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BASEL II AND BANK REGULATION INTERNATIONAL AND AUSTRALIAN PERSPECTIVESMelbourne Centre for Financial Studies

17 July 2006

Bernie EganProgram Director, Basel IIAustralian Prudential Regulation Authority

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Basel

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Why the need for capital regulation

•Banks in the business of taking risks

•Banks hold capital

– as a buffer against potential losses

– to provide them with financial flexibility

– as a sign of strength to their customers

•Banks manage their own capital levels

– they have the skills and the incentives

•But there is also a need for regulatory capital

– for systemic reasons

– statutory obligations eg depositor insurance or in Australia’s case the

Australian Banking Act states “It is the duty of APRA to exercise its powers

and functions ….. for the protection of depositors …..”

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Recent history of Australian bank regulatory capital

• To 1970s: regulation of banks’ assets

• 1970s: an arrangement between RBA and banks that capital would not fall

below the then levels

• Early 1980s: shareholders’ funds at least 5% of on-balance sheet assets

• 1986: two tests had to be met; 5% SHF + an expanded definition of capital

had to be 6.25% of on-balance sheet assets

• 1988: Basel I; tier 1 and 2 capital and risk-weighted assets

• 1996: a capital charge for market risk

• 2008: Basel II

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Background to Basel II: 1

•Basel II

– required because of advances in risk management practices, technology and

banking markets since 1988

– primarily directed at securing international convergence to supervisory

regulations governing the capital adequacy of internationally active banks

• Australia like many other countries will apply it to all deposit-taking

institutions (for prudential and competitive reasons)

– establishes minimum levels of regulatory capital for internationally active

banks

– provides more risk-sensitive capital requirements

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Background to Basel II: 2

•During late 1980s/early 1990s some banks developed– credit risk models– economic capital models (addressing all significant risks)

•By late 1990s– banks sought to use their own credit-risk models to calculate their

regulatory capital requirements– Basel Committee keen to leverage off what banks do in managing risks– but banks’ models were not sufficiently robust or comparable– Basel II a “half way house” on the way to regulators accepting the use of

economic capital models•Supervisors acknowledge value of models

– manage risk– create incentives for the development of appropriate risk/reward structures

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Basel II timeline

• June 1999: First consultation paper issued by BCBS

• January 2001: Second consultation paper issued by BCBS

• April 2001: QIS 2 conducted

• November 2001: QIS 2.5 conducted

• December 2002: QIS 3 conducted

• April 2003: Third consultation paper issued by BCBS

• June 2004: BCBS releases final version of Basel II

• 2004: ongoing work on trading book and double default issues

• November 2005: BCBS updates June 2004 release

• 2005: QIS 5

• January 2008: implementation of all approaches

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The three pillars of Basel II

•Basel II consists of three mutually reinforcing pillars

•Pillar 1

– Sets out the minimum capital requirements for credit, market and

operational risk, providing a menu of approaches

•Pillar 2: Supervisory review

– Banks must be able to demonstrate that their capital targets are consistent

with their overall risk profile and the current operating environment with

supervisors ensuring that banks have sound internal processes in place to

assess the adequacy of their capital

•Pillar 3: Market discipline

– Complements Pillars 1 and 2 through enhanced (market) disclosure of

capital, risk exposures and risk measurement

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Basel II: Credit and Operational Risk Capital

Credit Risk Capital

Minor modifications to the current (Basel I) Accord, allowing the use of external ratings and some collateral recognition.

Standardised Internal Ratings Based (IRB) - Foundation

Internal Rating Based (IRB) - Advanced

Allows application of internally developed rating systems with greater recognition of physical collateral.

Internally determined default probabilities, loss given default and exposure at default factors can be used, subject to very stringent criteria.

A calculation based upon a straight percentage (15%) of gross income. (Not being offered in Australia)

Basic Indicator Approach Standardised Approach for Operational Risk

Advanced Measurement Approaches

A similar calculation based on a % of gross income using distribution factors across eight Basel-defined business lines.

A range of advanced capital assessment techniques will be allowed, subject to a set of stringent qualifying criteria.

Operational Risk Capital

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How will the global framework be adopted in Australia

– Exercised a number of local discretions (especially in the standardised approaches)

– Under the standardised approaches retained “other retail” at 100% and introduced greater granularity to residential mortgage lending

– As all Australian banks with global operations are IRB/AMA we considered that we had more scope to tailor the standardised approaches – which will be used solely for the domestic banks – to the Australian environment

– Framework is the “1st draft” of the local Basel II rules and changes are made only when there is good reason to do so

– Pillar 2 will comprise an important component of total regulatory capital. It will commence with a discussion on each bank’s ICAAP but “supervisory over-rides” possible

– Australian banks have large residential mortgage portfolios – scope for some reduction in overall level of regulatory capital?

– Basel II is more risk sensitive – some banks will hold less regulatory capital and some more – but a commitment not to change the competitive landscape.

