33 New Capital-Adequacy Rules for Banks Suzanne Hyldahl, Financial Markets INTRODUCTION In January 200 the Basle Committee issued its second consultative document on new capital requirements for banks 2. In February 200 it was followed up by the second consultative document from the European Commission 3. The process of revising the capital-adequacy rules for banks has thus taken an important step forward. The work of the Basle Committee and the European Commission on the new capital framework has been conducted in parallel, and the two consultative documents are expected to be similar in many ways. The Basle Committee has focused on standards for the large international banks, while the European Commission has taken a more EU-specific approach, covering both banks and investment companies. The European Commission therefore stresses that uniform rules for the EU member states' banks and investment companies, irrespective of size and national affiliation, must be ensured. The consultation for the Basle Committee's proposal runs until end-may 200, and the Committee expects to have completed the new standards for capital-adequacy rules by the end of 200. The work of the European Commission, which also includes translating the proposed new rules into EU legislation, is expected to be completed during 2003. The new standards are expected to be implemented in national legislation in the member states in 2004. This article outlines the Basle Committee's general ideas about new capital-adequacy rules for banks. It should be emphasised that the new rules are still at the proposal stage. 2 3 The Basle Committee, whose secretariat is at the Bank for International Settlements, BIS, was set up in 975 with the purpose of strengthening the stability of the international financial system. The following countries are represented on the Committee: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, UK, USA, Switzerland and Luxembourg. The New Basel Capital Accord, January 200. The document can be seen at BIS' home page www.bis.org. Commission Services' Second Consultative Document on Review of Regulatory Capital for Credit Institutions and Investment Firms, February 200. The first consultative documents related to new capital-adequacy rules were issued by the Basle Committee in June 999 and the European Commission in November 999. The response of the Nationalbank can be seen at www.nationalbanken.dk.
34 BACKGROUND FOR REVISING THE CAPITAL-ADEQUACY RULES In view of the special role of banks in the economy, this sector must comply with special requirements regarding equity, etc. The present capital requirements for banks date back to the Basle Accord of 988, which includes a number of solvency recommendations for internationally-oriented banks. Within the EU these recommendations have been followed up by directives applying to all credit institutions. The existing rules have proved to have certain weaknesses, since the capital requirements do not necessarily reflect the actual risks to which a financial institution is exposed. They have not been updated in line with financial innovations (e.g. new risk-reducing financial products) and modern risk-management techniques. In addition, other risk types besides credit and market risks are not included. Finally, there is an increasing need to distinguish between credit risks for the various categories of counterparties. The present credit-risk-weighting system is relatively unrefined, and there are currently only limited opportunities to distinguish between credit risks within counterparty categories. For instance, all private borrowers and business customers are weighted at 00 per cent. This means that today a standard capital requirement of 8 per cent applies, regardless of the rating of the loan portfolio. A need has therefore arisen to update the rules in order to achieve greater coherence between capital requirements and the actual risk profile of the banks, and to ensure that risk management and capital adequacy are recognised to a greater extent. At the same time it must be ensured that the capital reserves of the banks are adequate to cover risks of the relevant type and size. To a greater extent than the current rules the proposed new rules take into account financial innovation, modern risk-management techniques and internal control procedures, as well as new types of risk in general. The structure of the new capital-adequacy rules gives the banks an incentive to enhance and improve their risk management. The underlying philosophy is that the individual bank is best at assessing its own "true" risk profile, and that this should be taken into account on determining the capital requirements. STRUCTURE OF THE NEW RULES The definition of liable capital as core capital and supplementary capital will not be changed. Likewise, the 8 per cent capital requirement is maintained as an absolute minimum. In addition to the present credit
