A cost/benefit approach to Basel II
The cost of implementing Basel II could put banks at a competitive disadvantage compared with non-banks, and spur them to ‘de-bank’ to avoid this regulatory burden. Harry Stordel and Andrew Cross say regulators must look at the provisions from a cost/benefit perspective.
This development, to some extent, is due to regulatory arbitrage. The latter has operated through the different treatment of banks and other financial service providers in three areas: capital requirements, cost of operating and the profitability of the product mix composition. The new Basel Accord’s provisions have repercussions on all these three areas.
Basel II’s impact on capital requirements has been widely discussed and approximated by the Quantitative Impact Studies, with a general acceptance that the current calibration is too severe. However, the cost and product mix composition implications of Basel II have so far received little attention. These are crucial when choosing whether to provide financial services as a bank or a non-bank.1 The high costs involved in operating Basel II would provide a strong incentive to de-bank. This would speed up the regulatory crowding-out process and further exacerbate the eroding relevance of banking supervision for the stability of the financial system.
The aim of this paper is to provide a framework for evaluating the cost/benefit issues resulting from Basel II. First, it reviews the cost of moving to the various provisions of Basel II, then a high-level gap analysis framework is discussed and a scenario analysis of the gap cost implication for the banking community is performed. Finally, core processes required by the internal rating-based foundation (IRBF) approach are analysed in terms of the benefits and running costs they trigger, and concrete examples are identified to improve Basel II’s cost/benefit ratio.
Costs of moving forward
The requirements of the three Basel II pillars have wide-ranging implications for risk assessment methods, risk management processes, data collection, staff, training and IT systems. They will result in higher staff costs – driven by a stronger need for specialists – significant investments in IT systems and the redesign of work processes. The cost implications are further exacerbated if an identical risk management approach would be needed across an entire organisation, particularly for units currently using solutions tailored to their specific business.
Basel II’s provisions, while resulting in additional cost, will also provide benefits via improving the quality and robustness of bank risk management systems. Figure 12 summarises the combined relevance/cost impact for each pillar 1 option, relative to the present state.
The positions of the pillar 1 options in a relevance/cost assessment depend on the congruence between Basel II’s provisions and the expected trend in risk management practices, as well as the features of each individual bank. Generally it would be expected that the relevance gain as compared to a typical present state would increase as an institution moves from the standardised to the IRB foundation (IRBF) and finally the IRB advanced (IRBA) option. Similarly, the additional cost compared with the present state increases markedly as one moves from the standardised through IRBF and to the IRBA approach. However, the additional cost also depends upon the path taken to move from the present state to the various options, as the more ‘indirect’ this path is, the higher the cost reflecting the inefficiencies of changing processes and systems. So, for example, moving from present state to the IRBA via the standardised and the IRBF will be more costly than moving directly to the IRBA in one go. The path taken by a bank is relevant, as only a limited number of institutions will be able to enter the new regime at the IRBA level.
The cost efficiency frontier reflects the boundary at which the additional regulatory cost corresponds to the relevance gain. All points below this line are sub-optimal for banks targeting the evolutionary approach towards IRBA.3 While figure 1 provides a coarse assessment of pillar 1 cost/benefits, it is not sufficient to provide indications on how to effectively improve the cost/benefit ratio of the Basel II provisions. It is thus important to work out the details of this coarse indicative cost relevance impact for the IRBF approach. For that purpose, the cost/benefits of operating with a Basel II bank licence and without when offering financial services needs to be compared at a higher level of detail. In this context, it is helpful to distinguish two cost components:
· the gap costs, ie, costs related to moving from present state to Basel II requirements. These include the costs in moving from one Basel II approach to another; and
· the running costs, ie, costs related to remaining compliant with Basel II on an ongoing basis, once a bank has filled the gap between the present state and Basel II requirements.
Gap costs
Basic framework. A Basel II gap analysis evaluates the present state of an individual institution in terms of its ability to fulfil the provisions of Basel II. Based on this gap analysis, each individual bank would estimate the cost and benefits for filling the identified gaps. The cost and benefits analysis constitutes the basis upon which management decides which Basel II implementation option to take. As the stringency of the requirements increases, so too does the cost (and regulatory capital charge benefits) associated with reaching them. The left-hand side of figure 2 reflects this for the three different Basel II approaches.
Two dimensions for performing such a mapping need to be considered:
1. Basel II requirements, and
2. the areas affected by these requirements within the bank.
