Reform of International Banking Standards: Implications for APEC

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1 (Customer APEC Relation Management, CRM) JULIUS CAESAR PARREN ~ AS 1 / Taiwan Institute of Economic Research Broaddus, J. A. (1998), "The Bank Merger Wave: Causes and Consequences", Economic Quarterly, Federal Reserve Bank of Richmond, Summer, Vol. 84/3, pp Caves, R. E. and Bradburd, R. M. (1988), "Empirical Determinants of Vertical Integration", Journal of Economic Behavior and Organization, Vol. 9, pp Davis, P. S., Robinson, R. B., Pearce II, J. A. Jr., and Park, S. H. (1992), "Business Unit Relatedness and Performance: A Look at the Pulp and Paper Industry", Strategic Management Journal, Vol. 13, No. 5, pp Davis, R. and Thomas, L. G. (1993), "Direct Estimation of Synergy: A New Approach to the Diversity-performance Debate", Management Science, Vol. 39, No. 11, pp (1991) P P Abstract Changes in rules governing the standards of bank capital are currently under way. The Basle Committee on Banking Supervision is working on its final revisions to the existing capital accord of These changes will greatly affect the operations of banks all over the world, but they promise to help prevent the recurrence of financial crises by using advances in risk management practices to develop a better regulatory framework. This paper looks at the implications of the new Basle capital accord on efforts within APEC and related institutions to promote greater financial stability, and the requirements it poses on policies and cooperative actions.. THE ROLE OF BANKS AND REGULATORY CAPITAL IN THE ASIAN FINANCIAL CRISIS Banks' lending practices played a central role in the Asian financial crisis of 1997/98. Excessive risky lending drove up the prices of risky assets. This generated a circular process, where asset price inflation made banks' financial conditions seem much sounder than they 1 The author, who is Senior Advisor at the Taiwan Institute of Economic Research, is also Senior Advisor to the Chairman of Chinatrust Commercial Bank and Head of the Asian Bankers' Association Task Force on the New Basle Capital Accord

2 really were, in turn encouraging continued expansion in risky lending and further unrealistic increases in asset prices. The bursting of the asset price bubble produced a reverse of this circular process. As asset prices fell, the insolvency of financial institutions became visible. This eventually led to credit contraction, further asset deflation, and even greater financial distress. 2 Adding to the severity of the crisis was the large magnitude of foreign currency lending and short-term foreign capital flows associated with this process. 3 This mirrored an excessive exposure to foreign exchange risk in both financial and corporate sectors, and paved the way for eventual currency crises in the wake of ensuing panic and speculation. Various factors contributed to the onset and aggravation of the crisis, but the central role that bank lending played in this process underscores the importance of promoting better risk management through an improved regulatory framework. 4 While lax prudential rules and financial oversight have been cited by the IMF as major factors behind the crisis, a closer examination shows that the framework itself badly needed an overhaul. 5 The 1988 Basle accord - the current framework - sought to provide international standards for calculating the adequate levels of capital that banks need to set aside as a cushion against the loan losses that are inevitable in every credit cycle. 6 It tried to incorporate risk sensitivity in measuring capital adequacy, which was not captured by simple traditional ratios such as equity to assets or equity to loans. The accord replaced these rudimentary ratios, which lumped all assets or loans together, with a ratio of capital to risk-weighted assets, where the denominator varied with the level of risk attributed to the bank's assets. The accord arbitrarily set the level defining minimum capital adequacy at 8%. 7 The risk-weighting schedule assigned various types of assets to certain buckets according to various categories, in an attempt to achieve a measure of risk sensitivity. [See Table 1.] The accord has been supplemented several times since its inception, such as in 1996, when market risk exposures were given separate capital charges. TABLE 1: 1988 Capital Accord Risk Weightings (Simplified) 8 Risk Weight Assets Included Bucket 0% Cash and cash equivalent: Cash Local currency deposits with the central government or central bank Deposits with OECD central governments and central banks Claims collateralized by cash, by OECD central government securities or guaranteed by OECD central governments Claims on domestic public sector entities other than the central government Loans guaranteed by domestic public sector entities other than the central government 20% Assets representing claims on OECD banks and multilaterals: Loans to and debt issued by or guaranteed by banks incorporated