## Basel II

Basel II, the new global regulation designed to better align capital charges with the risks that banking institutions hold, will be officially adopted by Australian banks at the start of 2008. Globally, the adoption of the Basel II framework has been technically challenging and controversial, and has demanded massive amounts of human resources. A major schism emerged in 2003 when US regulators decided the new Accord would only be applied to its largest international banks. Since then, Europe has started the formal implementation stage, while the US is now gearing up for its own adoption of the framework.

Australia has fallen in line with the European approach to Basel II with its intention to apply the Accord across its entire banking system. Post-implementation, however, Australia looks set to move ahead of Europe in terms of the extent to which the most advanced parts of Basel II are adopted.

Australia's integrated financial regulator, the Australian Prudential Regulation Authority (Apra), has decreed that any bank implementing the advanced internal ratings-based (IRB) approach must also apply the most advanced operational risk measure. Meanwhile, the regulator has been at the forefront in proposing possible approaches to some of the more esoteric risks outlined in Pillar II (the part of the framework that covers supervisory review and the assessment of capital adequacy) - for instance, liquidity risk and strategic risk. Apra has also conducted analysis on the relationship between economic and regulatory capital, under the assumption that most banks will be basing their capital adequacy assessments on internal economic capital models (Risk June 2006, pages 45-49).

For their part, Australia's banks moved quickly to understand the requirements and implications of the Accord and were, in some cases, able to build on sophisticated economic capital models already in place. What is more, many of the Australian banks had existing databases for probability of default, loss given default (LGD) and exposure at default - all inputs required for the advanced IRB approach. While the data, in some cases, was not in the required format specified by the Basel Committee, it nonetheless gave Australia a head start compared with many of the banks elsewhere in the Asia-Pacific region.

"Australian banks are doing work on economic capital, they are doing the advanced IRB approach and they are doing the advanced measurement approach for operational risk. How many banks in western Europe are really taking these things at that level of seriousness? A few in the UK perhaps, but not many otherwise," says Chris Marshall, Singapore-based managing director and Basel II expert at risk management systems supplier SunGard.

Fate also played a hand in helping Australia along the path to Basel II. Ironically, a near catastrophe in the country's banking sector in the early 1990s meant that its financial institutions started to invest in risk management upgrades then, rather than when Basel II was first mooted several years later. According to economists at the country's central bank, the Reserve Bank of Australia (RBA), the sum of banks' individual losses before tax in 1990, 1991 and 1992 exceeded A$9 billion ($7.4 billion), equivalent to over 2.25% of gross domestic product in 1990, or over one-third of the aggregate level of shareholders' funds in the banking system in 1989. The losses stemmed from strong credit growth that had been secured against increasingly overvalued commercial property. In 1989, a combination of high interest rates and a softening commercial property market ultimately led to severe losses across the banking sector.

"Generally speaking, the quality of risk management in the Australian banking system has improved substantially. The spur was the substantial losses incurred by a number of banking institutions in the early 1990s recession in Australia, particularly those exposed to the commercial property market," said John Laker, chairman of Apra, in a speech at a conference organised by the RBA in August.

Formative steps

The improvements in risk management over the past decade, especially within Australia's larger banks, have been crucial formative steps in the evolution of economic capital modelling in the country, says Laker. For a bank, economic capital is often referred to as the unexpected loss at a given confidence level - that is, the maximum amount of unexpected losses arising from any situation or risk that could be absorbed while remaining solvent, with a given level of confidence over a given time frame. Australia's move towards economic capital-based models has made the transition to the new Accord much easier, at least for the largest banks.

