Basel II heralds a new ‘golden age’ for risk, says BofE’s Jackson

Basel II is creating a new lingua franca for risk that will usher in a “golden age” of risk management, said Patricia Jackson, special adviser to the Bank of England, at Risk magazine’s Basel II Forum in London today. The debates surrounding the wording of the Accord should be largely over, according to Jackson, with market participants now moving towards the implementation process.

Jackson believes the overall impact of Basel II will be neutral for banks. She added that most reservations about Basel II are overstated or: “The Accord won’t change the basic structure of the market, no matter what some people would like to think.” But she admitted the outcome of the recently published third quantitative impact study (QIS 3) left some areas of concern. For example, QIS 3 flagged differences in standards and approaches to risk weightings by banks, meaning the supervisory process leading up to 2006 will be even more critical than previously thought. But Jackson said she expected the variability evident in interpretation today to narrow considerably over the next two years.

Jackson believes the main issue pinpointed by QIS 3 was pro-cyclicality, with the stress testing of regulatory capital remaining a problem until better pricing methodologies emerge. Jackson believes Basel II is likely to cope with credit crunches better than its predecessor – Basel I – but there remains work to be done in understanding the extent to which capital requirements should rise during a recession. This, she said, is a critical focus for regulators and banks alike, as the extent of any rise is presently method-dependent under the terms of the new Accord, and there is little consistency among models used. Merton simulation models, for instance, produce much greater volatility than Moody’s-based ratings models. To counter this, says Jackson, banks must stress-test capital, not just portfolios.

Jackson added that data is fast becoming the underlying key to almost all Basel-related debates. “The Accord is data driven,” she said, noting that there are no allowances for risk mitigation without supporting data – particularly where collateral is concerned. Data management is not an area of traditional strength for banks, said Jackson, but she believes the increased focus on data management in the wake of Basel II will prove highly positive for banks, resulting ultimately in beneficial changes in their lending behaviour.

“Basel I was a revolution that resulted in first-generation risk models, many of which were not really effective, especially for credit risk,” said Jackson. But she argues it was a necessary revolution without which there would have been no foundation for Basel II. The present Accord is a recalibration of its predecessor, she said.

Post 2006, as Basel II data builds up, the stage for a shift to even more sophisticated risk management models will inevitably be set. But Jackson believes Basel III will not come for some time yet, however, she predicted a lengthy period of risk management stability ahead.