The Basel Accord: A tough nut to crack
Crafting a capital charge for operational risk has proven to be a project fraught with controversy. International regulators’ first attempt raised the industry’s hackles. David Keefe reports on recent – and further expected – compromises by the Basel committee.
Global banking supervisors are finding operational risk a tough nut to crack in their controversial efforts to bring it firmly within the remit of bank capital-adequacy rules. Bankers await the supervisors’ further thoughts, expected in the middle of this year, on plans to make major banks set aside capital for the first time to guard against the risk of loss from operational hazards such as fraud, computer system failure, trade settlement errors and catastrophes like the September 11 attacks on New York.
They are part of the complex, risk-based Basel II bank capital-adequacy Accord proposed for 2005 by the Basel Committee on Banking Supervision. The committee, which comprises senior banking supervisors drawn mainly from the Group of Ten (G-10) leading economies, is the body that in effect regulates international banking. At the centre of the operational risk debate is the so-called ‘quantitative versus qualitative’ argument. Can the odds on the sort of low-frequency/high impact event that could fatally damage a bank, such as rogue-trader Nick Leeson’s activities that scuppered UK investment bank Barings in 1995, be sensibly quantified to help calculate the amount of reserve capital needed to guard against the risk?
Or is it more sensible for regulators to ensure that a bank’s management structure and controls are of sufficiently high quality that the rogue-trading risk is cut to a minimum and the bank has a business continuity plan that can cope with September 11?
The Basel regulators say they back both approaches. They believe that between the operational losses that a bank can routinely expect – the level of credit-card fraud, for instance – and the most extreme and unexpected events such as the September 11 attacks, lies a range of operational hazards arising from “failed internal processes, people and systems or external events” that can be modelled and guarded against by capital charges. The Basel supervisors also want to ensure that the quality of bank management and controls is up to minimising the effects of the very extreme risks.
Tony Peccia, vice-president of operational risk at Canadian bank CIBC in Toronto, says the benefit of applying rigorous mathematics to measuring operational risk is that it enables judgement to be used in a systematic, coherent and consistent way. And the models can be used to determine capital charges, he adds.
But Karen Shaw Petrou, who leads a consortium of US banks opposed to operational risk capital charges, says such charges create a “perverse incentive” against banks taking measures to cope with such possibilities as the September 11 attacks. “Effective supervision and strict enforcement of standards on internal controls are the key to preventing operationally-related bank failure, not capital standards,” says Petrou, who is executive director of the Washington-based Financial Guardian Group (FGG), the consortium of opponents to the op risk charge.
The Basel Committee has conceded ground and revised its thinking on some aspects of its original plans for requiring op risk capital charges from major banks within the framework of the Basel II accord. The Accord will determine how much of their assets large international banks will have to set aside as reserve capital to guard against losses from the risks of banking, including credit and market risks as well as, for the first time, operational risk.
A central aim of the Accord is to bring regulatory capital – the protective reserves that regulators require banks to set aside to guard against banking risks – in line with economic capital, the capital that banks assign on their own assessment of the risks they face. That would be a departure from the current ‘one-size-fits-all’ minimum reserve/asset ratio philosophy of the Basel I capital adequacy regime dating from 1988.
Internal models
The Basel regulators thus want to encourage banks to use their own internal models to measure the risks they confront. Their intention is that banks using such advanced approaches should enjoy lower capital charges than banks using simpler approaches. In response to banker concerns, the regulators have cut the benchmark for the operational risk charge to 12% of regulatory capital from the 20% originally envisaged in the second Basel II consultative paper (CP2), issued in January 2001. The 20% figure was immediately a prime target of complaints from banks fearing its cost and arguing it was utterly unjustified in the light of their operational loss experience.
The regulators said they would consider a range of options – the so-called “let-a-thousand-flowers-bloom” policy – for advanced approaches to calculating the operational risk charge, instead of just the one they had initially proposed in CP2. They removed the threat of possible double-counting of op risk arising from aspects of the Basel II credit risk proposals. They said they would also consider a role for operational risk insurance in helping to reduce capital charges for banks using advanced approaches – although some, including FGG’s Petrou, believe the regulators should accept more readily that insurance is a better way of managing many operational risks than capital charges in all Basel II approaches.