The fact that the Australian banking sector is relatively small, with a limited community of risk managers and chief risk officers, also seems to have helped galvanise the adoption of sophisticated risk management techniques. This is also helping Apra when it comes to carrying out its oversight responsibilities, with the result that the assessment process is running smoothly. "The Australian-owned banks seeking accreditation to adopt the advanced Basel II approaches by January 2008 had to submit an application by September 2005 in which they were required to undertake a very detailed self assessment and identify any gaps that they had," says Bernie Egan, Apra's Sydney-based Basel II programme director. "Since that time, Apra has been working very closely with the banks, both on site and off site. We've had a number of our risk specialist teams visit the banks to look at various aspects of their preparations," says Egan

The banks are reluctant to discuss which Basel compliance level they are aiming for, but the four largest banks - ANZ, Commonwealth Bank of Australia, National Australia Bank (NAB) and Westpac - are almost certain to opt for the most advanced approaches to measuring credit and operational risk. Some of the smaller, regional banks are also expected to adopt the most sophisticated approaches. The 200 or so small deposit-taking institutions, meanwhile, are likely to initially opt for the standardised approach.

Apra has decided to adopt the Basel Committee's proposed guidelines fairly closely. However, any Australian institution looking to adopt the advanced IRB approach must also apply and be accredited for the advanced measurement approach (AMA) for operational risk - a requirement few other regulators have insisted upon. "None of the other Asian countries have taken the advanced measurement approach so seriously. That's important because it leads into this whole discussion of economic capital, because you can't do economic capital if you don't have that operational risk piece,"says SunGard's Marshall.

In recent years, two events have crystallised the importance of operational risk in the minds of the regulator and Australian risk managers. In July 2001, NAB was forced to make a provision of $450 million due to ineffective hedging activities at its US mortgage subsidiary Homeside. Only two months later, a further provision of$1.75 billion was allocated when external risk experts discovered an incorrect interest rate assumption in the mortgage servicing rights valuation model. Then, in 2004, the same bank lost A\$360 million from unauthorised foreign exchange options trading - a revelation that led to the resignations of its chief executive and chairman of the board (Asia Risk April 2004, pages 9-12).

Apra says the decision to require those banks adopting the advanced IRB approach to also apply the AMA approach was taken to remove the opportunity for banks to cherry-pick what advanced approaches they wish to take, and comes down to a belief that banks allowed to model risks should do so for all significant risk categories.

However, Egan says the regulator will provide banks with some leeway on this issue at the outset. He acknowledged this in a speech he gave in August to the Australian Bankers' Association. "Although Apra requires authorised deposit-taking institutions (ADIs) adopting the advanced approach to credit risk to also adopt the advanced approach to operational risk, Apra is prepared to allow ADIs to adopt one approach but not the other during 2008, or to take a little longer if they need and to stay on the existing Basel I approach. That reflects Apra's strongly held view that it is more important to get the Basel II implementation right than to meet an artificial deadline," he said. A number of institutions are availing themselves of the concession, he adds.

In two areas of risk estimation, Apra has decided to put interim arrangements in place until it conducts analysis to determine how it will proceed in the long term. For instance, the process for dealing with margin lending under Basel II would lead to a zero risk weighting for this activity. "Apra has long signalled that it does not believe that to be an appropriate outcome," says Egan.

Towards the end of August, Apra announced it will apply a risk weight of 20% to outstanding loans that are backed by listed equity investments as an interim measure. Otherwise, exposures are to be treated as secured loans. This will apply under both the standardised and advanced approaches to credit risk. In future, Apra may consider the application of variable risk weights to margin-lending exposures or recognition of internal models.

The second interim arrangement relates to mortgage lending risk. Banks seeking IRB status have to estimate the LGD on residential mortgage loans in downturn economic conditions. The Basel Committee has recommended a minimum downturn LGD of 10% on these assets. Apra, however, has taken a tougher stance and put in place a 20% floor. Although this is intended to be transitional, with the eventual aim of putting a risk-sensitive requirement in place, the regulator says the final floor is likely to be in the 20% range.

Basel II is likely to throw up other challenges as banks and regulators go live with the new framework next year. But the sophistication in economic capital models means the country's banks are likely to have one of the smoothest transitions to the new framework.

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The week on Risk.net, February 17-23 2017