced compliance can be as much as 5 basis points of total assets. Delaying advanced compliance by a two or three years – ie choosing to be in a second following wave of implementation – would reduce these costs substantially. We conclude that banks need to think very carefully before spending money on achieving 2007 advanced compliance.
We are not suggesting that the solutions to Basel currently being adopted by UK and other banks are inappropriate. But we have not seen any previous analysis of whether the benefits of rapid implementation are outweighed by the costs. If our message is heeded, there might well be some slow down in the pace of Basel implementation as we approach 2007. If the costs of rapid implementation does really outweigh the benefits then this will be no bad thing.
Advanced approaches will allow banks to achieve substantial reductions in regulatory capital. To take an important example, under the new accord the capital requirement for mortgages (which account for more than 50 percent of all UK bank lending) will be reduced by around one-half using the advanced IRB instead of the standardised calculations. Our point is that even a reduction of regulatory capital of this magnitude is only worth a relatively small amount to shareholders.
To quantify this shareholder impact it is necessary to take account of two offsetting effects – banks are using less relatively expensive equity capital but they must replace this with additional debt finance. Moreover reducing equity capital exposes shareholders to greater risk, and they require compensation for this risk in the form of a higher return on equity.
Netting out these two offsetting effects (the higher level of debt and the higher cost of equity capital), we see that the reduction in requlatory capital of one-half from advanced IRB treatment lowers the risk-adjusted cost of funding a mortgage portfolio by only 0.7 basis points per annum. Lower regulatory capital requirements are worth having, but only if these relatively modest benefits to shareholders outweigh the associated costs. The same point applies to all other regulatory capital requirements, whether for credit or operational risk.
The case for a slow adoption is perhaps strongest in the case of operational risk. At present UK banks are recruiting large numbers of new operational risk personnel, with the Basel deadlines in mind. However there are a range of approaches. Some banks are focussing purely on compliance (making the necessary investment in systems, data, and staff training to adopt the advanced management approach for operational risk). Other institutions are being more ambitious, taking the opportunity to substantial improve in the management of operational risk throughout their business processes.
There can be no doubt that regulators prefer to see operational risk management fully integrated with bank business. But this is not a short-term task, it requires not just changes in systems and procedures, but a change in attitudes to operational problems across the entire organisation (eliminating the ‘ticket in the drawer’ culture). Such a fundamental shift cannot be achieved in a short-time scale and certainly not to an arbitrary regulatory deadline like 2007. There is an obvious conflict between achieving 2007 compliance with the advanced management approach to operational risk and making operational risk management is an integral part of a bank’s business culture.
Even a purely compliance-focussed institution needs to think beyond the 2007 deadline. The FSA may well decide to use Pillar 2 of the new accord (the system of supervisory review) to reward banks that fully integrate operational risk management into all their business processes. If this turns out to be the case, then the bank that pushes hard to achieve advanced management approach by 2007, without making this a genuine part of their business management, will be disadvantaged. And as we have shown, the benefits of advanced compliance are relatively small. If they are focussed shareholder value, then banks need to think about their treatment of operational risk well beyond 2007.