05 July 2004

Observations on new Basel II Accord

In an article on the new Basel II Capital Accord Professor Benink from the Rotterdam School of Management states that the new Accord seems to express supervisory concern about the reliability of the internal ratings systems.

Basel II creates all types of problems with respect to the risk measurement from the supervisory point of view which have to be addressed by the application of a potentially substantial degree of supervisory discretion based on pillar 2 of the Basel II Accord.

Market discipline could play a counterbalancing role since the risk assessment would prevent banks from lowering their capital too much and, hence, would reduce the need for supervisory discretion.

The Basel II Accord contains many information disclosure requirements. At the same time, however, it fails to create incentives for professional investors to use this information in an optimal way. A mandatory requirement for credibly uninsured subordinated debt could improve this weak side of Basel II.

Full Article of Professor Benink

One of my main observations is that the Basel II Accord seems to express, much more than the 1999, 2001 and 2003 consultative papers, supervisory concern about the reliability of the internal ratings systems which are designed by the banks in order to determine the regulatory capital requirement. For instance, in point 9 of the overview paper the Basel Committee states that 'national authorities may use a supplementary capital measure as a way to address, for example, the potential uncertainties in the accuracy of the measure of risk exposures inherent in any capital rule or to constrain the extent to which an organisation may fund itself with debt'.

Moreover, in point 10 the Committee says that '... even in the case of the internal ratings-based (IRB) approach, the risk of major loss events may be higher than allowed for in this Framework'. As we know, exactly these major loss events, usually having a low probability but being hard to capture in terms of probability distributions and IRB systems, are key in terms of stability of the banking and financial system. Apparently, the Basel Committee is concerned that the IRB approaches are not able to capture low-risk, high-severity events and, therefore, raises the question of requiring additional capital above the minimum based on IRB models.

The issue is emphasised in Part 2 of the Basel II Accord (in the overview paper click 'Part 2: The First Pillar - Minimum Capital Requirements'). In point 45 the Basel Committee discusses transitional arrangements and so-called 'floors' with respect to implementation of the Accord. For instance, with respect to the advanced IRB approach, banks will be allowed to use their IRB models in order to calculate the regulatory capital requirement from year-end 2007 but the reduction in regulatory captital is limited to 90% of in 2008 and to 80% in 2009. So even if a bank's IRB model indicates that a reduction to 60% of the current 1988 Basel I requirement would be justified, the floors of 90% and 80% will prevent this to happen. Interestingly, the Basel Committee is keeping open the option of keeping the floors after 2009, preventing banks to grasp the full benefit of lower regulatory capital. In point 48 it says that 'should problems emerge during this period, the Committee will seek to take appropriate measures to address them, and, in particular, will be prepared to keep the floors in place beyond 2009 if necessary'.

In point 49 the Committee elaborates on this issue and says that 'the Committee believes it is appropriate for supervisors to apply prudential floors to banks that adopt the IRB approach for credit risk and/or the Advanced Measurement (AMA) for operational risk following year-end 2008'. Naturally, this supervisory discretion in defining floors is not rather consistent with the current exercise of supervisors validating the reliability of banks' IRB systems.

Moreover, there is a huge scope for an unlevel playing field based on this regulatory discretion when the Committee reasons in point 49 that 'supervisors should have the flexibility to develop appropriate bank-by-bank floors that are consistent with the principles outlined in this paragraph, subject to full disclosure of the nature of the floors adopted'.

In point 14 of the overview paper the Basel Committee reiterates that it wishes to keep the aggregate level of capital in the banking system stable. In this respect, the Committee will further review the calibration of the Accord prior to its implemention. Based on the last Quantitative Impact Study (QIS-3) published in May 2003, overall banking capital in the G-10 and EU countries would be falling, which would have to be 'repaired' by using a single scaling factor of 1.06 to the IRB capital requirement. This scaling factor is likely to change because of the QIS-4 exercises which will be conducted later this year and early 2005 in the U.S. and several other Basel Committee countries.

The question remains to what extent national supervisors will be willing to have overall regulatory capital fall for the whole group of banks operating under their jurisdiction. For instance, if the Basel Committee sets the scaling factor in such a way that overall banking capital in the EU and the G-10 remains more or less the same, it could still be the case that, based on the risk characteristics of their portfolios, all banks in a particular country could be entitled to lower regulatory capital. What is unclear is whether national supervisors would be willing to allow this to happen in their national market (e.g., regulatory capital in the British banking system falls by 40%).

Although the Basel II Accord provides sound incentives for banks to professionalize their risk measurement and risk management, it creates all types of problems with respect to the risk measurement from the supervisory point of view which have to be addressed by the application of a potentially substantial degree of supervisory discretion based on pillar 2 (supervisory review or pillar 2) of the Basel II Accord. Market discipline (pillar 3 of Basel II) could play a counterbalancing role since the risk assesment by professional investors on financial markets would prevent banks from lowering their capital too much and, hence, would reduce the need for supervisory discretion. The Basel II Accord contains many information disclosure requirements. At the same time, however, it fails to create incentives for professional investors to use this information in an optimal way. A mandatory requirement for credibly uninsured subordinated debt could improve this weak side of Basel II. Unfortunately, we will have to wait for Basel III in order to incorporate such a more credible form of market discipline.

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