With the deadline having passed for submitting Basel II risk model applications to national regulators, Europe's financial institutions should be well on their way to compliance. But the reality is that many are still struggling to implement the new framework. By John Ferry From this month, Basel II kicks off for real. Some European banks that have opted for the standardised and foundation internal ratings-based (IRB) approaches to credit risk will begin operating under the new framework, while those pursuing the advanced IRB approach will be putting the final touches in place for implementation in January 2008.At least, that's the idea. When interviewed in the second week of December, the UK's Financial Services Authority (FSA) said it had received only a handful of formal applications from banks to have their Basel II risk models validated. What's more, most of those that had been submitted have been rejected. "We opened our door to applications about this time last year, and we looked at about half a dozen of them over the summer," says Matthew Elderfield, chair of the FSA's Basel II decision-making committee. "A couple of those we passed, and some of the others we said there's more work to be done." However, he expected another 15-20 applications to come in before the end of December.If an institution wants to have its internal models approved in time to go live in January 2008, they had to have their applications in by the end of last year. "If they do it during 2007, then it's on a best-efforts basis on our part," says Elderfield. "So, in terms of the major challenges that are ahead, it's really finalising the models, finalising their applications to regulators and working through doing the due diligence, on both our side and the firms', in order to get the approval process done."As Europe races to be Basel II-compliant, it seems many challenges remain, despite the massive amount of work that has already gone into the framework. "Certain parts of the Accord have not yet been fleshed out by the regulators," says London-based Emmanuelle Sebton, head of risk management and co-head of the International Swaps and Derivatives Association's European office. The treatment of default risk in the trading book is a case in point. "The Basel Accord Implementation Group has wanted to publish principles on the modelling of default risk in the trading book, but has not found agreement with the industry on the contents of the principles. As a result, firms negotiate their models bilaterally with the regulators."The use of downturn loss-given default (LGD) estimates are also an ongoing issue, and regulators are keen to ensure that firms aren't underestimating the amount of capital they hold in an economic downturn. "The application process is happening at a time when the credit cycle is very favourable, so there's a risk of underestimating the levels of capital needed. We've therefore said we want to be very convinced that the bank has looked at downside risk, so we need to look at the downturn LGD," says Elderfield.For example, the FSA has asked banks to consider what would happen to their portfolios if property prices dropped by as much as 40%. And Elderfield adds: "There are similar issues on the corporate LGD side that are perhaps even more technically challenging. We're asking the banks to look at the downside risk of LGD in terms of collateral and commercial property held, and people are struggling to come up with a sensible, conservative approach to that."UK financial institutions, in particular, are also required to carry out economic cycle stress tests and scenario analysis under the IRB approach to establish the impact on their credit risk capital requirements of a one-in-25-year economic downturn. Banks have to assess the impact and demonstrate through a capital management plan that they could cope with the recession and continue to meet their regulatory capital requirement throughout. It seems some institutions have struggled with this requirement. "Although stress testing throughout the industry has come a long way during the Basel II consultation process, it is unlikely that many UK firms had in place stress tests and scenario analyses that perfectly match this description. Much work in this area is therefore ongoing," says Ed Duncan, policy director at Isda in London.These outstanding issues have meant that some banks have found it more difficult and complex to achieve IRB status than had been thought. "Basel II projects have proved complex and many banks have found that the final hurdle, obtaining waivers for the internal ratings-based approach or advanced measurement approach (AMA) [for operational risk] models, has not been as simple as they had hoped, particularly given tough requirements for stress testing and management oversight, as well as independent verification," says John Tattersall, London-based Basel II consultant at PricewaterhouseCoopers.Pillar II, the part of the framework covering the supervisory review process, has also created plenty of challenges. "Pillar II is intended to capture those risks not fully captured by Pillar I, such as interest rate risk in the banking book and concentration risk, and those factors external to the bank, such as the effects of the business cycle," says Duncan. "In Europe, the capital requirements directive (European Union legislation that paves the way for the implementation of Basel II across the member states) requires Pillar II to be applied at the sub-consolidated level. However, both the risks associated with Pillar II and the stress testing requirements are more often than not managed by firms at the group holding level. For example, the flipside of concentration risk - the recognition of diversification and correlation benefits in firms' capital models - is typically determined and managed at group holding level."It will therefore be important for both home and host supervisors to co-ordinate their efforts to ensure that Pillar II capital requirements are not overly conservative, are not duplicated at the sub-consolidated level, and do not cover the same risks covered by the Pillar I capital charge, adds Duncan.In fact, the home/host issue is one that many bankers highlight as the key challenge for regulators, particularly in the application of Pillar II and the validation of internal models