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Table of Contents:

               

Synopsis. 1

Overview- Basel Accord Timeline and Proposed Changes. 3

Official Basel Documents. 3

Responses by Typical US Super-Regional Banks. 4

Other Comments- US Rating Services, Consultants, and Associations. 5

The Fed Reacts. 7

International 8

Electronic Banking / Technology. 8

Case Study. 9

Reference. 9  

 

 

The new Basel Capital Accord will change banks’ measurements and standards for capital. Although finalization has been delayed, the direction of banks’ future needed actions can be determined now. However, the industry impact of anticipated changes may be mitigated by the revised calibrations.

 

Increased Investments

Whatever happens, US regional and super-regional banks will see increased investment in:

 

• Data collection for credit risk time series
• Additional diagnostics to determine current status and deficiencies
• Credit risk modeling and wider diversity of resultant credit pricing
• Mark-to-market valuation of credit risk
• Industry pools of credit risk data, especially for small and medium enterprises (SME)
• More penetration and integration of current and future risk management technology into banks’ operations and policies – there will be an incentive for the advanced IRB approach
• Defining and measuring operational risk and implementing procedures to reduce those risks
• More public, after-the-fact reporting of risks
• More standardization of middle market lending and risks
• More standardization of global accounting principles
• More concern about, and controls on, “electronic banking,” most likely meaning online access for retail and corporate customers
• More outsourcing, as a way to get operational risk off the books of the bank

 

These investments will begin immediately, but will peak during 2003 and 2004. Preparatory actions, especially by vendors, are already underway.

 

Implications

The impact on, and implications for, the industry include:

 

• Higher capital requirements, which could result in less profitable asset mixes, lower P/E ratios, growth restrictions, and merger targets for the most impacted banks
• US regional and super-regional banks will most likely use the “foundation” IRB approach
• Increased consolidation to gain access to capital
• The SME lending business could be hurt depending on the recalibration
• The business cycle’s volatility could be amplified due to raising capital after default rates increase
• Capital allocation will be more transparent but also lead to regulatory capital arbitrage
• Probability of obligor default may influence incentive compensation
• US banks may need at least a single-A rating
• Sovereign borrowing works against lower-rated OECD countries

 

In short, banks and their suppliers should be working today on this issue. Those who delay too long may never catch up.

 

 

Introductory Article Summarizing Current Status of Basel Accord

Clip:

 

Source:  http://www.erisk.com/news/features/basle-update-Aug.pdf              Cached File:

 

Basel Accord II Delayed

Annotation: This is American Banker’s summary of the delay on the Basel Capital Accord from a US bank perspective and what the basic problems appear to be.

Clip: The January proposal was designed to reward, with lower capital requirements, the banks that spent money to upgrade their risk management systems. A bank could choose the "foundation" approach, under which regulators would supply an "internal-ratings-based" model for calculating capital, or the "advanced" approach, under which the bank designs its own IRB model. But as banks began trying on the foundation model, they realized it would produce higher capital requirements.

Source: www.thebankingchannel.com  (Username and Password Required)                                  Cached File:

 

 

Index to Basel Capital Documents

Clip:

• The New Basel Capital Accord: an explanatory note (PDF, 16 pages, 73194 bytes),
  (German translation on the Deutsche Bundesbank website)
• Overview of The New Basel Capital Accord (PDF, 39 pages, 225954 bytes),
  (German translation on the Deutsche Bundesbank website),
  French translation,
  Spanish translation
• The New Basel Capital Accord (PDF, 139 pages, 751224 bytes),
  (German translation on the Deutsche Bundesbank website),
  Spanish translation
• The Standardized Approach to Credit Risk (PDF, 56 pages, 317194 bytes)
• The Internal Ratings-Based Approach (PDF, 108 pages, 590602 bytes)
• Asset securitisation (PDF, 32 pages, 166501 bytes)
• Operational Risk (PDF, 30 pages, 191136 bytes)
• Pillar 2 (Supervisory Review Process) (PDF, 16 pages, 92539 bytes)
• Principles for the Management and Supervision of Interest Rate Risk (PDF, 42 pages, 202453 bytes)
• Pillar 3 (Market Discipline) (PDF, 63 pages, 376386 bytes)

Source:  http://www.bis.org/publ/bcbsca.htm                              Cached File:

 

BIS Response to Comments (June 2001)

Annotation: In response to the 270 comments received from financial service institutions, BIS lists in this press release the concessions made. They include these key points:

Clip:

·         First, consistent with the support that has been received on these points, the Committee remains strongly committed to the three pillars architecture of the new Accord and to the broad objective of improving the risk sensitivity of the minimum capital requirements.

