Bankers want the new Basel Accords to lower capital requirements. Regulators want a more robust financial system. Can both sides get what they want?
| From left to right: Banamex's Xavier Corvera, HSBC's Jose de Caso, Deloitte's Leon Bloom, Inverlat's Alfonso de Lara and LatinFinance's Alex Manda. |
The new accord, known as Basel II, is based on three pillars: more sophisticated risk measures, incentives for proactive management and market discipline through better transparency. But while analysts believe that this will make banks more focused, bankers worry that it will simply make them hold yet more capital. They would like a measure that helps boost their competitiveness. And while some think that the renewal promoted by the new regulation might help them raise their game, many more think competitiveness will only come from implementing an unwieldy process nimbly.
Finally, bankers worry that Basel II will intensify the effects of the business cycle by making their balance sheets look better than they are when times are good and making them look worse during downturns, and possibly drive banks into forced selling. A Spanish proposal for a counter-cyclical buffer is being discussed, but no one knows if it would work.
The Basel Committee on Banking Supervision has spent the best part of four years working on a new accord, tackling bankers' complaints that the current Basel I arrangement is too focused on credit risk and that its principal yardstick – 8% of assets on a sliding scale of risk weightings – is too crude to cope with the demands of today's financial markets. Disturbingly, it encourages banks to lend excessively to clients with an inaccurately low risk weighting. Nearly all Latin American governments allow banks to book their public bond holdings as risk-free assets.
The big complaint, of course, was that capital isn't everything. Holding more cash in reserve is no defense against bad management.
"If you look at Barings, about a $2 billion event, if it had held more capital, it simply would have lost more money," says Leon Bloom, deputy managing partner of Deloitte's global financial services industry practice, speaking at a LatinFinance Round Table on Basel II held in Mexico City in December.
Three Pillars
Basel II's approach is based on three pillars. The first deals with credit risk. The second pillar would allow supervisors to use measures that go beyond just setting capital requirements to decide whether banks are tackling risk appropriately. The third would require banks to disclose their risk management procedures, allowing investors and financial counterparties to judge the effectiveness of a bank's risk management policies. Markets would punish banks that disclose little information or manage risk poorly by raising their cost of capital.
As regards credit risk, banks have a choice between the internal ratings-based (IRB) approach and investing in proprietary advanced approaches. Under IRB banks use their own credit measures to assess the risk of each asset using PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure at Default) as benchmarks. Banks argue that this will force lower capital requirements, although it is unclear that this would be the case for all banks. Some analysts reckon that changes in reserves might be a good thing as long as banks properly allocate capital to match the risks they are taking.
"Banks will know where to focus because they know the risks they are taking. They will be able to decide if they want to take those risks at a better price," says Angélica Bala, associate director for financial service ratings for Standard & Poor's in Mexico. Ani Sanyal, director of research and development at Sungard's Bancware division, says that better risk management will improve the state of bank balance sheets and lending practices over time.
Sanyal says that bank marketing departments too often operate in a "me, too" culture, where marking departments push lending departments to replicate products that peer banks have created.
| Jose Luis Sanchez |
Banks are hoping that the second pillar, which is in the hands of regulators, will give them the capital relief they are seeking. Regulators have it in their power to reward good management with lower risk weightings. Deloitte's Bloom says that this is the best way to improve bank standards: "What you need to address risk is more proactive, more effective risk management, rather than just more capital. That is where most of the weighting should be." If a regulator finds that a bank meets or exceeds risk management and disclosure standards, then that bank would benefit from lower capital requirements.
The Basel Committee's November 2005 version of the framework document makes it clear that simply allocating sufficient regulatory capital alone would not be sufficient to avoid trouble. "Increased capital should not be viewed as the only option for addressing increased risks confronting the bank," the document states. It argues for "other means for addressing risk, such as strengthening risk management, applying internal limits, strengthening the level of provisions and reserves, and improving internal controls. Capital should not be regarded as a substitute for addressing fundamentally inadequate control or risk management processes."
This is especially the case in countries that have undergone acute financial crises, which tested bank balance sheets – and bankers' abilities. "One of the lessons of the [1994-95] Mexican crisis, which was very, very severe, is that you can't just rely on capital. There are other measures you have to check," says Javier Márquez, head of risk management at Banco de México, the central bank.
And while banks are less than enthusiastic about the idea of holding more capital in case of emergencies, they are much happier to compete in terms of using the most rigorous procedures. "With respect to capital adequacy standards, no one wants to go too far beyond what is mandatory, but exceeding risk management standards, that is a different issue," says Bloom. "There are many banks which, because of the policies and practices developed by the head office or corporate center, need to standardize procedures across the enterprise. Those standards, depending on the jurisdiction, often exceed what is typically expected at a local level."
However, local regulators are keen to stress that they will not simply accept regulations established by a big international bank's headquarters without question. Risk management models developed in London, Madrid or New York may work well in developed country markets, but they may work less well in developing countries, says Luis Eduardo Mendoza, head of risk analysis for Mexico's bank and securities regulator, the CNBV. "Maybe a bank could be approved by their home regulators for the global model. But if it does not reflect what is happening in Mexico, we may take into consideration whatever opinion they have, but we want them to reflect the Mexican reality."