But the regulators are still wrestling with fundamental problems. These include fears of there being little incentive to use the advanced operational risk approaches, because of the 9% floor for regulatory capital on any lower charges and the cost of putting in the systems needed for the advanced approaches. These advanced measurement approaches, which include the so-called loss distribution and scorecard approaches as well as an internal measurement approach, have yet to be fully defined, reflecting the difficulty of quantifying operational risk amid a scarcity of reliable loss data.
Critics also argue that the two simpler approaches – known as the basic indicator and standardised approaches – use a very risk-insensitive marker for operational risk, namely a bank’s gross income. A bank with relatively high gross income, and therefore liable to a higher capital charge under the two approaches, does not necessarily carry more operational risk than a bank with lower income, the critics argue.
Cynics among bankers say an operational risk charge would in effect work as a regulators’ tax to cover all “other risks” that aren’t credit and market risks. The tax would help the regulators with their aim of ensuring that while individual banks might secure lower capital charges under Basel II, the total of reserve capital in the global banking system would be unchanged from Basel I levels.
But concern about Basel II is not confined to operational risk.
In December, the Basel Committee postponed its third Basel II consultative paper (CP3) to around the middle of 2002 from end-February because of difficulties with the credit risk proposals. Germany has threatened to veto Basel II unless the Accord’s treatment of long-term lending to small- and medium-sized enterprises, which will incur higher capital charges than shorter-term lending, is revised. And the Basel Committee is looking at possible modifications to its overall credit risk proposals after seeing evidence that Basel II, as it stands, might work in precisely the opposite way to what was intended. Survey evidence from banks suggested that not only would banks face higher capital charges under Basel II than they do under Basel I, they would also face even higher charges if they used one type of advanced approach compared with a simpler method.
The difficulties with the credit proposals has in turn prompted speculation among some bankers that the operational risk charge might be reduced yet again through ‘horse-trading’ designed to get Basel II capital charges back in line with the Accord’s original intentions.
The objection to a further cut is that it would in practice remove any incentive for banks to use advanced operational risk-measurement approaches. The regulators hope to prevent yet another delay to Basel II’s implementation – they have already had to postpone the start date to 2005 from 2004 because of the complexity of the proposals. They still hope to issue the final version of Basel II by the end of the year to allow national governments and regulators to get ready and banks prepare their internal systems.
Banks of all sizes
Although Basel II is intended in the first instance to apply to the large G-10 international banks, the Accord is designed for banks of all sizes. Over 100 countries, for example, subsequently adopted the Basel I agreement for their banks. The European Union plans to introduce capital adequacy rules modelled closely on Basel II in 2005 for all banks and investment firms in the EU, which currently comprises 15 nations, but might by 2004 include an additional 10 countries.
It often seems forgotten that Basel II is based on a three-pillar structure in which capital charges form the first pillar of the three interdependent supports of the Accord. The second pillar of the Accord will allow regulators to supervise banks to ensure their risk management practices and controls are adequate, their databases accurate and their models rigorous.
The third pillar will be the market discipline exerted by the banks’ having to publicly disclose more information about their risk management practices so that investors, counterparties and credit-rating agencies can make better judgments about a bank’s prospects.
The Basel Committee is still preparing a much-delayed paper on sound operational risk-practices for non-G-10 banks and their regulators, which are likely to use the simpler Basel II approaches, and also to provide guidelines and benchmarks for the second pillar-monitoring of all banks. Basel regulators acknowledge that banker responses to their September operational risk working paper1 – dubbed CP2½ by bankers because it comes between CP2 and CP3 – shows bankers fall into three groups in their attitude to the proposals.
Opposition to capital charges
There is a significant group that rejects the idea of operational risk capital charges and argues that it should be handled under the second pillar – a matter for supervision by regulators to ensure good management practice, although regulators would still be able to insist on capital charges if they thought them necessary. A sizeable group accepts operational risk capital charges are coming, but would prefer regulators simply to nominate a charge rather like a tax and not get involved in complex advanced approaches.
The third and smallest group embraces the advanced approaches – and its members are either now capable of using them or will be in the near future. Many banks in this group see Basel II as a foundation for enterprise-wide risk management aimed at improving shareholder value. “CP2½ is a positive step forward in the debate about how op risk faced by banks should be treated for regulatory purposes,” says Tony Blunden, London-based director of operational risk services at business advisors Ernst & Young.