·         Second, the Committee reiterates its desire that the new proposals maintain an equivalent level of regulatory capital for the average bank under the revised standardized approach and that capital incentives between the standardized and IRB approaches should exist to encourage banks to adopt these more advanced approaches to credit risk. The evidence obtained by the Committee thus far, including an initial review of the comments, strongly suggests that the Committee's proposals need further adjustment to meet these objectives. In particular, the Committee anticipates the need for reductions in the basic calibration of the foundation IRB approach, both for corporate and for retail portfolios.

·         Third, the Committee has concluded that the target proportion of regulatory capital related to operational risk (i.e. 20%) will be reduced in line with the view that this reflects too large an allocation of regulatory capital to this risk as the Committee has defined it. The Committee is considering numerous other comments and suggestions related to operational risk.

·         Fourth, the Committee believes that further efforts are needed to ensure that the new proposals deliver an appropriate treatment of credit exposures related to small and medium sized enterprises (SMEs). This is likely to lead to lower capital for SME lending compared to the proposals in the January 2001 consultative paper.

Source: http://www.bis.org/press/p010625.htm         Cached File:

 

Quantitative Impact Study (QIS) Questionnaire

Annotation: Data collection questionnaire was supposed to be submitted to national supervisors by June 1, 2001 with publication later this year. The resultant database may be valuable and banks may see the questions asked as a paradigm of future reporting needs.

Clip:

Source: http://www.bis.org/bcbs/qisquest.pdf                                                 Cached File:

 

 

 

Bank of America Has Concerns

Clip:

We believe that the proposals contained in the Revised Proposal are a step in the right direction. However, we do not believe that the New Accord as proposed in the Revised Proposal is a significant improvement over the present Accord. The current proposals continue to be highly arbitrary. These proposals do not achieve the stated objectives of making minimum regulatory capital requirements a truly risk-related and consistent with economic capital requirements. The advanced approaches described in the Revised Proposal will be costly to implement, but there is little incentive for banks to adopt them rather than the standardized approaches. We believe that further changes must be made in order to produce a revised Accord that meets the stated objectives and provides incentive for banks to use the advanced approaches. Given the alignment of incentives and necessary changes, sophisticated banks should be allowed to immediately adopt the advanced approaches without consideration of floors and without interim periods using simpler approaches.

Source: http://www.bis.org/bcbs/ca/bkofame.pdf                                                Cached File:

 

Bank One Has Many of the Same Problems as B of A.

Source: http://www.bis.org/bcbs/ca/banonecor.pdf                                                      Cached File:

 

Fleet Also Has A List Complaints

Annotation: Fleet felt the Accord would have the unintended consequences of an uneven competitive playing field, of making the business credit cycle worse, of stimulating regulatory capital arbitrage, and criticizes the idea of including the probability of obligor default in incentive compensation.

Source: http://www.bis.org/bcbs/ca/flefincor.pdf                                                                 Cached File:

 

KeyCorp Summarizes Problems For the Retail Portfolio

Annotation: KeyCorp offered ten major comments on the approach to retail assets, including these:

Clip: 

Although the Standardized approach will be constructed at a later date, we still have a perspective on a general format. We envision a Standardized approach that takes into account the following:

1. Diversification effects (i.e., lower risk weights versus Commercial),

2. Different levels of loss depending on LGD (in effect, segmenting by product type),

3. A well-recognized industry tool (e.g., Fair, Isaac’s generic credit bureau score) to gauge credit risk for consumer portfolios.

We do see value in the creation of an industry-pooled database, which would clearly help institutions that do not have a full history of internal data. In reality, Fair, Isaac’s (and Credit Bureaus) databases, which are used to calculate credit scores, are industry-pooled databases. And the odds ratios associated with Fair, Isaac’s scores are based on much larger samples and are as widely accepted as Moody’s transition probability matrices on the corporate side.

Source: http://www.bis.org/bcbs/ca/keycorp.pdf                                                             Cached File:

 

 

 

Moody’s Reaction

Annotation: Moody’s believes that the Basel Accord would create:

·         More “rocket science,” e.g. models

·         More realistic credit pricing

·         More hassle about operational risk

·         Shift away from corporate lending will continue

·         Small banks disadvantaged

·        More consolidation

Source: http://www.moodysrms.com/news/baselaccord.pdf                                          Cached File:

 

Standard & Poor's Reaction

Annotation: They believe that industry pools will be critical to implementing Basel II, but that banks have historically not increased capital prior to business downturns but only afterwards, when they are in a poor position to raise capital, yet that is what the approach would make them do.