for the advanced approaches under Pillar I. While the home regulator is supposed to lead model validation for an internationally active banking group, risk managers grumble that differences in the interpretation of the rules by individual regulators will inevitably mean duplication of effort.Tattersall says inconsistencies between regulatory approaches will take time to resolve or reconcile. "The home/host debate remains problematic, both in theory and practice. Both the EU and the Basel Committee's Accord Implementation Group are engaged here, but many years of practice and deeply embedded culture in some countries takes time to change. These inconsistencies present significant challenges to banks that operate in many different countries," he says.Simon Hills, London-based director of prudential regulation and risk at the British Bankers Association, agrees. "For many EU states, this is a completely new area, and there is always a risk that different states will impose different requirements on the local subsidiaries of banks operating in more than one country," he warns. "My view is that good regulatory co-operation should be able to solve this problem, along with recognition of the fact that a top-down, group-level approach gives the best view of how a bank manages its risks. Requiring individual subsidiaries to undertake Pillar II processes will not give an overall view and will lead to unnecessary duplication of effort by regulators and banks alike."The FSA's Elderfield says national regulators are committed to avoiding duplication and overlap as much as possible. He also notes that there will be a degree of flexibility in how Pillar II is applied. "Pillar II is a much more flexible framework than Pillar I, and as the sophistication of the modelling approaches improves and they become more comprehensive, we will be willing to move our thinking with that."The ultimate question that has to be asked is whether the benefits, both for individual institutions and for the financial system as a whole, end up outweighing the costs of implementation. The jury is still out on this one, says Tattersall. "There is the risk that requirements for model approval imposed by some regulators could stifle innovation and diversity in banks and investment firms' approaches to the management and monitoring of risk, perhaps leading to less competition in product provision and pricing for consumers."The fifth quantitative impact study, carried out in early 2006, predicted what would happen to banks' capital levels as a result of applying Pillar I. For some of the large financial institutions, overall regulatory capital rules remained more or less unchanged, causing some to question the point of Basel II. Ironically, when the idea of a new capital framework was first mooted, the clarion call came from bankers, who wanted regulators to recognise the fact that their modern and sophisticated risk models should give them lower capital requirements.Now, a lot of the bankers are negative about the overall cost/benefit trade-off. "Most bankers I speak to do not think that their regulatory capital will be lower under Basel II than it was in the past under Basel I, but have spent significant amounts on implementation," says the BBA's Hills. "I think the payback they are looking for is recognition by regulators that they will take a pragmatic approach to implementation and not require 100% compliance from day one."Andrew Cross, London-based Basel II programme director at Credit Suisse, points out that the industry-wide benefits of a more uniform, risk-based approach to capital have been weakened by the rising importance of non-bank players, such as hedge funds and private equity firms, which are not subject to the framework. Much of the success of the Accord ultimately rests with the regulators, he says."The key rests with regulator approaches to the use of internal risk practices. The best-in-class regulators understand that leverage of actual risk processes used by banks is a robust foundation for an effective Basel II implementation. On the other hand, more prescriptively minded regulators could force banks to perform calculations in a particular way, undermining the leverage opportunity presented by using internal processes and detaching Basel calculations from real risk management. That type of approach will increase costs further, tilting the playing field against banks. Obviously, we hope that the wiser heads prevail in the development."The coming year will be a crucial time for financial institutions and regulators as they try to make the Accord work in practice. "The next year of parallel running will be a journey of discovery for both the regulators and the industry," says Hills.A MANAGER'S VIEW: CREDIT SUISSEThe path towards Basel II has been a long one for banks. Andrew Cross, Credit Suisse's Basel II programme director, discusses how his institution faced up to the challenge and highlights the issues that remain unresolved.Risk: Summarise how you managed to meet the implementation deadline.Andrew Cross: We manage our implementation through an executive steering committee chaired by our chief risk officer and including both the chief financial officer and chief investment officer. This committee is charged with monitoring progress towards the go-live date, budget oversight, issue management and senior regulatory relationship management. We aim to be operationally compliant by mid-2007 and, pending regulator approval, formally compliant by the end of 2007, in time for going live from January 2008.Risk: What has been the most difficult part of the process overall?Andrew Cross: A significant amount of time has been invested in communicating with regulators on how risk management works in practice within a bank in order to manage their perceptions as to what can be achieved in a given time frame. This is particularly relevant for banks that operate across multiple regulatory jurisdictions, as achieving a consistent regulatory approach is vital. Differing interpretations of rules and risk management standards can be a considerable challenge and regulators are still getting to grips with how to make this work in practice.Risk: Are there any issues still to be resolved, or concerns that you feel still need to be addressed?Andrew Cross: Some aspects of the Accord were