Sourcing the single-system solution

As head of the Basel project office at Bank of New York, Nicholas Silitch faces the toughest challenge of his 20-year career at the bank.

Nicholas Silitch is a rarity in the financial world in having worked at the same institution for his entire career. An economics alumnus of Colby College in Maine in the US, he began his career at the Bank of New York (BoNY) in 1983, and was most recently given the role of overseeing its Basel project office in May 2004.

In 2001, Silitch began running BoNY’s portfolio management division, charged with implementing a new ratings system and economic capital model to monitor the bank’s portfolio and measure its risk. The Basel project office he now heads will seek to fully implement all aspects of the Basel II capital Accord.

Silitch aims for BoNY to be Basel II ready by the first quarter of 2006 on a parallel basis with Basel I – this is an initial requirement of the new Accord. This places the bank almost a year ahead of the line drawn by its host regulators. “Basel II will lead to more transparency in the wholesale credit markets, which should encourage better decision-making at the margin,” Silitch says. However, although regulatory capital and economic capital will be more closely aligned, they are still not the same thing. Silitch concedes there is a lot of work to do before everyone gets there.

This is why Silitch attends events such as software vendor Algorithmics’ credit event in Vienna in November, where Risk spoke to him after he gave a presentation on building a comprehensive credit risk information system for Basel II.

Each bank has its own idiosyncrasies, according to Silitch. In the case of BoNY, it has a portfolio of predominantly high-grade corporates in addition to liquidity lines to low-risk mutual funds. Other institutions may be idiosyncratic for having exposure mainly to high yield. “Coming to a common global regulatory view on each asset on your portfolio is problematic. The home-host regulatory has yet to be resolved among the supervisors. And even once it has been worked out, I suspect it will be difficult to implement,” he says.

Pillar II in the Accord, which relates to validation and procedures, poses a particular challenge for BoNY. “Low probability-of-default (PD) portfolios are tricky from a validation perspective – it is difficult to quantify the risk via back-testing.” Back-testing is a method of measuring the PD of a category of credits. High-yield portfolio PDs are somewhat easier to measure because they are more volatile and cyclical. While single-B US credits may have had a PD of 6% in 2001, it is almost certainly lower now. Because of its low PD exposure, however, BoNY looks at other methods, such as external benchmarking. Here, default probabilities are implied from a larger population after comparing internal default figures with the default experience of external low-PD obligors.

Implementing the other pillars in the Accord will not be easy either. Pillar III requires additional public disclosure about risk exposures, parameters and risk management capabilities. This may therefore cause aggravation if it is not properly understood. Silitch says banks must meet the requirements of Pillar III in a way that makes it as easy as possible for the investor to understand.

As for Pillar I, the main difficulty is aggregating the data from the different source systems. BoNY has 35 source systems, but a larger organisation may have a great many more, which will consist of collateral data from a range of basic loan systems and other regulatory reporting requirements.

And the pitfalls to watch out for? Basel I created many opportunities for arbitrage, resulting in high-quality assets leaving banks’ balance sheets and being securitised. “The 364-day revolver loan was created under Basel I because it had zero capital impact,” says Silitch. If any market starts shifting dramatically – as it did under Basel I – Basel II will be under fire.

“If the changes in the new Accord move the markets in the right direction slowly over time, we will have taken a major step forward,” says Silitch. As to the future of the Basel project office at BoNY’s Wall Street offices, he says: “Hopefully, our Basel office will cease to exist in 18 months. Its tasks – the ongoing validation of ratings, the ongoing data requirements – will be absorbed back into other divisions in the bank. But the specific requirements of the Basel office should disappear.”