The goal of the Basel II Accord is to better align regulatory capital measures with a bank’s inherent risk profile based on credit, market and operational risks. The Accord is an outcome of more than five years of work by the Basel Committee against a backdrop of intense deliberations and dialogue within the industry, and among regulators around specific rules. The process also had more than its fair share of lobbying and political wrangling among a variety of constituents prior to approval of the Basel II capital adequacy framework in June 2004.
Implications of Basel II
Like most financial institutions across the globe, German banks have not been spared when it comes to the quality of data. In Germany, as in many other countries, data remains the key challenge. The main banking associations are actively guiding smaller industry institutions towards Basel II compliance by pooling credit risk data from all corners of the industry. Such cooperation is not typical in the fragmented German banking landscape and will be fundamental in giving smaller institutions access to the volume of data required. This is crucial if they are to remain competitive with less capital at their disposal.
It is interesting to note that Basel II has had less of an effect on the German capital markets industry than on the loan market for small and medium sized enterprises (SMEs). Indeed, the foremost change is centred around the need for more risk-adjusted pricing of loans such as the deployment of next generation rating systems and advanced loss given default (LGD) methodology. Furthermore there is even more pressure on smaller banks because of the scale effects in lending.
A source from a tier 1 German bank explained how the larger banks have models in place that should make them Basel II compliant in time for the deadline whereas some of the smaller banks have internal systems as well but generally these models need to be updated.
Moving on to the implications Basel II has had on individual organisations, there seems to be two main effects. The first one is the impact on internal models where some banks have built new processes and systems in order to comply with the impending mandate. The Bank for International Settlements (BIS) conducted a survey last year among all German institutions, which indicated that most of Germany’s internationally active banks such as Deutsche Bank, Dresdner Bank, HVB, Commerzbank, WestLB and DZ Bank, are preparing to implement the advanced approach at least on a sub-portfolio level by the implementation date. As far as the smaller banks are concerned, the survey highlighted that most of these smaller banks will use an internal ratings approach right from the beginning of Basel II. However, one might ask how there can be such a large number of institutions using the internal ratings approach. The answer is that German banking associations are providing centrally developed risk measurement methods, IT services, default information and so forth to member institutions. This partnership has in turn proved to be a very efficient way for these financial institutions to avoid development costs and to share information, for example, default data.
The second implication centres around the much-needed push for many banks in Germany to bring together the different processes to manage both the regulatory capital of the firm and its business steering via economic capital. In the past, and in some cases the present, there are banks in Germany that are still quite silo-based. Therefore, a significant firm-wide benefit of such an implication, according to an interviewee within another leading German bank is that it boosts more cooperation within different areas of the bank, with the ultimate aim of implementing an enterprise wide risk management framework.
Germany Leading Basel II Compliance Effort?
German banks are using Basel II as the ‘once-in-a-lifetime-opportunity’ to become more competitive. According to research conducted last year by Datamonitor, two Germanic countries, Germany and Switzerland, stood out ahead in terms of Basel II compliance efforts in Europe. This was primarily due to strong regulatory pressures at a local level associated with capital adequacy requirements. The same study went on to state that the UK, Spain, Benelux and the Nordic countries were midway with regards to Basel II implementation but banks in France and Italy were lagging behind.
Broadly speaking at present, there are a few banks in Germany that are leading the Basel II compliance effort and a few, primarily smaller banks, that are lagging behind. Many banks in Germany have invested heavily in elements of Basel II and some German banks are currently leading in some areas of Basel II compliance but not in others. In addition, according to a source from a leading German bank, ultimately, there will be individual banks from different countries leading the effort for mandate compliance as opposed to entire countries such as Germany. Having said this, benchmarks may be established because German financial institutions have had to invest heavily into risk management, in order to obtain the leading edge and that is clearly a benchmark.
