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The Basel II banking regulations will encourage willing financial institutions to focus on handling more diverse sources of risk. High-street stores try to meet more diverse risks because they recognise that just focusing on one risk (shoplifting) will lower returns at the margin on risk management efforts. Similarly, RAROC analysis shows that we gain through diversification, and that the areas for new investment can be identified profitably.
Rapid progress has been made in analysing market risk; value at risk and its variations still lead the way. Yet, we still have to recognise the correlation between different risks of which market risk is only one. The risk factors are combinative and not mutually exclusive. Loss data will only be useful when the theme of causality is tackled. Then regulators will truly have a safer banking system. Basel II, under Pillar 3, will force banks to become more transparent as they will disclose more information. The Basel II regulations contain some of our organic risk management themes to treat companies as changing dynamic entities, rather than on a static one-size-fits-all basis. Organic risk management techniques complement and build upon components present in Basel II. Organic risk management and Basel II are part of the road for developing more amenable structures for corporate governance and risk-balanced companies.
The Basel and regulatory clout upon the financial institutions means that the banking and funds industry is forced to meet the new Basel II-based guidelines. How they meet the regulatory authorities’ demands in practice is another question.
The Basel II project will most likely cost ten of millions US dollars for large global banks. This will include major changes in bank business and accounting procedures. Staff training, specialist consultancy time and new IT systems will add to the costs. Guesstimates are already flying around. One figure of $50 million has been given for Basel II standard certification, while $150 million has been banded around for a large global bank aiming for the highest advanced certification. How these costs can be expected to compare with business benefits will be a matter for strategic planning and effective project implementation to resolve.
Many banks are unhappy with the high costs of Basel II project implementation. They are still unsure as to the exact reduction in capital charges in some cases. Some banks are unwilling to go for the “Big Bang” for Basel II. They will choose to adopt a migration from standard to advanced level. Other banks may opt for taking a combination of risk management levels. One can pick advanced AIRB credit risk management level on its mortgage loan portfolio because it is a highly volatile and high value business line, while selecting standard operational risk management level on its asset management business line, which is lower volatility and value. Banks have really begun to splinter into different strategy groups.
Banks seeking to implement the Basel loss database have to think of the business rationale in the first place. We are discussing whether it is sensible to think of operational risk in terms of the questions: “Where did go wrong? How much did it cost us? How can we avoid or mitigate it?”
Not all banks will choose to adopt the loss database. Used properly, a loss database can encourage companies to think usefully about the nature or causes of operational risk. It offers three advantages towards building an understanding of risk.
1) Initially, we can think of operational risk in terms of risk events. The loss database matrix in this raw form is not yet detailed enough to be of use for risk management purposes. We need causal modelling, where an incident has a concomitant in a cause-effect relation. 2) The second phase is to link events with their causes. The matrix is just a set of boxes, where to put an initial incident and link it to a subsequent result. This cause-effect relationship is sometimes known as ‘forward chaining’ in knowledge management. Yet, we have yet to see substantial evidence that such data-mapping exercises create real value-added.
The global effects that Basel II will have are not yet clear-cut. Side effects are unknown. However, a two-tier banking world is likely to emerge from the Basel II banking regulations, where there will be those who are in the fast-track for Basel compliance (more regulation and lower risk), versus those banks in the slow lane of compliance. These “slower” banks will have less regulation but more risk, even if they are guarded by more regulatory capital.
This is the possible outcome that there will be a two-tier banking system in the Basel domain:
Fast-track: Advanced banks doing well with lower capital requirements, excellent risk management and risk reporting systems. They will thrive in the new markets.
Slow-track: Other banks, slightly paralysed by higher capital reserves and regulatory requirements, will need to install more sophisticated risk management and risk reporting systems. The market perception of them can be negative (i.e. more risky banks or funds), so they can be doubly penalised by lower credit ratings /raised insurance premiums and lower customer respect.
More likely, there will be a large middle ground of banks and funds that are muddling along, not excelling themselves in advanced Basel II risk classifications, trying to find a niche.