35 and market risks, in future the 8 per cent requirement will also apply to operational risks. A three-pillar structure is proposed for the new capital-adequacy rules: minimum capital requirements, a supervisory review process, and effective use of market discipline. The three pillars should supplement each other. According to the Basle Committee, they should be regarded as one "package." National part-implementation of one or two pillars will therefore not provide a sufficient degree of financial soundness. MINIMUM CAPITAL REQUIREMENTS (PILLAR ) Pillar, minimum capital requirements, includes capital to cover banks' credit risks, market risks and operational risks. In addition, the risk-reducing elements which could lower the capital requirement are outlined. Capital requirements for credit risks is a central element of banking, as credit risk is the principal source of losses. The present rules comprise only capital requirements for credit risks in the banking book 2. Since the new rules for capital requirements for credit risks will be more specific, it is assessed that the excess capital requirement resulting from the present rules (and indirectly covering other risks) is likely to be eliminated. Capital requirements will therefore be introduced for other risks than credit risks, i.e. for operational risks. The new standards are based on the concept of offering banks a "menu" comprising various regulation models. This is a departure from the 988 standards, which are based on the one-size-fits-all concept. Capital requirements for credit risks In relation to the Basle Committee's initial consultative document the first column now operates with 3 methods for determining minimum capital requirements, cf. Box. The first method is a revision of a standardised approach 3 based on external credit ratings of the borrower. The capital-adequacy requirements in relation to market risks remain unchanged and will therefore not be discussed further. 2 The solvency requirement means that the liable capital of a bank must be at least 8 per cent of the bank's weighted assets, etc., including items with market risk. The capital requirements for the positions comprised by the trading book are calculated in accordance with the rules on market risk, while the capital requirement for the banking book (the "other" assets) is calculated in accordance with the credit risk rules. The capital requirement to cover foreign-exchange risk is, however, calculated for the balance sheet as one in accordance with the market risk rules. Under the present rules, capital requirements for interest-rate risk for banking-book items (e.g. fixed-interest loans and deposits) do not apply. Danish banks must report their total interest-rate risk to the Danish Financial Supervisory Authority, but these risks are not covered by the capital-adequacy requirement. 3 In relation to the Basle Committee's initial proposal from June 999 the standardised approach has been refined. For corporate borrowers a further risk weighting of 50 per cent has been introduced in addition to the original proposal with risk weightings of 20, 00 and 50 per cent, respectively.
36 THREE APPROACHES TO DETERMINING CAPITAL REQUIREMENTS IN RELATION TO CREDIT RISK Box The Basle Committee's three proposed approaches which the banks may use to determine minimum capital requirements in relation to credit risk are outlined below.. Revision of the standardised approach The revised standardised approach is based on external credit ratings, e.g. external rating agencies and credit registers. The table below shows the Basle Committee's proposed risk weightings for various categories of counterparties, based on the relevant counterparty's external rating. As a general rule, the standard risk weighting for all other counterparty categories (e.g. retail customers) is 00 per cent. WEIGHTING OF COUNTERPARTY RISK, PER CENT Table AAA to AA- A+ to A- BB+ to BB- B+ to B- Lower than B- BBB+ to BBB- Nonrated Sovereign... 0 20 50 00 00 50 00 Banks (model )... 20 50 00 00 00 50 00 Banks (model 2)... 20 50 50 00 00 50 50 Corporate... 20 50 00 00 50 50 00 The external rating-based approach is illustrated using Standard & Poor's ratings. Model : The bank's risk weighting is based on the rating of the country where it is registered, plus a weighting level (with a 00 per cent ceiling for banks in countries rated BB+ to B- and non-rated countries). Model 2: The bank's risk weighting is based on an external credit rating. However, banks should not resort to "mechanical" risk weighting on the basis of external credit ratings. Supervisory authorities and banks are both responsible for assessing the methods applied by the rating agencies and the quality of their ratings. External rating agencies must thus comply with a number of criteria for acknowledgment. 2. The internal rating-based approach (basic approach) Banks may only implement internal rating if they comply with certain supervisory standards. Under the basic approach, the banks themselves assess the probability of default (PD) for borrowers, while the supervisory authorities supply the other risk factors such as loss given default (LGD) and exposure at default (EAD), i.e the size of the loan at the time of default. 3. The internal rating-based approach (advanced approach) Banks may only implement advanced internal rating if they comply with certain stringent supervisory standards. Under this approach, the banks themselves may estimate more risk components, e.g. LGD and EAD. Approaches 2 and 3 both allow for a higher degree of risk differentation than approach. The minimum capital requirements under the internal rating-based approach will not only depend on the banks' own risk assessments of the individual borrowers. As a consequence, a type of "concentration risk factor" has been proposed, as a bank's
