Basel II: Status of work

2. Basel II: Status of work • June 2004 Publication of the revised framework: Basel II • April 2005 Consultative paper on Trading Book issues and Double default • July 2005 Incorporation of Trading Book and Double default into June 2004 text • Fourth quarter 2005 Data collection for recalibration exercise • Spring 2006 Recalibration • Jan 2007 Standardised Approach and Foundation IRB available • Jan 2008 Advanced IRB available (full implementation)

3. Basel II • Represents a significant step towards achieving a more comprehensive and risk sensitive supervisory approach => Bringing regulatory capital closer to economic capital. • Overall objective => to enhance banks’ safety and soundness, thereby strengthening the stability of the financial system as a whole. That, in turn, will improve the ability of the financial sector to serve as a source of sustainable growth for the broader economy. • Basel II is about much more than just setting better quantitative minimum capital requirements. It is about establishing an incentive-based approach to risk management and capital adequacy, within a framework of three mutually-supporting pillars. • It represents an unparalleled opportunity for banks to improve their capital strategies and risk management systems. It provides supervisors with an opportunity to improve their ability to identify banking risks and to enhance the dialogue with the industry and among banking supervisors.

4. Critical issues • Basel II implies a far-reaching shift in the regulatory paradigm. • Three critical issues for the success of Basel II. Important to ensure that: • It works at micro level - Prudent, appropriate and risk sensitive capital requirements. Risk management incentives. Improving risk management without imposing a single model. • It works at macro level - Not only sound in the micro dimension but also enhancing macro performance: favouring growth potential, appropriate behaviour in terms of procyclicality, flows to emerging markets etc. • Implementation is consistent - Level playing field. Home host issues. Finding ways to reduce the tension between banks’ organization and home-host supervisory relationships.

5. Points to be covered • I will not discuss the micro issues, which relate to the basic elements of Basel II (although let me emphasize the importance of the three pillars and their mutually reinforcing effect). I will focus on the other two issues: • First, I would like to say something about the macro perspective, because I am not convinced by some of the analysis of Basel II that points to excessive procyclicality or difficulties in flows to emerging markets. I will try to summarize my perspective and certainly I propose that we all continue to monitor the effects. This is really important. • Second, I will concentrate on implementation issues, which in a broad sense includes at least three strands of the present work of the Committee: • Calibration. • Validation. • Home Host issues.

6. Macro perspective • Micro-prudential regulations may have significant macroeconomic implications. It is important to analyze and understand them. • Basel II has been thoroughly scrutinized by many parties to evaluate its consequences in terms of procyclicality, and its implications for cross-border financial flows, especially to emerging markets and areas of strategic importance to the economy. • We welcome all these contributions (some of which have been very critical of the proposals), which have significantly improved the framework as well as our understanding of very important issues. • Furthermore: It is important to continue to monitor and analyse effects.

7. Procyclicality • Procyclicality is an excellent theme for discussion in relation to the potential macroeconomic effects of Basel II, because • There have been many studies and discussions on this issue during the development of Basel II • It is relevant to the analysis of other issues • For example economic capital versus regulatory capital as a driver of bank decisions, which is also relevant for flows of funds to emerging countries

8. Procyclicality – the issues • There is clear evidence that many banking variables are correlated with economic cycles. • Banking business is risk-sensitive today and as a consequence implies some degree of procyclical behaviour today. • The question is whether Basel II will exacerbate this aggregate behaviour? • I appreciate the work in this field, and I hope that it will continue and help to shed light in areas where results are not conclusive. • Although I share many of the arguments and some concerns, I tend to have a more positive view of the macroeconomic implications of Basel II. • The Basel Committee has taken this issue seriously and introduced a number of changes to the framework. There are also a number of mitigating elements that allow a positive assessment to be made of the macroeconomic effect of Basel II.

