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May 2000

Basel’s big exam


Proposals from Basel to reform the bank capital adequacy framework have triggered a wide-reaching debate on the nature of bank capital, liquidity and valuation. A hasty conclusion could waste some valuable new thinking.




If the Basel Committee on Banking Supervision's proposals for a new capital adequacy framework were applied raw tomorrow, they would be a disaster. Nearly everyone agrees about that.
But the draft of that framework, unleashed on the banking sector in June last year, has certainly stimulated active thought. Bankers, regulators and credit analysts have wrestled with the conundrum: how do you get a fair assessment of a credit portfolio, in order to apply a capital charge to it, consistent enough to encourage a level playing field?
Credit rating agencies at first expected a bonanza, with a heavy increase in demand for their services. But that was quickly followed by concern that external credit ratings are too blunt an instrument to reflect the day-to-day riskiness of a credit portfolio - and not enough companies, banks and other bank customers are rated, except in the US.
However, the use of banks' internal credit ratings instead is fraught with difficulty too, since that is like asking each bank to set its own standard. It threatens to give supervisors - or auditors hired by supervisors - a huge amount of extra work.
The Basel committee's three pillar concept - 1) a numerical charge for credit and other risks; 2) continuous supervisory review; 3) the use of market discipline to promote transparency - has thrown the debate wide open, even to the level of philosophy or religion. How far should the numbers reflect stress tests; what are the dangers of micro-management by supervisors; and above all, how do you define and capture these "other risks" that the Basel committee wants to see a capital charge against?
Multiple industry bodies responded to the proposals by the deadline of March 31. The International Swaps&Derivatives Association (Isda) was the most outspoken in rejecting the idea that a capital charge for "other risks" - operational risk - can be standardized. It proposed the use of a detailed credit risk metric to overcome the shortcomings of external ratings. The Basel committee is having to come out with a more concrete synthesis by the end of the year. The threat is, that if no sensible consensus emerges from talks with the industry, a framework will be imposed "top-down" using rating agencies for credit risk and imposing operational risk charges based on size and business volume.
Danièle Nouy, secretary-general of the Basel committee, says they have been surprised by the number and category of banks with an interest in using their own, internal, rather than external credit models. That is just as well, since the independent rating agencies could not hope to cover a fraction of the credits involved in a non-US bank credit portfolio.
But when it comes to application, supervisors will have a huge amount of extra work, assuming this applies to all banks, not just the top-tier of those internationally active.
Then there is the question of defining operational risk. The Basel committee appears to have got as far as looking at around seven or eight business lines, each of which would be charged according to an appropriate business-volume-to-risk ratio. A member of the Basel committee's risk management group, Klaas Knot chief of banking and supervisory strategies de Nederlandsche Bank, recently explained four possible approaches to an operational risk capital charge: 1) the use of internal models; 2) the use of a bank's own internal business lines and risk assessment; 3) a business line approach using Basel-imposed capital ratios; 4) the use of basic indicators (with no attempt to quantify the finer shades of risk).
A group of leading banks are working on a closer definition and quantification of operational risk, however. The MORE (Multinational Operational Risk Exchange) consortium has identified the need to develop a database on operational risk loss experiences. Dan Mudge, former head of risk at Bankers Trust, and now a partner of NetRisk which acts as agent for MORE, argues that MORE gives a perfect front to "go back to regulators and say 'give us a year and we'll come up with something better'". But other risk managers are sceptical that quantifying the major operational risks is possible or useful. Some even say "there's no such thing as operational risk".
Another approach by the two Shadow Financial Regulatory Committees, one in the US, one in Europe, is to back the use of banks' subordinated debt as a supervisory surrogate (see Euromoney, April 2000, page 144). But regulators close to the Basel committee see problems with this approach: bank subordinated debt is only actively traded in the US; elsewhere the price might not be transparent, especially in emerging markets.
And yet another approach is the purchase by banks of insurance to mitigate the cost of capital for operational risk. Swiss Re already has a product - Fiori - but the cover is small, up to only $200 million, and the payout would take time - up to 30 days. "We're looking at a product that pays out in three to four days," says Dean White a director at Swiss Re New Markets. But even three days could hardly protect a bank from a liquidity crisis.
There is a sense of urgency about reaching an answer. The Basel committee is the unofficial leader of the intellectual debate on capital adequacy, not only for banks, but also for securities firms. If it doesn't get there first, there are other bodies, such as the European Commission's directorate general for the internal market, likely to impose a regime that has been less carefully debated.
However, recent forums that have been discussing these proposals suggest the debate is not very far advanced, and that perhaps it should go in a completely new direction.
Back to basics
A round-table in Geneva in early April, held by the International Financial Risk Institute (Ifci), found itself careering off into questions of fair valuation, liquidity and the implicit role of the central bank as lender of last resort.
The first big question, addressed by Robert Gumerlock, former head of risk control at UBS, was how to value a banking book. Mark-to-market valuation has proved useful to measure the market risk of a portfolio, but credit risk is a different animal, since it depends more on the intention and time-horizon of the holder. Fair value is difficult to apply to illiquid financial instruments and their value sometimes depends on whether the management intends to hold or trade them. Moreover, the so-called fair value doesn't necessary hold up when you need to sell in a hurry - liquidation value. Fair value, said Gumerlock, "systematically overstates true worth". For market risk "this has been appreciated and allowed for. But for credit instruments so far there has been little mention of 'adjustments'".
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