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Practical Guide to Basel II Implementation: Part 2 of 6

In part 1, we provided a general overview to get started with the Basel II implementation. We will now discuss the factors to be considered in determining the application of Basel II from both a supervisor and a bank perspective.

A key objective of Basel II is to encourage improved risk management through the use of three mutually reinforcing Pillars. In their efforts to achieve improved risk management, focusing on one pillar and neglecting the others is not suggested. So, apart from the minimum capital requirements under Pillar 1, it is important to build strong risk-based supervisory review with early intervention and market discipline under Pillars 2 and 3.

Given the economic and banking conditions, the supervisors in each country will adopt the Basel II standards to suit their needs. For example, supervisors in some jurisdictions may wish to retain their current approach to minimum capital requirements and to focus their efforts on building a robust supervisory review framework and to enhance market discipline, consistent with the principles underlying Pillars 2 and 3. Supervisors will also have to consider the cross-border implications of their implementation choice.

Banks in each jurisdiction will be required to follow the Basel II requirements in their jurisdiction. A few requirements for banks a briefly discussed below:

Supervisory framework: All banks should look at developing processes for assessing their capital needs and a strategy for maintaining capital levels, consistent with the principles embodied in Pillar 2. Supervisors are encouraged to review these. The capital level and processes should be tailored to the bank’s risk profile, operations and controls. In turn, supervisors should engage in a dialogue with the bank regarding these processes.

Disclosure requirements: All banks are required to make periodic disclosures of information that are timely, accurate and sufficiently comprehensive to provide a basis for effective market discipline.

Human resources: Having the right personnel will be critical to the successful implementation of Basel II. This may involve hiring more qualified staff and enhancing training programmes. In particular, for countries implementing the advanced approaches for Basel II, there is a need to retain both bank and supervisory personnel with the quantitative expertise and skills to understand banks’ rating systems, models and capital assessment strategies in advance of Basel II implementation. Even for the simpler approaches, both bank and supervisory staff may need to upgrade their skills in the areas of credit risk mitigation and operational risk as well as capital adequacy assessment under Pillar 2.

Factors to be considered in choosing a Basel II approach

The decision to implement a particular approach to capital regulation should not be driven by a bank’s desire to minimize regulatory capital requirements. At the same time, banks must evaluate what the differences between Basel I and Basel II will mean in practice, and assess the costs and benefits of making such a transition. The main decision points for evaluating the transition to the simple and advanced approaches, respectively, are set out below.

The simpler approaches under Basel II

Use of external assessments

In many countries, low rating penetration and a lack of domestic rating agencies may pose a challenge to implementation of the standardised approach, particularly in respect of corporate claims. If external ratings are to be used, supervisors will need to evaluate the soundness and reliability of the institutions performing the assessments.

Supervisors will need to determine if they have the capacity (in terms of human resources, budgets and time) to perform this function and whether there is sufficient depth to the market discipline in their jurisdictions to supplement this.

Supervisors should also discuss with banks how they intend to monitor changes in external rating or country risk scores, and how these will be reflected in systems for capital computations.

Suitability of supervisory-determined risk weights and estimates

Within the Committee, the supervisory estimates used in the Basel II calculations (e.g. the standardised risk weights for claims included in the retail portfolio – including claims secured by residential property – and supervisory estimates of key parameters in the foundation IRB approach) are minima. These estimates were based on experience in Committee member countries. As such, national supervisors should evaluate the loss experience for these types of exposures to see if these estimates are appropriate and relevant for their jurisdiction.

Credit risk mitigation

In assessing the costs and benefits of migrating to the simpler approaches of Basel II, supervisors should give consideration to the relevance of the additional credit risk mitigation permitted under Basel II for their banks. In turn, this will depend on which additional eligible instruments are used as collateral in a particular jurisdiction, whether the legal basis for the enforcement of collateral is effective, the existence of liquid markets to obtain reliable collateral valuations and the availability of a larger range of guarantors, including providers of credit derivatives.

Operational risk

A capital charge for operational risk is not an option but a fundamental part of Basel II. The simpler approaches – basic indicator, standardised or alternative standardised approaches -are relatively straightforward to implement (the last two require banks to be able to provide an appropriate breakdown of gross income into business lines).

When considering moving to Basel II, supervisors should be aware of the impact of the operational risk charge and understand that it is designed to provide incentives for banks to develop suitable approaches to operational risk measurement and ensure that banks are holding sufficient capital for this important risk.

Pillars 2 and 3

Supervisors are encouraged to implement the key principles underlying Pillar 2 and 3, even before they move to a Pillar 1 implementation. Thus the consideration of whether banks should adopt Basel II must not be solely based on Pillar 1 issues. Supervisors have to consider the additional efforts that may be required to achieve, and benefits to be gained from, compliance with the Pillar 2 and 3 requirements. This will depend on the nature of activities undertaken by banks and the extent to which risk-based supervision is presently carried out. In evaluating these factors, supervisors should consider banks’ capabilities to carry out the internal capital adequacy assessment programme and their own readiness to perform the capital assessment review.

Banks moving on to Basel II must also make the applicable disclosures under Pillar 3.

Supervisors have to ensure that they are in a position to require and enforce such disclosures before permitting banks to adopt Basel II.

Moving to advanced approaches

Of the options set out in Basel II, the IRB approach to credit risk and the AMA approaches to operational risk (together, the “advanced approaches”) most closely link capital requirements to underlying risks. Given their increased emphasis on banks’ internal assessments, the advanced approaches also require banks to meet a rigorous set of standards which provide a level of comfort as to the accuracy of these risk estimates and an appropriate control and oversight environment at banks. Adoption of these approaches also triggers additional obligations under Pillars 2 and 3. The process for determining which banks may be subject to the advanced approaches will require assessment of a number of factors, including a bank’s risk profile, the nature of its operations, and its ability to meet the eligibility requirements for these approaches. For the IRB approaches, supervisors must also evaluate the suitability of the risk weight functions, which are based on asset correlations observed in Committee member countries. The relationship between PD and capital needed to cover UL in the IRB curves reflects the experience in mature markets. Countries may need to require more capital if there has been a higher loss history.

For jurisdictions where supervisors decide to make the advanced approaches available to all banks, these factors are relevant when considering whether the banks who do apply for an advanced approach meet the minimum requirements.

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