9. Arguments in three categories: • Which measure of capital is most relevant in explaining the cyclical lending patterns of banks?, How risk sensitive is bank behaviour today? Will Basel II unduly exacerbate procyclicality? • What elements in the Basel II package run in the opposite direction and what mitigating factors can contribute to offset procyclical tendencies? • Long term influence of better risk management/ transparency in terms of better resourceallocation, efficiency of the financial system and growth potential of the economy. Will Basel II improve the ability of the financial sector to serve as a source of sustainable growth for the broader economy? • What the three arguments have in common is that perhaps too much attention is placed on the minimumcapital rules of pillar 1 and too little attention on the effects of higher transparency of risk profiles and better risk management driven by incentives. • These latter aspects are difficult to measure. But I tend to think that they are the main channels through which the positive effects of Basel II will be felt.

10. Capital requirement procyclical? • To the extent that BII is more risk sensitive => additional element of procyclicality? • It can be argued that a downturn has two effects: • => loan losses => reduction of available capital • => credit deterioration => higher capital requirements • However, this analysis is too mechanical. The process is more complex. It will depend e.g. on the dynamic features of a credit rating system and the characteristics of the PDs associated with that rating system. • “Risk blindness” can be even more procyclical, i.e the most abrupt and procyclical behaviour will probably occur in a poorly provisioned and poorly capitalized bank with inadequate risk management. In a downturn => unpleasant surprises and little room for manoeuvre => abrupt cut-back on lending.

11. More procyclical behaviour? • Basel II appropriately addresses the main contributors to procyclicality: • Inadequate shock-absorbers (provisions and capital) • Poor risk management (Lack of understanding and proper controls) and weaknesses in the balance sheets • Weak financial supervision. • It is one thing to say that minimum capital requirements are procyclical but quite a different thing to say that the behaviour of banks is more procyclical. • Perhaps the degree of risk sensitivity of banks’ behaviour today is underestimated and the role of regulatory capital in this regard is exaggerated. • Nowadays, well-managed banks already allocate economic capital and take decisions on the basis of risks incurred. Their economic capital is procyclical today. Basel II does not alter the calculation of economic capital, but it can help to promote cycle awareness.

12. Offsetting factors • In addition, there are a number of effects working in the opposite direction, as well as other mitigating factors. • Even in the most mechanical part of the framework, pillar 1: • Although the time horizon used in PD estimation is one year, banks are expected to use a longer time horizon in assigning ratings. • The design and validation of the classification systems => less procyclical. The Basel Committee modified its guidance for ratings processes to encourage banks to take more account of uncertainty over the full economic cycle. • Risk parameters estimated as a long-run average (PD) or to reflect downturns (LGD).

13. Buffers under Basel II • Banks will be required to perform a meaningfully conservative credit risk stress test of their own design => capital buffers. • Can capital buffers make regulatory capital less of a constraint ? • At present, actual capital is in general well above minimum regulatory requirements. Some evidence of a negative relationship between the capital buffers and the cycle. Countercyclical behaviour in buffers could be accentuated by Basel II. • Pillar 3 may reinforce these elements and it may in many cases have a stronger effect than pillar 1 calculations. • It is not easy for markets to analyse the risk profile of financial institutions. The contribution of pillar 3 to transparency in this area could significantly enhance market discipline. • In sum, Basel II places capital in the centre of the bank’s responsibility and strategy, and requires managers to be very conscious of and serious about understanding the drivers of risk through the cycle within a medium term time horizon.

14. Risk management channel (1) • The improvement of risk management is an important channel of influence of Basel II. • A word of caution: Quantifying risk involves making assumptions and judgements. But no model or software package, no matter how sophisticated, can replace the skills and judgement of a trained, experienced and conscientious risk manager (although such judgement should, of course, be reinforced with the best possible information and techniques). • In other words, risk management is not just about quantitative models, but also about qualitative issues, i.e. promoting a risk culture. • That is why we have made sure that the Basel II framework is much more than numbers and models.

15. Risk management channel (2) • Risk management entails: • Comprehensive firm-wide analysis and quantification of risk… • Governance, control systems and structures: Board involvement; establishing dedicated risk management function to foster more integrated and systematic approaches to risk; consistent reporting etc. • Investments in risk infrastructures - systems, technology and telecommunications - in order to gather, collect and analyse large amounts of data on exposures. • Constructing compatible and efficient management information systems across all of the bank’s businesses, on the basis of common risk measures across business lines.