But while welcoming the expanded range of advanced measurement approaches potentially available, Blunden queries the heavy emphasis on the collection and analysis of historical loss data. Banks should be run on a management’s view of future prospects with only half an eye on historic data, he says.
The operational risk debate will clearly continue.Risk
They are part of the complex, risk-based Basel II bank capital-adequacy Accord proposed for 2005 by the Basel Committee on Banking Supervision. The committee, which comprises senior banking supervisors drawn mainly from the Group of Ten (G-10) leading economies, is the body that in effect regulates international banking. At the centre of the operational risk debate is the so-called ‘quantitative versus qualitative’ argument. Can the odds on the sort of low-frequency/high impact event that could fatally damage a bank, such as rogue-trader Nick Leeson’s activities that scuppered UK investment bank Barings in 1995, be sensibly quantified to help calculate the amount of reserve capital needed to guard against the risk?
Or is it more sensible for regulators to ensure that a bank’s management structure and controls are of sufficiently high quality that the rogue-trading risk is cut to a minimum and the bank has a business continuity plan that can cope with September 11?
The Basel regulators say they back both approaches. They believe that between the operational losses that a bank can routinely expect – the level of credit-card fraud, for instance – and the most extreme and unexpected events such as the September 11 attacks, lies a range of operational hazards arising from “failed internal processes, people and systems or external events” that can be modelled and guarded against by capital charges. The Basel supervisors also want to ensure that the quality of bank management and controls is up to minimising the effects of the very extreme risks.
Tony Peccia, vice-president of operational risk at Canadian bank CIBC in Toronto, says the benefit of applying rigorous mathematics to measuring operational risk is that it enables judgement to be used in a systematic, coherent and consistent way. And the models can be used to determine capital charges, he adds.
But Karen Shaw Petrou, who leads a consortium of US banks opposed to operational risk capital charges, says such charges create a “perverse incentive” against banks taking measures to cope with such possibilities as the September 11 attacks. “Effective supervision and strict enforcement of standards on internal controls are the key to preventing operationally-related bank failure, not capital standards,” says Petrou, who is executive director of the Washington-based Financial Guardian Group (FGG), the consortium of opponents to the op risk charge.
The Basel Committee has conceded ground and revised its thinking on some aspects of its original plans for requiring op risk capital charges from major banks within the framework of the Basel II accord. The Accord will determine how much of their assets large international banks will have to set aside as reserve capital to guard against losses from the risks of banking, including credit and market risks as well as, for the first time, operational risk.
A central aim of the Accord is to bring regulatory capital – the protective reserves that regulators require banks to set aside to guard against banking risks – in line with economic capital, the capital that banks assign on their own assessment of the risks they face. That would be a departure from the current ‘one-size-fits-all’ minimum reserve/asset ratio philosophy of the Basel I capital adequacy regime dating from 1988.
Internal models
The Basel regulators thus want to encourage banks to use their own internal models to measure the risks they confront. Their intention is that banks using such advanced approaches should enjoy lower capital charges than banks using simpler approaches. In response to banker concerns, the regulators have cut the benchmark for the operational risk charge to 12% of regulatory capital from the 20% originally envisaged in the second Basel II consultative paper (CP2), issued in January 2001. The 20% figure was immediately a prime target of complaints from banks fearing its cost and arguing it was utterly unjustified in the light of their operational loss experience.
The regulators said they would consider a range of options – the so-called “let-a-thousand-flowers-bloom” policy – for advanced approaches to calculating the operational risk charge, instead of just the one they had initially proposed in CP2. They removed the threat of possible double-counting of op risk arising from aspects of the Basel II credit risk proposals. They said they would also consider a role for operational risk insurance in helping to reduce capital charges for banks using advanced approaches – although some, including FGG’s Petrou, believe the regulators should accept more readily that insurance is a better way of managing many operational risks than capital charges in all Basel II approaches.
But the regulators are still wrestling with fundamental problems. These include fears of there being little incentive to use the advanced operational risk approaches, because of the 9% floor for regulatory capital on any lower charges and the cost of putting in the systems needed for the advanced approaches. These advanced measurement approaches, which include the so-called loss distribution and scorecard approaches as well as an internal measurement approach, have yet to be fully defined, reflecting the difficulty of quantifying operational risk amid a scarcity of reliable loss data.
