"Basel 11:General Remarks"

Presented by

Mr. Andrew CrockettPresident of JPMorgan Chase International

The Twenty Ninth Annual Meeting of theCouncil of the Governors of the ArabCentral Banks & Monetary Agencies

Beirut -Lebanon

5 - September 2005

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Basel 11 and the Emerging Markets

Remarks to the 29th Annual Meeting of the Council of the Governors of the Arab Central Banksand Monetary Agencies, Beirut, September 5, 2005

Andrew Crockett, President, JPMorgan Chase International.

Mr. Prime Minister, Governors, Ladies and Gentlemen:

It is an honour and a pleasure to participate in this 29th Annual Meeting of the Council of theGovernors of the Arab Central Banks and Monetary Agencies, and to give this keynotepresentation. I am particularly happy, as a former central banker myself, to be with so manyfriends from the region.

Central banks play a crucial role in modern economies through their pursuit of monetary andfinancial stability. Sustainable stability is at the heart of the effort to efficiently mobilize andallocate~scarceresources. It is thus a precondition for durable, high quality growth of output andliving standards.

While the pursuit of monetary and financial stability is basically a national concern, centralbanks have increasingly understood the international dimension of their responsibilities. Theyhave therefore sought mechanisms to develop cooperation with central banks in other countries.One manifestation of this cooperation is to be found in the global committees that meet at theBank for International Settlements. Another is the development of regional forums, such as thegrouping meeting here today. The global and regional efforts are in no way competitive.Indeed, in my ten years at the BIS, I valued highly the regional groupings that helped promoteunderstanding of shared problems, and spread best central banking practice.

This morning, I want to discuss one of the elements of international central bank cooperation thathas arguably progressed furthest, namely, the effort to develop high quality standards for bankregulation and supervision. The focus of my remarks will be the revised capital accord that hascome to be known as "Base! 11". I will examine the underlying philosophy of the new accord,and assess some of its potential consequences, both for banking systems and for economicperformance more generally. I will pay particular attention to the potential impact of new rulesfor emerging markets. Before embarking on this discussion, however, let me say a few wordsabout the historical background to international cooperation in banking supervision.

The need for such cooperation became apparent as the forces of liberalization and innovationwere leading to increased globalization of the financial system. But, as often happens, the spurto concrete action was provided by the need to respond to crises. The first significant crossborder financial crisis of recent times was the failure of Bankhaus Herstatt in Germany in 1974.This led to the creation on the Basel Committee on Banking Supervision, whose first majoraction was to define the relative responsibilities of home and host supervisors in the case ofcross-border financial activity.

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A more profound challenge to global financial stability was provided by the Latin American debtcrisis ofthe 1980s. In the wake of this crisis, it became apparent that capital adequacy standardsvaried widely across jurisdictions, and that many international banks were severelyundercapitalized. The Basel Accord of 1988 was one important element of the response to thiscrisis. It prescribed common minimum levels of capital holding (the famous "Cooke ratios")that, for the first time, linked capital holding to risk.

The 1988 accord was, in my view, a resounding success. It strengthened banking systems in themajor industrial countries, and helped level the international playing field. And the effect of theAccord was felt well beyond the G10 countries that negotiated its terms. The vast majority ofbank supervisors around the world voluntarily decided to adopt these same standards for theirown banking systems.

In 1996, the Committee extended its capital adequacy framework to embrace market risk as wellas credit risk. And the following year, the Committee published the "Core Principles forBanking Supervision". These "Core Principles" provided supervisors with a comprehensiveguide to best practice in supervising the establishment, ongoing operation, merger and closure ofbanking institutions. They were a milestone in that they recognized explicitly the interest ofemerging markets in the development and coverage of supervisory rules. Supervisors fromemerging markets were closely involved in the drafting of the principles.