16. Risk management channel (3) • Improved and more formalized risk management will bring: • More awareness and better assessment (and quantification) of risks. The firm is less likely to ignore material sources of risk. • Using the concept of economic capital and its elements, banks can develop sound policies to determine their risk profiles and for monitoring exposure limits, risk-adjusted pricing policies and sound provisioning practices based on the inherent risks of the portfolios. They can measure returns and assign capital on a risk-adjusted basis. • The ability to understand and use appropriately new mitigation techniques. • “Perhaps more critically, better risk management and the associated quantification have the real potential for reducing the wide attitudinal swings that are associated with the historical cyclical pattern in bank credit…” A. Greenspan. • Capacity to communicate, in a transparent manner, complex issues such as positions and policies in risk management. • Less surprises. Early detection => prompt reaction

17. Risk management channel (4) • To the extent that risk assessment and control methods become more formalised and rigorous, this will lessen the likelihood of making bad decisions and under-pricing. It will also contribute to the prompt detection of errors and deviations from targets, allowing banks to implement corrective measures at an early stage => lower losses. • Awareness and early reaction is likely to lead to a smoother adjustment to new conditions or to correction of mistakes, making decisions less abrupt. • This early reaction will be supported by the supervisory second pillar and by the transparency of the third pillar, which will also reduce the temptation of forbearance. • Reduction of losses because of better risk management could moderate the most important effect of downturns on capital ratios: lower capital base (the other being higher capital requirements). • Summing up: It is difficult to think that all these investments in technology, governance structures and advances in risk management will not bring significant improvements to the efficiency and soundness of the financial system. This should benefit the overall economy.

18. Trends and Cycles • Shock absorbers more risk sensitive and cycle conscious • + • Enhanced Transparency => improve conditions to raise capital as well as incentives to have adequate capital • + • Better and pre-emptive risk management, based on improved control structures and corporate governance, investments in technology, information databases and human capital. • Banking system more stable and efficient in allocation of resources, and also more risk-efficient. • Even if procyclicality continues it is very likely that it will be around a superior trend.

19. ● ASSESING THE VALUE-ADDED OF BASEL II REQUIRES CONSIDERATION OF BOTH TREND AND CYCLE ▪ Trend: enhanced risk-sensitivity and transparency ▪ Cycle: procyclicality and volatility Basel II Output • Superior trend • Less surprises Basel I Time

20. Partial summing-up (1) • Difficult to be conclusive, it is important to be attentive. • I tend to be optimistic: To the extent that Basel II leads to better risk management, I have difficulty in accepting that better risk management will bring poorer macroeconomic performance of the aggregate banking system. • Following the same kind of reasoning, based on the joint result of enhanced transparency, better risk management systems and shock absorbers that are proportional to risks, it would not be surprising if in the medium and long term Basel II’s forward-looking elements take over and as a result the financing of all kinds of economies is improved. • Furthermore, market dynamics may reinforce this process and those banks that adopt higher standards of risk management and capital and countries that embrace the new supervisory approach could be perceived by markets as less risky, resulting in lower risk premiums and better access to financial markets.

21. Partial summing-up (2) • Even if we regard the new capital framework as more comprehensive and a better framework, it is very important to analyze and monitor macro implications and to ensure that the financial system contributes to the stability and growth of the economy. • I hope that the analysis will continue. We followed a very open and consultative process during Basel II preparations, we have learned a lot and we intend to continue in the same spirit. • I also hope that other areas of regulation, such as provisioning, will receive as much attention, because it is also my firm view that this is an area where significant improvements and additional compensating factors (if necessary) could be obtained. • IAS 39 or incurred losses procyclicality, and dynamic provisioning as a counterbalance, are academic and supervisor challenges that, hopefully, will attract as much attention as Basel II procyclicality in near future

22. Implementation issues • Three strands of work that will have to take into account the critical factors mentioned earlier to ensure success: • Calibration. Important for the assessment because it will be based on a considerable body of data. We will need to understand cyclical factors. • Validation. One of the greatest challenges – for both banks and supervisors – is the need to validate systems and processes. Essential to understand the dynamics of different models and ensure effective application by the banks. • Home Host issues. Consistency of implementation across jurisdictions, e.g. application of pillar 2. • Before implementation: some refinements in the trading book area.