in the OECD Short-term exposure to non-oecd banks: Loans to and debt issued by or guaranteed by banks incorporated outside the OECD having a residual maturity of one year or less 2 Paul Krugman presents a detailed description of this process in a January 1998 paper (Paul Krugman, What happened to Asia? [ 3 This comes out clearly in an analysis by the Asian Development Bank Institute, which states that short-term bank borrowing constituted the largest part of the great financial boom, denominated mainly in US 4 The East Asian crisis and many other serious episodes of financial troubles demonstrate that bad lending still poses the greatest threat to financial stability, much more than losses in securities trading. Even the most spectacular trading losses at such institutions as NatWest, UBS and Barings, which all amounted to less than US$1.5 billion, look small compared to the huge losses caused by bad lending at Credit Lyonnais in the 1980s, which ran up to over US$20 billion, and the hundreds of billions of dollars lost by East Asian banks in recent years. 5 Stanley Fischer, The Asian Crisis: A View from the IMF. Address at the Midwinter Conference of the Bankers Association for Foreign Trade, Washington, D.C., February 3, This is also to reduce moral hazard by ensuring that shareholders of a bank have sufficient funds at risk so that they do not lightly engage in operations that place depositors funds - which compose most of the banks debt - in jeopardy. 50% Residential mortgages: Loans fully secured by mortgages on owner occupied residential property 100% Corporate exposure and everything else. 7 The 1988 accord was centered on minimum capital requirements. It required internationally active banks in G-10 countries to hold capital equal to at least 8% of a basket of assets measured according to their riskiness. For this purpose, capital has been defined as Tier 1 capital, corresponding to shareholders' equity and retained earnings, and Tier 2 capital, corresponding to additional resources available to the bank, primarily subordinated debt. Thus the resulting formula: Capital Adequacy Ratio = Tier 1 Capital + Tier 2 Capital = 8% (minimum) Risk-Weighted Assets Whereby Tier 1 Capital is basically shareholders' equity and Tier 2 Capital is subordinated debt. Banks are required to hold at least half of its measured capital in Tier 1 form

3 The 1988 capital accord made the concept of risk-weighted capital adequacy the global standard and introduced uniformity in capital measurement. Over 100 jurisdictions have implemented its guidelines into law. The accord has therefore contributed to facilitating cross-border comparisons of banks' financial conditions. It represented an improvement over previous practices by attempting to link the capital that banks have to set aside with the risks that they are running. Ideally, banks would have to Incentives for risky lending and wider use of capital arbitrage contributed to the deteriorating quality of bank loan portfolios in recent years. 13 This was reflected in the bad lending decisions on the part of both local and global banks that led to the Asian crisis and the bad loan problems that continue to beset several Asian economies today. Clearly, a thorough revision of the 1988 capital accord is necessary for preventing the further recurrence of financial crises. increase their holdings of capital as the riskiness of their assets increase. This goal, however, was not achieved due to certain factors. First, the rules did not sufficiently discriminate between different levels of risk, and in certain cases rewarded risky lending and investing. 9 The amount of capital that the accord requires banks to put aside against loans to corporations is the same, regardless. REFORMING INTERNATIONAL BANKING STANDARDS AN OVERVIEW OF THE PROPOSED NEW BASLE CAPITAL ACCORD 14 of whether they are lending to robust or shaky borrowers. When a bank buys an AAArated bond of a leading multinational corporation, it is even required to allocate more capital than when it lends to a marginal bank in an OECD member economy. 10 The new accord is structured along 3 mutually reinforcing pillars These are minimum capital requirements (Pillar One), supervisory review process (Pillar Two), and market discipline (Pillar Three). Second, the accord has not kept pace with the growing sophistication of risk management, which has increasingly enabled banks to structure their portfolios in ways that go around the capital standard. 11 This has made it easier for banks to resort to capital arbitrage, 12 in the process moving high quality assets off their balance sheets and retaining lower quality assets that they believe should entail more capital than the Basle rules require. Pillar One: Minimum Capital Requirement This maintains the current definition of capital, as well as the minimum requirement of 8% of capital to risk-weighted assets contained in the 1988 Accord. In measuring the riskiness of assets, operational risk has been added to credit and market risk. 15 The new accord 8 To compute the minimum capital requirement for an asset, the risk weight is multiplied by the minimum requirement of 8%. Thus, a 20% risk weight for a claim on a bank would translate into 1.6% of the value of the claim (20% x 8 = 1.6), and the 100% risk weight for a claim on a corporation means that the lending bank has to set aside the full 8% of the value of the claim (100% x 8 = 8). 