Perspectives from Across the Pond - US Banks and Basel II

The long voyage of Basel II towards its ports of adoption in Europe and the US has been a journey around the treacherous waters of risk theory, banking-industry interests and national concerns. It hasn’t been an unexpected trip,because to achieve the longer-term benefits of the Basel II framework, a period of discomfort was inevitable: the potential for adopting banks to experience temporary disequilibrium in the system. This may exhibit itself through new internal systems, different capital and portfolio models, and changing business franchises.

Two-tier Approach

Nowhere, have these broader issues been more fervently debated than in the US and what has emerged has not been the wholesale adoption of Basel II by all banks, but rather a two-tier or bifurcated approach, which has caused some concern among European institutions.

US banks are regulated by up to four agencies: the Federal Reserve; the Office of the Comptroller of Currency; the Federal Deposit Insurance Corporation; and the Office of Thrift Supervision. Together these agencies have formulated a joint approach to Basel II, which ensures that while the US follows the general tenets of the Accord, it retains independence from the European adoption programme (see table 1).

In brief, only the very largest US banks – those with assets of over $250bn, or international assets of over $10bn – will have to adopt the Accord (mandatory adoption). Some eight to 10 banks will be required to implement Basel II under these guidelines. Additionally, other banks will be allowed to opt-in (opt-in adoption), and the agencies have welcomed initial discussions on adoption with any bank. However, a key point is that any bank switching to the Accord, mandatory or opt-in, will have to adopt the advanced internal ratings based (IRB) approach and Advanced Measurement Approaches (AMA). Partly due to the cost, partly due to the project requirements, the number of opt-in banks is expected to range from between five to 15. Interestingly, 30 banks took part in the recent QIS4 survey, which may provide an indication of final numbers (see table 2).

Basel Business Benefits

Whoever eventually adopts, the bottom line remains that banks using Basel II post-2008, will receive significant business benefits, in addition to the more clear benefits of risk management improvement. Any observer of the banking industry’s tentative progress towards risk management nirvana would have noticed conventional wisdom passing through a series of waves. Firstly, there was the initial reaction of “it’s too complex”, followed by “it will cost too much”, then “it will never happen”.

In my conversations with Citigroup clients, it is becoming clear that the top banks in the industry are now getting over the reactive phase, and becoming active in using Basel II as a tool to re-engineer the entire franchise (even if some aspects of Basel II, such as the ongoing home-host issue for US banks in Europe adds complexity to any restructuring). The heightened volumes of bank “in-fill” M&A testify to this.

For Basel II is not just about capital levels, it is about putting in place a higher level of qualitative risk management and control functions, and about communicating this better to external stakeholders (see Figure 1). The opt-in US institutions especially, have understood these core benefits derived from the Accord: they “get it”.

Figure: 1 The industry is past the point of no return, so now must use the Accord as an opportunity

The largest US banks are among the leaders in risk capital thinking, and practical systemic application via measurement, control and mitigation, indeed, the Basel Committee borrowed some best practices from these banks when drafting the final Accord. However, driven by Basel, US banks have been re-enlisting in ‘risk boot-camp’.

For example, we see a comprehensive upgrading of internal risk systems, both technology and overall control architecture. We note the promotion of risk management training and culture within the banks: for example, the active participation of risk management alongside the business franchise. Most importantly, the changes have resulted in US banks stepping back to take a fresh look at their risk systems, and how they can do things better.

Moving Risk Management Forward

One key spin-off from this revaluation has been quite simple – the identification and appreciation of the nature of the full range of risks faced by a modern bank. This has been significant, for example in the field of operational risk, where the US sector is fast moving from a view where operational risk is something handled by the cash-flow, to where all operational risks are identified, and systems put in place to control them.

This is not such an obvious point, because often, US banking practices before the formal adoption of an operational risk framework, involved such risk being over-looked or even ignored – and if a bank can’t identify a risk, how can it control it? Once risks have been identified and controlled, this should result in cost savings to the P&L.

A similar situation exists with regard to the credit portfolio. For example, the matching of collateral or other mitigation to a credit exposure has sometimes been beyond current banking systems, and the Basel Committee in their 2003 response to the QIS3 results noted this². Similarly the US agencies, note a wide variety of cases where system inadequacies resulted in poor data during the same survey³. Results from QIS5 are likely to show a much better matching or risks and mitigation.

More Responsive to Risk

A result of Basel II for advanced approaches, is to ensure that banks can identify risk norms – whether probability of default, or loss given default – at a much more granular level than ever before. In effect, Basel II is shifting the potential to manage risk from the strategic business unit’s CFO, to the sub-SBU (subsidiary business unit) risk and business manager level. Though the board is unmistakably responsible for the risk, the institution itself can become much more responsive to risk. This progress benefits shareholders (who will of course, have access to increased risk transparency through Pillar 3).

