Diapositiva 1

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Basel II Status of work

• June 2004 Publication of the revised
  framework Basel II
• April 2005 Consultative paper on Trading Book
  issues and Double default
• July 2005 Incorporation of Trading Book and
  Double default into June 2004 text
• Fourth quarter 2005 Data collection for
  recalibration exercise
• Spring 2006 Recalibration
• Jan 2007 Standardised Approach and Foundation
  IRB available
• Jan 2008 Advanced IRB available (full
  implementation)

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Basel II

• Represents a significant step towards achieving
  a more comprehensive and risk sensitive
  supervisory approach gt Bringing
  regulatory capital closer to economic capital.
• Overall objective gt to enhance banks safety
  and soundness, thereby strengthening the
  stability of the financial system as a whole.
  That, in turn, will improve the ability of the
  financial sector to serve as a source of
  sustainable growth for the broader economy.
• Basel II is about much more than just setting
  better quantitative minimum capital requirements.
  It is about establishing an incentive-based
  approach to risk management and capital adequacy,
  within a framework of three mutually-supporting
  pillars.
• It represents an unparalleled opportunity for
  banks to improve their capital strategies and
  risk management systems. It provides supervisors
  with an opportunity to improve their ability to
  identify banking risks and to enhance the
  dialogue with the industry and among banking
  supervisors.

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Critical issues

• Basel II implies a far-reaching shift in the
  regulatory paradigm.
• Three critical issues for the success of Basel
  II. Important to ensure that
• It works at micro level - Prudent, appropriate
  and risk sensitive capital requirements. Risk
  management incentives. Improving risk management
  without imposing a single model.
• It works at macro level - Not only sound in the
  micro dimension but also enhancing macro
  performance favouring growth potential,
  appropriate behaviour in terms of procyclicality,
  flows to emerging markets etc.
• Implementation is consistent - Level playing
  field. Home host issues. Finding ways to reduce
  the tension between banks organization and
  home-host supervisory relationships.

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Points to be covered

• I will not discuss the micro issues, which
  relate to the basic elements of Basel II
  (although let me emphasize the importance of the
  three pillars and their mutually reinforcing
  effect). I will focus on the other two issues
• First, I would like to say something about the
  macro perspective, because I am not convinced by
  some of the analysis of Basel II that points to
  excessive procyclicality or difficulties in flows
  to emerging markets. I will try to summarize my
  perspective and certainly I propose that we all
  continue to monitor the effects. This is really
  important.
• Second, I will concentrate on implementation
  issues, which in a broad sense includes at least
  three strands of the present work of the
  Committee
• Calibration.
• Validation.
• Home Host issues.

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Macro perspective

• Micro-prudential regulations may have
  significant macroeconomic implications. It is
  important to analyze and understand them.
• Basel II has been thoroughly scrutinized by many
  parties to evaluate its consequences in terms of
  procyclicality, and its implications for
  cross-border financial flows, especially to
  emerging markets and areas of strategic
  importance to the economy.
• We welcome all these contributions (some of
  which have been very critical of the proposals),
  which have significantly improved the framework
  as well as our understanding of very important
  issues.
• Furthermore It is important to continue to
  monitor and analyse effects.

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Procyclicality

• Procyclicality is an excellent theme for
  discussion in relation to the potential
  macroeconomic effects of Basel II, because
• There have been many studies and discussions on
  this issue during the development of Basel II
• It is relevant to the analysis of other issues
• For example economic capital versus regulatory
  capital as a driver of bank decisions, which is
  also relevant for flows of funds to emerging
  countries

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Procyclicality the issues

• There is clear evidence that many banking
  variables are correlated with economic cycles.
• Banking business is risk-sensitive today and as a
  consequence implies some degree of procyclical
  behaviour today.
• The question is whether Basel II will exacerbate
  this aggregate behaviour?
• I appreciate the work in this field, and I hope
  that it will continue and help to shed light in
  areas where results are not conclusive.
• Although I share many of the arguments and some
  concerns, I tend to have a more positive view of
  the macroeconomic implications of Basel II.
• The Basel Committee has taken this issue
  seriously and introduced a number of changes to
  the framework. There are also a number of
  mitigating elements that allow a positive
  assessment to be made of the macroeconomic effect
  of Basel II.

