Fiducitation: Basel Capital Accord

Author: John Munson

Dated: September 21, 2001 – Updated April 20, 2002   © 2001-2002 Fiducité, Inc.

 

Fiducitation: A synthesis of Internet resources, including:

 

Instructions:   Each citation has four parts: Fiducite Annotation, Clip, Source, and Cached File. The Annotation explains the significance of the citation; the Clip is a text or graphic excerpt to help you decide whether to view the complete document, which can be viewed by clicking on the Source URL or the embedded Cached File. All information is attributed to its source.

 

Synopsis

 

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:

 

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

 

Implications

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

 

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

 

 

Overview- Basel Accord Timeline and Proposed Changes

 

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:

 

Official Basel Documents

 

Index to Basel Capital Documents

Clip:

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:

 

Responses by Typical US Super-Regional Banks

 

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 Of 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:

 

 

 

Other Comments- US Rating Services, Consultants, and Associations

 

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 & Poors 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

 

1-year average rate

3-year average cumulative

Minimum (3-year)

Maximum (3-year)

CCC

21.94

32.32

9.09

52.08

B

5.3

14.93

7.9

24.38

BB

0.98

5.27

1.24

12.24

BBB

0.22

0.77

0.0

1.97

A

0.04

0.19

0.0

0.63

AA

0.01

0.08

0.0

0.33

AAA

0.0

0.03

0.0

0.45

 

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:

 

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:

 

The Fed Reacts

 

 

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:

 

What Banks Have To Do For Basel II According To The Fed

Annotation: PowerPoint presentation by Marc Saidenberg of the Federal Reserve Bank of New York, specifically addressing the Pillar 2 Supervisory Review Process of the proposed new Basle Accord. Includes their Economic Capital Competency Center and emphasis on credit risk measurement and modeling

 

Source: http://www.erisk.com/news/Events/pdfs/basle2_saidenberg.pdf          Cached File:

 

RMA Journal

Annotation: This is a seminal paper by the Fed on enhancement of internal credit risk rating systems. Precedes Basel II but reflects Fed thinking.

Clip: A revolutionary change. An IRB approach would be a revolutionary change from the current Basel Accord. Regulatory minimum capital requirements for credit risk would be based on the bank’s internal rating system and the measured risk characteristics associated with each grade and certain other aspects of the bank’s exposures.

Source: http://www.erisk.com/reference/archive/001_treacy.pdf                                     Cached File:

 

 

 

International

 

OECD vs. Emerging Countries

Annotation: This document discusses how the volatility of emerging country capital flows would be worsened by the Basel Accord’s greater emphasis on market assessments of risk.

Clip: The trouble is, with the new proposal to use independent credit ratings to set the risk weights, the reverse becomes true. In fact, OECD countries currently rated below double A have much to lose under the Basel II proposals. For example, risk weights for claims on Turkish sovereigns, whose B credit rating puts them in a non-investment grade, would jump from the zero rating they get from being an OECD member to 100%, a rise which would probably drive up borrowing costs. In contrast, non-OECD countries could benefit from the changes, particularly some emerging markets.

Source: OECD Observer                                                Cached File:

 

 

Electronic Banking / Technology

 

Worries That Electronic Banking Creates Operational Risk

Annotation: If technology has made progress in assessing risk in the banking industry, it has also contributed significantly to increasing it. In fact, risks from electronic banking activities account for a great deal of the Basel II revisions. On May 3, of this year, the Basel Committee issued a report entitled Risk Management Principles for Electronic Banking which addresses cross - border banking and the risks inherent in transmitting information globally to countries that may have differing security standards.

Source: http://www.bankersonline.com/vendor_guru/fo/fo_century.html                      Cached File:

 

Coley Clark: An Outsourcer’s View

Annotation: Coley Clark, head of EDS’ Financial Services Division, discussed the relationship between technology and Basel II in an interview

Clip: One of the things you want to do is get some of the operational risk off your books, and outsourcing is one way to help do that. There is, though, a regulatory consideration. It varies from country to country. Some governments are looking at relationships once they are in place, while others want to approve outsourcing relationships ahead of time. Basically they just want to ensure the company being outsourced is financially viable and operationally capable.

Source: Link                                                                                                                    Cached File:

 

MKIRisk

Annotation: Risk management vendors are already preparing for Basel II requirements. Below is an example.

Clip: In light of the latest recommendations from Basel, MKIRisk will extend the functionality of Risk Vision to specifically integrate support of all 3 credit risk calculation methods detailed in the Standardized option and the Foundation and Advanced Internal Rating Based (IRB) approaches of the New Accord

Source: http://www.cats.com/news/index.asp                                                                 Cached File:

 

Numtech

Annotation: This vendor is also working on Basel II related functions and research.

Clip: The multi-factor correlation theory or the portfolio theory described in Harry Markowitz's doctoral dissertation at the University of Chicago in 1952 forms the theoretical foundations of modern risk management models. It seems common now, but was a path breaking idea. Markowitz won a Nobel Prize in economics in 1990 for this achievement. However, his theory had the weakness of requiring huge numbers of calculations where all of the risk elements must do round robin, which meant the theory was difficult to implement pragmatically. Instead, the single-factor model, i.e., the capital asset pricing model (CAPM) created by William Sharp, one of his pupils has become standard. Due to the limited computing capacity of the time, he had to progress on the basis of several rough assumptions. Generally, the CAPM is well known as the "stock beta theory." The recent proposal for capital standards issued by the Basel Committee on Banking Supervision are simply rules based on the assumptions made in the CAPM context. Today's financial theories are still built on many other assumptions (e.g., an infinite liquidity), which do not exist in the real world. The content of financial textbooks for universities and graduate schools is also far removed from the real financial world. However, the reality often acts against pure mathematics. Boundless faith in financial theories built up on rough assumptions have been responsible for destroying the operations of many financiers, including those involved in the dynamic hedging of options (and the successive rise of listed options), the death of portfolio insurance (PI) strategy on the Black Monday (1987), and the collapse of the LTCM (1998). It sometimes was one of the sources of crisis facing the financial system. Time has changed. Solutions can now be obtained for thousand-dimensional dense matrices or millions-dimensional sparse matrices at a reasonable cost, without using expensive hard-to-handle supercomputers and library from FORTRAN. We suggest with confidence leaving aside CAPM and the like and getting straight to the output! Simulation is not a panacea for every problem, but surely great progress when looking back the history up to the establishment of CAPM.

 

Source: http://www.numtech.com/                                                                                                Cached File: NA

 

 

Case Study

 

Cap Gemini Ernst & Young IRB Solution

Annotation: Vendors have already begun to help banks prepare for Basel II. This unidentified trust bank invested in diagnostics and improvement projects.

Clip: The project put into place the infrastructure to meet requirements for the IRB advanced approach. Had this not been undertaken, the company expected it would have had to increase its capital by approximately $10 million. Additional value provided included:

·         New system selection to replace outdated limits management system

·         Improved information to senior and executive management

·         Enhanced credit risk management knowledge transfer

·         Updated credit policies and procedures

·         Data availability through new warehouse

·        Preparation for Basel Accord Operational Risk requirements