9 Financial regulation: Basle bust, The Economist, April 13, Jonathan Golin, Basel 2 and the New Contours of Capital, Finance Asia (June 2001), p Yung-san Lee, The New Basel Accord and Asian Banking, ICBC Economic Review (March-April 2002), p Capital arbitrage refers to the strategy whereby a bank reduces its regulatory capital requirements without a commensurate reduction of its risk exposure. An example is the practice of shifting off of the balance sheet such assets with economic capital allocations below regulatory capital requirements, while retaining those for which regulatory requirements are less than the economic capital burden. The result is aggregate regulatory capital that is lower than the economic risks require. 13 Sweeter Basle, The Economist, January 18, This is based on the current consultative paper (as of January 2002), which was circulated by the Basle Committee on January 2001 as a revised version of the original June 1999 consultative paper. More than 250 comments on the January 2001 paper were received by the Basle Committee from the banking industry, regulators and other institutions. The Committee is expected to release a revised paper in the second half of 2002, although it has indicated that the overall structure and the principal features of the proposed accord would remain largely intact. 15 These risks are defined as follows: Credit risk: the risk of loss arising from default by a creditor or counterparty. Market risk: the risk of losses in trading positions when prices move adversely. Operational risk: the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events

4 allows banks to choose from a menu of approaches to measure these risks. In measuring credit risk, banks may choose among the following approaches: Standardized Approach. This is a modified version of the 1988 accord's method for measuring credit risk according to a risk weighting schedule. It has been refined by linking risk weights to ratings given to sovereigns, financial institutions and corporations by external credit assessment institutions (e.g., credit rating agencies, export credit agencies), meeting strict standards. A fifth risk weight bucket of 150% has been added for application to low-rated claims (claims on sovereigns and banks rated B- and below and corporates rated BB- and below, or their equivalents). Greater risk sensitivity would be achieved by taking into account collateral, guarantees, credit derivatives and securitization. Under this approach, the bank allocates a risk weight to each asset and off balance sheet position, producing a sum of risk-weighted assets. Each individual risk weight is allocated based on the broad category of the borrower. [See Table 2] TABLE 2: New Capital Accord Risk Weightings (Simplified) AAA A+to BBB+ BB+ B+ to Below Un- Claim to AA- A- to to BB- B- B- rated BBB- Sovereigns 0% 20% 50% 100% 100% 150% 100% Banks - Option 1* 20% 50% 100% 100% 100% 150% 100% Banks - Option 2** 20% 50% 50% 100% 100% 150% 50% Banks - Option 2 short-term*** 20% 20% 20% 50% 50% 150% 20% Corporates 20% 50% 100% 100% 150% 150% 100% *Based on risk weighting of sovereign in which the bank is incorporated. **Based on the external credit assessment of the bank itself. ***Short-term claims under Option 2 are claims on banks of a short original maturity of 3 months or less. approach constitutes a single framework for using banks' own assessment of various risk components associated with an exposure to calculate minimum capital requirements. Under the foundation methodology, the bank estimates the probability of default associated with each borrower, and the supervisor supplies other inputs. The results are translated into estimated amounts of potential future loss and used as a basis for calculating the minimum capital requirement. Advanced Internal Ratings Based (IRB) Approach. The bank supplies other necessary inputs in addition to those already specified in the Foundation IRB Approach. The internal ratings based approach introduces additional risk sensitivity by making possible a finer differentiation of risks than what can be achieved with the five risk weight buckets under the standardized approach. Both Foundation and IRB approaches are subject to strict methodological and disclosure standards established by the BCBS and to supervisor approval based on these standards. The design of regulatory capital requirements is supposed to contain incentives for banks to migrate from the standardized to the IRB approach, and from the Foundation IRB to the Advanced IRB approach (evolutionary approach). In line with the BCBS' evolutionary approach, the IRB framework is expected to evolve, mirroring the ongoing evolution of credit risk management, to some point in the future where banks would be allowed to calculate capital requirements based on their own or vendor portfolio credit risk models, once problems with regard to data quality and the ability of banks and supervisors to validate model outputs have been sufficiently addressed. 