Taking the slow road to Basel II

Brazil’s central bank published Basel II implementation guidelines at the end of last year,giving the country’s banks a firm timetable for the introduction of the new framework.What progress have banks made so far? John Ferry investigates

In December, the Banco Central do Brasil published preliminary guidance for its banks to implement Basel II, the global capital adequacy framework that aims to more accurately align banks’ capital requirements with underlying risks. The release does not describe minimum qualifying criteria for the internal ratings-based (IRB) approaches or provide details on the validation of internal models. That, says the central bank, will come later. But it does set out a timescale for when it expects different parts of the Basel II framework to be in place, with full implementation set for 2011.

“Brazil intends to implement the framework as soon as possible following the Basel calendar, but with some differences,” says David Salles de Barros Valente, senior adviser to the head of department of financial regulation at Banco Central do Brasil.

Under the guidelines, Brazil’s banks will be able to choose from the full array of approaches for measuring credit risk outlined by the Switzerland based

Basel Committee on Banking Supervision – the standardised, foundation IRB and advanced IRB approaches. However, those banks aiming to implement the advanced IRB approach will have to undergo a lengthy transition period, during which time they will have to adopt the more straightforward approaches.

The aim is for the central bank to validate advanced internal models by 2009–10. “We are going to be validating their systems and if they can’t prove to us they have good internal systems, then the IRB approach will not be allowed for them,” says Beatriz Simas Silva, deputy adviser within the central bank’s department of regulation.

This approach differs significantly from the suggested implementation schedule outlined in the Basel II framework. The Basel Committee has proposed that banks apply the standardised and foundation IRB approach for credit risk, plus the standardised and basic indicator approaches for operational risk, from year-end 2006, with one year parallel running for the foundation IRB approach throughout 2006. However, banks have an extra year to implement advanced IRB and the advanced measurement approach for operational risk, with two years of parallel running required from 2006.

It is likely that the country’s largest banks – Banco Itau, Bradesco and Unibanco, plus one or two others – will aim for the most sophisticated approaches to Basel II. “We expect only the biggest banks to use the IRB approach because there are huge costs to the development of those systems,” says Silva. The rest, she says, will probably implement the standardised approach.

“It is still very unclear which banks will qualify, but we expect the largest banks – around 10– will adopt Basel II. It all depends on the results of studies being carried out right now. The other banks will effectively remain with the Basel I rules, with some adjustments we are planning to implement,” adds Valente.

Details of how the central bank will go about validating internal models and exercising national discretion in the implementation of Basel II are sketchy.

However, the guidelines do give banks a starting point. The central bank has outlined a simplified version of the standardised approach, similar to the current 1988 Basel Accord, which was adopted by Brazil in 1994 (although with some differences – the central bank set a minimum capital requirement of 11% rather than the 8% set by the Basel Committee). However, it will include new elements consistent with the Basel II framework, such as the recognition of specific instruments for credit risk mitigation, which should lead to a better alignment of capital requirements to actual exposures.

“Credit derivatives are already recognised to some extent,” says Valente. “However, we are studying changes in the rules regarding guarantees and collateral, netting agreements and credit derivatives taking into consideration the Basel II rules for the recognition of credit risk mitigation techniques. The proposed changes will then be submitted for the consideration of the board of directors.”

The central bank has also said it will not make use of ratings assigned by external credit assessment institutions for the purposes of calculating capital requirements. Under Basel II, capital weightings for the standardised approach are based on ratings set by agencies such as Moody’s Investors Service and Standard & Poor’s. In Brazil, however, the central bank will set the risk weightings. For the most part, they will be similar to the 1988 Accord, with claims on corporates risk-weighted at 100%. “This was a decision taken mainly because most of the corporates are not rated in Brazil. Therefore, the costs of recognising rating agency ratings alone would bring few benefits,” says Silva.

The Banco Central do Brasil will allow all of Brazil’s banks to choose whether to aim for the more sophisticated approaches. That’s different from the approach taken by US regulators, which have stated that only the top dozen banks will be able to implement the advanced approaches, with the remainder staying on the current Basel I framework. “We don’t want to place a heavy burden on the smallest banks, but if they look at the costs and benefits of implementing the IRB approach and decide on balance that it is positive, then they will be welcome to use the approach and we will validate their systems,” says Silva.

The validation of operational risk methodologies is last on the central bank’s to-do list, set at 2010 to 2011 (with the deadline for validating internal market risk models set at 2008 to 2009). The central bank says studies are being carried out “to identify the best form of capital requirement and the most appropriate methodology”, according to its December release. Other than that, there are few details on what will be expected.

“I think [operational risk] is the most challenging point of Basel II. It is new, and we don’t have much expertise within banks or the central bank on this issue,” says Valente. “But the other pillars are also a challenge for us and we expect to deal with them also.”

As with banks in the US, Europe and Asia, one of the biggest challenges for institutions in the region is the creation of the default databases required for internal modelling. “Collecting, cleansing and managing data on loss-given default, exposure-atdefault, and so on – this is something the local banks have never had to do,” says Jose Molina, Chicago-based Ernst & Young risk management consultant for Latin America. “The availability of the relevant data is not going to be there for at least two or three more years.”

“The database is always a big challenge, even for the international players,” adds Caio David, director of risk management at Banco Itau in São Paulo. “We are going to see the use of internal data and some use of external data, which will demand a lot from local banks but also from the central bank, which has to validate that data.”

Nonetheless, the banks insist they are well on their way to Basel II compliance, with some making headway on the development of risk-based pricing systems. “Over the last few years, we have developed a lot in terms of credit and operational risk control, so that our internal models are pretty much in line with Basel II already,” says David. “We are already using advanced risk-based capital adequacy for pricing, and not just for modelling. So far we have 70% of all operational losses modelled, and we are probably going to have 90% by the end of this year.”

The central bank agrees with this analysis: “The biggest national banks are in the advanced stages of developing their models, so this was not a regulatory-driven process for them,” says Silva.

The problem, however, is whether the central bank itself will be ready to validate the internal models of banks. “The most important problem today is not on the market side but on the central bank side, because it is not prepared,” says Luiz Henriqu Lobo, São Paulo-based director of consulting company Risk Control.

The worry is that the central bank will not have the in-house quantitative expertise to properly understand bank internal measurement models. The Banco Central do Brasil admits it has a lot of work to do, but says it is confident it will have the experts in place to successfully validate models. “We have a long-term plan to train the supervisors to ensure that when the time to validate the models comes the central bank will be ready,” says Silva. This could include sending employees abroad to train, she adds.

But no-one doubts that the country’s central bank is now fully committed to the Basel II process. “Every 60 days they come to see how things are progressing, mainly with the database. And every week I send them a progress report,” says Roberto Hollander, head of risk management at Bradesco in São Paulo. Indeed, the central bank has formally set the implementation of Basel II as one of its priorities and already has staff committed to the process.

On an overall cost/benefit analysis, will the time and effort put in and the money spent on Basel II be worth it? The general consensus seems to be that it will, eventually. “I think in the long term it will be beneficial, because it grants a long-term faith in the Brazilian financial sector, and hence the economy, and therefore it will be good for foreign investment. But we’re not going to see the benefits of that for quite a long time,” says Jan Smith, director of financial services at Miami-based consultants Info Americas.

“It will bring in more sophistication,” says Banco Itau’s David, “and that’s going to be very important, not only for the development of Brazilian banks but also for the development of the financial markets as a whole.”

Latin Risk