Creating Value from Basel II Implementation
International banks typically proceed through three distinct stages along the continuum. While banks may have implemented differing vendor solutions or built technological frameworks during each of the stages outlined below, the existence of technology platforms erected during each stage does not appear to be a barrier to progress along subsequent stages of the continuum.
In the first stage of compliance, banks often struggle with data issues. These are:
Banks have varying expectations of the Basel approach they undertake. For instance, bank A, adopting an internal ratings-based advanced approach for credit risk, will have to handle significantly more data than bank B who is planning to adopt the standardised approach. Common to both approaches is the validation of internal ratings data. For this, banks would depend on default data supplied by an external data provider. However, only the internal ratings-based approach requires data about recoveries – and not the standardised approach.
In all cases, data availability begins with an understanding of the data required for a chosen approach (also the ability to find incremental data when mandated by the home or host country). Data element identification ensures that the bank knows the data that is required for its preferred approach.
Once data is identified and available, banks need to ensure that the proper channels are created to move data out of the appropriate transaction systems into a repository or central risk warehouse. Many banks have several such warehouse investments, but often these do not have nearly enough of the risk data elements required. Even if they do, the data elements are often not at the suitable level of granularity required for downstream capital computation of risk weighted assets. Subsequently, the pain of enhancing such repositories to include the appropriate data is a challenge that must be properly addressed.
Banks must seek to reconcile accounting system data with general ledger data, and pass necessary adjustment entries in order to ensure that they are synchronised.
The importance of ensuring strong data quality processes during the build and delivery of the risk central repository, should not be underestimated. International banks will be serving multiple regulatory masters during the Basel II supervisory review process, and bad data entering into a capital computation system, no matter how powerful the system, will result in extra work for the finance organisation in correcting the numbers.
As banks grow more confident in the quality and availability of their data, and move along the continuum, they face a new set of challenges. Inherent to the Basel II compliance process, is an accurate means of estimating the probability of default (PD) of an obligator or the loss given default (LGD) of an exposure.
Here, numerous landmines await most banks. Given that models for PD must be based on historical default data, the lack of availability of such data severely compromises the bank’s ability to estimate and validate its PD models. Many banks attempt to solve this problem by purchasing published default data from various vendors, but then the bank must ensure that their portfolios correlate to the external default data.
For some businesses, such as private banking, this data is difficult to collect as there is seldom sufficient internal default history or any external data provider. This restricts a bank’s ability to use validated IRB models for estimating PDs or LGDs.
The above problems also lead to the possibility of supervisors being unwilling to accept the PD/LGD estimates provided by the bank since they would be unable to back-test and validate them.
In most cases, the risk group within the bank is the primary owner of the development and implementation of the statistical models used in estimation of PD and LGD, among others.
The Basel II compliance initiative at a bank is complete when it is able to compute regulatory capital and provide the appropriate capital adequacy return reports to regulators. Banks which have progressed through the first two stages of the continuum begin exploring in detail the capital computation process which they perceive to be both well defined (which it is) and easy to implement using simple tools such as spreadsheets (which it is not).
In fact, one may consider the capital computation process to be the most challenging stage of the compliance continuum; due in a large part to the gulf between early expectations and late-stage realisation of the nitty-gritty details, compounded by the ever-shrinking number of days left to comply.
These capital computations performed by a bank span credit, market and operational risk (though in Basel II there is little new on market risk).
Many banks believe that the only decision they will need to take is to pick one of three approaches for calculating unexpected loss – advanced internal ratings-based (AIRB), foundation IRB (FIRB), or standardised. However the abundance of options prescribed in the Accord within these three basic approaches, need to be considered. For instance, there are two options for assigning risk weights and two collateral handling options to choose from within the standardised approach itself.
In addition, within the IRB approaches, there are two different options for treating specialised landing and equity exposures. When one considers all the permutations, and couples these with the requirements for multi-jurisdiction reporting and the necessity to support different approaches for each jurisdiction, the computation process becomes immensely complicated. Therefore, any computational engine, whether bought or built must have the ability to support any and all of these approaches simultaneously, and support the ability to switch between these approaches when necessary.
Moreover, adequately addressing Pillar I and Pillar III to the satisfaction of their supervisors is often overlooked by many banks caught up in the mechanics of the Pillar I calculations. With Pillar III, the requirement to support multiple reporting formats brings its own challenges. For example, supervisors may at any given point, for market discipline purposes, call on a bank to share new information about the risk being carried in their books, which may imply a new set of reports at very short notice. Banks must ensure that the appropriate level of Pillar III capabilities are provided in the solution they implement.
Banks today are discovering the continuum the hard way – by uncovering problems as they stumble along the path to compliance. However, if they benchmark themselves on which stage they fall in along the continuum, and prepare themselves for the challenges that lie ahead, it will not only serve them well in their endeavours towards Basel II compliance but also help them enjoy the benefits of maintaining reduced capital.