Still much to do

Banks globally still have work to do to implement the Basel II guidelines, and most are lingering on pillar 1, while efforts on pillar 2 are only in their infancy, says a recent Ernst & Young survey. Jill Wong reports

Most financial firms implementing the Basel II guidelines will continue to prioritise core pillar 1 requirements during 2006, with less focus on pillars 2 and 3, despite the imminent implementation dates (see figure 1), says a recent survey by consultancy Ernst & Young. Respondents said the biggest challenge for 2006 is "embedding Basel II in credit risk business processes", followed by "model validation" and "business and technology planning" (see figure 2).

Yet the survey also found different key priorities for 2006 for respondents across different regions. European respondents are more focused on embedding Basel II in the credit risk process, model validation and operational risk requirements. North American institutions, meanwhile, are concentrating on business and technology planning and data management. Asia-Pacific institutions are more mixed in terms of their choice of credit risk approaches and are focusing less on operational risk than their European and US peers.

Phillip Straley, partner, global financial services and risk management at Ernst & Young in Hong Kong, says big US firms are mandated to use the advanced internal ratings-based approach (AIRB) for calculating minimum capital requirements for credit risk. European institutions are not directly mandated by regulators to use a particular approach, he says, but the large European firms feel compelled to adopt, at a minimum, the foundation internal ratings-based approach (FIRB) and within a fairly short time graduate to the AIRB approach.

Some Asian regulators have not put as much pressure on banks and have not been as prescriptive, says Straley. However, there are exceptions - in Japan, Korea, Singapore and Australia, the regulators are expecting the large banks to comply with at least the FIRB approach and, in some cases, AIRB, he says. The Australian regulator has mandated both the AIRB and the advanced-measurement approach (AMA) operational risk approach directly for large banks.

Banks globally see operational risk as a much lower priority than credit risk - and especially so in Asia, where the credit risk management infrastructure is less developed, says Straley. In particular, the Hong Kong Monetary Authority (HKMA) bans banks operating in the territory from using the AMA approach, which has led banks to focus on credit risk. Globally, less than 30% of the respondents expect to implement AMA in line with the current time frame.

"The HKMA certainly has a strong view as to what the priorities of their authorised institutions and the regulated banks in Hong Kong are," says Straley. "And because of that, they have said internally and externally that, since operational risk modelling is in a very early stage of development, they don't believe it's a high priority for - or is going to bring a lot of value to - banks in the near term.

"They want to steer the banks towards putting their capital investment and their implementation effort into things viewed as more important. That's the main issue," he says. "Instead of sitting back and saying 'do what you want', the HKMA has taken a positive stance and by not allowing AMA, made a clear signal that they see this as a high priority now."

This does not mean the HKMA isn't taking operational risk seriously, says Simon Topping, executive director, banking policy at the HKMA. "On the contrary, the HKMA regards the greater prominence given to operational risk as a key feature of Basel II, and to highlight this, it issued detailed guidance to the industry on the management of operational risk in November. But the HKMA's focus is on getting banks to recognise and manage operational risk, rather than measure it - hence they are not pushing AMA at present."

Many banks expect further delays to the adoption of advanced approaches - FIRB and AIRB for credit risk and AMA for operational risk - with some looking to take a more phased approach. Of the three regions, respondents were least positive that the US would be able to meet the schedule for adopting the advanced approaches, with more than 50% of respondents expecting further delays there.

In September 2005, the four federal agencies responsible for regulating US banks jointly had announced they would postpone the implementation of Basel II by a year. A dozen or so of the biggest US banks will now implement AIRB in January 2009, with January 2008 as the first opportunity for banks to conduct parallel running.

While many Asia-Pacific banks expect delays, several jurisdictions in the region are moving forward with their implementation timetables. For example, it is understood that the large Singapore banks are expected to adopt FIRB on the initial implementation date and AIRB fairly shortly after that. Large Korean banks, meanwhile, are looking to implement IRB approaches by January 2008.

The US timetable is less closely aligned than the European one with that in the Asia-Pacific. As a result, in some jurisdictions, a US bank with operations in Asia will have to implement earlier in certain Asian countries than on a consolidated basis in the US, says Straley. "This is less of an issue for European institutions here in Asia, because the timetables are more aligned," he adds.

The survey also found that the cost of implementing Basel II differs by region, with North American institutions spending on average more than European or Asia-Pacific institutions. Estimates of Basel programme costs have risen over the past two years. On average, more than half of respondents expect Basel II to cost their organisation at least $50 million. However, more than 90% of respondents agreed that Basel II will bring more comprehensive risk information and a better understanding of risk.

The 2006 Basel II Global Survey is the third annual global Basel survey from Ernst & Young. The latest survey was conducted online by the Economist Intelligence Unit on behalf of Ernst & Young from 31 January to March 10, 2006. Ernst & Young also conducted an Asia-Pacific Basel survey that was published in the December 2004 issue of Asia Risk.