The need for a New Accord

Given the achievements of the original Basel accord, it is reasonable to ask why the BaselCommittee felt the need, in 1999, to embark on a comprehensive revision ofthe Accord. Theanswer, quite simply, is that the original accord (Basel I) had become outdated. Developments infinancial technology had transformed risk monitoring and management, while banks had foundmeans to arbitrage their way around some of the original capital standards.

It is no secret that financial technology has developed with astonishing rapidity in the years sinceBasel I came into force. Back in 1988, derivative financial instruments were in their infancy,and whole categories of contracts (credit derivatives and structured options, for example) had yetto be introduced. These new instruments generated new categories of risk, while offering newpossibilities for risk mitigation. At the same time, their complexity, and the need forsophisticated information technology to track complex exposures, focused attention on thegrowing significance of operational risk. Operational risk is the risk of breakdowns in systems,controls or physical infrastructure, along with the danger of human error or fraud.

As new instruments were transforming the financial landscape, banks were using financialengineering to find ways around some of the minimum capital requirements. Responding to theincentives inherent in the regulatory rules, banks tried to economize on capital holding, in waysthat maintained their most profitable lending opportunities. For example, securitization enabledthem to offload the senior tranches ofloans, (with high credit ratings) while retaining exposure tomore risky, and more remunerative, tranches. High quality credits were increasingly pushed intothe capital markets, while banks concentrated on more profitable, but more risky lending. And

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new forms oflending, such as the provision of back up facilities for securitized loans, assumedgrowing importance.

Even more fundamentally, however, the passage of time saw a growing gap between regulatorycapital requirements, and the economic capital indicated by the banks' own internal models. Asa result, incentives in portfolio management were becoming misaligned.

It therefore became clear to the supervisors meeting in the Basel Committee that something hadto be done to restore the realism of minimum capital standards. But it was also clear thatprudential behaviour involved far more than simply holding a prescribed minimum level ofcapital. It required, as well, a comprehensive credit culture, in which all sources of risk would beidentified and consciously managed. Promoting this wider agenda required a much morefundamental evolution in the supervisory approach.

The basic philosophy of BasellI

The objective of promoting convergence on best risk management practice influenced importantelements of theprocess by which the new Accord was arrived at. Rarely can a majorinternational agreement have been reached with such a broad-ranging and painstaking process ofconsultation. Since the negotiations began, there have been three full-scale consultativedocuments, and five surveys of the quantitative impact of the new rules.

Nearly a thousand responses to the consultative documents have been carefully considered by theCommittee, and extensive modifications have been made to the originally published proposals.While not everyone is satisfied with all aspects ofthe final agreement (I myself have someremaining criticisms) nobody can fairly claim that their concerns have not received a hearing.Emerging market countries, in particular, have been brought into the consultative process atevery stage.

Much of the commentary on Basel 11has been on the appropriateness of the new risk weights.This is unfortunate, in my view. Basel 11is much more than a set of risk weights. It represents acomprehensive attempt to align supervisory practice with modem risk management techniques,and to provide a set of incentives to encourage heightened risk consciousness at the firm level. Itdoes this through three mutually reinforcing "Pillars".

Pillar One consists of minimum capital requirements, based on updated risk weights. In thisrespect, Pillar One corresponds to the approach of Basel I. However, it includes several featuresthat make it a considerable advance on the old capital requirements.

In the first place, it allows for much greater discrimination in credit risk weights, based onempirical estimates of probability of default and loss-given-default, as well as on third partyassessments of creditworthiness. Second, it is much more flexible that the old capitalrequirements. Banks can choose between a simplified model and more complex models,depending on their own degree of sophistication and the complexity of their portfolios. Third, it

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takes account of techniques of risk mitigation, even if the way in which this is done somewhatrudimentary for the time being.

Finally, explicit allowance is made for operational risk. Recent years have amply underlined theimportance technological or human failures. As financial instruments become more complex, asthe size of financial institutions has grown, and as reliance on information technology hasincreased, the scope for operational losses has grown.

