Basel II: The Home-host Issue
In January 2005, Lepus released an executive summary focusing on the reaction of banks to the Basel II framework. Within this report the participating banks were asked to highlight what they perceived to be the negative facets of the framework. In response, the majority put forward home-host issues at the top of their list – a sure sign that home-host issues will continue to command much attention in the coming months.
So what is the furore around home-host all about? Essentially, from the perspective of an investment bank, we are talking about the difficulties in reconciling the demands of regulators in countries that host branches of the banking group with those of the centralised group regulator in the home domain. Conversely, from the regulatory perspective, the Accord appears to hold a fundamental contradiction in offering the potential for banks to allocate capital at a group level that is less than the sum required if each of the individual subsidiaries is calculated together. Such a scenario would appear to seriously undermine the responsibilities of individual host regulators to ensure adequate capital allocation within their jurisdiction. Clauses to strengthen the position of host regulators have in turn only served to further alienate the banking community.
The difficulties that Basel II inspires for regulatory bodies around the globe are driven by the paradox of global banking corporations being monitored by sovereign regulators. Each national regulator has a responsibility to certify that a bank operating within its boundaries has set aside a sufficient amount of regulatory capital to offset the risk in that particular entity. However, the crux of the problem with Basel II, specifically with regard to operational risk, is that approaches taken by banks at group level do not always infer adequate allocation at subsidiary level. For instance, if a bank adopts an Advanced Measurement Approach (AMA) at group level, the amount of risk when diversified around the entire group can be less than the sum of operational risk in the group’s subsidiaries around the world, thus leaving host regulators exposed. Of course, in such a situation host regulators are able to allocate additional capital to ensure that the risk in a subsidiary within its jurisdiction is appropriately offset. While this move is understandable it does impact heavily on the benefits of diversification for major banking organisations.
Adding to the regulatory mix is the growing perception in the banking community that there is a lack of consistency in the implementation of the Accord around the globe. Without a body to drive the global convergence of regulatory interpretation, each national supervisor has naturally developed its own specific understanding, reflecting individual preferences toward banking supervision and regulation.
These differences lie at the heart of home-host for banks trying to cope with divergent interpretations in order to satisfy host regulators around the world. In Europe, the translation of Basel II into the Capital Requirements Directive (CRD) and the work of the Committee of European Banking Supervisors (CEBS) aim at fostering a uniform view of the Accord across the continent, however, even if these moves are successful there is still the prospect of other jurisdictions to consider, not least for example, the situation unfolding in the US.
US regulators propose to offer only the advanced options as stated in Basel II for credit and operational risk to those banks that fit certain size or foreign exposure criteria. Inevitably this has caused concerns for banks, especially those which are thinking of employing a foundation approach within the consolidated entity. Such a scenario would leave the bank having to gather the necessary data to establish loss given default (LGD) and exposure at default (EAD), neither of which is required even under the full foundation approach.
Against this regulatory background, Lepus consulted a number of banks to expand on the impact of home-hosts and to highlight their specific concerns. Ostensibly, as a source from a leading European bank stated, one of the main fears that home-host reconciliation brings is the prospect of having to embark on multiple validation exercises with individual regulatory bodies. The threat of having to trawl through the same validation process time and again in order to satisfy host regulators inevitably infers the devotion of substantial resources.
However, home-host extends much further than simply time consumption and allocation of resources. Many banks argue that they are being forced to completely re-evaluate their approach to operational risk for Basel II as a consequence of the removal of diversification benefits. Indeed an interviewee at a prominent British institution noted that ultimately the organisation will probably adopt an AMA to operational risk at a group level but will be forced into using stand alone calculations for a couple of its subsidiaries and a standardised approach for the others as the concept of an AMA for certain subsidiaries is simply unworkable.
From a subsidiary perspective, the outlook is no less confused with a representative at another European bank alluding to the fact that the issue has become entrenched in a political struggle. The source commented that as a subsidiary it has received very little information or instruction from its home regulator as to how to proceed. As a consequence of certain regulators asserting their independence the flow of information down to subsidiaries is slow at best, if not stagnant.
With such uncertainty, it is only natural that banking organisations are seeking to obtain a greater understanding of what is required of them by both home and host regulators. All of the banks that Lepus consulted indicated that they have actively pursued clarification from regulatory bodies around the globe. Significantly, as a British-based bank noted, unless an institution is deemed sufficiently international to be allocated a co-ordinated college of supervisors, it is forced to work bi-laterally to establish understandings with individual regulators. This has proven something of an uneven playing field with certain host regulators willing to conduct detailed discussions and others less so.
It was suggested that on the whole regulators in the US and some Asian locations, such as Singapore and Hong Kong, have been extremely open with their requirements while in Spain, Japan and South Africa obtaining the necessary information has been extremely difficult. It is the perceived lack of understanding of Basel II by some regulators that frustrates banks. While most institutions have spent millions handling the Accord, some regulators have merely resorted to ‘box-ticking’ exercises.
Certainly the feedback received by banks from regulators appears to have been mixed. Moreover, there also exists a belief that, contrary to accusations delivered in recent months by the head of the Accord Implementation Group (AIG), Nicholas Le Pan, that certain banking subsidiaries are not sufficiently informed of the wider group approach to Basel II; the new accord fails to reflect the conventional organisational structure of investment banks.
On the matter of informing subsidiaries, the banks that Lepus spoke to suggested that demands by host regulators have to take into account that banks do not, as a rule, run off geographical entities. In this sense the home-host issue is very much crystallised, while host regulators are operating within national boundaries, large investment banks operate a global mandate, emphasising business units rather than an individual branch network.
Nevertheless there is acknowledgement that to an extent at subsidiary level there has to be ‘hand-holding’ from the group, given that the emphasis for Basel II falls more on business unit heads than national figureheads. As an interviewee at a European bank affirmed, while staff operating at the subsidiary level may be aware of the methods undertaken to comply with Basel II, they do not have full access to a global view at corporate level. In this sense it is hard for subsidiaries to go through a detailed validation process, especially for operational and credit risk as the models the group is using are known at group level but not at subsidiary level.
Unquestionably, home-host is a significant sticking point for Basel II. A resolution acceptable to all parties will not be easy to come by. For now the situation remains unclear, as a representative of a leading tier one institution commented, the unpredictability of the outcome is enhanced by the political side of the process. Ultimately, banks are preparing themselves for the worst-case scenario, despite the fact that this only adds to the complexity that surrounds Basel II.
Certainly, from the perspective of the banking community the hope is that regulators around the world will begin to co-ordinate their efforts towards Basel II in a better way. As one source that Lepus spoke to commented, regulators have got to begin to trust each other more. For instance, where there is a global system in place, collaborated at group level, host regulators must be able to rely on validation conducted by the home regulator. Whether or not this is realistic is another matter.