## Basel II

When Morris Batty, Melbourne-based head of the Basel II programme at Australia and New Zealand Bank (ANZ), officially started work on his bank's revised capital framework plan at the end of 2001, his understanding was that he was starting a marathon. Seven years later, he thinks that initial sentiment was a little naive. "At the end of December, I realised I haven't been running a marathon - I've only been training for one. The marathon has started now," he says.

Batty is not alone. The new risk-based capital regime kicked off on January 1 this year, and having already put a lot of time, effort and money into complying, Australia's banks find they are as busy as ever. Not only do they have a global credit crisis to contend with, the country's financial services regulator, the Australian Prudential Regulation Authority (Apra), has demanded improvements in the risk frameworks banks currently have in place.

"Advanced authorised deposit-taking institutions still have a way to go in demonstrating the adequacy of their risk estimates and the robustness of the underlying systems and processes," noted Katrina Squires, Sydney-based head of Basel II at Apra, in a speech at the end of February in which she updated Australia's banks on their progress to Basel II. Although it is still too early to assess the exact capital requirements for banks using the Basel II advanced approaches, the regulator will continue to take a conservative approach to capital requirements, she added.

Last December, Apra announced the various levels of accreditation Australia's banks had achieved. While those deposit-taking institutions granted approval to adopt the internal ratings-based (IRB) approach for measuring credit risk and the advanced measurement approach (AMA) for operational risk had met all the prerequisites, Apra continues to "discuss a number of risk estimates and categorisations" with each institution. Until these discussions are completed, "detailed analysis of the individual impacts of Basel II must be treated with caution", the regulator added.

In other words, plenty of work remains to be done within banks. "Although some Australian banks are experiencing Basel fatigue, there is definitely an acknowledgement that they are not finished with it," says Corinne Neale, a Singapore-based Basel II implementation consultant at Algorithmics, a risk management software provider.

Only three banks - ANZ, Commonwealth Bank of Australia and Westpac - achieved both advanced IRB and AMA approaches (see box 1). Macquarie Bank, meanwhile, met the criteria for the foundation IRB and AMA (see box 2). The consensus seems to be that Apra has taken a tough but fair line with banks.

"I think some of the regulators in the Asia-Pacific region have been tempted to have at least one of their banks IRB-compliant, but Apra has always taken the view that they don't mind if nobody passes the test. They want to make sure Basel II accreditation has real meaning, and as a result they have tried to stay true to the spirit of the Accord," says Neale.

Batty of ANZ agrees the supervisor has been exacting in validating models. "They really wanted us to push the work ethic towards the accreditation deadline," he says. "A lot of that was to do with the refinement of the risk attributes to be used in the risk modelling process to come up with the capital requirement. They were very keen for the banks to have validated and to have refined the downturn attributes they wanted to use for loss given default (LGD). That took quite a bit of effort."

Refining methodologies

For ANZ, the final stage of implementation focused on refining its LGD methodologies and ensuring Apra was comfortable with its approach. "Our approach in the past to measuring LGD has been on a default-weighted basis, which I think most banks have used as part of their economic capital modelling," Batty says. "Clearly, the Basel capital function, being a single-factor model, doesn't handle LGD downturn very well, so Apra wanted to ensure the capital function was adequately adjusted for this deficiency. We therefore had quite a bit of work to do in proving that our factors are reasonable and would compensate for the weaknesses in the Basel capital function."

It is no surprise that one part of the Accord the supervisor would like to see banks improve on is LGD data. One of the areas in which Apra has taken a more stringent approach to capital adequacy under Basel II centres on how banks 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 - but Apra thinks this is too low.

"Even with the 10% floor, we were unable to get comfortable with the risk estimates of the various deposit-taking institutions seeking to adopt the advanced approaches," Apra's Squires tells Risk Australia. "Further, in our view, the differences were so great there was little chance of reaching agreement by January 2008, and certainly not without disrupting other essential work the advanced authorised deposit-taking institutions were undertaking. In light of that, we have set a minimum downturn LGD of 20% for all applicants for the advanced approaches."

Apra says this figure is meant to encourage banks to undertake further work. However, it stresses that when agreement is reached on a more risk-sensitive measure, it will be closer to 20% on average than some of the lower estimates financial institutions were generally proposing. The banks, though, still hope the 20% figure will be reduced after further in-depth analysis. "Apra still expects the banks to do further work around LGD rates in the mortgage portfolio. The banks may find the 20% floor can be relaxed if we can prove something better for a downturn estimate," says Batty.

Apra decided to take a more rigorous view of mortgage-based exposures long before the subprime crisis brought this type of risk to the world's attention. The regulator had particular cause for concern, having gone through a recession in the early 1990s that led to major losses for those banks exposed to the commercial property market. In events that seemed to anticipate the much larger US subprime crisis, the losses stemmed from strong credit growth that had been secured against increasingly overvalued commercial property. Australian banks' individual losses before tax in 1990, 1991 and 1992 exceeded A$9 billion ($8.4 billion) - the industry's worst losses in almost a century.

There was one upside to this crisis, however - the early investment in and adoption of advanced economic capital modelling techniques. This effectively put Australia's banks on the path towards Basel II well ahead of much of the rest of the world.

It is therefore unsurprising that Australia would take a singular approach to Basel II implementation. Apra has decided, for example, that any bank looking to adopt advanced IRB must also apply and be accredited for AMA - although the rule will not kick in until 2009. The regulator says it applied this rule to remove the opportunity for banks to cherry-pick the advanced approaches they wish to take. Meanwhile, Apra has imposed what it refers to as a transitional floor, which means regulatory capital cannot fall below 90% of what it would have been under Basel I. This floor remains in place until Apra determines otherwise.

