Basle II Draws a Mixed Response

Basle II Draws a Mixed Response
Rob Jameson, ERisk

Thursday, June 07, 2001

A famous cartoon from an 1895 edition of the British satirical magazine Punch showed a bishop and a curate tucking into their breakfast with unequal enthusiasm. “I’m afraid you’ve got a bad egg, Mr Jones,” says the bishop. “Oh no, my Lord, I assure you!” says the curate, “parts of it are excellent!”

The cartoon neatly summed up a human dilemma: how to respond to a higher authority that’s given you something you can’t stomach. A similar spirit infuses many of the responses that beat the May 31 deadline for comment on the Basle II proposals on capital adequacy. Many of the 225-odd responses (the number is still growing) posted on the Bank for International Settlements’ Web site contain carefully worded congratulations. Bouquets are awarded to the regulators for the thrust of their new risk-sensitive rules, and for their hard work in fleshing out the “three pillars” of the new approach: capital, supervision and risk disclosure.

But further on in each response, industry noses quickly begin to turn up at the “bad parts” of the proposals. Some of the complaints are familiar and rather technical, and are covered in our earlier feature articles on the general proposals, the credit risk and operational issues, as well as in the detailed responses of key associations listed at the end of this article. But others are more idiosyncratic and show why individual institutions and professionals now have such a bee in their bonnet about Basle II.

Merrill Lynch, for example, adds fuel to the debate about bank operational risk. In a polite warning that ends up sounding suspiciously like a threat, the securities giant points out that the operational risk charge will have a disproportionate effect on firms with large trading books. It says this effect might be so great as to “call into question the viability and/or geographic location of these organisations”.

This refrain is taken up by Credit Suisse Group in one of the more passionately critical responses to the regulators. It argues that the regulator’s operational risk approach has been hijacked by those with “a vested interest for models – but with little responsibility for their results, interpretation and the costs involved”. It says banks will end up spending hundreds of billions of dollars on Basle II compliance, with little certainty of real-world benefits in terms of risk mitigation. The fact that banks will have to comply with 80-odd rules if they are to implement the internal ratings based approach might even mean, it says, that “some outstanding risk managers will no longer want to work in this field”.

Credit Suisse also observes that the banking regulators have taken little heed in their framework of the convergence of the world’s financial industries. It’s ironic, then, to see among the responses a small queue of insurers offering their views on a potentially profitable issue: can an insurance contract be devised that will fully transfer a bank’s operational risk in a way satisfactory to the regulators?

Insurance broker Willis says there’s no real chance of the insurance industry developing an all-risks policy that will answer the regulators’ concerns in one fell swoop. But in arguing for a more evolutionary approach, the firm offers a useful survey of how banks and their regulators already use insurance as a risk mitigant. The submission of the Basle Accord Insurance Working Group, a group of major interested insurance companies, takes a more visionary line and explores thorny issues, such as the construction of a truly industry-wide loss database, the definition of loss triggers and the defusing of concerns that an insurer might not pay out on a contract.

Worries about the operational risk charge aren’t only the preserve of insurance providers and larger institutions. Jeryl Story, a banking veteran with 25 years’ experience and senior executive vice-president of Southside Bank, an EastTexas consumer and small business bank with $1 billion assets, says the regulators’ “basic indicator” approach to operational risk cannot accurately measure the risk and the alternatives are too complicated. Story is no keener on the credit risk proposals and says these will be difficult to apply to many financial institutions and extremely expensive in terms of the outside resources and software programs a bank will need. The qualification criteria mean that supervisors will gain more detailed authority over a bank’s approach yet, Story says, “we have no evidence that the supervisory agencies have more expertise than the individual institutions themselves”.

Camden Fine, president and CEO of Jefferson City, Missouri-based Midwest Independent Bank has many of the same worries. But he says he’s also worried that complexity will itself create loopholes. Disclosure is always easy when things are going well, he says. But with commendable frankness he points out that when there’s a problem, “the tendency of bank management is to minimise disclosures or ‘spin’ risk information in the most favourable light”. Like other respondents arguing the corner for smaller banks, he’s also concerned that as they stand, the proposals will “create an unfair competitive advantage for the very largest financial institutions in the US over all other financial institutions”.

On this at least, the CEOs of smaller US institutions agree with the national banks of far-flung countries. The Bank of Korea points out that most banks in emerging countries will end up using the standardised approach, putting them at a disadvantage to major banks in industrialised countries. The Bank of Thailand echoes this concern, while worrying that real estate collateral is not appropriately recognised as a credit risk mitigant. It also says there aren’t many credit rating agencies in developing markets. As the International Monetary Fund sums up in its submission, “even the standardized approach under Pillar 1 runs the risk of being too complex for many countries”. It suggests an even simpler standard approach should be developed – an idea that’s been mooted and already run into trouble in the context of US regulation.

Which of these worries will the regulators be able to answer? The truth is that even before the responses were all in, the lead regulators were working away at the problems in the proposals that look tractable through adjustment and compromise. These include the definition and admissability of credit risk mitigants, the treatment of expected losses in the retail book, the treatment of real estate as collateral, and the details of the disclosure orders. But chances are that other problems – such as the right trade-off between simplicity and complexity argument, or the argument about an operational risk charge – simply can’t be solved in a way that makes everyone happy.

This article is based on responses sent into the regulators by 31 May. Other responses continue to be posted at the BIS website, at http://www.bis.org/bcbs/cacomments.htm.

Selected banking association responses:
America’s Community Bankers (ACB)
British Banker’s Association (BBA)
Institute of International Finance (IIF)
International Swaps and Derivatives Association (ISDA)
Risk Management Association (RMA)
Swiss Bankers Association