Operational risk experts ponder future of Basel II

The ongoing financial crisis has led risk professionals to question whether the Basel II framework needs to be modified to improve firms' ability to assess and manage risk. And while the general consensus is that revisions are needed, questions remain as to how extensive they should be.

Over the past 12 months, the Basel Committee on Banking Supervision has released several consultation papers, ranging from guidance on liquidity risk management and stress testing to the possible introduction of an incremental risk charge for banks' trading book assets. The committee is also looking at ways of addressing the issue of pro-cyclicality, a major criticism of the current accord.

Beyond the proposals, some observers have even speculated that a Basel III could be in the works. "Whatever update we see on Basel II, whether it is Basel III or reworked guidelines, it will certainly feature more of a focus on model risk and governance," asserts Michael Schuchardt, Chicago-based managing director in consulting firm Protiviti's financial risk strategy and management group. "The ratings agencies have come under fire; I think in the next phase, we will see even more of a push towards internal ratings and less reliance solely on external ratings. That inherently requires data - the means of collecting it and the means of verifying its accuracy."

The original capital requirements allowed for regulatory arbitrage, for example, enabling banks to hold less capital against assets in the trading book than those in the banking book. Resolving this will be a key challenge for the Basel Committee, as will determining the level of capital banks should hold during times of stress.

"If you raise regulatory capital requirements as times are getting bad, and liquidity is squeezed, you end up in the same situation that we saw during this crisis - a credit crunch," says Schuchardt.

Meanwhile, there have been suggestions that US institutions are holding off on full implementation of Basel II until any changes to the accord have been made. While European banks have been operating under Basel II since the start of 2008, US banks are still implementing the rules.

According to Ron Burtnett, executive director of operational risk measurement and assessment at Morgan Stanley in New York, the financial crisis has led to US banks postponing parallel runs, a year-long process during which banks calculate their capital requirements under Basel II standards. "Some banks have pushed parallel runs back because of all of the changes," he says. "I think firms are still committed to Basel II and want to implement it. Though nothing is perfect, it is still viewed as an improvement over Basel I. But I think that, as time goes on, the US implementation strategy will be cautious."

See also: Trading book capital must be "several times" higher, FSA says

Basel Committee prepares to raise capital requirements with 'stressed VAR' test