US Regulators Play Hardball on Basel II
Major US banks have a tough time ahead over the next 12 months. The current credit crunch has undermined confidence in risk management requirements, giving banks and regulators motivation enough to question current methods and systems. There is, however, already a plan underway to tighten up these disciplines in the US with the implementation of Basel II.
Due for implementation in 2009 by regulatory agencies, Basel II is intended to create a global ‘level playing field’ for banks in terms of risk/reserve ratios. Variation in worldwide implementation has, however, been common. In the US, for instance, the Accord will only be applied to the first and second tier banks for which strong risk calculations are imperative and those regional banks that believe they will benefit from potentially reduced capital reserves through improving their risk measurement.
Regulators had envisioned the implementation of Basel II in other markets as a force for good in underpinning the risk management of banks and financial services houses. In Europe, its introduction was seen as a critical update to the original Capital Adequacy Directives (CAD I and II), and an extension to the credit risk-intensive Basel I.
Basel I was adopted by the vast majority of countries with any significant financial services industry in various forms during the late 80s and early 90s, however its limited focus on credit risk constricted the situations in which it could be effective.
Basel II broadens the area of coverage to include operational risk with differing levels of complexity in the risk measurements – for credit risk, the Accord offers a Standardised Approach, a Foundation Internal Ratings Based (IRB) Approach and an Advanced IRB; for operational risk there is a Basic Indicator Approach (BIA), a Standardised Approach (STA) and an Advanced Measurement Approach (AMA); market risk is simply measured by the Value at Risk estimate (VaR). These variations allow banks to reduce their capital reserves by providing more detailed analysis of their individual risk exposures.
The US regulatory agencies, like most national regulators, are not adopting the Accord without some adjustment:
Before Christmas 2007, the SEC announced its Final Rule on the use of the Advanced Approach of Basel II. The Final Rule defines the measures that must be taken by banks that are to use the Advanced Approach, with a ruling on the Standardised Approach to be confirmed in 2008.
Time is tight. The last date for submitting a plan to the regulatory agencies for using the advanced measures is April 2008 and banks doing so should push ahead. Experience from Europe and Canada tells us that leaving this to the last minute can create significant problems.
But the international experience does not easily translate across to the US. US regulators have created a conservative framework for institutions, with tougher interpretations of the rules in a number of areas. For example, US institutions will not have an interim reporting period such as that implemented by the regulator OSFI in Canada. For the most part, core institutions will also not be able to switch between approaches as they have done in certain other jurisdictions.
The capital floor levels during transitional periods – the maximum amount of capital that banks can reduce their holdings by in proportion to their original capital levels per year of reporting – is one major difference between US and European businesses. As the original idea of the Accord was to have international capital floors that are the same across the world this could have a significant impact on competitiveness.
Where the New Accord offers banks floors of 90% and 80% for the first and second years respectively, the Final Rule floors are much more conservative, set at 95%, 90% and 85% for each respective year. With three of the top five world banks (by tier one capital) based in the US, the levels of capital in question are significant.
One of the major differences occurs in the requirements for data. In order to calculate credit risk requirements, agencies are asking wholesale banks to provide the following levels of data:
Retail banks have the same data requirements except LGD calculations only require five years of data. Overall, US regulatory agencies are looking for greater detail regarding the exposures a bank has than those in other countries. For example, if there are multiple credit risk mitigants to cover a single asset the exposure must be split into parts with each covered by one mitigant and the risk-based capital requirement must then be calculated for each portion separately. This is not the method used by all banks currently and many will be required to adapt their data models accordingly.
Operational risk measurements are also tighter. A big difference between those required in other countries and the US is the historical data requirements. Under Final Rule requirements, banks need five years of historical data where the New Accord requires it is three years of data. Banks are already struggling at the three-year history level, so this could prove problematic. In addition, the operational risk weighting of assets has only been looked at recently – historically, there hasn’t been the same level of attention paid to it that there has been on the credit risk side of the business.
In calculating operational risk exposures, regulators are requiring a 99.9% VaR value over a one-year horizon, which is a very high level of accuracy to be calculated. They realise, however, that many institutions are struggling to have that data and get that level of accuracy so they are allowing institutions to use a standardised approach or an allocation approach if they cannot reach the 99.9% level.
The enormous data requirements and the work that will have to go into credit analytics were both reasons for the delay in the implementation of the Basel Accord in the US. Regulators saw the struggle that institutions were having with this and allowed operational risk work to be put on the back burner. Working out these numbers represents a large challenge for the financial institutions.
There are good reasons for the tougher measures. Regulators wanted a robust and extended scenario analysis to cover any downturn in economic conditions – and the current situation in the CDO/sub-prime markets is a good example of the conditions that need to be considered. This has created a lot of work for the banks, however, many of whom pushed back during the comment period.
Much of the work to be done by banks in the next few months will involve data analysis, cleaning and modelling. Overall it is safe to say that the Final Rule on the Advanced Approach is more ‘prescriptive’ for US risk managers than has previously been seen.