16 The new accord does not propose any changes to the current (1988) accord with regard to measuring market risks, which offers two alternative approaches: Standardized Approach. Banks measure market risks according to a standardized measurement method establishing market risk capital requirements for banks not using the internal models approach. Foundation Internal Ratings Based (IRB) Approach. The new accord introduces the use of banks' own internal ratings, in consideration of the fact that banks are supposed to have more information than credit rating agencies about their borrowers. This 16 Difficulties in developing credit risk models arise from the fact that unlike market risk models that can be tested every day as markets go up and down, credit risk models need to be tested over a whole economic cycle. See Banking regulation: Growing Basle, The Economist, June 3,

5 Internal Models Approach. Banks are allowed to use proprietary in-house models for measuring market risks, subject to fulfillment of a number of strict quantitative and qualitative criteria. For measuring operational risks, the new accord proposes three alternative approaches: Basic Indicator Approach. This uses one indicator of operational risk for a bank's total activity. Standardized Approach. This specifies different indicators for different business lines. Internal Measurement Approach. This requires banks to utilize their internal loss data to estimate required capital. Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. Principle 2: Supervisors should review and evaluate banks' internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a Pillar Two: Supervisory Review Process particular bank and should require rapid remedial action if capital is not maintained or restored. The new accord also endorses other principles related to banking supervision identified in other documents issued by the BCBS. 18 Pillar Two entails more detailed dialogue between banks and supervisors. The BIS' Financial Stability Institute and the newly-formed Accord Implementation Group established by the BCBS are expected to provide assistance to promote the required expertise among supervisors. The supervisory review process is explicitly recognized as an integral part of the new accord, being important to achieve the objectives of the new accord. Specifically, it is needed for the following purposes: To ensure that banks meet the necessary requirements for the recognition of internal methodologies, credit risk mitigation techniques and asset securitizations for regulatory purposes, 17 and monitor their ongoing compliance with these requirements. To encourage banks to meet the disclosure recommendations set out in Pillar Three. To address areas that are not taken into account nor fully captured by the Pillar One process, such as specific risks of institutions that are not adequately covered by the proposed operational risk charge in Pillar One, as well as interest rate risk and factors Pillar Three: Market Discipline Pillar Three proposes an overarching principle that banks should have a formal disclosure policy and implement a process for assessing the appropriateness and frequency of dis- that are external to the bank. The new accord sets out four key principles as the basis of the supervisory review process. These principles are as follows: 17 These requirements include risk management standards, as well as disclosure, especially of features of their internal methodologies where they are used to calculate minimum regulatory capital requirements for credit and operational risk. 18 The BCBS names the following documents: (a) Part B of the Amendment to the Capital Accord to Incorporate Market Risks; (b) Core Principles for Effective Banking Supervision; (c) The Core Principles Methodology; (d) Risk Management Guidelines for Derivatives; (e) Risk Management for Electronic Banking; (f) Framework for Internal Controls; (g) Sound Practices for Banks' Interactions with Highly-Leveraged Institutions; (h) Enhancing Corporate Governance; (i) Sound Practices for Managing Liquidity; (j) Principles for the Management of Credit Risk; (k) Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions; (l) Principles for the Management and Supervision of Interest Rate Risk; and (m) Operational Risk Sound Practices

