An investigation of the impact of Basel II on the improvement in risk management practice globally

An investigation of the impact of Basel II on the improvement in risk management practice globally

Introduction

This essay is going to have a deeper look on h ow risk management globally is affected by Basel II. Therefore the author is going to summarise the key aspects of Basel II in comparison to Basel I, followed by a critical evaluation of these changes taking the reader through points wide ly considered as positive accompanied by some opinions from market representatives, equally drawing the attention to some drawbacks and suggested improvements. The essay will be closed with concluding remarks from the author.

The initial Accord: An Overview.

Basel II is going to replace the former Basel I accord by the beginning of 2007. The initial accord, adopted in 1988, basically set a capital reserve requirement on internationally active banks from the G10 countries of eight percent of risk-adjusted assets ( Basel Committee on Banking Supervision, 1999, 2001). This measure was to cover expected losses on loans outstanding (Diana, 2005). Table 1 gives a brief overview over the Basel I accord risk weights.

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The initial intention of Basel I was to create a playing field for international banking. Large financial institutions of some countries were able to take tremendous risks without having large amounts of capital as their governments spoke out implicit guarantees (Rochet, 2004). “So the fundamental idea behind the Cooke ratio was harmonization” (Rochet, 2004, p. 14).

Jim Herrity, a Director of Moody’s KMV, noted that “Many bankers were dissatisfied with the one size fits all regulatory capital requirements of Basel I, arguing that banks that have more accurate risk rating systems should be allowed to calculate their own regulatory capital requirements” (cited in Diana, 2005). The exact figure of eight percent, into the bargain, was always a topic for discussion and was usually criticised for being too crude (Decamps et al, 2002). For example an adequately collateralised loan required equal capital weighting as an inadequately collateralised one. However, more than 100 countries adopted the Basel I Accord which makes it a major milestone in the history of banking regulations (Ghosh, 2004).

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An investigation of the impact of Basel II on the improvement in risk management practice globally

In June 1999 the Basel Committee on Banking Supervision (“Basel Committee”) of the Bank for International Settlements (BIS), with its headquarter in Basel, Switzerland released a proposal for a new capital accord with the name: “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” which came to be referred to as Basel II. Basel II introduces more sophisticated risk measurement techniques and allows the use of internal ratings, called IRB-approaches, in addition to external ratings (Grunert et al, 2002).

The main objectives of the new Basel Capital Accord are: an improvement of risk- sensitivity in banks’ capital allocation, calculation of detached capital charges for operational risk 1 and credit risk and bringing the Regulatory capital requirements more in formation with banks’ Economic Capital requirements.

Finally Basel II is supposed to give confidence to banks to use their internal systems and models in order to calculate adequate levels of Regulatory Capital as Jaime Caruana, Chairman of the Basel Committee on Banking Supervision and Governor of the Banco de España, said in his Hong Kong speech on February 4 th 2005: “Basel II is to provide an economic incentive for banks to develop reliable risk management techniques, because those with the best risk assessment systems will be viewed more favourably in the marketplace” (Caruana, 2005). To reinforce these objectives the regulatory framework of the new Basel Accord consists of three pillars that reciprocally reinforce each other: Minimum Capital Requirements, Supervisory Review process and Market Discipline (Ghosh, 2004). Three factors determine the amount of capital requirements faced by a bank: Capital Risk, Market Risk and Operational Risk. Figure 1 shows in how far Basel II revises the requirements and tools used to measure Credit Risk and Operational Risk. There is no re-regulation of Market Risk in Basel II (Grunert et al, 2002).

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1 The Basel definition of operational risk states it is “the risk of direct and indirect loss resulting from failed or

inadequate processes , systems or people or from external events” (Basel Committee on Banking Supervision,

2001)

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An investigation of the impact of Basel II on the improvement in risk management practice globally

Basically there are two approaches to determine capital requirements and credit risks: On the one hand side we have a standardised approach whi ch is based on external ratings for example Standard & Poor’s or Moody’s. Table 2 gives an overview of the risk weight under the standardised approach with the new Basel Capital Accord.

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On the other hand side the banks are now allowed to use an Internal Ratings Based approach, called IRB-approach. Using the latter one and based on Probability of Default (PD) banks have to determine the minimum capital requirements for every single loan by themselves 2 . The IRB-approach for corporate loans is divided into a Foundation Internal Ratings Based approach and an Advanced Internal Ratings Based approach. Besides these two a third one for “retail exposures”, hence credits given to private customers or small business, is suggested by the BIS (Basel Committee on Banking Supervision, 2001), the author, however, is not going to focus on this last proposition in detail as it is not identified as one of the main points in discussion.

IRB-Approaches: The details

To provide a more sophisticated understanding of the matter in question, the author gives a quick overview about the IRB approaches as to the reader is able to understand without any difficulty the praise and criticism that will follow. Using the Foundation IRB- approach the banks only estimate the probability of default by themselves. For the Loss given Default (LGD) the amount of 50% is used which can be reduced using some calculation depending on the level of insurance the creditor provides ( Basel Committee on Banking Supervision, 2001). Table 3 provides proposed IRB Risk Weights for hypothetical corporate exposure with loss-given-default equal to 50% calculated by Reisen (2001).

2 Ewert and Szeczesny (2001) as well as Norden (2002) examine the different approaches banks use to

determine the Probability of Default.

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An investigation of the impact of Basel II on the improvement in risk management practice globally

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Likewise, using the advanced IRB-approach the banks determine not only the probability of default but as well the amount of loss, the effective remaining life (M) and the exposure at Default (EAD) using their own methods.

Following the suggestions of the Basel Committee on Banking Supervision (2001) the calculation of the Benchmark-risk-weight (BRW) is illustrated by equation one with N(x) being the Standard Normal Distribution and G(x) the Inverse Standard Normal Distribution.

Taking into account the Loss given Default (LGD) the author finds the final risk- weight (RW) which is calculated using equation two.

LDG

To prevent the capital requirements exceeding the amount of loss in case of default the ceiling (12.5 x LGD) is introduced. However, the recent Quantitative Impact Study II (QIS II) shows that capital requirements would increase by 14% on average using this IRB- approach, hence the Basel Committee proposed to reduce this augmentation in a way represented by the following set of equations (equation 3 to 5) where M equals the maturity adjustment factor and R equals the average correlation between the assets of the company (Basel Committee on Banking Supervision, 2001).

R

RW

With

3 This equation is made up of three terms. The first term (976.5) is meant to scale in such a way that with a PD of 0.7% and a LGD of 50% the BRW equals 100%. This equals the old risk weight for corporate costumers. The middle term represents the sum of the expected and unexpected losses of a hypothetical portfolio of one-year loans with a LGD of 100% dependent on PD. The coefficients are calibrated for an average correlation of the creditors of 0.2 and a confidence interval of 99.5%. The last term is to simulate an average remaining life of the loan of three years.

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