Default Rates for Static Pools 1981-2000

 

Source: http://www.gtnews.com/articles_se/3164.html Cached File:

 

Oliver Wyman Commented at Length

Annotation: They saw five benefits, including removal of old perverse incentives, recognition of advanced risk measurement technology, incentives for improved risk management, supervisory flexibility, and greater market role. However, they felt calibration was off and that capital under pillar I would rise and that the Foundation IRB approach would hurt middle market lending. Like others, they panned the operational risk proposal.

Source: http://www.bis.org/bcbs/ca/olivwyma.pdf                                                  Cached File:

 

McKinsey Analysis

Clip: Significant changes in the proposed new Basel Capital Accord are needed to avoid placing unintended burdens on banks and discouraging them from embracing the sophisticated risk-management practices it was intended to promote.

 

             

 

Source: http://www.mckinseyquarterly.com/article_page.asp?L3=71&tk=362299:1119:19&ar=1119&pagenum=1            Cached File:

 

Freddie Mac Had Specific Problems with Mortgages

Annotation: They feel the Accord doesn’t at all reflect the unique risks of mortgages. In particular there are:

 

Clip:

Source: http://www.bis.org/bcbs/ca/fremacrev.pdf                                                    Cached File:

 

Risk Management Association

Annotation: This RMA article states that the greater disclosure required would ultimately lead to risk positions being on a mark-to-market basis and would hurt banks’ P/E ratios.

Source: http://www.rmahq.org/whatsnewRMA.html                                     Cached File:

 

 

ERisk: Measuring Economic Capital

Annotation: PowerPoint presentation giving graphical displays of quantitative data to be needed in banks’ commercial loan portfolios.

                    

 

Source: http://www.erisk.com/news/Events/pdfs/basle2_nakada.pdf     Cached File:

 

CIBC

Annotation: A paper by CIBC discusses the credit risk data banks would need to collect and process:

Clip:

Source: http://www.erisk.com/news/features/crouhymark2.pdf                                           Cached File:

 

Capital Transparency Might Be A Bad Thing

Annotation: “Banks will probably be subject to a much more transparent capital allocation process. Everyone’s view of ‘economic capital’ will change.” Banks will probably be forced to maintain at least a single-A rating, says Guldimann. “Otherwise, their funding costs will be higher in the banking community. That could have a considerable impact.”

To gain an edge against peers who will be held to the same standard capital charges, bankers will have to document the efficiency of their risk controls and resource allocations. That is because the standard capital charges in the new accord can be adjusted by the views of supervisors and by the market.

Source: http://www.banking.com/aba/management_breed.asp Cached File:

 

Subordinated Debentures

Annotation: Some believe that the market could regulate banks’ capital through subordinated debentures. This document is from a conference debate about that topic. John Heimann, ex-Comptroller of the Currency, said:

Clip: I agree that the market is the best regulator. Supervisors and regulators are bloodhounds chasing greyhounds. The bloodhounds may have the scent, but the greyhounds are over the hill in the next county. That is reality. It is not a knock on supervisors and regulators; it is just that they do not have the resources to keep up with the private sector. Therefore, the market is the best regulator. And I think the concept of subordinated debt is excellent. It is worth a try.

Let me tell you a story. When I first became comptroller of the currency, there was a problem, and the examiners figured it out. After we had a long discussion, the head of the department of economics said, and I quote, "I know it works in practice, but the important thing to determine is whether it works in theory." I know subordinated debentures work in theory; the question is whether they will work in practice. That does not mean it is not worth a try. But if it is applied, will it work for the smaller banks, which do not have markets for their securities? In the United States, at least, we have loads and loads of smaller banks. Something has to be done about them, because the market is not going to regulate them using subordinated debentures, and this approach certainly does not apply in the developing countries or most of the developing countries, which represent a lot of the world and most of its people.

So that is problem number one, which brings me to the last point that was discussed--the need for international accounting standards, which I wholeheartedly support. The first part is useless unless you have accounting standards that mean something that everybody understands and unless you have transparency and disclosure.

Source: http://muse.jhu.edu/demo/pfs/2000.1calomiris_comment.html Cached File:

 

 

 

Basel Capital Accord II Summary by Board of Governors of the Federal Reserve

Annotation: This 16-page summary of the Basel Committee proposal was prepared by the Fed, along with a series of questions that are intended to focus commentators’ attention on certain key issues raised by the proposal. It is a good discussion by the Fed of its overview of the first pass at Basel II.

Clip: The proposal embodies a “three-pillars” approach for assessing a banking organization’s capital adequacy. These pillars are: a more risk sensitive minimum regulatory capital requirement; effective supervisory oversight; and strengthened market discipline through enhanced public disclosures.

Source: Link                                                                         Cached File: