Basel accord brings segmentation issues for systems companies
Basel II will segment the market for firms providing IT services to banks.
That’s because the accord, which will permit banks to use their own internal risk management models to set the levels of protective reserve capital they need, will clearly lead to more complex risk management processes.
The methodologies introduced by Basel II also have deep implications for systems integration and organisation within banks.
Basel II is the new set of rules on what proportion of their assets major banks must set aside as a guard against the risk of losses from the hazards of the banking business. The final version is now expected some time next year.
For the first time regulators will require the banks to set aside capital specifically against operational risks such as technology failure, fraud and trade settlement failures. The op risk capital charge will sit alongside those already established for credit risk and market risk to form an unchanged minimum reserve/asset ratio of 8%.
The new accord, whose start-date was put back in June to 2005 from 2004, is intended in the first instance for large international banks. Regulators with the Basel Committee on Banking Supervision, the body that in effect regulates international banking, designed Basel II to be more risk-sensitive than the one-size-fits-all minimum ratio of Basel I, the current accord that dates from 1988. Basel I was later adopted by bank regulators in over 100 countries.
We expect the new operational risk requirements to generate tremendous consulting work. This is more an organisational and a methodology issue than a pure software issue, and many banks will be requiring the services of well-established international professional services firms such as Accenture and PricewaterhouseCoopers.
The new credit risk recommendation will also require consulting work in terms of methodology. Firms such as KMV, the provider of quantitative credit risk products for credit risk investors, for example, will be advising on how to calculate default probabilities and ratings.
These large consulting firms anticipate additional business and are actively recruiting to cope with this expected surge of new business. The job market for this industry has already started to stiffen as firms encounter difficulties in meeting their recruitment objectives.
The internal ratings based approach generates an important need in terms of data on default probabilities and recovery rates, for instance, especially in Europe. We have already noticed that firms such as the credit rating agency Moody’s Investors Service and the French credit export insurance organisation Coface are keen to fill in this gap and are developing plans to enter this field.
We believe software providers should concentrate on the software business. They have neither the experience to deliver default probability and recovery rates data nor the skills to provide consulting and methodology services.
Basel II offers banks a choice of methods of calculating capital charges for credit and operational risks that range from the basic to the more complex internal ratings approaches. The more complex the approach used, the lower will be the capital charge.
As operational risk remains mainly unquantifiable, most banks will probably select one of the two simpler approaches of the three on offer, namely the basic indicator or standardised approaches.
The basic indicator approach to arriving at an op risk capital charge simply involves multiplying a bank’s gross revenue, for example, by a factor called alpha. The standardised approach divides a bank into standard business lines, with each business line using a standard risk indicator that is multiplied by a factor called beta to arrive at the charge.
The standardised approach will obviously be the favourite option as it allows users to differentiate between sectors, such as retail or wholesale banking, that are fundamentally different in terms of risk.
Major banks in the Group of 10 (G-10) leading economies are expected by the Basel Committee, which largely comprises banking supervisors from the G-10 countries, to use at least the standardised approach.
The internal measurement approach to finding an op risk capital charge is more complex. The bank is divided into business lines and so-called risk types. The charge is arrived at by multiplying the probability of loss, which is derived from operational loss data now being gathered, by a factor called alpha.
With credit risk, the advanced method is more attractive than the foundation method as it is expected to yield lower capital charges. This method allows banks to use their own data in terms of recovery rates and their own replacement cost methodology. However, recovery rates are particularly difficult to find as data. Indeed credit data is very scarce compared with market data which fluctuates every second.
Moreover, replacement-cost models are expensive methods to develop and computer-intensive to operate. They involve either complex add-on calculations often based on value-at-risk, or Monte Carlo simulations. Monte Carlo simulations are based on a scenario which calculates a portfolio’s possible exposure paths of profits and losses over a specific time horizon. Monte Carlo runs allow users to calculate several statistical estimators, such as the average exposure across all simulations or the maximum exposure for a given confidence level.
By contrast, the foundation method for finding the credit risk capital charge provides standard recovery rates and standard add-ons. It will therefore be an attractive option for banks looking for a quick and pragmatic method to comply with Basel II.
Most banks are focusing on credit and operational risk issues. However, within a European Union context, Basel II will be implemented via changes to the EU’s capital adequacy directive. The European Commission plans to apply Basel II principles to all banks and investment firms within the 15-nation EU.
It appears that the EU puts more emphasis on asset and liability management (ALM) issues, that is, the management of the various risks to which the balance sheet of the bank is exposed. The main risk here is interest rate risk. ALM within the EU capital adequacy framework includes the obligation to report the sensitivity of the global position of the institution with respect to interest rate risk.
This ALM reporting is achieved through a duration, or a static gap, method that includes in particular an adequate model of the prepayment risk inherent in mortgages.
The new methodologies introduced by the new accord will also have deep impacts on the organisation of the bank and on the integration of its different systems.
The data needed to comply with Basel I was mostly based on a unique accounting system. In order to be fully compliant with Basel II, banks will need to extract details of counterparties and deals from various operational systems, such as the different trading systems used in dealing rooms or counterparty masterfiles. Hence our expectation that major integration work will have to be carried out.
The new internal based ratings methods will require banks who do not already offer this, to set-up a specific department responsible for counterparties’ rating.
Jacques Sauliere is head of marketing and new business at Paris-based Ubitrade, a leading supplier of advanced systems solutions for trading, risk management and back office on capital markets.Operational Risk
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