The private banking edge to Basel II

If Europe’s private banks want to take full advantage of the Basel II Accord on bank capital, they have to rethink risk management. But modelling the riskiness of the super-rich isn’t as straightforward as it might first appear. By Laurence Neville

Common sense dictates that Basel II should benefit independent small and medium-sized private banks. The overriding rationale for this update to the original Basel Accord of 1988 has been to strengthen the soundness and stability of the banking system. And what could be sounder than the unassailable conservatism of private banks and their wealthy clients?

Yet the reality of Basel II implementation – scheduled for the end of 2006 – is more complex for private banks. “You would expect – given that Basel II is a more risk-sensitive approach to measuring risk, and private banks’ counterparties are good quality – that they would benefit,” says Steven Hall, executive adviser, financial risk management at KPMG in London. “However, the unfortunate truth is that the rules are written for large commercial banks.”

The most obvious example of this is the necessity of scale in order to benefit substantially from Basel II. Generally, Basel II encourages banks to use more sophisticated approaches rather than the most basic – the standardised approach with regard to credit risk and the basic indicator approach for operational risk – through lower capital adequacy requirements. But anything other than these approaches will be expensive to implement.

“We want to introduce Basel II as cost-efficiently as possible,” says Ivo Enderli, head of the group risk department at LGT Group in Liechtenstein. “We won’t use the high-level methods but the standardised [and basic indicator] methods – we want to do it with as little expense as possible.” Enderli says it was clear from LGT’s initial examinations of Basel II proposals that the next step up the credit risk ladder, the ratings-based approach, would be too expensive. “For a relatively small bank like LGT, we couldn’t have expected to get enough relief from such a method.”

Yvan Chappuis, chief financial officer at Union Bancaire Privée (UBP) in Geneva, says most private banks in Switzerland are using the standard approach for credit risk. Anecdotal evidence suggests that the basic indicator approach has been favoured by banks for operational risk. But while costs are a dominant factor in adopting approaches to Basel II, there are other issues that hinder the use of more advanced approaches.

As KPMG’s Hall notes, while private banks tend to have high-quality counterparties – their clients are by definition highly solvent – that very solvency could prove problematic. While commercial banks have lots of data and homogeneous portfolios, private banks’ portfolios are about relationships rather than models. “They cannot be put into established risk parameters,” he says.

In addition, it could prove problematic for private banks to build statistical models to support a ratings-based approach, as historically they are unlikely to have had many defaults, according to Hall. Private banks might also have problems with concentration risk as they have large exposures with a small number of individuals and therefore cannot conform to the ‘reasonable granularity of portfolio’ requirement under Pillar I.

Operational risk

While Basel II builds on the previous Basel Accord with regard to credit risk, the inclusion of operational risk as a factor in determining capital adequacy is new. “For private banks in Switzerland using the standardised approach, it is expected that operational risk will incur a level of capital adequacy of between 10% and 15% of gross income, compared with the current system, which requires no capital adequacy,” says Pascal Gisiger, head of risks at UBP.

The problem with operational risk, as KPMG’s Hall notes, is that people think they have structures in place to manage it but they tend not to have it formalised or documented. “For small private banks, that could be a real problem,” he says. LGT, which will use the basic indicator approach, sees the qualitative impact of Basel II as an important part of an evolutionary approach to operational risk. “We were already looking at this area before Basel II,” says Enderli. “We had worked to improve processes and therefore there shouldn’t be too much change with Basel II. We have monitored papers on expected changes under Basel II for the past five years.”

For some banks, the investment in operational risk management in recent years has been sufficient to allow them to adopt the more advanced standardised approach. “We intend to use the standardised approach for operational risk. However, we consider that the advanced measurement approach is desirable and we are currently performing a review of our major processes in order to update our documentation and define systematically key performance indicators,” says Gisiger.

While the processes and controls are already in place, his colleague Chappuis notes that the systematic nature of collecting new information is new. “We are currently revisiting all the major processes of the bank, their documentation, the risk assessments, as well as policies and procedures,” he says. “We are performing this work internally as we have reinforced our risk management team with some people from the organisational side and with an audit background.”

For all private banks, regardless of what approach they take, skills are a crucial issue. As one observer notes, private banks are especially prone to “things have always been done this way” type of thinking and therefore may have to hire outside talent. But as KPMG’s Hall notes, while private banks might need to hire individuals to help them implement new risk management systems, “Basel-related talent is being spread incredibly thinly and these organisations may not be well placed to attract that talent”. In addition, there continues to be a lingering resentment of having to hire people in order to comply with Basel II who are perceived to bring limited added value, according to one banker.

For most independent private banks, Basel II is expected to be broadly neutral in its impact on capital adequacy. “We might come out of it looking slightly better but it won’t be a major change,” says LGT’s Enderli in a typical comment. “Any [credit risk] benefit that we probably could gain from the new regime is partly offset by the new operational risk requirements.”

The Swiss Federal Banking Commission’s (SFBC) ambition has always been to retain the current high capital adequacy levels in Switzerland – 20–50% higher than necessary under Basel I – under Basel II so that the country’s reputation as a haven of banking stability is maintained. Given the substantial buffer of existing high capital adequacy standards, Ray Soudah, founder of private bank consultancy MillenniumAssociates in Zug, Switzerland, says the impact will be “almost insignificant”. He adds: “The majority of small private banks are already substantially overcapitalised according to current standards.”

