Don't Rush Basel III

Introduction – from Basel I to Basel II

Perhaps the most fundamental shift in the ethos of banking regulation since the introduction of the Basel Accord of 1988¹ (now known to the financial community as Basel I) is the introduction of the revised Basel Accord, Basel II². While Basel I marked the first global attempt to standardise the levels of capital required to be held by banks relative to their risks³, Basel II substantially revises the philosophy behind, and the methodology for the calculation of, capital requirements and firmly places credit risk at the forefront of prudent capital adequacy practices.

Whilst it is often said that the Basel Committee was making plans for Basel II even before the ink was dry on the text of Basel I, some 12 years elapsed before the first text of the revised standard was released for consultation in June 1999. A further five years of consultation and impact studies were to be required before release of the “final” text of Basel II in June 2004.

Basel II retains the definition of capital and the critical 8 per cent ratio of capital to risk-weighted assets originally set out in Basel I. However, it allows banks⁴ to implement more sophisticated methods of measuring and assessing the risk-weighting of loans and other assets than at present. The “one-size-fits-all” approach of Basel I is replaced by a three-pillared framework (see box) that is designed to implement an advanced, more risk-sensitive and precise approach to capital measurement as well as provide robust regimes for supervisory monitoring and market disclosure.

Credit Risk Under Pillar 1 and the Corporate “Credit Crunch”

Fundamental to the concept of Basel II is its ‘menu’ of available approaches for the measurement of credit, market and operational risks. Two approaches are available for measuring credit risk which between them offer three options, demonstrated below using the corporate borrower category as an example:

The Standardised Approach

The Standardised Approach is essentially a more risk-sensitive revision of the single approach to measuring credit risk available under Basel I. The Basel I approach allocates a set risk-weight to each asset dependent upon the broad category of borrower (e.g. sovereign, bank, corporate). A single corporate risk-weight of 100 per cent is available under Basel I, meaning that the full value of each corporate exposure is included in the bank’s calculation of risk-weighted assets and the calculation is as follows:

Exposure amount (100) X Risk Weight (100 per cent) X Capital Ratio (8 per cent) = Capital Requirement (8)

Using the Standardised Approach under Basel II, four risk weights for corporate exposures will be available: 20 per cent, 50 per cent, 100 per cent and 150 per cent, refined by reference to a rating provided by an external rating agency⁵. To demonstrate the sensitivity of this approach, the calculation of the capital requirement for a loan to a AAA-rated corporate (corresponding risk weight 20 per cent) and an unrated corporate (corresponding risk weight 150 per cent) will be as follows:

Exposure amount (100) X Risk Weight (20 per cent) X Capital Ratio (8 per cent) = Capital Requirement (1.6)

Exposure amount (100) X Risk Weight (150 per cent) X Capital Ratio (8 per cent) = Capital Requirement (12)

It is apparent that the Standardised Approach links corporates’ cost of borrowing inextricably to their credit ratings, a somewhat vulnerable position when considered against the recent market backdrop of corporate scandals and potential rating downgrades. Given the current climate of corporate responsibility, pressure is placed on both borrowers and lenders to adopt ever more prudent practices. More highly rated corporate borrowing will result in lower capital requirements for the lender; conversely, a weaker corporate credit profile will increase the cost of lending. This corporate ‘credit crunch’ reflects in a nutshell the very essence of Basel II: to make the capital applied to lending more risk-sensitive.

The Internal Ratings-Based (IRB) Approaches

More sophisticated banks will be able to use their own internal assessments of borrower creditworthiness to establish credit risk, resulting in greater risk-sensitivity. Banks must make those calculations based on four risk components: probability of default (PD); expected loss (EL); exposure at default (EAD); and loss given default (LGD). The foundation IRB Approach uses banks’ own estimates of PD but employs supervisory figures for EL, EAD and LGD; the advanced IRB Approach allows banks to use their own estimates of each risk component, resulting in more finely-tuned risk-weights for individual loans (a corporate customer borrowing from bank A and bank B, both using the advanced IRB approach, could expect to receive a different risk-weighting from each bank).

