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Could the Basel II op risk charge be cut again?

BASEL - Might banking regulators agree again to lower the capital charge for operational risk proposed under the controversial Basel II bank capital accord as part of horse-trading over the credit risk charge?

    • David Keefe
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The question arose for some bankers after the Basel Committee on Banking Supervision, the architect of Basel II and the body that in effect regulates international banking, confirmed their fears in November that currently proposed Basel II credit risk charges would be higher for many banks than they are under the Basel I accord.

The idea of a compromise involving a further cut in the op risk charge has a certain deal-maker’s logic about it, regulators said. But a strong objection is that it would practically eliminate any incentive to use advanced approaches to calculating op risk charges, and would thus undermine one of the key aims of the risk-based Basel II accord.

The Basel Committee, acknowledging that higher charges on average would be contrary to the intention of the Basel II accord, said it would look at possible modifications to the credit risk proposals. The regulators want to ensure that the complex, risk-based Basel II accord doesn’t result in banks using the standardised approach for calculating credit risk charges, the simplest of the three approaches offered, having to set aside more reserve capital on average than they do under the current Basel I capital accord.

The committee also reiterated its Basel II objective of providing "modest incentives" in the form of reduced capital charges for banks using advanced approaches based on a bank’s own risk modelling and data.

The Basel II accord will from 2005 determine how much of their assets major banks will have to set aside as reserve capital to guard against banking risks, including credit and market risks as well as, for the first time, operational risk.

But the results of the Basel Committee’s second quantitative impact survey (QIS2), which sought information from banks on the likely effect on them of Basel II, indicated that credit risk charges for large international banks in the Group of 10 (G-10) leading economies, for instance, would increase by 6% for banks using the standardised approaches. The increase for the same banks using the foundation internal ratings based (IRB) approach, the less complex of the two advanced methods, would be 14%.

But when the proposed charge for operational hazards such as fraud, system failures and trade settlement errors is added, the overall increase is 18% for banks using the standardised approach and 24% for banks using the IRB foundation approach. And a 5% reduction in credit charges for banks using the IRB advanced approach, the most complex of the methods on offer, becomes a 5% increase when the op risk charge is added.

QIS2 polled 138 banks in 25 countries, and the results suggested both large and small banks would experience an increase of some sort in capital requirements under the Basel II proposals as given in January’s second Basel II consultative paper (CP2), particularly when the op risk charge was taken into account.

Application
Basel II is intended in the first instance to apply to large G-10 international banks, but is designed to fit banks of all sizes. Over 100 countries, for instance, have adopted Basel I.

The regulators were seeking further information in another survey - QIS 2.5 - to test the effect of possible modifications to the credit risk proposals, including adjusting the so-called risk-weight curve.

The modifications, if implemented, could bring the credit risk charges back into line with the regulators’ intentions for Basel II.

But one way of helping the process would be to further reduce the operational charge which was cut to 12% of regulatory capital in September from the 20% proposed originally in CP2. Banks using advanced op risk approaches could reduce the charges to a limit of 9%.

Some bankers think the op risk charge should be lower still, and also argue there is already little enough incentive to use advanced approaches, given the 9% floor.

But other bankers join regulators in noting that a reduction of a few more points would almost entirely remove any real advantage to be had using advanced approaches. In practice, banks would be likely to pay a one-size-fits-all basic charge and simply regard it as a tax.

However, regulators acknowledged that responses to the Basel Committee’s September op risk working paper, which confirmed the lower 12% charge, showed there are still many bankers who would prefer to keep the op risk charge simple and apply it as a kind of tax.

But regulators warned against accepting the results of the QIS2 survey at face value, because of doubts about the quality of some of the information. Not all of the 138 banks managed to calculate capital charges under all three credit risk approaches.

The Basel Committee, already harassed by a German threat to veto Basel II over the treatment of longer-term loans to small- to medium-sized, hopes to issue its third consultative paper (CP3) on the accord by late February.

Basel regulators will have some hard thinking to do at their mid-December meeting, where they are expected to give their final instructions to the officials drafting CP3, bankers said.

Meanwhile, regulators continued to assess banking industry responses to the September paper on operational risk, which also said that supervisors would consider a range of advanced approaches for op risk instead of the single one put forward in CP2.

Regulators intend to refine the Basel II op risk proposals further in the light the comments received and incorporate them into CP3.Operational Risk

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