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What is Basel II?

What is Basel II?

This section describes the nature of Basel 2, written for banking operations managers and IT strategy folk. The reader does not have to be a qualified banker nor an accountant but it does assume some familiarity with the basis of a bank’s balance sheet. It is divided into the following sections

  • Introduction to capital adequacy
  • Central Banks and Politicians objectives of Basel II
  • Key features of the new approach

Introduction to Capital Adequacy

One can imagine a banking world without regulation. In such a world depositors would decide to put their money into a bank based on two factors – what rate of interest their deposits would earn and what is the risk that the bank will go bust, leaving them with no money. In this regulation free world the banks would lend the depositors money where they saw fit based on the rate of interest they can charge and the risk of the borrower defaulting on the loan.

In practice banks are regulated, for a number of reasons but probably the principle one would be to protect depositors. It is felt that they need to be protected because they have very little information about the lending activities of banks and also that lending is very complex for the average man in the street to understand (for example it often involves sophisticated corporate loans with tricky financial instruments such as derivatives). The two principle measures that have been devised are

  • Banks should put up enough of their own funds (Capital) to cover any bad loans that they have made.
  • Banks should supply an independent regulator with information on a regular basis showing the adequacy of the funds that it has put up.

The amount of money that a bank (or more realistically its shareholders) has to put up to cover loans is very important as far as the share price is concerned. The more it has to put up, the more shares it has to issue, the lower the earnings per share and hence the lower the share price. (See worked example for a quantitative illustration). This is a truly vital issue for bank boards and shareholders.

Since many of the banks of the world compete internationally, an international agreement on “how much” money banks should put up was needed to ensure fair competition. The original 1988 International agreement on Capital Adequacy (grossly simplified) was that banks should put up money according to the formula

Sum(loanvalue * risk weight * 8% ) for all loans

The risk weights are centrally defined and are fairly crude, not making much distinction between different classes of risk. The loan valuation rules are also not very sophisticated. This agreement is known as Basel I.

The people who made this agreement are called the Basel Committee on Capital Adequacy and it is composed of the central bankers of the 13 biggest banking countries in the world plus numerous hangers on such as the IMF, the world bank and the EU. More about this organisation can be found at the Basel Committee web site.

The agreement is then implemented in each country, for example, by passing a law or in the case of the UK by the regulator (the Financial Services Authority) creating rules.

Central Banks’ and Politicians’ Objectives for Basel II

The reasons why the original accord must change are several

  • It does not encourage “good risk management”; the current supervisor imposed risk weights do not distinguish whether the loan is rock solid or very iffy.
  • Overall, too much money is set aside to guard against default of very good loans. If the money could be better targeted at riskier loans a huge amount of funds could be freed up to invest in new projects. This could have a material impact on global growth.
  • Some risk areas, particularly operational risk do not get enough management by banks, in part because there is no “Capital Penalty” associated with it

So Basel II is an attempt to redraft the international rules on Capital Adequacy to address the above issues. It has proved a very long process as different countries and banking groups have different priorities. It is hoped we are getting very close to the end. In May 2003 the committee issued its third consultative paper (CP3 in the jargon) which it hopes to formally ratify by the end of this year with a view to implementation in all G10 countries by the end of 2006.

What are the key features of the New Approach?

The best source of information is the 18 page ‘Overview of the New Basel Capital Accord’ dated April 2003 which can be found on the Basel website.

The accord is applied to banks according to the regulators discretion but as a minimum covers all internationally active banks and all major “in country” banks. The following is a brief summary written with business operations and IT strategy folk in mind. The structure of this summary reflects the structure of the New Basel Accord which is divided into 3 “pillars”

  • Pillar 1 – Minimum Capital Requirements
  • Pillar 2 – Supervisory Review
  • Pillar 3 – Market Discipline

Pillar 1 – Minimum Capital Requirements

Currently minimum capital requirements are calculated in two categories

  • Credit Risk
  • Market Risk

With Basel II the capital requirement calculations associated with Market risk are unchanged; the Credit Risk capital requirement calculations are radically changed and a new category Operational Risk has been added. Additionally for these areas a bank has a choice as to how to calculate the minimum capital requirement according to the following table.

fig2-1-1

As you go down the table there are two effects. Firstly, the bank provides more data into the calculations; for example in the IRB approaches, a bank internal view of the probability of default in the Credit Risk calculations is used (as opposed to a value set by the supervisor). These values have to be based on sophisticated statistical models subject to supervisor scrutiny (see Pillar 2 – Supervisory Review).

Secondly, on average, across a large number of banks the calculated minimum capital requirement goes down as you go down the table. (See the results of the Committee’s Quantitative Impact Study(3) of the proposed new accord on the Basel website.) This is in line with the objectives of encouraging more sophisticated risk management processes in banks. It should be noted that in the study there was a wide range of changes in calculated minimum capital requirements as a bank moved from one impact assessment approach to another. Thus whilst the average was for less capital required, some banks required more and others a great deal less.

From an IT strategy point of view there will be a requirement for new richer risk management systems that can get a bank down the table as the potential financial threats and opportunities are awesome. To illustrate this we have put together a simple quantitative example. The IT systems requirement is discussed further in MI Systems Architecture Implications of Basel II and IAS 39. Examples of “richer” systems include treatments of collateral, securitised loans, long term historical averages and statistical analysis of defaults including “stress tests”.

From a Business Operations and IT strategy point of view the appearance of Operational Risk will force the creation of currently non-existent MI systems and processes for analysing and quantifying Operational Risk.

Pillar 2 – Supervisory Review

Because important aspects of the capital adequacy assessments are left up to individual banks, it is felt this freedom must come with a supervisory price. It is expected that regulators, the FSA in the UK, will want to assess the quality of the risk management systems and processes of the banks. Where these are considered inadequate the supervisors can require actions from the bank, including but not limited to disposing of risks or raising extra capital. Aspects of the supervisory pillar that will probably be of interest to business include

  • Data quality, cleanup and maintenance
  • Correct identification of counterparties for concentration risk analysis
  • Stress tests covering infrequent but severe situations such as sectoral or geographic recessions
  • Operational risk management procedures, particularly event logging

More on this can be found in Impact on Business Operations and IT systems.

Pillar 3 – Market Discipline

This last pillar is very sensitive for the banks. The idea is that by forcing banks to publicly disclose more information about their risk profiles and processes the investors and ratings agencies will price the shares more accurately and/or advise depositors on the risk of bank default. These investors and ratings agencies will effectively act as a spur to banks to improve their risk management processes.

From an IT strategy point of view the key here is to ensure such disclosures clearly reconcile with the statutory reporting requirements of the bank’s accounts, which are themselves subject to considerable change as a result of IAS 39. More on this IT implication can be found in MI Systems Architecture Implications of Basel II and IAS 39.

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