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Arguments in three categories

• Which measure of capital is most relevant in
  explaining the cyclical lending patterns of
  banks?, How risk sensitive is bank behaviour
  today? Will Basel II unduly exacerbate
  procyclicality?
• What elements in the Basel II package run in the
  opposite direction and what mitigating factors
  can contribute to offset procyclical tendencies?
• Long term influence of better risk management/
  transparency in terms of better resource
  allocation, efficiency of the financial system
  and growth potential of the economy. Will Basel
  II improve the ability of the financial sector to
  serve as a source of sustainable growth for the
  broader economy?
• What the three arguments have in common is that
  perhaps too much attention is placed on the
  minimum capital rules of pillar 1 and too little
  attention on the effects of higher transparency
  of risk profiles and better risk management
  driven by incentives.
• These latter aspects are difficult to measure.
  But I tend to think that they are the main
  channels through which the positive effects of
  Basel II will be felt.

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Capital requirement procyclical?

• To the extent that BII is more risk sensitive gt
  additional element of procyclicality?
• It can be argued that a downturn has two
  effects
• gt loan losses gt reduction of available capital
• gt credit deterioration gt higher capital
  requirements
• However, this analysis is too mechanical. The
  process is more complex. It will depend e.g. on
  the dynamic features of a credit rating system
  and the characteristics of the PDs associated
  with that rating system.
• Risk blindness can be even more procyclical,
  i.e the most abrupt and procyclical behaviour
  will probably occur in a poorly provisioned and
  poorly capitalized bank with inadequate risk
  management. In a downturn gt unpleasant surprises
  and little room for manoeuvre gt abrupt cut-back
  on lending.

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More procyclical behaviour?

• Basel II appropriately addresses the main
  contributors to procyclicality
• Inadequate shock-absorbers (provisions and
  capital)
• Poor risk management (Lack of understanding and
  proper controls) and weaknesses in the balance
  sheets
• Weak financial supervision.
• It is one thing to say that minimum capital
  requirements are procyclical but quite a
  different thing to say that the behaviour of
  banks is more procyclical.
• Perhaps the degree of risk sensitivity of banks
  behaviour today is underestimated and the role of
  regulatory capital in this regard is exaggerated.
• Nowadays, well-managed banks already allocate
  economic capital and take decisions on the basis
  of risks incurred. Their economic capital is
  procyclical today. Basel II does not alter the
  calculation of economic capital, but it can help
  to promote cycle awareness.

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Offsetting factors

• In addition, there are a number of effects
  working in the opposite direction, as well as
  other mitigating factors.
• Even in the most mechanical part of the
  framework, pillar 1
• Although the time horizon used in PD estimation
  is one year, banks are expected to use a longer
  time horizon in assigning ratings.
• The design and validation of the classification
  systems gt less procyclical. The Basel Committee
  modified its guidance for ratings processes to
  encourage banks to take more account of
  uncertainty over the full economic cycle.
• Risk parameters estimated as a long-run average
  (PD) or to reflect downturns (LGD).

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Buffers under Basel II

• Banks will be required to perform a
  meaningfully conservative credit risk stress test
  of their own design gt capital buffers.
• Can capital buffers make regulatory capital less
  of a constraint ?
• At present, actual capital is in general well
  above minimum regulatory requirements. Some
  evidence of a negative relationship between the
  capital buffers and the cycle. Countercyclical
  behaviour in buffers could be accentuated by
  Basel II.
• Pillar 3 may reinforce these elements and it may
  in many cases have a stronger effect than pillar
  1 calculations.
• It is not easy for markets to analyse the risk
  profile of financial institutions. The
  contribution of pillar 3 to transparency in this
  area could significantly enhance market
  discipline.
• In sum, Basel II places capital in the centre of
  the banks responsibility and strategy, and
  requires managers to be very conscious of and
  serious about understanding the drivers of risk
  through the cycle within a medium term time
  horizon.

