Basle II prompts strategic rethinks

THE BASLE II ACCORD is expected to be implemented in 2007 as the basis for global bank regulation, directly affecting the capital required to support an estimated $50 trillion of global credit exposures. Like Basle I in 1988, Basle II will have consequences for a wide range of banking activities, and has already led to extensive political lobbying and pre-emptive strategic positioning.

We estimate that banks will spend around $25 billion (five basis points of assets) preparing for implementation, with the largest banks typically investing $50 million to $200 million over five years. Investments in credit risk measurement and management (which have the strongest impact on risk-weighted assets - RWAs) and supporting IT will be the most significant. Maximizing value from these expenditures should be a key element in any bank's strategy, and is increasingly being given priority at the highest levels in leading banks.

The changes in capital requirements that are likely to result from the better alignment of regulatory capital with banks' risk profiles - the core purpose of Basle II - along with the impact of the apparently softer Pillars 2 and 3 will drive structural changes in the financial services industry. The relative changes in capital costs will alter the perceived attractiveness of individual products, countries and businesses, leading to strategic and tactical shifts as players respond to the new environment.

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We have calculated the impact of these requirements across geographies, bank types, retail product types and corporate customer segments using all three compliance standards as laid out in the most recent quantitative impact study (QIS 3).

In total, for banks in North and Latin America and in Europe, aggregate credit risk capital requirements will be about 3% higher than currently, if all banks remain at standardized level, but with a reduction for foundation IRB of around 12% and a larger reduction for advanced IRB of around 17%.

In addition, the new operational risk capital charge (not yet finalized) will add an expected average 12%, so that under the IRB foundation approach the total banking industry requirement is roughly unchanged.

Asset management, advisory and custodial services, which are currently treated as "risk-free", will thus become subject to explicit capital requirements, forcing banks to reassess the merits of allocating capital to such operations.

Winning and losing lending portfolio segments stand out clearly. The major losers are sovereigns and banks, which enjoyed very low risk weightings under Basle I, and small and medium-size enterprises (SMEs), whose lower average credit quality will attract higher capital requirements. Coincidentally, all three of these segments are to some extent distressed and currently feeling the credit crunch. This will have a negative impact on the funding of SMEs, a concern that drove the German government's successful lobbying of the EU on this topic.

Also, public funding debates will need to take note of the structural impact caused by a likely disincentive for banks to provide credit to local and national governments, combined with a possible reduction in inter-bank liquidity.

One of the questions raised after earlier impact studies concerned the incentives for banks to develop more sophisticated risk methodologies for SMEs, since IRB approaches appeared to assign these significantly increased capital requirements.

It appears this has been resolved in QIS 3, since reaching IRB advanced will give a smaller increase in capital requirements for this important customer segment than standardized. However sovereigns are still subject to such a misalignment of incentives, a problem exaggerated by the recently introduced maturity adjustments implicit in the capital calculation.

The frequently complex structures and importance of collateral for many types of specialized lending - for example commercial real estate, asset finance and project finance - will mean that unless institutions can reach IRB advanced, they will be significantly disadvantaged from a regulatory capital perspective. For project finance, our results confirm that the modified foundation approach (there is no standardized approach for project finance) has risk and capital weights, effectively forcing players to develop sophisticated risk tools or suffer heavy regulatory capital penalties, leading to the possibility that they will exit the market.

In response to the better alignment of regulatory capital with underlying risk, it is possible that super-monolines will emerge, with retail or large corporate portfolios taking advantage of capital requirement reductions, as more homogeneous portfolios make IRB advanced more easily achievable.

Similarly, many banks will come under increasing pressure to scale down or exit businesses in which they hold only relatively small portfolios. Only the most sophisticated of the banks are likely to manage broad portfolios and compete successfully on this basis.

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The overall impact on capital levels nationally across Europe could have serious ramifications for competitiveness. As the EU presses for regulatory harmonization, banks will be liberated from national regulatory protection and banks in northern Europe look to be getting an advantage in a more competitive environment via lower regulatory requirements.

Incentives for banks in emerging markets are a potential worry, as IRB assigns these a lot of capital. Following the most recent debate and the interest that is being taken by the IMF, Basle II is very much on the agenda for the emerging markets, albeit with possible delays.

This will also have an obvious knock-on effect on western banks that have emerging-market subsidiaries, not least Spanish banks in Latin America (all numbers in Figure 2 exclude non-domestic subsidiaries), and a possible disincentive to invest in developing countries might have negative implications for their general growth prospects.