Supervisory Capabilities of German Regulators
Given that Germany has a non-centralised banking system with important banks in various cities coupled with the shortage of BaFin’s (the federal financial supervisory authority) supervisory examiners, it may prove to be a challenge for BaFin to be able to effectively audit each bank’s compliance efforts. However much of a strain this will be on BaFin, the regulator has been preparing for such an eventuality. For instance, BaFin is already working closely with the Bundesbank which has a high regional presence. In addition, both of these regulators will have additional resources at their disposal such as external auditors, if required.
On another note, it could be argued that from the regulatory point of view, BaFin and the Bundesbank would like to see not only the types of methodology and formulae that banks use but also if the banks are actively using risk management reports and other outputs in the actual steering of their business lines and firms as a whole.
In order to aid banks, a recent development has taken shape in the German banking industry whereby, the Association of German Public Banks (VÖB) and the Association of German Banks (BdB) have presented a common standard for capturing losses due to operational risk. The standard, which supplements the rules set by the German regulators, deals with the composition of an operational loss, its classification and its separation from losses resulting from credit risk or market risk.
Risk Management
When looking at how Basel II has impacted individual banks’ risk management systems, it seems as though the impending regulations have led German banks to update their internal ratings systems. For instance, one of the leading banks in Germany recently updated nearly all of its 36 rating systems. Generally speaking, it seems as though Pillar 1 of the Basel II Accord has proved to be the most work for banks in terms of implementing measures such as probability of default (PD), loss given default (LGD), exposure at default (EAD) estimates and regulatory capital calculations. However, it would be surprising to find critics that would argue against the idea that the most expensive aspect of Basel II in terms of risk management systems has been the actual collection of data.
Broadly speaking, most of the banks in Germany, predominantly the smaller institutions are aiming for Foundation Internal Ratings Based (FIRB), whereas the larger, namely tier 1 and large tier 2 banks and those banks with real estate lending are striving towards Advanced Internal Ratings Based (AIRB). In support of the larger banks, two sources at two leading German banks cited that their respective organisations are aiming towards AIRB. Furthermore, there are even some banks at present that wanted to use the standardised approach, but are now being forced by BaFin to use the FIRB methodology. Needless to say that these institutions are not too happy about spending a double-digit million-euro amount on IRB.
Moving on to the area of operational risk management, many leading banks are still collecting data for the Advanced Measurement Approach (AMA). Intriguingly, in some cases, even these banks do not have enough data to assess the impact of AMA, therefore it could be argued that, some institutions will try AMA, but at the beginning of Basel II, every German bank will use the basic indicator and standardised approaches. Furthermore, two sources that Lepus consulted, both explained that their respective organisations, being leading German banks, are striving towards AMA.
BaFin conducted a study into the implementation of Basel II by German banks in 2003 and below is a diagram, which depicts responses from 1476 German banks with regards to their Credit risk and Operational risk management.
Source: Derived from BaFin
Looking at the graph above, it is hardly surprising to note that the majority of German banks are aiming for the Foundation/Standard approach with regards to their credit risk measurement and Basic Indicator Approach in terms of their operational risk measurement. This could be due to the fact that there are many small financial institutions in Germany at present and perhaps these organisations can only afford to comply with Basel II at the most basic level.
Going Forward
In conclusion, it is important to emphasise that Basel II is a comprehensive Accord that will undoubtedly change the German banking landscape. It could be argued that the smaller institutions might not fully appreciate the investment they need to factor into their compliance efforts but surely given time, they should reap the benefits and possibly build their own ratings based models in-house rather than having to rely on banking associations.
The regulators, both BaFin and the Bundesbank, have their work cut out if they are to properly supervise and audit each bank. It is reassuring to see these two regulators forging links and working closely together. However, they may still have a shortfall when it comes to the number of staff they actually have who are appropriately trained to audit banks but only time will tell.
It will also prove interesting to note if Germany alongside Switzerland will still lead the Basel II compliance effort in the months running up to the deadline date and if countries such as France and Italy suddenly emerge as rising stars and begin the contest to lead the race. Having said this, it seems unlikely that the countries that are currently lagging behind will be able to ‘catch up’ with the leading two Germanic economies in time for implementation.