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Risk management channel (1)

• The improvement of risk management is an
  important channel of influence of Basel II.
• A word of caution Quantifying risk involves
  making assumptions and judgements. But no model
  or software package, no matter how sophisticated,
  can replace the skills and judgement of a
  trained, experienced and conscientious risk
  manager (although such judgement should, of
  course, be reinforced with the best possible
  information and techniques).
• In other words, risk management is not just about
  quantitative models, but also about qualitative
  issues, i.e. promoting a risk culture.
• That is why we have made sure that the Basel II
  framework is much more than numbers and models.

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Risk management channel (2)

• Risk management entails
• Comprehensive firm-wide analysis and
  quantification of risk
• Governance, control systems and structures Board
  involvement establishing dedicated risk
  management function to foster more integrated and
  systematic approaches to risk consistent
  reporting etc.
• Investments in risk infrastructures - systems,
  technology and telecommunications - in order to
  gather, collect and analyse large amounts of data
  on exposures.
• Constructing compatible and efficient management
  information systems across all of the banks
  businesses, on the basis of common risk measures
  across business lines.

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Risk management channel (3)

• Improved and more formalized risk management will
  bring
• More awareness and better assessment (and
  quantification) of risks. The firm is less likely
  to ignore material sources of risk.
• Using the concept of economic capital and its
  elements, banks can develop sound policies to
  determine their risk profiles and for monitoring
  exposure limits, risk-adjusted pricing policies
  and sound provisioning practices based on the
  inherent risks of the portfolios. They can
  measure returns and assign capital on a
  risk-adjusted basis.
• The ability to understand and use appropriately
  new mitigation techniques.
• Perhaps more critically, better risk management
  and the associated quantification have the real
  potential for reducing the wide attitudinal
  swings that are associated with the historical
  cyclical pattern in bank credit A. Greenspan.
• Capacity to communicate, in a transparent
  manner, complex issues such as positions and
  policies in risk management.
• Less surprises. Early detection gt prompt reaction

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Risk management channel (4)

• To the extent that risk assessment and control
  methods become more formalised and rigorous, this
  will lessen the likelihood of making bad
  decisions and under-pricing. It will also
  contribute to the prompt detection of errors and
  deviations from targets, allowing banks to
  implement corrective measures at an early stage
  gt lower losses.
• Awareness and early reaction is likely to lead to
  a smoother adjustment to new conditions or to
  correction of mistakes, making decisions less
  abrupt.
• This early reaction will be supported by the
  supervisory second pillar and by the transparency
  of the third pillar, which will also reduce the
  temptation of forbearance.
• Reduction of losses because of better risk
  management could moderate the most important
  effect of downturns on capital ratios lower
  capital base (the other being higher capital
  requirements).
• Summing up It is difficult to think that all
  these investments in technology, governance
  structures and advances in risk management will
  not bring significant improvements to the
  efficiency and soundness of the financial system.
  This should benefit the overall economy.

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Trends and Cycles

• Shock absorbers more risk sensitive and cycle
  conscious
• Enhanced Transparency gt improve conditions to
  raise capital as well as incentives to have
  adequate capital
• Better and pre-emptive risk management, based on
  improved control structures and corporate
  governance, investments in technology,
  information databases and human capital.
• Banking system more stable and efficient in
  allocation of resources, and also more
  risk-efficient.
• Even if procyclicality continues it is very
  likely that it will be around a superior trend.