As part of the SFBC’s intention to broadly maintain existing capital adequacy levels, most bankers expect to see a decrease in some credit risk-related charges to compensate for the charges of operational risk. The SFBC is currently considering what stance to take on a number of crucial issues related to local implementation of Basel II. Among these are risk weightings accorded to retail mortgages – Basel II stipulates a 35% weighting compared with the current Swiss standard of 50–100% – and, most importantly, Lombard loans, which are collateralised by securities and form a major part of private banks’ portfolios.

Lombard loans are relatively expensive from a capital adequacy perspective, at 75% of the standard charge of 8% for capital adequacy. “That is too high given that it’s a conservative instrument with a very low credit loss history,” says Bernhard Hodler, head of global risk management at Julius Baer. “The Swiss regulator agrees that it is too high so there is no doubt that that charge will be lower in the future.” A charge of around 35% for Lombard loans is expected in the draft Swiss Finish – the Swiss implementation of Basel II – scheduled for release this autumn.

The final version of the Swiss Finish is not now expected until the second quarter of 2006 – worryingly late for many banks. Some plan to use external software to monitor risk and are concerned about deadlines. “We are working on the things that are already concrete and are in contact with our auditor to see what we can do,” says LGT’s Enderli. “But on the quantitative side we are still waiting for the new software releases. We are educating ourselves so that we are prepared. But time is very tight.” Holder adds: “It is important that the Swiss standards are defined soon. Otherwise there will be little time for implementation.”

Julius Baer: keeping it in the family

Founded in 1890 in Zurich, Julius Baer is one of the Swiss private banks that help to define the country as a sanctuary of banking conservatism. As Bernhard Hodler, who joined Julius Baer as head of global risk management in 1998 from Credit Suisse First Boston, explains, this culture is largely as a result of the involvement of the Baer family. Members of the third and fourth generation of the family still substantially shape the destiny of the group – the chairman and many members of senior management are Baers – and they own a sizeable chunk of the company, although they have recently relinquished part of their voting rights in a bid to improve corporate governance. Hodler says the bank has always invested relatively heavily in risk management resources, systems, people and processes. “Of course, risk management doesn’t come for free,” he says. “But now we are quite well prepared for Basel II because we have always spent some money on the basics of risk management.” For credit risk, Julius Baer has a relatively sophisticated in-house built system. “It is easy for us to change some parameters to make that compliant with Basel II’s standardised approach,” says Hodler. “We have no intention of going for the advanced measurement approach as credit risk is not a major factor for us. We obviously have some credit risk such as Lombard lending, mortgages and a bit on the trading floor, but standardised works best. We participated in the quantitative impact study one, two and three, and tried to ascertain what each would mean for us if we invested in the advanced measurement approach and how much capital we could save. We worked out that it was not that much, and compared with the relatively heavy investment requirement we came to the conclusion last year that it was not worth it.” Although the final details of the Swiss Finish, most importantly in relation to Lombard loans, are not yet known, Hodler says that while Julius Baer will use the standardised approach for credit risk, it will “implement a more rigorous strategy and analyse the volatility and risk of each individual security [underlying a Lombard loan]”. He adds: “Were you to do that, the change could actually be zero, but it would require a larger investment in risk management systems. Our intention is to take that approach for Lombard loans and securities lending so we will save money in terms of capital.” Of course, operational risk is a new cost under Basel II, which Hodler believes could be substantial. Partly for capital reasons, but mainly because the operational risk management framework is already in place, Julius Baer will use the standardised approach rather than the simpler basic indicator approach. “A few years ago, we began to implement a new risk management system,” says Hodler. “We think we have all the tools in place – such as the loss database, which has been in place for one year, key risk indicators, an annual operational risk mapping exercise and operational risk self assessment – but we will need to refine them this year and next year to be compliant with the qualitative requirements of Basel II.” Although these strategies have been developed internally, Julius Baer is also looking at external systems. It is in close contact with vendors and may introduce a monitoring system next year. “But with operational risk the critical thing is not the systems, which are a facilitator, but the process and the people,” says Hodler. “The major challenge from an operational risk point of view is to change the behaviour and attitude of employees. It’s very important that they feel they have the support of top management.” Hodler also believes it is important to use Basel II to view operations in a different light. “Basel II implies qualitative requirements for an integrated approach to risk management so that you look at different risks together,” he says. “We have tried to integrate risk analysis – what we call the risk landscape – closely with strategic planning. I work very closely with the chief financial officer to make sure risks are always discussed when we consider what business we want to push or change. We have to refine that process further. Not all the banks have realised that there is more to Basel II than the quantitative stuff.” As all banks have to comply with Basel II, it is hard to argue that complying could be a positive business factor or diffentiator. But the way you integrate Basel II is the real challenge, according to Hodler. “In the past risk management was tactical – market risk, credit risk and operational risk – but in the future it will be more strategic risk management, better integrated with business and reputational risk. If that process works well, it could be a differentiator.