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The shifting sands of Basel II

Four months after the Basel Committee on Banking Supervision closed the consultation period on its January 2001 draft for a new international capital Accord, it has already made major amendments to its proposal.

    • Carola Schenk
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It has, for example, cut the capital charge for operational risk to 12%, from 20%. It has also moved the capital charge for credit risk mitigation techniques, the ‘w’ factor, from pillar one of the new Accord, the minimum regulatory capital rules, to pillar two, the supervisory process. And it has delayed implementation of the new Accord, dubbed Basel II, by one year to January 2005, while lightening the information disclosure burden on institutions.

The banking industry broadly welcomes these moves. They meet some of its key concerns about the January proposals, and indicate that the Committee is willing to listen to the industry. “I am pleased, to say the least,” says Michael Ong, chief risk officer at Crédit Agricole Indosuez in New York. “A lot of the complaints made about the January version are quickly being corrected.”

But the industry expects further key modifications to the January proposals in the next few months, in particular with respect to credit risk management. “The announcements over the past four months have mainly been on operational risk and on disclosure obligations. On the credit risk side, some of the major changes have yet to be announced,” says Christine Palmer, a senior manager in the credit risk management practice of Ernst & Young in London. The Basel Committee last month published working papers on operational risk and market discipline (see www.bis.org).

The credit risk rules are at the heart of Basel II, whereas the old Accord focused very much on market risk. A key concern for bankers is that the charges in the standardised approach for calculating regulatory credit risk capital lack granularity. Calibrations for risk weightings in the internal ratings-based (IRB) approach also remain unclear, and bankers want more capital incentives for adopting the advanced IRB approach.

Concerns also remain on the controversial ‘w’ factor, designed to cover residual risks from credit risk mitigation techniques such as credit derivatives. Moving it to pillar two, as the Committee has done, will lead to a more risk-sensitive regime, but may also result in an un-level playing field, as some supervisors may implement an additional charge for residual risks, while others may not. To avoid this, the Basel regulators must come up with clear guidance on the circumstances in which supervisors can apply the ‘w’ factor and define what residual risks they consider problematic.

The industry also wants detailed proposals on how the ‘w’ factor will be applied to the trading book. So far, the Basel Committee has only said the factor will also apply to that book, not just the banking book, as the January proposals seemed to indicate. “One key concern is the relationship between capital and accounting rules that apply in the trading book, which is marked to market,” says Robert Charnley, head of European regulatory reporting at Goldman Sachs in London. The banking book typically is not marked to market.

Issues that bankers also keenly await clarification on from Basel include the treatment of specialised lending activities and its approach to asset securitisation. The Committee will publish working papers on these topics in early October, but it declines to elaborate. Bankers also expect more details on the treatment of banking book equity and expected losses in retail portfolios. The Committee recently published a working paper on the former and is working on the latter.

Operational risk, the other key new issue for Basel II, was dealt with, but in broad terms in the January draft, and bankers have welcomed the Basel Committee’s recent working paper. Most importantly, banks will have more flexibility in measuring operational risk and room for progress in doing so, they say. But more work is necessary. For example, Basel must define the criteria insurance contracts would have to meet to qualify as risk mitigants.

The Basel Committee will not elaborate on the topics it is working beyond what it has already made public on the Bank for International Settlements website. It says it will publish its third and final consultative paper on the new Accord in the first quarter of next year, and that it aims to finalise Basel II by the end of 2002.Risk

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