37 CONTINUED Box concentration of exposures to individual borrowers, or groups of "related" borrowers, has proved to pose a major risk to the bank. On the other hand, the capital requirement may be reduced if the concentration is lower than for a selected standard reference portfolio. This "concentration risk factor" should not be applied to retail customers as this portfolio is typically characterised by a large number of smaller exposures. For retail customers the banks need not assess PD for each individual customer, but can split the private-customer portfolio into segments (i.e. pool loans with similar risk characteristics) and possibly assess the expected losses (the product of PD and LGD) without first identifying PD and LGD separately. The other methods are based on internal ratings, i.e. the credit risks related to the individual loans are determined on the basis of the banks' own ratings of their customers. An innovation in relation to the initial consultation paper is that the Basle Committee has now introduced an advanced internal rating-based approach which is more dependent on parameters determined by the banks themselves. This gives them greater flexibility to determine for themselves the capital required to cover any losses on loans. The key argument for introducing the internal rating-based approach is that banks are best at assessing their own risks. However, if internal rating is to be applied the banks must comply with a number of supervisory requirements, e.g. in relation to their internal rating system and the actual rating process, documentation, data collection, internal control and validation, and disclosure to market participants (cf. Pillar 3 below). The internal rating-based approach will therefore also pose a challenge to certain supervisory authorities. The internal rating-based approach lays down the framework for each of the following six categories of exposure: corporate, banks, sovereigns, retail customers, project finance and equity not included in the trading book. The Basle Committee has made most progress in respect of the first four categories, and the work with the internal rating-based approach is expected to continue during the consultation period. Initially, the advanced rating method can be applied only to corporate, bank and sovereign exposures. Banks are encouraged to improve their risk management and assessment on an ongoing basis, although it is not explicitly suggested that banks may use their own credit models to assess their capital-adequacy requirements. Continuous development of risk-management methods and modelling are assumed to provide for the use of credit models in See also Jens Verner Andersen et al., Models for the Management of the Banks' Credit Risk, Danmarks Nationalbank, Monetary Review, st Quarter 200.
38 the future. The major drawbacks of using credit models for assessing capital adequacy are the data quality and the ability of the banks and supervisory authorities to validate the output from the models. In comparison with the internal rating-based approach, in which data quality and output are also key factors, the use of credit models allows banks to assess portfolio effects such as concentration and diversification. In addition to the three approaches to determining credit risks, Pillar also includes a number of principles for recognising credit risk mitigation, e.g. collateral and guarantees, credit derivatives and netting agreements. Application of these techniques could mean that for asset items covered by credit risk mitigation the attributable risk weighting may be lowered. This technique depends, inter alia, on the method applied by the bank for assessing its credit risks, cf. Box. Capital requirements for operational risks The Basle Committee's preliminary definition of operational risk is "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events". Strategic and reputational risk is not included in the definition, and there are thus no explicit capital requirements in this respect. Examples of operational risks are system errors, procedural errors, IT downtime, fraud, fire, etc. System errors related to banks' involvement in Internet banking and e-trading are examples of relatively new types of operational risks. The capital requirements for operational risks and the possibilities of introducing risk mitigation in this area have yet to be determined. The Basle Committee thus encourages ongoing dialogue with the banking sector in this respect. The capital requirements for operational risks as for credit risks allow banks to apply more or less advanced methods, and here, too, three approaches are introduced: the basic indicator approach, the standardised approach and the internal measurement approach, cf. Box 2, the latter being the most sophisticated approach. However, the Basle Committee is of the opinion that the banks do not at present have sufficient data quantities to calibrate the capital requirements under the internal measurement approach. Consequently it cannot yet be implemented by the banks. Banks are encouraged to use different approaches to determine operational risks, depending on the business area. The basic indicator approach may be used for certain areas, and the standardised approach for others.
