Basel II costs rising, says survey

A survey of banks in Europe and North America, sponsored by the consultancy firm Accenture, has found dwindling optimism and rising predicted costs for the implementation of Basel II, with the cost of compliance now estimated to be £2.5 billion for the UK alone.

Paul Cartwright, global head of risk and regulation at Accenture, says banks are starting to realise just how difficult the implementation process will be. He compares it with the last banking compliance project of similar scale – the effort to upgrade banks' IT systems in the late 1990s to avoid the Y2K bug.

"For Y2K, costs didn't change that much as the work went on. In fact, the cost came down as the work went on. Basel II is different," he says. "The start of the process, dealing with Pillar I, was quite easy. But Pillar II and Pillar III are quite different, and they have found that they are not as easy as they thought – they needed to embed risk practices throughout the entire organisation."

The lack of familiarity with large-scale risk compliance projects probably made the initial cost estimates inaccurate, says Cartwright. "Credit risk mitigation is always complex, but they did not realise how complex it would be. It is probably because the project was being run by the bank's risk people, who had not done any big projects before."

Most European banks expect to spend more than e50 million each to implement Basel II, with one UK bank expecting to spend more than e200 million, according to Cartwright. Of these costs, 36% on average is expected to go on IT spending, 52% on improving credit risk management and 12% on improving operational risk management, the survey found.

However, European banks expect to save money by exploiting synergies with other regulatory compliance projects: 55% see overlap between Basel II and International Financial Reporting Standards and 65% between Basel II and Sarbanes-Oxley.

No cause for optimism

US banks, on average, estimate the cost of compliance will be slightly lower than their European counterparts. But this is not necessarily a cause for optimism. "North American banks appear to not yet comprehend the full impact of Basel II on their organisations, as 39% reported they expect to spend no more than e25 million on their compliance programmes," the report states.

Andrew Wilson, managing partner for risk and regulation management in North America at Accenture, says: "Last year, most US respondents didn't have a handle on the cost. They have come in lower than the Europeans, and in part that reflects the phase they are in. But they also feel they have invested heavily in the past 10 years, and so have a smaller gap to close."

At present, US banks are around 12–18 months behind European banks, an improvement on the situation in 2004. A year ago, only 21% of US banks had reached the stage of building and testing their compliance plans or beyond; the figure is now 39%, although this is still well behind Europe, which had reached 67% in 2004 and is now at 82% (see chart).

Cartwright and Wilson say better direction from the country's regulators explain the improvement in the US. "The Federal Reserve has been watching closely for missed deadlines, and has quite firmly said it would hold fast to the date [for the implementation of the framework]," says Wilson.

The Basel Committee has proposed that banks apply the standardised and foundation internal ratings-based (IRB) approach for credit risk, plus the standardised and basic indicator approaches for operational risk, from year-end 2006. However, banks have an extra year to implement advanced IRB and the advanced measurement approach for operational risk. US regulators have indicated that the most sophisticated dozen US banks will be expected to implement the advanced IRB approach, while all other banks will remain on the current 1988 Basel framework.

Cartwright adds: "The politics in the US was quite complicated. They have multiple regulators – the Fed, the OCC and the SEC – not just one, so a lot was needed to push Basel II into action. A lot of the time, US banks were just playing politics because it would cost a lot of money and there was a perceived lack of government concern. But the regulators are now making it clear they will push it forward; it's regarded as in their best interests to make it happen."

However, enthusiasm for the benefits of Basel II has waned in the last year. The most widely expected benefit of Basel II was improved capital allocation, with 35% of respondents naming it as a benefit compared with 55% last year. Enhanced market perception, which 59% of respondents pointed to as a key benefit of Basel II last year, attracted just 19% of the votes this year.

Cartwright says: "As the [implementation] date gets closer, they have to focus on meeting the schedule and lose sight of the business benefits. Those that are further ahead with implementation are less pessimistic." He adds that the case for improving risk management, whether under Basel II or not, is not always easy to express. "It is easy to measure the benefit of cost cutting and evaluate whether it was worth it. But it is very difficult to work out a counterfactual for changing risk management. Seeing the revenue enhancement benefits can require an act of faith."

Alexander Campbell