6 closure. It sets out disclosure recommendations and requirements 19 for banks 20 in the following areas, where disclosures are classified as core or supplementary disclosures: 21 Scope of application of the new accord (which corporate entities within a banking group are captured within this scope, and the approach used to capture these entities). Structure of capital (nature, components and features). Risk exposures and assessment for four key banking risks: Credit risk in the banking book: disclosures for all banks, those using the standardized approach, those using the IRB approaches, credit risk mitigation techniques, and asset securitization. Market risk: disclosures for banks under the standardized measurement method and for those under the IMA. Operational risk. Interest rate risk in the banking book: qualitative disclosures on methodology and key inputs and quantitative disclosures relating to required information for risk assessment and to ex post performance as an indication of quality and reliability. Capital adequacy. Pillar Three also discusses the role of materiality of information 22 and frequency of disclosures. CHANGES UNDER THE NEW ACCORD The proposed new accord seeks to redefine the regulatory approach to bank supervision and encourage banks to improve their risk measurement procedures in three major ways. The proposed new accord makes the setting of a regulatory minimum for capital, on which the 1988 accord solely relied, part of a more elaborate three pillar-structure, which now also includes increased supervisory review of banks' assessments of their own capital adequacy and additional public disclosure of bank risk profiles. 23 It seeks to replace the previous accord's one size fits all approach (the use of only one option for measuring appropriate capital) with a flexible and incentive-compatible menu-based approach that encourages banks to continue improving their internal risk management practices. It seeks to introduce greater risk sensitivity, to put capital requirements more in line with underlying risks, while retaining the overall level of regulatory capital. Replacing the 1988 accord's broad-brush structure with a more risk-sensitive one would facilitate the measurement of relative risk, which is critical for avoiding capital arbitrage. The proposed new accord contains the following significant innovations. In measuring the riskiness of assets to determine the minimum capital requirement, operational risk has been added to credit and market risk in order to reflect the broader set of risks involved in bank operations. Major changes are being introduced in measuring credit risk, which remains the most important factor in determining banks' minimum capital requirements. The new 19 While the BCBS in general is introducing disclosure recommendations, Basel II also includes requirements which are preconditions for the use of particular methodologies or instruments for regulatory capital purposes. 20 Disclosure requirements for External Credit Assessment Institutions and supervisors are located in Pillar One under the standardized approach; additional ones for supervisors are located in Pillar Two. 21 Core disclosures are defined as those which convey vital information for all institutions and are important to the basic operation of market discipline, while supplementary disclosures are those which are important for some, but not all, institutions. Supplementary disclosures, however, are not to be regarded as optional whenever they contain significant information for the operation of market discipline in relation to a particular institution. The distinction is made for the purpose of reducing the disclosure burden on institutions. 22 Materiality drives the decision on which disclosures are made. Information is considered material it its omission or misstatement could change or influence the assessment or decision of a user relying on that information. accord proposes a menu of approaches from which banks could choose. The proposed three-pillar structure underscores the crucial roles of supervisory authorities and disclosure rules in making the new accord work. It also reflects the 23 The three-pillar structure requires both supervisors and banks to work more closely together to promote the natural evolution of bank supervision in line with the evolution of risk management practices. See Laurence H. Meyer, Remarks at the Bank Administration Institute's Conference on Treasury, Investment, ALM, and Risk Management, New York, New York, October 15,

7 necessity of adjusting to the increasing sophistication of markets and complexity of modern banking organizations. The interdependence among the three pillars has been well summed up as follows: The proposed accord requires banks to establish comprehensive risk-management policies and then follow them. Supervisory oversight is designed broadly to test that this is occurring. Public disclosure is intended to harness market discipline so that supervisors can, in fact, be less intrusive as the market becomes more so. 24. THE NEW BASLE ACCORD AND BANKS IN THE ASIA- PACIFIC 25 Since it started its work on the new accord, the Basle Committee has been pushing its timetable further back in order to accommodate various demands for further consultations and revisions, and to