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? ASSESING THE VALUE-ADDED OF BASEL II REQUIRES
CONSIDERATION OF BOTH TREND AND CYCLE ?
Trend enhanced risk-sensitivity and
transparency ? Cycle procyclicality and
volatility

Basel II
Output

• Superior trend
• Less surprises

Basel I
Time
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Partial summing-up (1)

• Difficult to be conclusive, it is important to
  be attentive.
• I tend to be optimistic To the extent that
  Basel II leads to better risk management, I have
  difficulty in accepting that better risk
  management will bring poorer macroeconomic
  performance of the aggregate banking system.
• Following the same kind of reasoning, based on
  the joint result of enhanced transparency, better
  risk management systems and shock absorbers that
  are proportional to risks, it would not be
  surprising if in the medium and long term Basel
  IIs forward-looking elements take over and as a
  result the financing of all kinds of economies is
  improved.
• Furthermore, market dynamics may reinforce this
  process and those banks that adopt higher
  standards of risk management and capital and
  countries that embrace the new supervisory
  approach could be perceived by markets as less
  risky, resulting in lower risk premiums and
  better access to financial markets.

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Partial summing-up (2)

• Even if we regard the new capital framework as
  more comprehensive and a better framework, it is
  very important to analyze and monitor macro
  implications and to ensure that the financial
  system contributes to the stability and growth of
  the economy.
• I hope that the analysis will continue. We
  followed a very open and consultative process
  during Basel II preparations, we have learned a
  lot and we intend to continue in the same spirit.
• I also hope that other areas of regulation, such
  as provisioning, will receive as much attention,
  because it is also my firm view that this is an
  area where significant improvements and
  additional compensating factors (if necessary)
  could be obtained.
• IAS 39 or incurred losses procyclicality, and
  dynamic provisioning as a counterbalance, are
  academic and supervisor challenges that,
  hopefully, will attract as much attention as
  Basel II procyclicality in near future

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Implementation issues

• Three strands of work that will have to take
  into account the critical factors mentioned
  earlier to ensure success
• Calibration. Important for the assessment because
  it will be based on a considerable body of data.
  We will need to understand cyclical factors.
• Validation. One of the greatest challenges for
  both banks and supervisors is the need to
  validate systems and processes. Essential to
  understand the dynamics of different models and
  ensure effective application by the banks.
• Home Host issues. Consistency of implementation
  across jurisdictions, e.g. application of pillar
  2.
• Before implementation some refinements in the
  trading book area.

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Status of work on the trading book

• The Committee re-iterated its intention to
  maintain an active dialogue with the industry to
  ensure that the new framework keeps pace with,
  and can be applied to, ongoing developments in
  the financial services sector.
• There are two areas where both banks and
  supervisors recognised that this work could
  already commence and existing refinements could
  be included
• double default, where the risk of both a
  borrower and a guarantor defaulting on the same
  obligation may be substantially lower than the
  risk of only one of the parties defaulting.
• The other area concerns the application of Basel
  II to certain exposures arising from trading
  activities.
• Because both banks and securities firms have a
  great interest in the potential solutions to
  these particular issues, the Basel Committee has
  worked jointly with the International
  Organization of Securities Commissions (IOSCO) to
  consult with industry representatives and other
  supervisors.
• I must say that this co-operation with IOSCO in
  areas of mutual interest has been a very fruitful
  and beneficial experience

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Calibration

• The Committee has long stated its intention to
  conduct work to re-confirm that the new framework
  meets our objective to broadly maintain the
  aggregate level of capital requirements, while
  keeping the incentives for banks to move to more
  sophisticated risk measurement methods.
• We will begin recalibration exercise in autumn
  this year gt finalise in spring 2006. Data will
  be collected during the so called fifth
  quantitative impact study between October and
  December 2005. (QIS5)
• This early recalibration will allow us to
  accommodate the needs of rulemaking processes and
  will provide banks and supervisors with more time
  to reflect and facilitate implementation.

