Regulators looking at possible changes to Basel II credit risk plans

Large international banks, contrary to the regulators’ intentions, could face an increase of as much as 14% in their credit risk capital charge under Basel II, and an overall increase of as much as 24% when the operational risk capital charge is taken into account.

The evidence confirmed banking industry fears that many banks faced higher capital charges under Basel II as proposed in January this year by the accord’s architect, the Basel Committee on Banking Supervision, the body that in effect regulates international banking.

And crucially, the evidence showed that banks using a more advanced approach to calculating a credit charge under Basel II would incur greater charges than they would if they used a simpler approach.

The Basel Committee acknowledged in early November that such an outcome would run counter to the basic intention of the risk-based Basel II accord. The idea is to give the incentive of lower capital charges to banks using use advanced internal risk measurement approaches.

The accord will determine from 2005 how much of their assets major banks will have to set aside as reserve capital to guard against banking risks, including credit and market risks as well as, for the first time, operational risk.

The evidence emerged from the results of the Basel regulators’ second quantitative survey (QIS 2) that sought to assess the potential effects of Basel II on banks. Overall, 138 banks from 25 countries participated in QIS 2.1.

The committee said it would issue yet another survey - QIS 2.52 - seeking statistical information on the effect that the possible modifications to the credit risk proposals might have. The committee wanted banks to answer the survey by the end of November.

QIS 2.5 entails incorporating the modifications that the Basel regulators are considering in the calculation of credit risk capital charges using the foundation internal ratings based (IRB) approach.

The IRB approach is the less complex of the two advanced approaches to calculating credit risk capital charges offered under the credit risk proposals set out in the regulators’ second Basel II consultative paper (CP 2) issued in January.

The QIS 2 survey found that many banks using the foundation IRB approach would have to set aside more capital than they would using the standardised approach, the simplest of the credit risk methods.

The possible modifications put forward by the regulations are 3:

1) A modified risk-weight curve for all corporate, sovereign and interbank portfolios. The effects of the modified curve would flow through to other portfolio treatments defined relative to the corporate IRB risk weights, including aspects of the securitisation, equity and specialised lending proposals.

2) Greater recognition of physical collateral and receivables.

3) Modified risk-weight curves for both residential mortgage exposures and for other retail exposures.

The Basel Committee reiterated that its aim was to maintain the equivalent on average of the capital charges required under Basel I and the Basel II standardised approach, and provide ‘modest incentives’ for banks to use the more advanced approaches.

The Basel regulators hope to issue their third Basel II consultative paper by the end of February, and to publish their final version of the accord by the end of next year.

1 Results of the Second Quantitative Impact Study

2 To participants in the Quantitative Impact Study 2.5

3 Potential modifications to the Committee’s proposals

All three documents issued by the Basel Committee on Banking Supervision, and available on the Bank for International Settlements’ website: www.bis.org.Operational Risk