S&P: compromises could lead to “meaningless” Basel II

S&P is concerned that regulators may feel obliged to allow banks in their jurisdictions to use the foundation or advanced internal ratings-based (IRB) approach to measuring credit risk whether or not the banks are competent to do so. “This would be a mistake as it could negatively impact existing capital levels,” S&P said in its report on the ratings implications of the Basel II for North American banks.

The complex, risk-based and oft-delayed Basel II Accord will determine from late 2006 how much of their assets major banks must set aside as protective capital to guard against the risk of loss. Bank using sophisticated risk management techniques, such as the IRB approaches, would enjoy lower capital charges than banks using cruder methods.

S&P said some degree of conflict among regulators is inevitable because banks have different recovery rates and balance sheet structures in different legal jurisdictions. “The risk is that this could end up completely jeopardising the ‘level playing field’ concept, depending upon where, and to what extent national discretion is permitted.”

The Basel Committee on Banking Supervision, which is the architect of Basel II and the body of senior banking supervisors from the leading economies that in effect regulates international banking, has little choice but to allow some flexibility in dealing with issues of national interest, S&P said.

S&P said many banks should not be allowed to use the IRB approaches because they lack the necessary systems and controls to measure risks. The biggest stumbling block will be for them to come up with sufficient historical default and correlations data. To a lesser extent, they will be challenged by the adequacy of their internal systems to track risk management performance.

S&P said at present all of the major banks in Canada, and at least 30 large banks in the US will probably qualify to use the advanced IRB approach. This number could increase depending on how long it takes to implement the new Accord.

But credit rating downgrades could result if banks attempted to reduce their protective capital levels due to more favourable treatment under the Basel II Accord while keeping their risk profiles unchanged. S&P said this reflected the agency’s view that banks in general are currently not overcapitalised, and that many emerging market banks are vulnerable to even moderate levels of stress.