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Australia: Basel II standardised approach to credit risk

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The standardised approaches

• Are intended for those institutions whose business mix, risk profile and risk

measurement and management practices do not demand the use of the

IRB/AMA approaches

• They should not in themselves be regarded as inferior

• For individual institutions whose business mix and risk profile is

demonstrably more suited to the IRB/AMA approaches the standardised

approaches would clearly represent a second best outcome

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Accreditation to adopt the IRB/AMA approaches

• Those ADIs seeking to adopt the IRB/AMA approaches must seek

accreditation from APRA

• Application for accreditation based around a self assessment of compliance

with the Framework

• Application must be signed-off by the board

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General pre-requisites for adoption of the advanced Basel II approaches

Banks seeking accreditation to use the IRB and AMA approaches under the Basel

II Framework must:

1. have a board approved, well articulated statement of overall risk

appetite, broken down by major risk types;

2. have board approved definitions (that are consistently used) and risk

measurement methodologies for all significant risk types;

3. have credit, market and other risk limits and delegated authorities

expressed in terms of the approved (consistent) definitions;

4. be well advanced in the development of a board approved,

comprehensive and credible internal economic capital model;

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General pre-requisites for adoption of the advanced Basel II approaches

5. have a board approved methodology for determining the cost of

capital and required hurdle rate(s) of return;

6. be able to demonstrate awareness of what actual pricing implies in

terms of returns relative to the break-even cost of allocated capital;

7. be able to evaluate business line and product performance in terms of

the returns achieved relative to the underlying risks reflected in the

capital allocated by the economic capital model;

8. have performance assessment and incentive compensation for

executive managers materially influenced by the amount of risk

assumed; and

9. evaluate significant business initiatives on the basis of projected

returns on risk based allocated capital

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Cyclicality

• In times of stress banks reduce their lending - aggravating any economic

downturn that led to the initial stress

• Under Basel II a general economic downturn will feed into banks’ credit risk

models through ratings migration (ratings assigned to companies will be

downgraded) leading to increases in banks’ regulatory capital requirements

• This is the so called “pro cyclicality effect” of Basel II

• Banks can include in Pillar 2 capital, a buffer against a general downturn in

the cycle. But during a downturn the supervisor has to allow the bank to run

down the buffer (ie the supervisor has to agree to a reduction in capital

when his instincts tell him that the bank should be holding more capital, not

less)

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Validation

Internal ratings and default and loss estimates must play an essential role

in the credit approval, risk management and internal capital

allocation and corporate governance functions of banks using the IRB

approach

Bank management has the responsibility for validating the inputs to the

IRB approach

Supervisors have responsibility for assessing compliance of banks’

validation and rating systems and their inputs with the minimum

standards of the Framework

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Information exchange and the college of supervisors

Legal responsibilities of home and host supervisors

Supervisors responsible for supervision of banking operations in their jurisdictions (Concordat/Supervision of Cross-Border Banking)

With bank-wide models and processes inevitably some information will reside outside subsidiary banks (and possibly outside parent banks)

Issues of regulatory burden on banks

Required information may be available from another supervisor

Confidentiality laws/banks’ proprietary information

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Information exchange and the college of supervisors

Supervisory contact

– Bilateral

– Multilateral (college of supervisors)

Structure of college of supervisors

– Typically bank specific

– Typically home supervisor convenes a meeting of host supervisors

– If many supervisors may have regional colleges

– No formal structure – for each college to determine

– Bank may be invited to some sessions

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Coordination of Basel II roll-out from group risk management to subsidiaries

Each bank free to decide on its Basel II roll-out strategy, but host supervisor determines how it will meet its (legislative) obligations

– Typically a central office

– For certain aspects there may be “centres of excellence”

– May be global models for corporate business – local data?

– Retail models more likely to be country specific with local data

– Where global models are used local management/board has obligations issue of “black boxes”

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Cross-border issues: Australia/New Zealand a case study: 1

Background

– Australian banks dominate the New Zealand banking industry

– Australia to adopt all Basel II approaches (stand alone + consolidated group) –(initially) NZ only standardised

– Banks concerned about regulatory burden

– APRA was agnostic as to what the RBNZ required – APRA’s obligations to local banks + consolidated groups

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Cross-border issues: Australia/New Zealand a case study: 2

The way forward

– APRA and the RBNZ agreed benefit in better understanding each other’s position

– A number of meetings and secondment

– (No “pressure” from APRA but) RBNZ reviewed its policy and decided to allow IRB/AMA

– APRA and RBNZ agreed on a Terms of Engagement - regular meetings, sharing of information, secondments -working well in practice

– Helped by long standing relationship, a common language and a common legal system. There was also goodwill on both sides and a shared determination to arrive at a sensible outcome

A good example of Basel II home/host colleges in practice. The college helps build relationships and where sensible the home and a host can then engage in bilateral discussions - not the college breaking down, but rather it is a complement to the college.

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Accreditation of Australian banks: early findings

Level of robustness

Lag in documentation for model development and validation

Senior management information

Low default portfolios

Greater risk sensitivity is being achieved

Definition of default

Operational risk

Emerging discipline

Measure capital + manage risk

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Basel II and regulatory capital: Australia

Australian banks have large residential mortgage portfolios – scope for some reduction in overall level of regulatory capital?

Basel II is more risk sensitive – some banks will hold less regulatory capital and some more – but a commitment not to change the competitive landscape.

Accreditation to adopt IRB/AMA: integrity + pragmatism