Impact of Basel II on Bank's IT Strategies

Today, banks are investing heavily in information systems in order to adopt the Basel II approach and consequently meet the regulatory requirements. Nevertheless, this costly compliance investment provides a great opportunity for the credit institutions to design their future business strategy. Credit institutions have great expectations by investing in IT infrastructure as this investment can provide reduced costs through standardised procedures, as well as new marketing strategies, improved risk management and finally a competitive advantage through the efficient and effective use of technology.

Capital adequacy regulations require a high level of investment in data, models, IT systems and skilled personnel. For example, in the model development process, one huge task is to gather the data in a standardised format, store the data in a data warehouse where it can be easily retrievable and capture enough historical data to stimulate statistical models. This process advocates the development of sophisticated models for identification, measurement and forecasting of the undertaken credit, market and operational risk that requires a sufficient IT infrastructure in order to capture and store large data sets.

As a result, the current priority for banks in terms of technology is to develop a central data warehouse with reconciled data and support the bank to meet the regulatory requirements (e.g. Basel II, Markets in Financial Instruments Directive/MiFID). Most of the European credit institutions are preparing to adopt the advanced approaches under Basel II, thus the need for large data sets and enough historical data is highly regarded. The model development process requires not only historical data sets but also an adequate data quality. According to Basel II guidelines, the data used as inputs into models should be:

• Accurate – data shall be accurate enough to avoid any interpolation of the model’s outcome.
• Complete – data shall provide complete information for the credit institution.
• Appropriate – data shall not contain biases.

Additionally, a regular reconciliation process against the bank’s accounting data shall be established providing an additional quality check. All material divergences shall be further investigated and shall be well documented.

Due to the tight deadlines of Basel II and the lack of adequate resources in IT units, the majority of European banks are planning to buy specialised Basel II software and not develop in-house solutions. The advantage of this strategy is that the bank doesn’t require large resources for developing software, however all these software solutions from vendors have to be tailored to the individual bank, ensuring perfect regulatory compliance. This is not an easy task as this software solution has to deal with many demanding regulatory requirements, especially under advanced approaches:

• Asset segmentation (e.g. corporate – retail asset classes).
• Rating process from external credit assessment institutions (ECAIS) and mapping of their credit assessments.
• Loss collection database and reporting (for operational risk).
• Use of credit risk models as well as monitoring and tracking reporting.
• Validation of credit risk models.
• Stress testing scenarios.
• Risk weights classification per type of financial instrument for market risk.

This is only an indicative list, and in practice the bank is obliged to use most of its effort to have a tailored software solution for its business operations.

New regulatory demands such as Basel II or MiFID put the pressure on the information systems function making banks develop an integrated information systems strategy (ISS) and consequently amend the existing IT infrastructure. Banks should have a sound IT infrastructure that will ensure the integrity of the capital adequacy calculation. The bank’s databases, which are used for this purpose, should be backed up and the IT unit should have documented the respective workflows, the procedures and the IT systems related to data collection and storage. The IT databases should also enable the archiving historical data due to fact that they are essential for the monitoring and testing the effectiveness of models. All the above-mentioned requirements as well as the data strategy and the model architecture shall be included in a bank’s ISS.

ISS is an important factor in supporting the bank’s business, but it can also help the bank meet regulatory requirements. ISS should take into account the prioritisation of key initiatives in terms of costs, benefits, resources and available timeframe regarding regulatory requirements and enable the integration of business activities and data. However, it is important that the key stakeholders understand how ISS can be used strategically and enable the planning of information systems within the organisation, as well as identifying the areas of competitive advantage through analysing the internal resource position and the opportunities provided by the latest information systems technology.

The need for a well-documented ISS that is distributed to key stakeholders and is not highly focused on technology is important. The ISS should articulate how information systems align to bank’s business objectives and priorities and should not be a document in a self.