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Calibration

• In addition, national field tests are already
  underway in some jurisdictions, while there will
  be a period of time during which banks will
  calculate their capital requirements in parallel.
• The Committee does not intend to set data
  requirements or timeframes for the parallel
  calculation that will be conducted in 2006. So
  there is no duplication of work.
• This exercise will provide a significant amount
  of information. In addition, it will be important
  to have the necessary tools and to understand the
  effect of the cycle on the calibration exercise.
  In relation to this, it might be important to
  distinguish changes in capital requirements that
  are due to the content of Basel II from changes
  that are due to the stage of the cycle in which
  the measurement is carried out.

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Validation

• The term validation encompasses a range of
  processes and activities that contribute to an
  assessment of whether ratings adequately
  differentiate risk, whether estimates of risk
  components (such as PD, LGD, or EAD)
  appropriately characterise the relevant aspects
  of risk, and to understanding the dynamics of the
  systems and their use by banks.
• Although validation is foremost the
  responsibility of banks, supervisors must have a
  thorough understanding in order to ensure the
  overall integrity of banks activities.
• Validation comprises
• Validation of the rating system itself (model
  design, assessing the forward-looking accuracy of
  the banks risk estimates)
• Validation of the rating process gt how the
  rating system is implemented (use test and
  governance, reporting, problem handling,
  training, etc.)
• BCBS published six principles that will guide
  our future work Studies on the Validation of
  Internal Rating Systems.

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Validation principles

• Principle 1 Validation is fundamentally about
  assessing the predictive ability of a banks risk
  estimates and the use of ratings in credit
  processes. Validation should focus on assessing
  the forward-looking accuracy of the banks risk
  estimates, the processes for assigning those
  estimates, and the oversight and control
  procedures.
• Principle 2 The bank has primary responsibility
  for validation
• Principle 3 Validation is an iterative process
  Validation is likely to be an ongoing, iterative
  process.
• Principle 4 There is no single validation method
  
• Principle 5 Validation should encompass both
  quantitative and qualitative elements.
• Principle 6 Validation processes and outcomes
  should be subject to independent review for
  integrity by parties within the banking
  organisation that are independent of those
  accountable for the design and implementation of
  the validation process. Regardless control
  structure, internal audit has an oversight
  responsibility

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Validation challenges

• Supervisors and bank risk managers will need to
  understand how a bank assigns risk ratings and
  how it calculates default probabilities in order
  to accurately evaluate the accuracy of reported
  PDs.
• Basel II establishes minimum standards but it
  permits banks a great deal of latitude in
  determining how obligors are assigned to buckets
  and how pooled PDs for those buckets are
  calculated.
• Although this flexibility allows banks to make
  maximum use of their own internal rating and
  credit data systems in quantifying PDs, it also
  raises important challenges for PD validation.
• An obligor-specific PD may or may not embed
  stress-scenario assumptions about future economic
  conditions.
• Rating philosophy will vary from bank to bank.
  Practitioners use the terms point-in-time or
  through-the-cycle to describe the dynamic
  characteristics of rating systems, but these
  terms often mean different things to different
  people.
• Banks tend to focus more narrowly on current
  conditions in setting ratings than do public
  rating agencies. Rating systems may conform more
  closely to a point-in-time philosophy.
• LGD, EAD in credit risk and AMA in op-risk
  represent additional challenges. gt Accord
  Implementation Group

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Cross border issues

• Cross border issues are not new. One of the
  goals of both Basel I and Basel II is to foster a
  more level playing field for internationally
  active competitors. BUT
• Markets are changing. Cross-border activity is
  growing, financial groups are becoming bigger and
  transactions more complex and there are some
  countries with a systemic part of their financial
  system in foreign hands.
• In addition, international banks are
  centralizing some functions and tend to apply to
  the whole group common techniques, systems and
  culture. At the same time, banking regulation and
  supervision remains predominantly a national
  responsibility.
• With or without Basel II gt need to enhance
  cooperation in a world that moves towards larger
  scale cross-border activities and a greater
  presence of systemic foreign banks in domestic
  economies.
• Basel II implementation will need carefully
  structured Home/Host relationships.