Senior management at a bank, possibly for the first time, will know exactly what the skeletons in the cupboard are, rather than just knowing which room the cupboard is in. Basel thus allows management to better handle the risk-reward profile of a bank, and this may mean, limiting risk exposure in one area, or build up risk exposure in another, more attractive, area. In other words, banks will have the ability to pre-empt problem exposures, rather than constantly having to fire fight them.

Regional US Banks

However, this brings its own problems, which have surfaced in the US market place. While some European banks have commented that US non-Basel adopters will have a competitive advantage, the perception of the thousands of US regional and community banks is very different. On the one hand these smaller banks do not wish to spend the daunting amounts of dollars required to introduce the systems and processes which the qualitative side of Basel II requires, on the other they are worried about subsequent competitive effects.

A natural focus has been on the retail mortgage and SME markets, where it is expected that Basel II banks will have an advantage in terms of pricing and the ability to extend more credit. Hence, the community banks envisage the opening salvos of a credit war in their back yards. It is estimated that early Basel adopters, control just 30 per cent of the domestic home loans market in the US, so they have plenty of room to build share⁴. There have been a number of papers providing conflicting views on this point, but of note, one expresses scepticism as to whether a large bank can ever actually extend credit to an “information-opaque” SME⁵.

More Inclusive Standardised Approach

Nevertheless, while the Basel-effect is uncertain, a big lobbying effort has ensued with much discussion between the industry and the agencies. Consequently, the agencies plan to introduce a revision to current risk-based capital requirements in parallel with the new Basel II-based rules by mid-2005. In fact Alan Greenspan is a supporter of such an approach⁶. These new rules are likely to follow the enhanced granularity of the Basel II Standardised Approach without the parallel requirement for expensive qualitative risk control systems.

While such rules would probably satisfy the smaller banks, one needs to pay attention to another Basel II benefit, which is the better picture investors have of a bank’s risks through Pillar 3 disclosure, and their increased comfort in knowing that a bank’s risk systems are up to a certain Basel II standard. To ignore these benefits, may be to ignore shareholder considerations.

This golden thread of risk transparency has run throughout the Basel II debate with relatively little rebuttal, as banks realise the benefits for regulators, investors, analysts, and ultimately their share-price. Indeed, Pillar 3 of the Accord seeks to use the powerful forces of market discipline to ensure that banks take on risks appropriate to their franchise and crucially, disclose the risk control and mitigation measures in place.

We have seen the effects of the new transparency in the accounting regime, with Fannie Mae’s issuance of $5bn of preference shares in December, and the increased number of reinstatements by financial firms⁷. So interestingly, while we are seeing bank capital rules move from principle- to prescription-based, so we seeing a similar trend in the worlds of accounting and corporate governance.

Sarbanes-Oxley

The introduction of Sarbanes-Oxley (SOX), particularly section 404, which requires management to report on the effectiveness of operational and internal control structures, is another example of the wave of future for banking organisation in their external dealings. While SOX is aimed at better corporate governance in the wake of large scandals at US firms, by using the markets as enforcer, much like Basel, it ensures that firms either respond or face investor consequences. Indeed, the “eyebrow raising” increase in financial restatements since the introduction of SOX, must lead to questions about just how rigorous was US corporate governance before 2002.

Many European banks, apart those which are SEC-listed, criticise SOX, but its rules look likely to eventually impinge upon even the most domestic of European banks. One piece of good news, however, is that the requirement of Basel II, go quite a way – and in many cases – beyond what SOX s.404 demands. The ability of Basel to take a risk exposure at a small-scale level, and via the qualitative risk architecture, ensure that that ultimate responsibility rests with the board, is in tune with the SOX philosophy. Indeed, the best practices I’ve seen by US banks have semi-combined the systems requirements and cultural practices of the audit-based SOX and management-centric Basel II into one overall programme. This is a cheaper and more efficient method than a piece-meal approach.

Conclusion

Basel II remains the banking industry’s greatest challenge over the next three to four years, and the need of a bank to respond at the strategic level to this issue, is essential. The US banks may be on the other side of the pond, but they face fundamentally similar challenges and issues as those faced by banks adopting Basel II throughout the world.

¹ See, de Fontnouvelle, Patrick et al, “The Potential Impact of Explicit Basel II Operational Risk Capital Charges on the Competitive Environment of Processing Banks in the United States”, Federal Reserve Bank of Boston, 12th January 2005.

² See Basel Committee on Banking Supervision, “Quantitative Impact Study 3 – Overview of Global Results”, 5th May 2003.

³ See Federal Reserve Bank et al, “Introduction to QIS-4 Survey Package”, 27th October 2004.

⁴ See Calem and Follain, “An Examination of How the Proposed Bifurcated Implementation of Basel II in the US May Affect Competition among Banking Organizations for Residential Mortgages”, 14th January 2005.

⁵ See Berger, Allen, “Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the United States”, Wharton, February 2004.

⁶ As reported in Global Risk Regulator, March 2005, p.11.

⁷ See Fitch, “Accounting and Financial Reporting Risk: 2005 Global Outlook”, 14th March 2005, for a summary of the issues.

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