Basel harmony still a long way off, notes IIF

“No-one really appreciated the complexity of the whole [Basel Accord] process,” says Charles Dallara, managing director at the Institute of International Finance (IIF). “It is only in the last nine months that regulators and bankers have woken up to the potential significance of the specific issues.”

Dallara chaired a meeting of the IIF in Madrid last month, which was attended by a mix of regulators and bankers including Jaime Caruana, chairman of the Basel Committee on Banking Supervision, gathering to assess the new framework for the Basel Accord, released by the Committee at the end of last month. While there have been some successes, the meeting focused on a number of key unresolved issues (see box) and concerns over implementation, which continue to dog the process, more than a year after the third quantitative impact study (QIS 3) (Risk June 2003, page 63) was released.

The new framework still leaves much work to be done, and it seems the progress has been slower than expected following the release of the last QIS report. Dallara says QIS 3 fell below expectations. “QIS 3 was not satisfactory,” he says. “It was widely agreed to be imperfect. The data was spotty and many issues were left unresolved.”

And now nine countries – including the US and Germany – are set to conduct a fourth QIS to be released later this year, which could potentially see a full or partial recalibration of the Basel framework within the individual countries.

Aside from the specific unresolved issues, the participants in the Madrid meeting discussed the wider concerns over implementation, cost and complexity of the new Accord. The staggered timetable that the Basel Committee announced last May, with the basic and intermediate approaches being implemented a year earlier than the advanced internal ratings-based approach at end-2007, has already added an extra unwanted layer of complexity to the proceedings, says Dallara. “The staggered implementation could allow for inconsistencies across borders, which is a concern.”

Dallara says that while there is some flexibility in the implementation of the Accord for different types of institutions, this is dependent on the local regulatory frameworks allowing this. The concern is that some regulators will be overly prescriptive. Furthermore, there remain some worries over the cost of implementation, which could be exacerbated if there is a disharmonious approach among individual regulators. “It is a hugely costly exercise if you have multiple and differing requirements for different regulators,” says Dallara.

There have been some successes for the banks within the new framework. The regulators seem to have come to a better acceptance of banks’ proposed credit risk modelling abilities, says Dallara. Certainly there has been an improved recognition of credit risk mitigation by the Committee, notably in the expanded range of eligible financial collateral. The retail book issues, which had been addressed in the third consultative paper last year with the recognition of the need for lower risk weightings for the retail book, also appear to have been resolved.

Full reaction to the details of Basel II can be found on page 56

The major outstanding issues

• Scaling factor. Regulators have stated that they want roughly the same amount of capital in the system once Basel II is established, and have retained the right to arbitrarily bump up capital if they feel it is insufficient. Dallara says this “goes against the grain” of the Accord. “It’s not about how much capital there is in the system, it’s whether there is the right amount for each individual institution,” he says. • Diversification of risks. The regulators have not as yet embraced the benefits that this gives to banks, according to Dallara. A collaborative effort is being developed between the industry and the regulatory community to develop the basis for recognising credit risk models and taking account of the benefits of diversification.” • Stressed loss-given default. The question of how to calculate loss-given default during periods of economic downturn remains unresolved. • Trading book capital treatment. Crucial provisions on the capital treatment of assets held on a trading-book basis (generally shorter-term assets and hedges) are now being taken up by a joint working group of the International Organization of Securities Commissions and the Basel Committee. “We are participating in an industry consortium doing the intellectual spadework necessary on some highly technical topics. We have urged the joint working group to advance this project as quickly as possible, so that the trading book can be included in the new Accord when it goes into effect. This is vital to both our commercial bank and investment bank members,” says Dallara. • Double-default risk. The current treatment of double default is held to be excessively conservative by the industry. “It just doesn’t reflect the real reduction of risk you get when you have a guarantee or derivative covering an exposure,” says Dallara, “but a lot of good work on the theory has been done and we expect agreement on an approach in time for inclusion in the new Accord when it goes into effect.” • Counterparty risk issues. “As with double default, we now have a lot of very good methodological work and we hope the industry can agree with the regulators on practical solutions in time for implementation with the rest of Basel II,” says Dallara.