Op risk floor removed to give flexibility

BASEL, SWITZERLAND - Global banking regulators have removed the operational risk capital floor previously proposed under the Basel II capital accord to give banks flexibility in developing op risk management systems.

So said the Basel Committee on Banking Supervision, the architect of the accord, in its July 10 statement announcing agreement on many of the outstanding issues relating to Basel II, which it wants to bring into force for major banks in late 2006.

The decision to remove the op risk floor and instead create a single capital floor for credit risk and op risk for the first two years of the accord’s operation, was generally greeted favourably by bankers. Many had argued that the original op risk floor was a major disincentive on cost grounds to their adopting the advanced approaches the risk-based Basel II accord was designed to encourage.

The op risk floor decision was part of a package that removed most of the roadblocks that had held up progress with the controversial pact. Basel II is intended to make the world’s banking system safer by aligning bank protective capital more closely with the market, credit and operational risks that banks actually face. Banks using advanced risk management techniques should enjoy lower capital charges than banks using cruder methods.

Central to the July agreement was the compromise on the politically charged question of how the risks of lending to small- and medium-sized enterprises (SMEs) would be treated under the Basel II credit provisions.

The Basel Committee, the body of senior national supervisors from the leading economies that in effect regulates international banking, reaffirmed there would be a pillar 1 op risk capital charge under the three-pillar structure of Basel II.

But it said the floor would be dropped in light of the significant progress made by banks in developing approaches to measuring and managing the op risks they face from such hazards as fraud, technology failure and trade settlement errors.

The original op risk floor provisions would have meant capital charges for a bank using advanced approaches based on its own internal risk models and loss data would have been limited to 75% of the capital charges under the simpler standardised approach. The floor would have been reviewed by the regulators two years after Basel II’s coming-into-force.

Bankers argued that with op risk capital charges representing 12% of regulatory capital under Basel II, this in effect meant a floor of 9% for advanced approaches; not enough, they said, to justify the cost of the systems needed to implement an advanced approach.

The Basel regulators wanted a floor to ensure banks had sufficient capital to act as a cushion against operational losses while Basel II bedded down and the advanced approaches proved themselves reliable guardians of the banking system.

But a few months ago, the regulators signalled they were looking at the conditions under which the op risk floor could be abolished.

In its July statement, the Basel Committee said the new single capital floor for op risk and credit risk would be related to the current, and simpler, Basel I accord that dates from 1988.

In Basel II’s first year, the internal ratings based (IRB) capital requirements for credit risk, together with op risk capital charges, cannot fall below 90% of the minimum 8% capital/asset ratio of Basel I. In year two, the floor will fall to 80%. Originally the regulators had proposed a floor for the advanced IRB approach of 75% of the simpler foundation IRB approach.

The Basel regulators said in July that they would take action if problems emerged during the two years; in particular, they would be prepared to keep the floor after 2008 if necessary.

Some bankers were concerned that the new Basel I-related single floor would in effect form a higher floor overall than the separate floors for credit and op risk originally proposed. But Basel regulators said this was very unlikely, although the final outcome would only be known after the results of QIS 3 -- the third Basel II quantitative impact study -- were known towards the end of this year.

The Basel Committee said many banks had made substantial progress in developing approaches with the potential to improve op risk management. The committee has invited banks to offer their own ideas for advanced op risk approaches, but it has also outlined three models that could be used.

The committee said it expects progress to continue and strongly encourages further work on the different approaches to op risk now being explored.

"In particular, the committee believes industry co-operation and information sharing are important elements in further enhancing approaches to operational risk," the July statement said.

Meanwhile, on other fronts, the committee confirmed that capital against loans to SMEs, defined as businesses with sales of less than e50 million ($49.3 million), would on average be around 10% lower than the capital charges for loans to bigger companies.

This compromise assuaged fears, particularly in Germany, that the Basel II credit risk provisions would penalise lending to SMEs, which are seen as the engine of economic growth in many countries. Germany dropped its objections to Basel II when the compromise was first agreed by Basel Committee technical experts. The country had threatened to veto Basel II if the SME proposals weren’t softened.

The committee also confirmed that capital charges against credit card exposures would be "materially below" those previously proposed, while other non-mortgage retail lending will require "modestly higher" charges.

Banks using the most advanced IRB approaches will need to take account of a loan’s remaining maturity when determining capital charges. But national supervisors can exempt smaller domestic borrowers, defined as firms with sales or assets of less than e500 million, from this requirement.

The Basel regulators also agreed that "meaningfully conservative" credit risk stress testing by banks will be required under IRB approaches as a means of ensuring banks hold a sufficient capital buffer under pillar 2 of the accord. This is to help address fears about the potential ‘cyclicality’ of the IRB approaches - namely that they could reinforce the downturns and upturns of the economic cycle.

Pillar 2 of Basel II provides for the close supervision of banks by regulators who can make banks hold additional capital.

Pillar 3 of the accord requires banks to give more information about their risk management policies as a means of exerting market discipline on them. The Basel Committee said in its July statement that the pillar 3 requirements have been streamlined with the aim of providing investors with enough information to understand a bank’s risk profile without imposing an undue burden on any bank.

The committee plans to issue a paper on the treatment of asset securitisation, where portfolios of loans are put into a pool that is used to back the issue of new securities, around the time QIS 3 is issued. The technically difficult asset securitisation question is now the biggest outstanding issue in Basel II, but regulators are confident of solving it before October.

The committee also plans to publish a Basel II overview paper that will address several themes, including the question of the accord’s complexity versus its risk-sensitivity as well as the cyclicality issue.

(The Basel Committee’s July 10 statement is available on the Bank for International Settlements’ website:

www.bis.org.)

The Basel II timetable The latest timetable for the implementation of the Basel II bank capital adequacy accord is as follows: Late July, 2002 - Basel Committee issues draft spreadsheets and information package to more than 300 banks in nearly 40 countries for the Basel II quantitative impact study - QIS 3 - that in October will seek information on how banks will be affected by Basel II. October 1, 2002 - the Basel Committee issues the risk weight functions and formulas to be applied in QIS 3. The committee issues a Basel II overview paper on October 1 and also around this date a paper on the Basel II treatment of asset securitisation. December 20, 2002 - deadline for QIS 3 replies. Second quarter (possibly May), 2003 - Third Basel II consultative paper (CP 3) issued with 90-day comment period. Fourth quarter, 2003 - Final version of Basel II issued. 2003/2006 - Period in which banks and their regulators ready themselves for Basel II’s coming-into-force. Late 2005 - Banks using advanced approaches to measuring their risks will have to do parallel calculations with the current Basel I accord for one year prior to Basel II implementation. Late 2006 - Basel II comes into force for the large international banks of the world’s leading economies. Late 2008 - The single capital floor for the IRB approaches in credit risk and for operational risk charges ends, although the Basel regulators reserve the right to extend it.

Operational Risk