Cost-benefits under basel

Banks and funs should already be developing more sophisticated risk analysis and more effective risk managemet. Creating risk profiles for the bank’s counter-parties in the manner of a murder investigation may sound sinister. This process operates within CRM (credit risk management) where risk probabilities, default exposures and customers’ records are logged. A detailed risk map of the customer’s current risk position, plus probabilistic directions, should be drafted for banks.
Business counter-party profiling takes in the whole range of risk appetites, from the conservative to the wildly speculative. Another CRM (customer relationship management) or a detailed KYC (know-your-customer) process will further spotlight the customer’s track performance. Basel II offers incentives for identifying losses and knowing your wise owl to the thieving magpie. Profiling of past risk events will form part of the loss database under Basel II to offer forecasting potential. This is similar to the VaR principle of using a historic dataset to predict the future. The Basel II Accord assumes that in operational risk, past errors and losses can be a guide to the future using the loss database. History repeats itself.
No standard set of business scenarios will fit the bill for any one institution. There will be different reasons why banks lose money. Furthermore, there will most likely be different categorisation money for the same case of why a bank lost. Standardisation will be tough to enforce across all banks, but the regulators will try to advise.
Compliance with regulation has now become more worthwhile. Basel estimates a 6 % drop in capital reserves for a large EU bank that wishes to manage its credit risk at the advanced AIRB level. A similar large EU bank aiming to achieve the lower standardised level on its core portfolios will most likely pay an additional 6 % capital charge.
Nevertheless, there will be some groups who will feel aggrieved that Basel II punishes them unfairly. For example, the EU leasing industry is probably faced with a 6 % capital requirement, derived from a gamma (fi) risk weight of 75 % multiplied by the 8 % capital ratio. The Basel II documentation implies a probability of default (PD) in the 5 % to 25 % region, which is particularly high. The empirical research by the leasing industry indicates that the PD is realistically nearer 3 %.
This is because physical collateral assets such as real estate, cars, trucks and plant machinery have a long-established time-series for developing financial control skills. Understanding of the specific industrial sector, plus the option for securing the lessor’s assets through repossession, means that default risk is low. External banking regulators have given little consideration for these risk mitigation factors, so the leasing industry becomes harshly treated.
The regulator’s seal of good housekeeping is worth winning under the new rules. The Basel II Accord recognises that levels of risk management skills should rise commensurately with lowering capital reserve limits as an encouragement. Fines and punishment of higher capital limits rise to the tipping point of where the pain becomes overbearing. Thus, the probability of being detected by better supervision and monitoring, together with the financial fines impact, make compliance an activity that creates return on investment.
Basel II has to be well designed for every bank so that regulatory capital will be commensurate with their risks. The worst-case scenario is that Basel II will misallocate capital and increase regulatory reporting constraints. Market risk and credit risk may demand more regulatory capital, but more administrative aggravation will hinder current business lines within some banks. Local supervisors would have to be more cognisant of specific industrial needs before applying capital charges in full.
Basel II rules will be applied in the UK by the FSA. There will be some input from the European Commission in Brussels. Some quarters have argued for an EU “super regulator” to coordinate the migration towards Basel II and to standardise EU standards for open financial markets. It would be desirable to have an effective form of Basel II coordination and supervision to monitor the complex migration process. This financial super-cop is unlikely to come about soon given the political and economic diversity within the EU, and the potential conflict between the numerous stakeholder groups.
The USA prefers to adopt a more laissez-faire attitude, where only their globally active major banks will be in the vanguard of Basel II adoption. These top 20 US international banks will have to comply with Basel II with the rest of the European rivals, but not the US domestic banks.
The FSA and SEC can move around banks during supervisory visits with a check-list for Basel II framework and other compliance controls. These have performance bands based upon aggregate data for similar banks in their banking sector. It is rather akin to the IRS or Inland Revenue tax authorities audit checks. A potential disadvantage of this check-list method is that financial supervisors may have less time to evaluate the banks’ financial modelling thoroughly. Just ticking off a check-list makes it simpler to hide errors and pass off riskier banks with advanced IRB and AMA risk management certification.