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Cross-border implementation of Basel II a key
challenge

• The issue of home-host co-operation is very
  practical, and far from the conceptual issues I
  have been talking about earlier. Nevertheless,
  these practical issues are as important as the
  theoretical ones.
• Areas to be considered
• Initial and ongoing validation of advanced Pillar
  1 approaches. Consistency across jurisdictions.
• Recognition of external credit ratings in
  different jurisdictions.
• The supervisory review process under Pillar 2.
• Banks to focus on managing their risks rather
  than managing the demands of different
  supervisors.
• Cooperation among supervisors need to be
  enhanced.
• How can Basel II be implemented in an effective
  and efficient way which minimises the burden on
  internationally active banking groups and still
  respects the legal responsibilities and
  legitimate concerns of home and host supervisors
  in maintaining safe and sound banking systems?

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Global perspective

• Around 100 countries intend to implement Basel II
  by the end of this decade
• Supervisors, as well as banks, have limited
  resources gt efficiency.
• Need to develop enhanced cooperation agreements.
  Basel II will be a catalyst for effective
  home/host relationships.
• Implementing Basel II in a way that strengthens
  the quality of bank supervision across countries.

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Basel II approach

• Basel II cannot and should not be expected to
  create perfect harmonization across all
  jurisdictions. Differences remain in legal
  systems, market practices, business environments
• Basel Committee created Accord Implementation
  Group
• Discusses home/host country issues
• Promotes consistency in the application of Basel
  II gt convergence of practices.
• Significant outreach to non-member countries
• Bottom-up approach. No prescriptive approach.
• It will help to avoid performing redundant and
  uncoordinated approval and validation work in
  order to reduce the implementation burden on the
  banks, and conserve supervisory resources and
  will therefore contribute to a more level playing
  field for internationally active banks.

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The work of the AIG/Committee

• Six high-level principles on the cross-border
  implementation of Basel II.
• Basel II does not change in any way the legal
  allocation of supervisory responsibilities
  between home and host countries.
• Basel II requires a more collaborative approach.
• Supervisors should avoid performing redundant
  work.
• Home country supervisors should lead
  collaboration and communication efforts
• Case studies involving real banks, based on the
  implementation plans of those banks as a starting
  point.
• Surveys and experience sharing.

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Information flows and trust

• Successful implementation of the high-level
  principles rests on adequate information flows,
  and trust among supervisors.
• The contribution of the industry
• Banks should develop solid implementation and
  roll-out plans for supervisors to react to.
• Home and host supervisors need to see and
  understand those plans in order to establish the
  most effective ways to share information,
  cooperate and discuss the scope.
• To improve internal communication of their plans.
• Sometimes the local staff are unaware of the
  banks plans, even for their own operations.

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EU perspective

• From an EU perspective, there are additional
  particularities, which bring both challenges and
  opportunities
• There is a political objective (Lisbon) to
  achieve a single market in financial services.
• We have a well-established body of EU banking
  legislation, including legislation that clearly
  sets out home and host responsibilities.
• We have a new regulatory and supervisory
  framework for banking the Lamfalussy approach.
• As part of this, we have the Committee of
  European Banking Supervisors (CEBS), which has
  already made good progress on supervisory
  cooperation and convergence.
• Therefore, we can, and should, go further in the
  EU in pushing for consistent implementation of
  Basel II, including effective home-host
  co-operation.

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Conclusions

• The publication of the revised framework was only
  the beginning of a new important phase
  implementation.
• Basel II allows a lot of leeway but having the
  rules is not enough
• Good implementation is essential.
• Need to keep in mind the three critical factors
• Micro effectiveness
• Macro effectiveness
• Consistency of implementation

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