satisfactorily work out many of the technical details. It issued the first consultative document in June 1999, and reflecting initial comments received from various quarters, issued a second consultative package in January It received more than 250 comments on the second package from within the industry, regulators and other market participants. Among the major issues raised by banks, industry associations and regulators from the Asia-Pacific region are the following: The negative impact on small and medium enterprises of the charge on capital exposures to SMEs, which was viewed as too high, as well as the exclusion of property collateral for use in credit risk mitigation. Higher capital requirements for banks arising from the introduction of a capital charge for operational risk and insufficient consideration of the conservatism contained in measures already being implemented by some banks, such as dynamic provisioning and economic loss provisioning. 24 Laurence H. Meyer [Governor of the U.S. Federal Reserve System], Remarks at the Annual Washington Conference of the Institute of International Bankers, Washington, D.C., March 5, This section draws extensively from the work of the author. See Julius Caesar Parrenas, The Proposed New Basel Accord: A Challenge for Asia's Banks and Regulators, ICBC Economic Review (March-April 2002), pp Insufficient recognition of collateral, as the new accord is viewed as giving too little capital relief for common collateral types and treating loans secured by commercial real estate in the same way as unsecured loans. Overly high (20%) proportion of regulatory capital allocated to operational risk, especially for financial institutions whose operations are largely conventional in nature and much less complex than those of large international banks. Problems with methodologies in measuring operational risk, such as an overly complicated internal measurement approach, the view that the basic indicator and standardized approaches are not risk-driven, double counting with regard to operational and credit losses, and the view that forward-looking indicators and the quality of a bank's internal control environment are better indicators than historical factors. 26 Problems with the regulatory use of external credit assessment institutions, including the small number of rated entities in most markets, problems with the reliability of rating agencies' practices and their access to reliable financial information, and the existence of a disincentive for borrowers to be rated through the lower risk weight (100%) given to unrated claims as compared to the 150% weight given to low-rated claims. Insufficient incentives for banks to migrate to more advanced approaches in measuring credit risk arising from the higher costs of improving IT system and risk rating models compared to the 2-3% estimated reduction in risk-weighted assets that would result from migrating to the Foundation IRB approach from the standardized approach, and the floor on the Advanced IRB approach equal to 90% of the capital requirements which would result under the Foundation IRB approach, which discourages migration from the Foundation to the Advanced approach. Problems with detailed disclosure requirements, arising from the view that voluminous and complex information would not add value for the general user, but would only allow banks to learn more about their competitors and could lead to misinterpretations and erroneous conclusions. 26 While there is wide agreement over the need to mitigate operational risks, the difficulty is in accurately quantifying what is essentially a qualitative risk. See Nick Lord, The Future According to Basel, Finance Asia (June 2001), p

8 Conservatism in the treatment of securitization under the standardized approach for measuring credit risk, in comparison to exposures to corporates and other counterparties, which several banks argue would be a disincentive for them to utilize securitization and potentially reduce its value as a viable balance sheet and risk management tool. Accordingly, the BCBS announced its intention to issue a third consultative paper, indicating probable revisions in the following areas, among others yet unspecified, under Pillar One: Reductions in the basic calibration of the Foundation IRB approach, both for corporate and retail portfolios, to ensure that there is adequate incentive for banks to adopt more advanced approaches to credit risk. Reduction of the target proportion of regulatory capital related to operational risk from the proposed 20%, which has been considered as too large. Modifications in the treatment of credit exposures related to SMEs, with a view to achieving lower capital for SME lending. Much progress has been made since the first consultative paper, and there is wide support for the objectives and the general approach of the proposed new accord. A much greater challenge lies ahead, however, as regulatory and supervisory authorities and banks prepare themselves for its implementation. 