Both these dimensions can be specified at various levels of detail. So, for example, the requirements of Basel II could be analysed on the pillar-level down to the paragraph level or for a subset of those. The areas affected by the Basel II requirements could be analysed on the division-level down to the individual working process-level, or a subcomponent of those. The right-hand side of figure 2 provides an example for such a gap analysis, considering Basel II requirements relating to the credit rating process, the risk mitigation, operational risk and reporting (in the rows) and major areas in risk management affected by these requirements, eg, the evaluation methods, work processes, IT systems and underlying data (in the columns). Figure 2 also provides a coarse qualitative assessment of the present state of three types of banks in that matrix.
It is most likely that banks will aim for a given pillar 1 option dependent upon their present state in fulfilling Basel II’s requirements, and not all will go for the IRBA approach. In this sense, the right-hand side of figure 2 provides the features of individual banks likely to go for the standardised, the IRBF and the IRBA options, respectively.
Gap cost scenario
According to consulting firms commissioned to perform gap analyses, medium-sized banks would have to expect costs of at least $50 million to get ready for the IRBF approach (Group F banks). It is reasonable to assume that banks aiming at the standardised approach (Group S banks), given their lower starting point, are likely to have to perform similar levels of investments to qualify for the standardised approach, but scaled down to their smaller size. Assuming such banks are, on average, 50 times smaller than medium-sized, banks they would have to spend about $1 million to get ready for the standardised approach. Owing to their size and complexity, banks aiming for the IRBA (Group A banks) are likely to have to spend much more than medium-sized banks aiming for the IRBF. Assuming a factor of 3, Group A banks would have to have investments up to $150 million to get ready for the IRBA. Table A summarises the cost implications for the banking community, for group S, F and A banks operating the standardised, the IRBF and the IRBA approaches respectively by 2006.
It is difficult to precisely assess the additional gap costs that banks will bear as a result of the implementation of Basel II, as they correspond to an investment in more sophisticated risk management systems and processes tailored to the very specific needs and the degree of complexity of the individual bank. It is also likely that indirect costs will rise with increased audit review and regulatory assessment in addition to any extra costs for regulators. However, based on relatively conservative cost assumptions, the additional cost of Basel II will be in excess of $150 billion for the banking community as a whole, ie, representing just under 10% of its total tier 1 capital. As a consequence, Basel II will significantly deteriorate the level playing field for banks versus non-banks. Given this, if the benefits/risk mitigation realised are not of equivalent scale then, arguably, Basel II will have failed and will accelerate regulatory crowding-out in the financial sector.
In this context, it is interesting to note that the IRBF for group F banks is an important driver of the costs for the banking system. Therefore, it is essential – while ensuring the minimum guarantees for a sound financial system – to provide banks with significant incentives on the capital side to make such an approach attractive, or to simplify some Basel II detail aspects in order to make it more cost effective.
Running cost of Basel II
Impact areas. Basel II will trigger new expenses on an ongoing basis that need to be tracked back to the very individual areas, both in terms of work processes and product types, impacted by the provisions of the new Accord.
Each organisation would have to identify which specific working process is affected by say the IRB eligibility provisions, and make an analysis of the likely impact of being compliant with the Basel II qualitative standards on an ongoing basis. This relates to a whole range of risk management processes, including:
1.credit risk assessment procedures
2.credit risk pricing mechanisms
3.credit risk data population and segmentation
4.credit risk data loading procedures and quality
5.credit risk data evaluation in terms of probability of default (PD), loss-given default, exposure at default and reporting
6.credit risk data modelling
7.credit risk mitigation recognition procedures, etc.
Smaller institutions using the standardised approach will suffer a smaller proportion of such costs. Indeed, the costs of complying with the IRB approach could give little or no additional incentive to use more advanced risk management methods. In comparison, non-banks not subject to Basel II will bear no cost at all.4
Furthermore, Basel II will also trigger reduced revenue potential on an ongoing basis. Certain provisions of the IRB approach, such as the new risk weighting, collateral weighting and maturity sensitivity, will affect the profit margin of individual financial products offered by banks. Each organisation would have to identify which products of its current spectrum are impacted the most and the terms at which it could offer them under the new framework. Areas likely to be affected include repos and stock loan/borrow, short-term lending and lending to low-rated counterparties and sovereigns. Capital requirements under the Basel II will make some of these products less profitable for larger banks compared with the less risk-sensitive smaller banks or non-banks. Also, Basel II could drive some banks to offer some products at uncompetitive terms compared with those at which non-banks could offer them. These impacts on particular product segments are difficult to predict, but could result in some dramatic rebalancing of bank portfolios.
