Kevin%20Davis

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Risk Management, Pricing and Capital Provisioning
under the New Basel Accord
Asian Bankers Association 19th General
Meeting Seoul 2-4 September 2002

• Kevin Davis
• Commonwealth Bank Group Chair of Finance
• Department of Finance
• The University of Melbourne

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The Three Pillars

• Minimum (Risk Based) Capital Requirements
• Effective Supervisory Process
• Market Discipline

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Basel 2 The Implicit Assumptions

• Capital is more costly, at the margin, than
  deposits for financing bank activities
• Unregulated banks will choose capital and
  activity risk profile which has socially
  unacceptable risk of failure
• Risk related regulated minimum capital is
  necessary
• Lower capital requirements for advanced risk
  management provide incentives to adopt those
  techniques

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Basel 2 The Implicit Assumptions

• Capital requirements mean that shareholders bear
  risk, but
• Management determine risk position
• Shareholder control of management may be limited
• Hence
• Effective supervisory processes as support
• Market discipline needs to be encouraged
• These are, to some degree, substitutes.

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Questions

• As a complementary /alternative approach, can
  distortions that make capital more costly be
  reduced?
• Is the relative cost disadvantage of capital (and
  thus the burden of capital requirements) constant
  across countries?
• Tax systems, structure of deposit insurance
  premiums, disclosure / transparency and depositor
  awareness of risk are relevant considerations

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Questions

• If advanced techniques are beneficial, why
  wont they be adopted anyway why is a
  distorting, potentially inequitable,
  tax/subsidy solution required?
• Should the capital incentives reflect
  international differences in the benefits of
  advanced techniques and in the cost of
  implementing them?
• What can be done to reduce impediments
  (transition costs) for banks to adopt advanced
  techniques?
• Impediments may include management resistant to
  change!

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Questions

• How does the adverse effect on risk to
  depositors/ insurance fund/ taxpayers of a lower
  capital requirement compare to the beneficial
  effect of advanced techniques on such risk?
• What should be the size of the capital incentive?

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Basel 2 The Challenges

• Understanding and Applying Modern Risk Management
  Techniques
• rocket science v basic principles
• Nobel prize winner explanations of their
  contributions to economics and finance include
• Demonstrating the merits of not putting all your
  eggs in one basket
• Demonstrating that a pizza sliced into eight
  pieces doesnt give more pizza than one sliced
  into quarters

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Basle 2 The Challenges

• Coping with Diversity
• Of country characteristics
• Legal and institutional structures differ
• Governance and market discipline implications
• Economic structure and business structures differ
• Risk weights have implications for pricing and
  flows of funds to different types of firms and
  activities

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Basle 2 The Challenges

• Coping with Diversity
• Of bank types
• Multinational v small regional
• Will multinational banks be able to leverage off
  favourable capital positions to make strategic
  loss leading incursions into regional markets?

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Pillar 1 Issues Credit Risk Measurement and
Management

• Banks in regional economies face challenges in
  moving to Advanced Status
• Internal Models
• Require extensive data for calibration and
  testing
• Capital Markets
• Availability of Market based information on
  corporate credit status differs substantially
  across markets
• Credit Risk Mitigation Techniques
• Markets for credit risk transfer (derivatives,
  securitisation) are in varying stages of
  development

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Pillar 2 Issues Supervisory Processes

• Regulator Education and Training
• Cross Border Cooperation
• Regulatory Structure
• Specialist v Integrated
• Regulator Funding
• Taxpayer/Budget, Industry, Seigniorage

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Pillar 3 Issues Market Discipline

• Regional Economies have differences regarding
• Governance Structures and the legal basis for
  stakeholder protection
• Disclosure Requirements
• Capital Market discipline

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Conclusion

• Three Pillars the Principle ?
• Three Pillars the Practice ?
• One size does not fit all
• Incentives and competitive neutrality in banking
• Risk weights and economic effects

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Thank You