23. Status of work on the trading book • The Committee re-iterated its intention to maintain an active dialogue with the industry to ensure that the new framework keeps pace with, and can be applied to, ongoing developments in the financial services sector. • There are two areas where both banks and supervisors recognised that this work could already commence and existing refinements could be included: • “double default,” where the risk of both a borrower and a guarantor defaulting on the same obligation may be substantially lower than the risk of only one of the parties defaulting. • The other area concerns the application of Basel II to certain exposures arising from trading activities. • Because both banks and securities firms have a great interest in the potential solutions to these particular issues, the Basel Committee has worked jointly with the International Organization of Securities Commissions (IOSCO) to consult with industry representatives and other supervisors. • I must say that this co-operation with IOSCO in areas of mutual interest has been a very fruitful and beneficial experience

24. Calibration • The Committee has long stated its intention to conduct work to re-confirm that the new framework meets our objective to broadly maintain the aggregate level of capital requirements, while keeping the incentives for banks to move to more sophisticated risk measurement methods. • We will begin recalibration exercise in autumn this year => finalise in spring 2006. Data will be collected during the so called fifth quantitative impact study between October and December 2005. (QIS5) • This early recalibration will allow us to accommodate the needs of rulemaking processes and will provide banks and supervisors with more time to reflect and facilitate implementation.

25. Calibration • In addition, national field tests are already underway in some jurisdictions, while there will be a period of time during which banks will calculate their capital requirements in parallel. • The Committee does not intend to set data requirements or timeframes for the parallel calculation that will be conducted in 2006. So there is no duplication of work. • This exercise will provide a significant amount of information. In addition, it will be important to have the necessary tools and to understand the effect of the cycle on the calibration exercise. In relation to this, it might be important to distinguish changes in capital requirements that are due to the content of Basel II from changes that are due to the stage of the cycle in which the measurement is carried out.

26. Validation • The term “validation” encompasses a range of processes and activities that contribute to an assessment of whether ratings adequately differentiate risk, whether estimates of risk components (such as PD, LGD, or EAD) appropriately characterise the relevant aspects of risk, and to understanding the dynamics of the systems and their use by banks. • Although validation is foremost the responsibility of banks, supervisors must have a thorough understanding in order to ensure the overall integrity of banks’ activities. • Validation comprises: • Validation of the rating system itself (model design, assessing the forward-looking accuracy of the bank’s risk estimates) • Validation of the rating process => how the rating system is implemented (use test and governance, reporting, problem handling, training, etc.) • BCBS published six principles that will guide our future work: “Studies on the Validation of Internal Rating Systems”.

27. Validation principles • Principle 1: Validation is fundamentally about assessing the predictive ability of a bank’s risk estimates and the use of ratings in credit processes. Validation should focus on assessing the forward-looking accuracy of the bank’s risk estimates, the processes for assigning those estimates, and the oversight and control procedures. • Principle 2: The bank has primary responsibility for validation • Principle 3: Validation is an iterative process Validation is likely to be an ongoing, iterative process. • Principle 4: There is no single validation method • Principle 5: Validation should encompass both quantitative and qualitative elements. • Principle 6: Validation processes and outcomes should be subject to independent review for integrity by parties within the banking organisation that are independent of those accountable for the design and implementation of the validation process. Regardless control structure, internal audit has an oversight responsibility

28. Validation challenges • Supervisors and bank risk managers will need to understand how a bank assigns risk ratings and how it calculates default probabilities in order to accurately evaluate the accuracy of reported PDs. • Basel II establishes minimum standards but it permits banks a great deal of latitude in determining how obligors are assigned to buckets and how pooled PDs for those buckets are calculated. • Although this flexibility allows banks to make maximum use of their own internal rating and credit data systems in quantifying PDs, it also raises important challenges for PD validation. • An obligor-specific PD may or may not embed stress-scenario assumptions about future economic conditions. • Rating philosophy will vary from bank to bank. “Practitioners use the terms “point-in-time” or “through-the-cycle” to describe the dynamic characteristics of rating systems, but these terms often mean different things to different people.” • Banks tend to focus more narrowly on current conditions in setting ratings than do public rating agencies. Rating systems may conform more closely to a point-in-time philosophy. • LGD, EAD in credit risk and AMA in op-risk represent additional challenges. => Accord Implementation Group