Overall, therefore, the requirements emerging from the application of minimum capital ratioswill correspond much more closely to banks' own estimates of the relative riskiness of the assetsthey hold. But this is still not enough to make minimum capital ratios, by themselves, anadequate basis for truly risk-sensitive oversight of the banking system. And that is the reason forthe other two pillars of Basel H.

Pillar Two is supervisory oversight. Pillar Two is in many ways the most important innovationof the new Basel accord. It seeks to develop common approaches among supervisors in theirappraisal of risk measurement and risk management practices. In so doing, it aims to establishstandards beyond simply the precautionary holding of capital.

There is not time today to deal exhaustively with the many aspects of supervisory oversight. Buttwo points are of particular importance. One is the need to assess the way in which banksmanage their overall portfolio of risks, and deal with issues of concentration and diversification.And the second is to judge the ability of the governance structure to provide adequate incentivesto measure, monitor and control a bank's risk profile.

The portfolio approach to risk management is a recognition ofthe simple point that risks can becorrelated. Banks should strive to avoid potentially dangerous correlations of risk bydiversifying their portfolios. This was a major lesson learned by emerging markets in the 1990s.Hidden concentrations of risks, and concealed currency and duration mismatches were a majorcontributor to the Asian crisis. So the "adding up" of risk weights across the individualcomponents of an asset/liability portfolio has to be complemented by a judgmental assessment ofthe portfolio's vulnerability to adverse correlations. Supervisors need to satisfy themselves that abank's management is equal to this task.

This leads naturally to the topic of governance. Governance is an equally important part ofsupervisory oversight. Good risk governance starts at the top. The Board of a bank must bedirectly involved in setting the bank's risk appetite, and in establishing clear guidelines for theactivities of the operational departments. These guidelines need to be effectively communicatedto line managers, with follow-up training and reinforcement to ensure that all staff understandfully the principles that are to guide their lending and hedging decisions.

Risk measurement and risk control functions should be staffed with high quality individuals whoare adequately remunerated. The risk control function should be fully independent of the risk-taking functions, and report directly to senior management. Likewise, internal audit should beseparated from other activities of the bank.

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Exposure reporting systems need to be robust and timely enough to enable risk managers to trackcompliance with risk guidelines.

Incentives built into compensation structures need to balance rewards with a proper assessmentof risks. Too often, problems have arisen because risk-takers have received compensation basedon revenues earned, without adequate discount for the risks incurred.

Lastly, special attention needs to be paid to legal and reputation risk. Recent events haveunderscored the importance ofthe highest ethical and compliance standards. Not only must abank ensure that its activities meet all legal and compliance requirements, it must also ensure thatit does not knowingly or inadvertently enable its clients to evade ethical or transparencyguidelines.

The foregoing requirements are all integral parts of supervisory oversight. Where riskmanagement falls short of best practice, supervisors should impose restrictions on risk takinguntil deficiencies are corrected, or, at a minimum, require an additional cushion of capital to beheld.

Pillar Three of the new Basel capital accord is market discipline. Most supervisors agree thatsupervisory judgments should work with the grain of market forces, and should encourageprudential behaviour through the discipline applied by counterparties. To be effective, of course,market discipline requires depositors and counterparties to have comprehensive informationabout the risk-taking activities of banks.

Pillar Three of the new Accord therefore has provisions to encourage the timely andcomprehensive publication of data needed by market participants to play this disciplining role.For the time being, it is probably fair to say that market disciplines are subsidiary to supervisoryoversight in ensuring prudential behaviour on the part of banks. But a number of techniqueshave been proposed that could give market forces a more direct role. Perhaps some of thesetechniques will form part of BaseI III if and when the time comes to update the new accord.

Economic Consequences of Basel 11

Let me now turn to some of the economic consequences of Basel Il. Much has been writtenabout the complexity of the new rules, about how they may raise the costs of borrowing for someborrowers, and about how they may increase the amplitude of cyclical fluctuations. I will cometo these criticisms later, but I want to begin by considering some ofthe beneficial effects therevised accord will have on the efficiency and stability of financial systems.