finalised at a late stage, which means the level of industry consultation was less than ideal. In some cases, such as for incremental default risk in the trading book, this has created unresolved issues around the meaning and implications of the text in the Accord. Going forward, we are concerned about how regulators will review implementation over time. Given the large number of systems and parameters that support Basel II, we must guard against a 'tick-the-box' approach that could increase the cost and decrease the relevance of the Accord. We believe it is critical to focus on broad compliance with the key principles of the Accord. However, this may be difficult in practice. Few regulators will have sufficient staff with a broad understanding of a complex Accord who can act on a principles basis, and that gap is likely to increase over time as the generation that designed the Accord is replaced with new personnel.Risk: In aggregate, do you think the Accord has been worth the money and resources it has taken to implement?Andrew Cross: For other participants it may be more useful, but for Credit Suisse the answer is no. Basel II has been a significant cost, and the benefit in risk management has been small versus our existing internal systems. Basel II has probably been a stimulus for upgrading risk standards across a number of banks - although it is unproven whether this has been a wise investment of time and money given the cost involved. If we had the chance to wind the clock back, knowing then what we know now, I doubt whether many major banks would strongly argue for Basel II in its current form.A MANAGER'S VIEW: ABN AMROBarbara Frohn, senior vice-president, credit ratings and portfolio management at ABN Amro, gives her thoughts on the Basel II process.Risk: Summarise how you managed to meet the implementation deadline.Barbara Frohn: ABN Amro took a long-term view when it set up its Basel II programme. It recognised that the journey would involve many parties, but primarily led by finance and risk, at different points in the process. Hence, for the first two years, the project was led by the risk division as the bank developed its thinking and interpretation of the requirements. This included active involvement in the lobbying process. The past two years of the programme has been headed by the finance division, to take account of the leading role finance will play in the final reporting process. Under both sponsorships, the teams across risk, finance, IT and operating and the business units have remained broadly the same, as the emphasis has evolved towards ramping up the implementation. This implementation peaked in 2006 as the bank started its own self-imposed internal parallel run.Risk: What would you say has been the most difficult part of the process overall?Barbara Frohn: The detail of the new capital regulations requires that hundreds of new data fields are gathered and stored that in the past were not sensitive for regulatory reporting. Also, the sheer number of models is daunting, and standardising validation processes took more time than expected. The fact that supervisors' expectations gradually developed over time made model validation a moving target. Model development and improvement is an iterative process, hence there is no black and white situation regarding compliance or non-compliance.Asset securitisation is also complex in its detailed regulations, and hence also complex to implement bank-wide and considering the many product variations that exist. Furthermore, some of the regulations proved to be very detrimental to the business and/or impractical to comply with. Consultation with the regulators and supervisors was taking place to address these problems, but that meant final requirements were only known very late in the implementation process. The discussions on more complex requirements and requirements with negative repercussions to the securitisation business as a whole are still ongoing.Risk: Are there any issues still to be resolved, or concerns that you feel still need to be addressed?Barbara Frohn: National discretion may lead to significant differences in capital requirements between countries. The level playing field issues that this will bring will need to be addressed in the coming period. Differences are most obvious between the US and Europe, but there is also a range of practices within Europe - for example, relating to solo reporting (that is, capital and reporting requirements at legal entity level per country).Model validation standards may also prove to diverge between countries - for example, relating to the desired degree of conservatism where no guidance has been given. In practice, this can lead to significant differences between countries.So far, efforts to streamline supervisory practices have focused mainly on the EU, although there is some discussion on the main topics between EU regulators and other G-10 supervisors. However, there is no real co-operation between G-10 and non-G-10 regulators outside the EU on Basel II regulation. This leads to dissimilar regulation in different countries and/or parts of the world, as well as major competitive issues. If not resolved in time, this situation defeats the Basel II objective of enhanced financial stability.Risk: In aggregate, do you think the Accord has been worth the money and resources it has taken to implement?Barbara Frohn: The Accord gave an impetus to advance risk management practices, and as such it has been worth the attention and investments that sooner or later had to be made anyway. However, costs have been higher than necessary given the sometimes very detailed nature of the regulations. Although a principles-based approach is advocated by regulators and banks, the practice is sometimes different. Home/host differences and legal constraints lead to the incurring of incremental costs without adding value to a bank's risk management. Pillar II should have been given much more weight in solving imperfections in the Accord. However, there is relatively limited experience with the Pillar II process, and hence there is a tendency to fall back on Pillar I with its detailed requirements. Basel II therefore in some aspects has become inadvertently more of a compliance exercise than anything else....
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