There are stringent supervisory systems and disclosure criteria that must be met before supervisory approval to use the IRB approach is granted and banks are required to hold at least three years’ historical data to support their calculations. Those corporates that have developed long-standing relationships with their banks are likely to succeed under the IRB approach; less favoured or unrated corporates may be well advised to cement their banking relationships in the very near future (preferably with those banks planning to use the most advanced approaches).

Scope for ‘lending arbitrage’ inevitably creeps into the IRB approach. Given the costs associated with Basel II compliance, banks will be seeking to maximise the return on their commitments and it seems likely that the symbiosis between preferred corporate borrowers and those sophisticated banks using the IRB approach will produce the best outcome. Indeed, non-G10 corporates and those in developing countries face a distinct disadvantage under the IRB approach to credit risk; risk weightings rise exponentially along the scale of higher probability of default.

Shifting Regulatory Environment

In a shifting regulatory environment, banks (and indeed corporates) are struggling to keep pace with the demands of not only Basel II, but International Financial Reporting Standards and the raft of legislation contained in the European Commission’s Financial Services Action Plan, not to mention national legislative and regulatory requirements. Uncertainty breeds caution in the financial industry, which, in turn, impacts corporates keen to gain an early foothold in the Basel II world. Indeed, European banks still await the final text of the Directives that will implement Basel II on a statutory basis within the EU⁶.

Looking beyond the (somewhat unclear, at least in Europe) implementation dates for Basel II⁷, a number of matters are tabled as part of the next stage in the Basel Committee’s schedule: Basel III. These include a reworking of the definition of capital, the introduction of a model-based approach to risk measurement and efficient capital allocation and, more generally, the introduction of rules that can take account of market developments and product innovation over time.

There are other more fundamental issues that must be considered before international capital standards may move beyond Basel II. While there is an immediate need to set a robust framework that can sustain future development, there is also a strong argument against a “Big Bang” implementation plan. Introducing enduring step-changes in banks’ risk management practices cannot be achieved by Basel II alone; rather, Basel II should be viewed as one component in a myriad of 21st century banking practices. Banks are currently tasked with establishing sound technological infrastructures, ensuring staff possess the necessary expertise and developing prudent risk management practices across all business lines, all the while seeking to gain a competitive advantage and increase profit. Looking beyond the periphery of Basel II itself, the alignment of accounting standards more closely with regulatory capital standards is an undertaking that will likely prove essential to the future of international capital adequacy standards.

However, it seems that, while the ink is still drying on Basel II, market participants are becoming overly concerned with how Basel III might look. There is a clear need to develop lasting prudential standards over time under Basel II before a move closer to Basel III is made. The Basel Committee and international bank regulators are urged to let the ink dry on Basel II before embarking on the long road towards a third Accord.

¹ International Convergence of Capital Measurement and Capital Standards, Basel Committee, July 1988.

² International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Basel Committee, June 2004.

³ The main risks to a financial institution are credit, market and operational risks; capital to cover other risks is generally regarded as being swept up by capital provisioning for these.

⁴ References in this article to banks should be regarded as including all types of regulated entity to which the Basel II rules will apply (e.g. within Europe, the Basel II Directives will apply to all “credit institutions” and investment firms).

⁵ The term used in Basel II to describe these agencies is “External Credit Assessment Institution”.

⁶ The “re-cast” Banking Consolidation Directive (Directive 2000/12/EC) and the “re-cast” Capital Adequacy Directive (Directive 1993/6/EEC).

⁷ At the time of writing, the implementation date for Basel II is still uncertain in many jurisdictions. Within the EU, implementation is likely to be required by 1 January 2007 for the standard approaches under Pillar 1 as well as Pillars 2 and 3; implementation of the advanced approaches under Pillar 1 will be required by 1 January 2008. National regulators, however, (in particular, the UK FSA) favour a single implementation date of 1 January 2008. A 1 January 2008 start date means almost 20 years will have lapsed between Basel I and Basel II.

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