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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The part of Basle II discussed most often concerns the minimum capital requirements spelt out in Pillar 1, which forces capital to be more closely aligned with the risks of portfolios held. Banks are offered two general approaches for calculating capital requirements: standardized and internal ratings based (IRB). IRB has two further sub-approaches: foundation and advanced. We summarize the differences between these with respect to risk weights, parameters and mitigation in Figure 1.
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.
Geographical gainers and losers
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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.
Figure 4 shows the total credit and operational capital requirements for four different composite bank types, with the difference between standardized and IRB foundation typically around 10% to 15%, rising to about 35% for the mortgage specialist. Capital requirements are skewed across the bank types, driven by portfolio mixes, with only mortgage banks and domestic retail banks using IRB advanced experiencing a reduction relative to current levels. Although this picture changes slightly across geographies, it is clear that bank type, combined with level of Basle II compliance achieved, will have a significant impact on the likelihood of benefiting from the new regime.
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The aggregate picture in Figure 4 may also entice more non-banking financial institutions that are free of Basle regulation to enter the market, as many banks are not yet investing enough to reach IRB at implementation in 2007. An alternative route for banks is through the credit risk transfer market, by which high-risk, and thus capital-intensive, portfolios could be removed from the balance sheet.
Similar tactics may be appropriate for institutions that will not be in a position to qualify for IRB treatment.
We foresee innovative credit products emerging and the current boom in credit derivatives being further fuelled by changes brought about by Basle II.
Figure 5 illustrates the estimated capital release due to mortgages for several UK banks, assuming IRB advanced compliance is achieved (IRB foundation and advanced are the same for retail exposures).
Basle II is likely to give significant skews in probable capital release within particular product segments in each individual country. This is likely to contribute to increased mergers and acquisition activity as more sophisticated banks take the opportunity to acquire less advanced competitors, with a view to implementing IRB-compliant frameworks and thus freeing up significant quantities of capital. Indeed, we expect regulatory capital synergies to emerge alongside cost and cross-sell synergies in the M&A story.
Judging by the volume of commentary from both the industry and regulators across the three pillars of Basle II, one might think that the minimum capital requirements in Pillar 1 are by far the most significant components of the new Accord. The Accord, however, is a balanced piece of regulatory drafting, which lays the foundation for evolving regulatory models, and ultimately Pillars 2 and 3 may well have a greater impact on banking regulation and strategy.
Pillar 2, whereby banks must assess the full spectrum of risks they face and demonstrate that they have adequate management processes and capital resources to protect against them, opens the door to a more models-driven (rather than rules-driven) approach to determining the actual capital held in excess of the regulatory minimum.
In addition, the disclosure requirements detailed by Pillar 3 lay the foundation for increased self-regulation. It is worth recalling that much more radical and entirely self-regulating models were being proposed early in the Basle debate, gaining most exposure immediately before the Russian debt crisis and the collapse of Long Term Capital Management.
It is also important to remember that the role of Pillar 1 is to determine the minimum acceptable level of capital that any regulated institution must hold. Today most banks hold capital that is comfortably in excess of the Basle I minimum, since this would typically equate to an S&P rating of around BBB, which is untenable for most institutions.
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The new Accord explicitly expects that most banks will continue to hold capital that is in excess of the regulatory minimum, and that the appropriate level of capitalization should be informed by a robust assessment of the risks faced. This also highlights the fact that a range of significant risks (such as structural interest rate risks, and risks arising from variability in margins, volumes and costs) are omitted from the Pillar 1 calculations.
Already in some regulatory regimes (for example, the UK, the US and Australia) the mechanism by which target levels of capital are explicitly set for individual institutions is familiar. In other countries, this is still an alien concept. One of the biggest concerns about Basle II implementation, especially in Europe, is the level playing field between different regulatory regimes and their application of target solvency standards. Interestingly, the evolution of insurance regulation is following a similar process, and in the UK (via the proposals laid out in CP136) is likely to be implemented before Basle II.
Pillar 3 will also have a significant impact on the way banks operate, manage risks, and allocate resources. In recent years numerous banks, such as Deutsche Bank, Barclays, BSCH and JPMorgan Chase, have experimented with more detailed disclosure of their risk and capital positions.
Banks have long been notorious for the opacity of their balance sheets and earnings but the implementation of robust risk measurement tools is enabling them to disclose far more detailed breakdowns of such data as asset quality, provision forecasts, and capital adequacy. As less willing banks are obliged both to implement and disclose the results of improved risk management and measurement systems, investors, rating agencies and regulators will be able to form a consistent view of the spectrum of the risk/reward profiles offered across the banking system. Overall, this could provoke much greater differentiation in valuations, funding costs, and capital requirements, and lead to the emergence of disclosure as a potential competitive advantage.
We therefore expect that Pillars 2 and 3 will have at least as great a role in determining actual levels of bank capitalization as Pillar 1. This will lead to a more tailored approach to regulation, with greater emphasis on assessing the appropriateness of internal risk management processes, rather than following a lowest common denominator, rules-driven approach. The current consultation process, largely focused on Pillar 1, has demonstrated that the market would always out-innovate the ability of any party to codify it. If more emphasis is placed on assessing banks’ own approaches to risk management and solvency, much greater responsibility will be placed on management to ensure that approaches and results are fairly represented.
Cyclical capital
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Most informed commentators thus rightly do not view the Basle II proposals as increasing systemic risk by kicking banks while they are down.
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Banks will, however, require a much more robust and dynamic approach to balance sheet and capital management. Many banks’ current capital planning processes can be summarized as guesswork: “what do you think – another 10%?”. Basle II will require a more rigorous approach, taking in on- and off-balance-sheet risks, volume growth, and the impact of future economic situations.
The fire-drills currently being conducted by life insurers should be a strong reminder that future prospects are not always a linear extrapolation of last year, and that downside planning is a vital ingredient in capital management. Indeed, the Basle II proposals are explicit in expecting that banks have robust capital management and solvency strategies, with responsibility resting with the bank’s senior management. Should regulators become uncomfortable with a bank’s capital management, there are also robust proposals for action under Pillar 2, as well as likely capital requirement penalties.
These challenges for capital management will drive significant product innovation over the next two to three years, as investment banks, reinsurers and others vie to address new client needs. One of the prime drivers of Basle II was the need to close down the arbitrage opportunities exploited by collateralized loan obligations and similar transactions that rarely involved any true transfer of risk. An increase in demand for more sophisticated and economically valid capital management products should help to offset the drop-off in demand for these balance-sheet window-dressing transactions.
Many features of today’s financial services industry landscape have been determined by the 1988 Basle Accord. Basle II is likely to have an equivalent, perhaps even greater, impact, via a combination of the Pillar 1 risk weight formulas and Pillars 2 and 3 adding pressures on bank management and regulators. Banks should therefore not view the preparations for Basle II as largely a compliance exercise with sunk costs.
First, to get maximum payback from our estimated five basis points compliance costs, banks must strive to exploit the business improvement opportunities available from the enhanced risk measurement and management approaches they are implementing. Second, they must consider how their business models, and those of their bank and non-bank competitors, will be changed and use this to derive strategic advantage from the introduction of Basle II.
As the time for implementation draws nearer, the need for such strategic pre-positioning will increase dramatically for banks that want to be among the winners in the post-Basle II era.
Dr Thomas Garside is managing director, finance & risk management, and Christian Pedersen is senior manager, at strategic consultancy Oliver, Wyman & Company
