Basel II : The New Capital Accord

1. Basel II : The New Capital Accord Implications for Bank Supervisors in our Client Countries and the World Bank’s Agenda

2. BASEL I • Basel I was aimed at international active banks in developed countries • Originally G-10 countries intended to raise the minimum capital levels of their large banking organizations and establishing a level playing field • Became the international standard worldwide

3. Capital Requirements under Basel I • Slotting of assets (off- and on balance sheet items) into four categories • Applying 8% to the sum of risk weighted assets A x 0% = a (A : government bonds, etc) B x 20% = b (B : interbank lending) C x 50% = c (C : mortgages, etc.) D x 100% = d (D : other loans, etc) Capital requirement = (a+b+c+d) x 8% 3) A specific capital charge against market risks could be added for banks incurring such risks - Weightings (0,20,50,00) were meant to reflect riskiness of underlying banking operations - Value of loans was supposed to fully reflect loans’ impairment

4. Basel I : overly simplistic ? • Not sufficiently risk sensitive • One size fits all framework • Capital ratio : a misleading indicator where other elements are lacking (adequate loan classification, etc.)

5. Basel II : a major change in approach • Regulatory capital (vs. economic capital) might not be adequate • Capital should be calculated based on actual estimates of unexpected losses rather than on arbitrary risk weights • Process oriented framework (multi-options system to account for diversity and complexity of banking operations) • Supervisory review (capital could be adjusted upward based on qualitative, supervisory judgment) • Public disclosure (necessary element as the suggested framework offers a menu of options) • Much more than just a technique for computing capital requirements : touches upon banks’ risk management system

6. Is Basel II overly complex for our clients ? • The Basel Committee’s core target population remains large complex banking organizations • The use of external ratings is very limited in non G-10 countries • The IRB approach is out of reach for most banks

7. Bank A Risk weighted assets = X Universal bank Network Good internal control Adequate corporate governance Similar capital requirement for Bank A and B under Basel I Bank B Risk weighted assets = X Specialized bank No branch Deficient internal control Deficient corporate governance Bank B’s capital requirement likely to be higher than Bank A’s under Basel II Possible Implications

8. Basel Committee’s response • As recognized international rule setter for banking supervision related issues, BC has become more sensitive to the need to broaden its audience • Non G-10 countries’ concerns are expressed under the auspices of the Core Principle Liaison Group (CPLG) • World Bank and IMF participate in CPLG meetings : The Bank represents the views of developing countries and we played a role in (i) advocating a framework of universal application and (ii) the implementation of Pillar 2 and Pillar 3

9. CPLG’s view on Basel II • Basel Committee is recognized as the international rule setter • Applying Basel II to G-10 and Basel I to non G-10 is not acceptable • Basel II should offer more options to fit non G10 countries’ needs

10. The “simplified approach” suggested by a sub group of the CPLG(Brazil, China, India, Russia, Saudi Arabia) Basel II = Basel I + Pillar 2+ Pillar 3 - Current risk weighted system (possibly with several changes including a capital charge to account for operational risk) - Supervisory review (possibility for supervisors to impose capital add-ons) - Disclosure (current extent of disclosure by banks on capital, loan classification, etc. is unsatisfactory )

11. Bank Supervisors will confront challenges in implementing Pillar 2 Pillar 2 ’s building blocks (principles) : - Assessment of the adequacy of capital needs by the banks themselves, i.e capital is to be adjusted to the overall risk profile of a bank - A bank’s assessment is to be reviewed by bank supervisors - Supervisors should be entitled to require capital in excess of minimum, if need be - Supervisors should have adequate tools at their disposal to intervene at an early stage before capital is depleted

12. Looking ahead • Basel II will become the standard • Most foreign banks in developing and emerging economies will strive to adopt the IRB approach (level playing field) • Non G-10 supervisors must provide incentive for banks to adopt the IRB approach in the medium term

13. The Bank’s role going forward • Most, if not all, IMF/WB lending operations in the financial sector have imposed/ recommended compliance with Basel guidelines on capital • WB future work will refer to and encourage the adoption of Basel II like frameworks • As a “knowledge institution” the Bank has no option but to disseminate international standards and best practices in our client countries • As part of the FSAP, the Bank will continue assessing compliance with Basel guidelines, including Basel II • The Bank staff needs to have the necessary skills in anticipation of TA requests

14. The Bank’s role going forward (cont’d) • In light of its experience, the Bank along with the Fund, should actively participate in the revision of Core Principles (2003?) • The Bank must continue being active in the CPLG where non G-10 specific issues are addressed • The Accord Implementation Group (AIG) will be instrumental in raising issues that non G-10 countries will confront going forward (Bank’s view is likely to be requested as we can provide useful input) • Staff need to be prepared to work with our client countries on implementation issues

15. Conclusion • Basel II will have far reaching implications over the long run (“Mc Donough” ratio likely to be as famous as the “Cooke” ratio) • As part of its work in the financial sector, the Bank must be prepared to continue to provide support to our countries to meet best practices, including those regarding Basel II • The Bank must invest in training for financial sector specialists to understand Basel II