There is a great deal of skepticism about whether the third pillar, the market discipline provided by disclosures, will have any effect. That pillar assumes that market participants will be more willing to invest and trade with banks that fully disclose their approach to risk management alongside their normal financial statements. "It remains to be seen the extent to which that market discipline will work in practice," Bloom says. "I [would] assume that if a bank is in business it meets the conditions for doing so, or it would not be in business. The disclosures I am interested in are risk-adjusted returns, not capital adequacy."
One big unanswered question is to what extent Basel II will make banks more competitive. Some banks are being forced to implement the new rules by regulators, but some have also chosen to adopt Basel II requirements as part of an overall review of their business processes. Some changes may improve efficiency and the reliability of the information they have about their clients. For others, the competitive edge may come from their ability to implement an unwieldy process faster than rivals.
"The competitive advantage does not come from Basel II. It comes from within the banks and how they decided to implement it, based on what it means for the whole of the enterprise," says José Luis Sánchez, general manager for Latin America - North at software company SAS. Instead, he says, banks should use the opportunity to renew their adequacy models to win business from new customers.
Says CNBV's Mendoza: "The competitive advantage will come from using more advanced risk models, and from adapting regulatory practices to the practices of the more advanced institutions." In the future, the role of the regulator could well be to act as a facilitator for the market, by promoting the dissemination of best practices throughout the industry.
Some banks are using their customer relationship management (CRM) systems for compliance by using these software tools to pull together information that marketing people want for sales reasons and regulators need for risk measurement purposes. "It used to be the case that if you wanted the complete story on a debtor it would be scattered in four or five different departments. Just getting everything together in one file is a major achievement," says Banco de México's Márquez.
Once the new regulations are implemented, it will be a bank's agility that will determine its competitiveness, says Bancware's Sanyal. "Out of the new structure will emerge new ways of doing business following from the new set of incentives and disincentives. Competitiveness will mean being more nimble in dealing with those," he says.
| Andres Corona |
Investors, regulators and bankers themselves are concerned about the effect of Latin America's severe economic swings on the region's banking systems. Banks are more robust and better managed than in the past, yet even the biggest and the best banks suffer from the impacts of sudden downturns, collapsing currencies or surging interest rates. Assets are worth more when times are good than when times are bad. This applies just as much to those assets counted as regulatory capital as it does for the securities that banks hold, or actively trade, and the loans they make to clients. "Right now, for capital measures, you use expected loss probabilities. In this context, the application of Basel II will make capital requirements lower than they are today, because it only considers unexpected losses through a credit cycle," says S&P's Bala.
But while that is fine right now, it might increase systemic risk when the economy turns down, encouraging banks to ignore weaknesses in their balance sheets. "It is important to note that bad loans are made in good times and not in bad times," says Bloom. In bad times, banks' assets will look poor, and they may have to sell more assets to maintain their regulatory capital. Forced selling could hurt the value of these assets, leading to a vicious cycle of forced selling for recapitalization. Good credits will suffer as much harm in such a scenario as bad ones.
Bancware's Sanyal believes that modern modeling techniques can solve that problem. Extrapolating from worst-case scenarios can produce capital adequacy figures that could remain appropriate even in the most extreme circumstances. "Rather than just use the point estimates for the default factors such as PD, LGD and EAD, it is possible to fit distributions around them or to stress-test these and other macroeconomic inputs. Several reasonable approaches can be designed to come up with a worst-case regulatory capital number," he says.
But bankers are unhappy with that idea. They worry about holding large amounts of capital. "It is impossible to have a deep capital buffer expecting that one day we will have a crisis. That doesn't work. It is very expensive," says Alfonso de Lara, head of risk management at Mexico's Scotiabank Inverlat. He says that the statistical measures that banks use to calculate their need for capital work well enough 99% of the time. However, there will be rare but high-impact crises – such as the Mexican currency crisis of 1994-1995 or the Argentine post-default crisis of 2001-2002 – in which no amount of regulatory capital will be enough to fully protect a bank or its clients. The Mexican government took over Inverlat following the 1994-1995 financial crisis and the bank was bought by Canada's Scotiabank in 2000.
Another proposal under consideration is that of Jaime Caruana, governor of the Bank of Spain and current head of the Basel Committee, for dynamic provisioning, a system put in place for Spanish banks in July 2000. This allows banks that have put aside extra capital in good times, up to a stated limit, to release these reserves, with regulatory permission, during an economic downturn.
Spain has not yet tested the effectiveness of the policy because the country has not fallen into recession in the last five years. Bank of Spain statements say that credit has been expanding quickly, even though banks have been setting aside upwards of 15% of profits to comply with the dynamic provisioning scheme. Spanish regulators demand that banks comply with this requirement both at the group level and at the level of individual subsidiaries. Spanish banks in Mexico are switching to the new system, and as a result they want Mexican regulators to adopt advanced tools to measure their risk-adjusted capital. "In all the Spanish banks in Mexico they are asking everyone to plan for the advanced models. Not next year, but today," says Andrés Corona, corporate director of risk management at BBVA Bancomer. "They are trying to do something concerted."