Evaluation principles. The running costs correspond to the expenses, eg, the additional work processes performed to remain compliant with regulatory provisions, and foregone revenues, eg, the banking products likely to be taken away by non-banks, as regulatory constraints allow them to offer these products at more competitive conditions, when operating under Basel II. The running costs are driven by two main components: 1) constraints on the flexibility in adjusting the internal structure and 2) constraints on the design and features of financial services provided. These costs need to be set against the benefits of the Basel II provisions in terms of their contribution to good management, ie, the materiality of the risk they address.Along these lines, each individual provision of Basel II can be coarsely evaluated based on the following criteria:
A. A scenario of the Basel II gap cost for the banking system | ||||
Bank type | Assumptions* | Total gap cost per bank group | ||
Number of banks | Estimated cost per bank ($m) | in $m | in % of total tier-one capital in 2000 | |
Group S banks moving to standardised approach | 27,000 | 1 | 27,000 | 1.35 |
Group F banks moving to IRB foundation approach | 2,970 | 50 | 148,500 | 7.43 |
Group A banks moving to IRB advanced approach | 30 | 150 | 4,500 | 0.23 |
Total banking system | 30,000 | - | 180,000 | 9.00 |
* The assumption of $15 million per bank/per year made in the CSG comment to CP2 has been refined on a conservative basis (consultants indicated that for some Group F banks, the figures are around $150 million). In 2000, total tier-one capital in the banking system amounted to about $2 trillion |
Materiality of risk
Relevance: does the importance of the issue in the overall context justify it to be addressed by the provision? Was the 80/20 approach used?
Credibility: does the complexity or degree of detail of the provision contribute to effectively improving the situation? Are the assumptions and the data underlying the implementation of the provision of good quality (ie, realistic/unbiased)?
Additional regulatory cost:
Flexibility: does the concept underpinning the provision constrain the development of evolving practices? Was the provision specified in the most pragmatic manner possible? Does the provision constrain the offering of typical banking products?
Transparency: does the provision focus on data quality, consistency and comparability? Is the nature and quantity of data required readily comprehensible by non-specialists?Incentives: does the provision result in an incentive to better assess, report, and proactively avoid undue risk? Does it constrain action in areas outside Basel II’s scope?
Detailed assessment
We performed this exercise focusing on key processes critical to our organisation and affected by a subset of the Basel II provisions, namely the processes generated by the IRBF, the processes generated by pillar 1 credit risk mitigation and other selected processes. This choice was driven by two considerations: 1) the assumption that our bank would qualify for at least the IRBF in the initial stage, and 2) the most essential processes allowing specialists to assess cost of the repercussions of Basel II provisions best, thereby reducing the arbitrariness of a top-down judgement of cost implications.
Figure 3 summarises the evaluation of these processes within the Basel II framework.
One group of the sub-processes generated by the IRBF are consistent with the flexibility, transparency and incentive objectives necessary for the good management of financial institutions. Financial institutions should adopt these practices independently of Basel II provisions. As a consequence, the additional regulatory cost imposed by these provisions via the processes they generate is low. These processes include, for example, the maintenance of a history of defaults. In figure 3, these processes are represented on the left side of the horizontal axis. Another group of processes tends to result in a low additional transparency and/or little incentives to better assess risks and prevent undue risk-taking. Under normal circumstances financial institutions would not adopt such processes when aiming at an efficient risk control environment. In this sense, these processes generate significant additional running cost, and are accordingly mapped on the right side of the horizontal axis in figure 3. Such processes include, for example, the calculation of the risk-weighted assets for each individual asset.
Similarly, regarding relevance and credibility, two groups of sub-processes generated by the IRBF emerge. There are those that are highly relevant and credible while imposing little constraints on the flexibility of adjusting them to evolving practice. These include, for example, the maintenance of a history of defaults. In figure 3, these processes are represented on the upper part of the vertical axis. Another group of processes tends to provide little relevance or credibility while imposing significant constraints on the flexibility of adjusting them to evolving practice. These include items such as the granularity adjustment. In figure 3, these processes are mapped at the bottom of the vertical axis.
Finally, we benchmarked these processes with the effective resource costs these processes require in our organisation. This is reflected by the bubble size attributed to the individual processes in figure 3. A large bubble, such as the assignment of a consistent internal rating to all counterparties, indicates high resource costs to perform the process. A small bubble, eg, the assignment of a justified PD to each rating, indicates little effective resource cost for performing the process.
In figure 45, the same exercise was performed for the operational risk Advanced Measurement Approach (AMA) and other processes that have to be maintained for being eligible for IRBF, for example the calculation of economic capital for all assets, the supervisory review (pillar 2), the detailed high-frequency disclosure (pillar 3) and credit risk mitigation. The credit risk mitigation provisions require the maintenance of the following sub-processes (green in figure 4): the collation and displaying of credit risk mitigation for each exposure; the assignment of a type, rating and maturity to physical collateral; the assessment of ‘low correlation’ status of collateral with regard to the counterparty; the application of standard regulatory collateral haircuts; the calculation of the eligibility of guarantees; the assignment of a rating to guarantors; the review of the enforceability of netting agreements; the assessment of the relationship between guarantee and guarantor; and the assessment of repo counterparties for a carve-out status.