27 The next section discusses the implications of the new accord on the work of governments and relevant authorities, especially within the framework of APEC. practices. As a consequence, it would require extensive preparation on the part of financial regulatory and supervisory authorities, significant legal and regulatory changes, and intensified international cooperation among relevant authorities. 28 Urgently undertaking these preparatory measures is necessary to ensure that the new accord achieves its purpose. Failure to do so would undermine the credibility of the new international banking standards, result in an uneven playing field, and pose serious dangers to financial stability. More importantly, effectiveness in essential to justify the huge costs to banks of implementing the accord. 29 Specifically, the adoption of the new accord will result in the following challenges to authorities throughout the region: As good supervision is a necessary requirement for the effective implementation of the new accord, additional resources need to be devoted to attain a significant upgrading of expertise and skills among staff of supervisory authorities in many emerging economies. Much work is also required in amending banking legislation and further developing supervisory policies and guidelines in many jurisdictions. There is a need to address problems of comparability of practices across jurisdictions. 30 It is important that the discretion allowed national supervisors to implement the new accord is based on similar standards. For comparability of the capital base used in the computation of the capital adequacy ratio, all jurisdictions need to comply with standard provisioning requirements for loan losses. There could be problems in applying the new accord to international banking groups on a consolidated basis across different jurisdictions if supervisors adopt different approaches for calculating. IMPLICATIONS ON BANK SUPERVISION AND APEC'S FINANCE AGENDA The adoption of the new accord entails an indispensable role for supervisory authorities and market discipline in encouraging banks to continually improve their risk management 27 Many observers point out that internal risk management systems in most Asian countries still do not measure up to the Basle standards. Adam Lincoln, Credit Ratings: A New Balance, CFO Asia (April 2001), p It has been argued that the Second Pillar (supervisory review process) is actually the most important issue for Asian banks, as these standards form the basis for internal improvement and adequate governance and regulatory supervision. Philip D. Sherman, Banking on Basel, Asian Wall Street Journal, August 2, Credit Suisse calculates that 30,000 banks all over the world would have to spend an average of US$15 million every year for the next five years, which would yield a total of US$2.25 trillion. Bank regulation: Basle postponed, The Economist, June 28, This has been a long-standing issue in bank supervision, as a former president of the Deutsche Bundesbank describes in an article. Advances on issues such as developing consistent rules for the treatment of risk, arrangements for the pooling of information, and closer cooperation between different supervisory authorities continue to be hampered by countries' different financial and supervisory systems. Hans Tietmeyer, Evolving Cooperation and Coordination in Financial Market Surveillance, Journal of Banking and Finance Vol. XIV (1999), No. 2, pp

9 capital charge, or if discretion is exercised by supervisory authorities using inconsistent standards. While there is a need to ensure the implementation of the new accord on a consistent, transparent and fair basis across jurisdictions, there may also be situations under which supervision should be able to override certain aspects of the accord in order to maintain its relevance. The new accord requires a lot of work in establishing infrastructure for data collection and credit rating systems in emerging markets. In many cases supervisory authorities in emerging markets do not maintain the time series data needed in the IRB approach, while most banks in these markets do not have robust rating systems and the required historical data. 31 Much work also needs to be done in ensuring effective and meaningful disclosure of financial information through improved accounting and auditing standards and in promoting comparability of financial information across jurisdictions. The Bank for International Settlements'Financial Stability Institute and the Accord Implementation Group newly formed by the Basle Committee are working toward this end. Nevertheless, there remains a wide scope for international cooperation in this endeavor, especially at the regional level, and APEC could play an important role to support the efforts of the above-mentioned institutions. Representatives of the region's banking community, as well as a majority of regulators within the APEC region, have expressed support for international cooperative measures to