29. Cross border issues • Cross border issues are not new. One of the goals of both Basel I and Basel II is to foster a more level playing field for internationally active competitors. BUT: • Markets are changing. Cross-border activity is growing, financial groups are becoming bigger and transactions more complex and there are somecountries with a systemic part of their financial system in foreign hands. • In addition, international banks are centralizing some functions and tend to apply to the whole group common techniques, systems and culture. At the same time, banking regulation and supervision remains predominantly a national responsibility. • With or without Basel II => need to enhance cooperation in a world that moves towards larger scale cross-border activities and a greater presence of systemic foreign banks in domestic economies. • Basel II implementation will need carefully structured Home/Host relationships.

30. Cross-border implementation of Basel II: a key challenge • The issue of home-host co-operation is very practical, and far from the conceptual issues I have been talking about earlier. Nevertheless, these practical issues are as important as the theoretical ones. • Areas to be considered • Initial and ongoing validation of advanced Pillar 1 approaches. Consistency across jurisdictions. • Recognition of external credit ratings in different jurisdictions. • The supervisory review process under Pillar 2. • Banks to focus on managing their risks rather than managing the demands of different supervisors. • Cooperation among supervisors need to be enhanced. • How can Basel II be implemented in an effective and efficient way which minimises the burden on internationally active banking groups and still respects the legal responsibilities and legitimate concerns of home and host supervisors in maintaining safe and sound banking systems?

31. Global perspective • Around 100 countries intend to implement Basel II by the end of this decade • Supervisors, as well as banks, have limited resources => efficiency. • Need to develop enhanced cooperation agreements. Basel II will be a catalyst for effective home/host relationships. • Implementing Basel II in a way that strengthens the quality of bank supervision across countries.

32. Basel II approach • Basel II cannot and should not be expected to create perfect harmonization across all jurisdictions. Differences remain in legal systems, market practices, business environments… • Basel Committee created Accord Implementation Group • Discusses home/host country issues • Promotes consistency in the application of Basel II => convergence of practices. • Significant outreach to non-member countries • Bottom-up approach. No prescriptive approach. • It will help to avoid performing redundant and uncoordinated approval and validation work in order to reduce the implementation burden on the banks, and conserve supervisory resources and will therefore contribute to a more level playing field for internationally active banks.

33. The work of the AIG/Committee • Six high-level principles on the cross-border implementation of Basel II. • Basel II does not change in any way the legal allocation of supervisory responsibilities between home and host countries. • Basel II requires a more collaborative approach. • Supervisors should avoid performing redundant work. • Home country supervisors should lead collaboration and communication efforts • Case studies involving real banks, based on the implementation plans of those banks as a starting point. • Surveys and experience sharing.

34. Information flows and trust • Successful implementation of the high-level principles rests on adequate information flows, and trust among supervisors. • The contribution of the industry: • Banks should develop solid implementation and roll-out plans for supervisors to react to. • Home and host supervisors need to see and understand those plans in order to establish the most effective ways to share information, cooperate and discuss the scope. • To improve internal communication of their plans. • Sometimes the local staff are unaware of the bank’s plans, even for their own operations.

35. EU perspective • From an EU perspective, there are additional particularities, which bring both challenges and opportunities: • There is a political objective (Lisbon) to achieve a single market in financial services. • We have a well-established body of EU banking legislation, including legislation that clearly sets out home and host responsibilities. • We have a new regulatory and supervisory framework for banking: the Lamfalussy approach. • As part of this, we have the Committee of European Banking Supervisors (CEBS), which has already made good progress on supervisory cooperation and convergence. • Therefore, we can, and should, go further in the EU in pushing for consistent implementation of Basel II, including effective home-host co-operation.

36. Conclusions • The publication of the revised framework was only the beginning of a new important phase: implementation. • Basel II allows a lot of leeway – but having the rules is not enough • Good implementation is essential. • Need to keep in mind the three critical factors: • Micro effectiveness • Macro effectiveness • Consistency of implementation