Improving the cost/benefit ratio of Basel II running costBased on the above examples, Basel II could consider dropping the provisions far below the cost efficiency frontier, ie, any item generating high additional regulatory cost and providing little additional transparency and/or little incentives to better assess risks and prevent undue risk-taking (bottom-right in a figure 3 and 4 framework). This would relate to the following provisions:
·operational risk (AMA)
·assessment of repo counterparties for carve-out status
·determination of the eligibility of guarantees
·granularity adjustment
Basel II could also consider simplifying the provisions below but near to the cost efficiency frontier, for example, focusing on those generating high additional regulatory cost and providing significant additional transparency and/or strong incentives to better assess risks and prevent undue risk-taking (upper right in a figure 3 and 4 framework). This would relate to the provisions involved in the following processes:ncalculation of the risk weighting for each individual assetncalculation of the add-ons for derivativesnstand-alone application of standard regulatory collateral haircutsnPillar 3 disclosurensupervisory review requirements under pillar 2ntreatment of securitisation assetsntreatment of specialised lending exposuresnlow correlation status collateralA simplification of these provisions could have the greatest benefit on the cost effectiveness of Basel II. Examples of such simplifications include the option to use internal haircuts, the full reliance on accepted accounting disclosure standards, the removal of artificial scaling factors in the treatment of securitisation assets and a pragmatic approach to those assets treated under the specialised lending criteria.
Conclusion
The cost repercussions of Basel II for the banking community are significant. If regulators omit to include cost considerations in the detailed specification of the new Accord, they will erode the level playing field for banks versus non-banks and weaken the scope of the evolutionary approach.
One possible way for regulators – for example, those within the Basel Implementation Group – to address Basel II cost issues could include a three-step approach:
· reassessing the need for highly constraining eligibility criteria for the IRBA approach
· identifying means to focus the new Accord on the essentials for ensuring the safety and soundness of the financial system; in this context, provisions far below the cost efficiency frontier could for example be dropped out of Basel II
· simplifying the operation of the Accord; in this context, provisions near the cost-efficiency frontier and with high-risk relevance could for example be simplified (say via an across-the-board treatment), or their focus be enhanced (say, by limiting their applicability to the central concern to regulators)
We outlined above some concrete examples for the last two steps in the area of credit risk. Above all it is imperative that regulators include cost/benefit assessment as an integral part of Basel II development. By including this perspective, the merits of further detailed specification in a particular area can be properly assessed, and over-specification of non-essential issues can be avoided.
On the macroeconomic level, the cost implications of Basel II will trigger a structural adjustment in the financial sector. Banks, under shareholder pressure, will aim at maintaining their present profit ratios by considering two options: 1) fully pass on the additional cost of Basel II to their clients, and 2) slim their operating cost by the amount of the additional cost of Basel II. The first option would probably result in making financial intermediation more expensive for the general public and benefit non-banks. The second option could potentially lead to increased cost-base pressure in the banking sector. For economic growth, both options will tend to have a lasting and dampening effect.
Harry Stordel is a director in risk management and is the Basel II co-ordinator at Credit Suisse Group in Zurich. Andrew Cross is the head of credit risk measurement and is the Basel II co-ordinator at Credit Suisse First Boston in London. The views expressed here are those of the authors, and do not necessarily represent those of Credit Suisse Group or Credit Suisse First Boston. We would like to express our gratitude to Tom Wilde and Jenny Furness for their valuable input to this article, and to Uwe Steinhauser for his valuable comments on an earlier draft
1 Non-banks are as much ‘systemic risk relevant’ as banks, especially in the context of convergence of products, markets and clients. Some aspects of Basel II will effectively exclude important existing activities of banks in the future, and thereby – if not materially changed – disrupt capital markets (particularly the repo and stock loan/borrow markets) and result in capital misallocation
2 Figure 1 is calibrated on the net gains from improved risk management set against net costs to implement Basel II provisions that are in excess of those a bank would implement without any regulatory constraints
3 Industry comments on the new Basel Accord and particularly those made by the Institute of International Finance give extensive rationale of the positioning of the various options relative to the cost-efficiency frontier. Note also that by making IRB foundation and IRB advanced more directly attainable, these options could be above the cost-efficiency frontier. A key determinant of whether this will be realised in practice will be the approach adopted by individual regulators. A rigid rule-based implementation will tend to add additional cost for little improvement in risk control
4 Similar comments apply to the use of the AMA for operational risk, as well as to pillar 2 and pillar 3 requirementsRisk
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