Critics also argue that the two simpler approaches – known as the basic indicator and standardised approaches – use a very risk-insensitive marker for operational risk, namely a bank’s gross income. A bank with relatively high gross income, and therefore liable to a higher capital charge under the two approaches, does not necessarily carry more operational risk than a bank with lower income, the critics argue.
Cynics among bankers say an operational risk charge would in effect work as a regulators’ tax to cover all “other risks” that aren’t credit and market risks. The tax would help the regulators with their aim of ensuring that while individual banks might secure lower capital charges under Basel II, the total of reserve capital in the global banking system would be unchanged from Basel I levels.
But concern about Basel II is not confined to operational risk.
In December, the Basel Committee postponed its third Basel II consultative paper (CP3) to around the middle of 2002 from end-February because of difficulties with the credit risk proposals. Germany has threatened to veto Basel II unless the Accord’s treatment of long-term lending to small- and medium-sized enterprises, which will incur higher capital charges than shorter-term lending, is revised. And the Basel Committee is looking at possible modifications to its overall credit risk proposals after seeing evidence that Basel II, as it stands, might work in precisely the opposite way to what was intended. Survey evidence from banks suggested that not only would banks face higher capital charges under Basel II than they do under Basel I, they would also face even higher charges if they used one type of advanced approach compared with a simpler method.
The difficulties with the credit proposals has in turn prompted speculation among some bankers that the operational risk charge might be reduced yet again through ‘horse-trading’ designed to get Basel II capital charges back in line with the Accord’s original intentions.
The objection to a further cut is that it would in practice remove any incentive for banks to use advanced operational risk-measurement approaches. The regulators hope to prevent yet another delay to Basel II’s implementation – they have already had to postpone the start date to 2005 from 2004 because of the complexity of the proposals. They still hope to issue the final version of Basel II by the end of the year to allow national governments and regulators to get ready and banks prepare their internal systems.
Banks of all sizes
Although Basel II is intended in the first instance to apply to the large G-10 international banks, the Accord is designed for banks of all sizes. Over 100 countries, for example, subsequently adopted the Basel I agreement for their banks. The European Union plans to introduce capital adequacy rules modelled closely on Basel II in 2005 for all banks and investment firms in the EU, which currently comprises 15 nations, but might by 2004 include an additional 10 countries.
It often seems forgotten that Basel II is based on a three-pillar structure in which capital charges form the first pillar of the three interdependent supports of the Accord. The second pillar of the Accord will allow regulators to supervise banks to ensure their risk management practices and controls are adequate, their databases accurate and their models rigorous.
The third pillar will be the market discipline exerted by the banks’ having to publicly disclose more information about their risk management practices so that investors, counterparties and credit-rating agencies can make better judgments about a bank’s prospects.
The Basel Committee is still preparing a much-delayed paper on sound operational risk-practices for non-G-10 banks and their regulators, which are likely to use the simpler Basel II approaches, and also to provide guidelines and benchmarks for the second pillar-monitoring of all banks. Basel regulators acknowledge that banker responses to their September operational risk working paper1 – dubbed CP2½ by bankers because it comes between CP2 and CP3 – shows bankers fall into three groups in their attitude to the proposals.
Opposition to capital charges
There is a significant group that rejects the idea of operational risk capital charges and argues that it should be handled under the second pillar – a matter for supervision by regulators to ensure good management practice, although regulators would still be able to insist on capital charges if they thought them necessary. A sizeable group accepts operational risk capital charges are coming, but would prefer regulators simply to nominate a charge rather like a tax and not get involved in complex advanced approaches.
The third and smallest group embraces the advanced approaches – and its members are either now capable of using them or will be in the near future. Many banks in this group see Basel II as a foundation for enterprise-wide risk management aimed at improving shareholder value. “CP2½ is a positive step forward in the debate about how op risk faced by banks should be treated for regulatory purposes,” says Tony Blunden, London-based director of operational risk services at business advisors Ernst & Young.
But while welcoming the expanded range of advanced measurement approaches potentially available, Blunden queries the heavy emphasis on the collection and analysis of historical loss data. Banks should be run on a management’s view of future prospects with only half an eye on historic data, he says.
The operational risk debate will clearly continue.Risk
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