As I have just emphasized, Basel Il aims to strengthen the incentives to efficiently measure,manage and price risk. Improving performance in this way means that one of an economy'smost important scarce resources, that is, financial capital, will be more efficiently used. In turn,this will lead to higher levels of investment, and more efficient investment, thus contributing tohigher rates of output growth and living standards. ;.

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Better risk management also means that, for a given quantity of capital, a banking system will bemore resilient to shocks that threaten its stability. In my view it is hard to argue that we will notbe better off when risks are better understood and managed, and more appropriately priced.

Of course, an increased focus on risk management has implications for the price of credit and thestructure of the banking industry. Weaker credits will attract higher capital requirements, andtherefore have to pay higher interest rates. With the growing complexity of bank portfolios andrisk mitigation techniques, and with the increased sophistication of information technology, thecost of developing state-of-the-art risk control systems has increased substantially. This hasprobably increased the availability of economies of scale in banking.

By itself, this process should make for a continuation of consolidation in the banking industry.Emerging markets would do well to recognize this trend, and not try to artificially resist it. Still,I do not see the pressures to consolidate as overwhelming. Small institutions often haveadvantages that can offset marginal savings in regulatory capital. They are nimble, closer totheir customers, and often specialized. Moreover, they can take advantage of one of thealternative "approaches" to capital holding allowed under the new rules. I do not accept thatBasel 11unfairly tilts the playing field against smaller institutions.

Some criticisms of Basel 11

I would like to turn now to some of the criticisms that have been made about Basel 11. It isapparent from what I have said so far that I believe improved risk sensitivity will make thebanking sector more stable and efficient and will improve the allocation of resources. For thesereasons, Basel II deserves to be welcomed. But that does not mean there will not be somelosers.

Greater risk sensitivity means that certain assets held by banks will attract greater regulatorycapital requirements than previously, while others will have lower requirements. So the cost ofborrowing may tend to go up for some borrowers from banks. Once again, I think it is hard toargue that this is a bad thing, given that borrowing costs will then more closely reflect trueunderlying risks, and that borrowers that end up paying more will be balanced by those who payless.

Moreover, it is not clear that those who seem to lose, in fact do so. I suspect that poor creditsthat had artificially low capital requirements under Basel I in practice found it difficult to obtainfavourable accommodation from their banks. Where it could be shown that the proposed riskweights under Basel 11were too conservative (for example in the case of lending to Small andMedium-sized enterprises) changes have been introduced to rectify the situation.

Another criticism often leveled at Base! 11is its complexity. It is true that certain provisions ofthe new rules are quite complex, but this should not be a surprise.Banking is a complex business, and it would not be a service to the industry to try to set simplecapital rules to govern the capital needed for a complex and constantly changing activity. Intruth, however, given the alternative approaches allowed under pillar one for the calculation ofminimum ratios, the implementation of BaseI II for a bank with a standard portfolio need notbe

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much more complex than under Basel!. Banking systems in emerging markets should thereforenot face major difficulties in eventually adapting to the new standards.

Another complaint is that the risk management provisions of the new accord encourageprocyc1icalbehaviour on the part of financial institutions. It is alleged that banks have an addedincentive to sell assets in a downturn, and to bid up their prices in an expansion.

There is some truth to this charge, but not a great deal. Even in the absence of capital rules,prudential considerations make banks cautious in bad times. So some procyc1icalityis aninherent part of risk management.

Good supervision can help to moderate excessive procyc1icality. Greater risk awareness on thepart of financial institutions will make them more able to react in a timely way to changingeconomic conditions. This should help moderate the build-up of over-extended lendingportfolios during expansions, thus reducing the "sudden stop" syndrome when recession arrives.Moreover, Pillars II and III can be used to encourage banks to keep a cushion of capital in goodtimes, to make them better able to weather inevitable downturns.