The other activity Apra believes requires additional attention is margin lending. The Basel II guidelines stipulate a zero credit risk capital requirement for this activity, but Apra would like to see banks hold capital against the credit risk associated with margin lending. Last year, it announced that, as an interim measure, it will apply a risk-weight of 20% to outstanding loans backed by listed equity investments; otherwise, exposures are to be treated as secured loans - a ruling that will apply under both the standardised and advanced approaches to credit risk. Again, the 20% risk weight is not risk sensitive, and Apra intends to review this sometime next year. "In the main, deposit-taking institutions that undertake margin lending have not disagreed with the general proposition that, although operational risk is arguably the major risk associated with margin lending, credit risk does nevertheless exist," says Squires.

However, such fine-tuning may be made redundant to some extent in the wake of the credit crisis. Already, the Basel Committee has announced it is reviewing the Accord to reflect lessons learned from the credit crisis when it comes to liquidity risk, and signalled on April 16 it would like to see banks set aside more capital against structured securitisations and off-balance-sheet vehicles. So how will Australia's banks and the regulator handle this new challenge?

"It has forced banks to think about their liquidity management practices a lot more closely," says Batty. However, he adds he does not believe holding additional capital is the right way to handle the risk of a liquidity crisis. "Before the credit crisis, my view on liquidity risk was that no amount of additional capital would help you in a liquidity crunch. The important thing is to have liquid assets available for sale to offset any needs, and I think the liquidity crisis has shown that to be the case. Obviously, the bank needs to be sound in terms of the amount of capital it holds, and that's what the Basel Capital Accord ensures, but holding additional capital buffers won't necessarily help if there's a liquidity crunch," Batty adds.

Squires says Apra has always reviewed banks' liquidity risk management policies and made judgements as to whether a particular bank is appropriately managing that risk. It will continue to monitor liquidity risk for each institution as part of the internal capital assessment process outlined under Pillar II, she adds. "The debate about capital and liquidity continues, but suffice it to say that while capital may not be a liquidity substitute, it does provide reassurance to lenders and a buffer against any liquidity premium."

The Basel Committee clearly feels the current guidelines are not sufficient post the credit crisis, so Australia's banks can expect a shake-up at some point. In the meantime, Apra will continue to refine the capital requirements along its own idiosyncratic lines. Clearly, Australia's Basel II experts are going to be kept busy for some time to come.

1. Who's doing what?

Apra announced last December that the following approvals would be in place from January 1, 2008:

• Australia and New Zealand Banking Group
• Commonwealth Bank of Australia
• Westpac Banking Corporation

Foundation IRB and AMA

• Macquarie Bank

AMA

• Bank of Western Australia
• National Australia Bank

Bank of Western Australia and National Australia Bank submitted applications to adopt the advanced IRB methodology during 2008 and Apra agreed to a request from them to remain on Basel I for this year. St George Bank submitted an application to adopt the foundation IRB and AMA approaches during 2008 and had also been given permission to remain on Basel I for this year.

2. Macquarie Bank - a special case

At first glance, it may seem out of place for Macquarie Bank, a respected investment bank with a global presence, to have only achieved approval to adopt the foundation internal ratings-based (IRB) approach from Australia's regulator. However, the nature of the bank's business means it deliberately did not try to obtain approval for advanced IRB. A Macquarie official says the firm opted for foundation IRB because its managers took an early decision that it does not have the loss history to support an application for advanced IRB.

"Foundation IRB and advanced IRB both lead to the same results for retail exposures. They are different for corporate, bank and sovereign exposures. However, Macquarie Bank has had so few losses in corporate, bank and sovereign debt that we do not have a statistically significant loss history to support the internal estimates of loss-given default (LGD) and exposure at default that advanced IRB accreditation would have required. This is partly due to the fact that, for Macquarie, lending is a less significant activity than it is for other Australian banks," the official says.

So, does this affect Macquarie's competitiveness vis-a-vis the banks that have reached more advanced levels of accreditation? The Macquarie official says the firm has a different business model from other Australian banks and does not necessarily consider them to be direct competitors, adding that other institutions are more heavily focused on domestic lending and retail banking than Macquarie.

Any material reduction in regulatory credit risk capital requirements under Basel II tends to be heavily weighted towards retail exposures, and foundation IRB and advanced IRB banks adopt identical rules for retail portfolios, she continues: "It is not clear to us that foundation IRB results in a higher credit risk capital requirement than advanced IRB. It depends on whether the LGDs under advanced IRB are higher or lower than the 45% assumed under foundation IRB."

In addition, the bank has historically tended to maintain capital well in excess of its minimum regulatory capital requirements - last year, its minimum Tier 1 ratio was more than 15%. "We consider ourselves well capitalised to withstand the difficult conditions currently prevailing in global markets," adds the official. "On balance, we don't expect that our competitive position against the other Australian banks has changed."

Macquarie has no plans at this stage to apply for advanced IRB. "However, we will no doubt reassess this at some point. We envisage it would require us to supplement our limited loss history with external data, and to map our internal risk assessments to that external data," the official says. "Our risk management systems would not necessarily need to change much. The upgrade from Basel I to foundation IRB required changes to our systems, which have been made, and they could largely accommodate the additional requirements of advanced IRB."

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