help bank supervisory authorities, especially those in emerging markets, cope with the requirements to implement the new capital accord. The following are specific measures that Development of a program for training staff of supervisory authorities in implementing the new accord. Promoting the development of infrastructure for data collection and credit rating systems in emerging markets in the region. Promoting best practices, consistency and convergence in approaches among supervisors in such areas as applying consolidation to international banking groups, assessment of external credit assessment institutions, and methodologies of validating IRB approaches. Development of model supervisory guidelines and banking legislation to help domestic authorities undertake the necessary changes to comply with the requirements of the new accord. Development of guiding principles to delimit the scope of national discretion. In the past few years, the APEC Finance Ministers have been working on various collaborative initiatives in response to recent episodes of financial crisis. Given the pivotal role that the banking system played in these crises, it is only appropriate that APEC devote more attention to strengthening the banking sector. The new capital accord that will be put in place within the next several years will be a central element in these efforts, but the success of its implementation will require a high degree of international cooperation, not only in terms of capacity-building, but also in terms of promoting consistency of approaches across jurisdictions. These are certainly areas where APEC, with its well-established mechanisms for regional dialogue and collaboration, could make important contributions. APEC and relevant authorities throughout the region could undertake in this regard: Addressing these problems involves cooperation between regulators and financial institutions. One example is the assumption by the regulator of a coordinating role in supporting the development of a data base, in education, and with knowledge transfer. See M.R. Pridiyathorn Devakula, Risk Management: Challenge for the Thai Financial Institutions and Regulator. Opening Remarks at the Market Risk Management Techniques for the BIS Capital Regime Seminar, United Nations Conference Center, Bangkok, October 12, These are reflected widely in comments from the banking sector in Asia. See Asian Bankers' Association, Position Paper: Cooperative Measures to Help Bank Supervisory Authorities in the Asia-Pacific Region Implement the New Basle Capital Accord, May

10 REFERENCES Bank regulation: Basle postponed, The Economist, June 28, Banking regulation: Growing Basle, The Economist, June 3, Financial regulation: Basle bust, The Economist, April 13, Sweeter Basle, The Economist, January 18, Asian Bankers' Association, Position Paper: Cooperative Measures to Help Bank Supervisory Authorities in the Asia-Pacific Region Implement the New Basle Capital Accord, May Basle Committee on Banking Supervision, Consultative Document: Pillar 2 (Supervisory Review Process), January Basle Committee on Banking Supervision, Secretariat, The New Basle Capital Accord: An explanatory note, January Basle Committee on Banking Supervision, Update of work on the New Basle Capital Accord, 21 September Lincoln, Adam, Credit Ratings: A New Balance, CFO Asia (April 2001), pp Lord, Nick, The Future According to Basle, Finance Asia (June 2001), pp Meyer, Laurence H., Remarks at the Annual Washington Conference of the Institute of International Bankers, Washington, D.C., March 5, Meyer, Laurence H., Remarks at the Bank Administration Institute's Conference on Treasury, Investment, ALM, and Risk Management, New York, New York, October 15, Parrenas, Julius Caesar, The Proposed New Basle Accord: A Challenge for Asia's Banks and Regulators, ICBC Economic Review (March-April 2002), pp Sherman, Philip D. Banking on Basle, Asian Wall Street Journal, August 2, Tietmeyer, Hans, Evolving Cooperation and Coordination in Financial Market Surveillance, Journal of Banking and Finance Vol. XIV (1999), No. 2, pp Yoshitomi, Masaru and Kenichi Ohno, Capital-Account Crisis and Credit Contraction: The New Nature of Crisis Requires New Policy Responses, ADB Institute Working Paper 2 (May 1999). Basle Committee on Banking Supervision, Update on the New Basle Capital Accord, 25 June Devakula, M.R. Pridiyathorn, Risk Management: Challenge for the Thai Financial Institutions and Regulator. Opening Remarks at the Market Risk Management Techniques for the BIS Capital Regime Seminar, United Nations Conference Center, Bangkok, October 12, Fischer, Stanley, The Asian Crisis: A View from the IMF. Address at the Midwinter Conference of the Bankers' Association for Foreign Trade, Washington, D.C., February 3, Golin, Jonathan, (June 2001), Basle 2 and the New Contours of Capital, Finance Asia pp Krugman, Paul What happened to Asia? [ TER.html], Lee, Yung-san The New Basle Accord and Asian Banking, ICBC Economic Review (March-April 2002), pp