Another criticism is that the risk weights of BaseI II are too conservative. Supervisors, it is said,have placed too great a weight on avoidance of bank failures in the calculation ofthe weights.Moreover they have not given sufficient attention to negative correlations among different risks.Diversification effects, in other words, have not been adequately taken into account.

This is a criticism with which I have some sympathy. Of course, it is the job of bank regulatorsand central banks to be conservative and to discourage excessive risk-taking. But we shouldremember the law of unintended consequences. Too much stress on avoiding risk means thatsome potentially productive opportunities will be missed. And excessive restraints on banks maydivert financial activity to other, less regulated, and perhaps more vulnerable channels ofintermediation. The Basel Committee will undoubtedly be paying attention to this possibility asit monitors the implementation of the Accord.

Basel 11and Emerging Markets.

What specific consequences should emerging markets expect to see from the introduction ofBasel II? I believe these are generally very positive, though there will be implementation costs,both for banks and supervisory authorities. Emerging markets, even more that developedeconomies, have a scarcity of capital. It is strongly in their interest to ensure that risks areproperly priced, and that capital is directed to uses where its risk-adjusted rate of retum ishighest. Emerging markets have also suffered in the past from periodic banking crises. Thesehave had large resolution costs, and have impaired economic performance over a considerableperiod.

The efficiency of lending has typically suffered from practices such as connected lending, hiddenrisk concentrations, currency and duration mismatches, poor accounting and audit oversight.This has sometimes been referred to as an underdeveloped "credit culture" that has led to a large

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volume of non-performing loans. Non-performing loans reflect a misuse of scarce capitalresources, since they reflect the accumulation of investments that are unable to justify their costs.To the extent that the implementation of BaseI 11helps address these problems, it will be stronglyto the advantage of emerging markets.

Of course, implementation is neither easy nor cheap. It should not be rushed. Commercialbanks need to work hard to upgrade their information technology, and to train their staffs in riskmanagement techniques. And supervisors need to make sure they have staff with the skills toexercise the needed supervisory oversight over regulated institutions. These are costlydevelopments. If time is required to put them in place, then countries should not be afraid todelay somewhat the implementation of BaseI 11. But the only thing more costly than makingthem would be not making them.

Basel 11 and Islamic Finance.

Let me end this brief review of the economic consequences of the Basel capital accord with afew words on the subject ofIslamic Finance. This has been a topic that has interested me for anumber of years, and I have even contributed to a volume on the subject. Still, I do not pretendto any expertise in the area, and ifI venture a view, it is with considerable humility.

It is my belief that the great majority of recommendations stemming from Basel 11,referring asthey do to better awareness, management and governance of risk, apply equally to Islamicfinancial instruments as to those in use in non-Islamic financial systems. What is needed now isintensive work to assess the particular risk characteristics of Islamic instruments, and theparticular implications of their use for overall portfolio management. In this way, supervisors inIslamic countries will be better placed to judge the modifications to minimum capital standardsthat flow from the use of Islamic financial instruments. Eventually, I am convinced, the bestpractice procedures developed around the world can be married with the insights provided byscholars and practitioners in Moslem countries.

Conclusion.

This brief review has done no more than touch on some of the aspects of a massively complexexercise, that of developing risk management and capital standards suitable to guide the bankingindustry for the coming decades. I hope I have managed to demonstrate what central bankcooperation has been able to achieve in underpinning the efficiency and soundness of bankingsystems around the world.

This cooperation, however, is a continuing process. It requires dedication and skill over acontinuing period. In this, there is a major role to be played by regional groupings such as theCentral Bank Governors of the Arab Countries. You can promote this process by analyzing howdeveloping standards affect your own economies, by helping manage the process ofimplementation, and by participating in the adaptation of standards to changing circumstances.

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I am confident that this body will play a central role in this process and thereby contribute toensuring that banking systems in this region continue to play their vital part in strengthening thebasis for improved growth and rising living standards for the peoples of the Arab world.