39 THREE APPROACHES TO DETERMINING CAPITAL REQUIREMENTS IN RELATION TO OPERATIONAL RISK Box 2 The three proposed approaches which the banks may use to determine minimum capital requirements in relation to operational risks are outlined below. Large international banks are expected to use the more advanced approaches (2 and 3).. The basic indicator approach Under this approach the capital requirement in relation to operational risk is linked to a single indicator acting as a proxy for the bank's total risk exposure. It is suggested that the gross income be used as the indicator and that the bank's capital requirements in relation to operational risk should constitute a fixed percentage ("alpha factor") of the gross income. 2. The standardised approach The standardised approach is similar to the basic indicator approach, but the bank's activities are divided into a number of standardised business lines. Within each line the capital requirement is calculated by multiplying an indicator by a fixed percentage (a "beta factor") determined by the authorities. Both the indicator and the beta factor may vary depending on the business line. The total capital requirement in relation to operational risk is calculated as the sum of the capital requirements for the individual business lines. In comparison to the basic indicator approach, the standardised approach gives a far better picture of the differences in the banks' risk profiles reflected in their business lines. At present the data available for assessing losses in relation to operational risk is very limited. On the basis of a survey of a number of international banks the Basle Committee has concluded that these banks' provisions for this type of risk constitute around 20 per cent of the capital. As the starting point for assessing the alpha and beta factors the Basle Committee therefore applies a capital requirement of at least 20 per cent of the current minimum regulatory capital. 3. The internal measurement approach This approach allows banks complying with certain minimum standards to use internal data to calculate their capital requirements. The bank must apply a fixed percentage (a "gamma" factor fixed by the supervisory authorities) for its own internal assessment of the expected losses resulting from operational risk in the various business lines. As under approach 2, the total capital requirement is calculated as the sum of the capital requirements for the individual business lines. Initially the Basle Committee provides for the internal measurement approach to apply standard definitions of business lines and the indicators used to assess expected losses. As the banks' gain experience in the use of internal systems for measuring operational risks, and as data collection is expanded, the Basle Committee will look into the possibilities of eventually giving banks greater flexibility to define their own business lines and risk indicators. However, at present the Basle Committee is of the opinion that there is insufficient data available to the banks for them to calibrate the capital requirements under this approach. As the banks' methods for calculating the capital requirements in relation to operational risk become more sophisticated and the banks develop more advanced risk-management procedures, this is reflected in a reduction of the capital requirements. This is achieved by calibrating the alpha, beta and gamma factors.
40 THE SUPERVISORY REVIEW PROCESS (PILLAR 2) The function of the supervisory authorities is an essential element of the new capital-adequacy rules. Supervisory authorities must ensure and encourage that banks have an adequate capital base, smoothly operating internal risk-management procedures and adequate internal control mechanisms. The supervisory authorities must review the banks' internal capital management to ensure consistency between the banks' capital reserves and risk profiles. As stated under Pillar, banks must comply with certain standards in order to use the more advanced approaches, and part of the supervisory review process will be to ensure that these requirements are met. The supervisory authorities must assess the capital requirements of each bank, and in principle banks are expected to operate with excess capital reserves (i.e. in addition to the 8 per cent minimum requirement). The supervisory authorities may intervene if a bank's procedures for calculating the capital base in relation to its risk profile and capital-base strategy are not deemed to be adequate. A higher capital requirement than the 8 per cent minimum may also be imposed on a bank. As regards the supervisory review process, supervisory authorities are working to ensure uniform terms of competition for banks as regards supervisory practice. In spite of full convergence of supervisory practices, differences in national taxation and accounting rules will still affect the competitiveness and flexibility of banks. Pillar 2 does not aim to harmonise national supervisory procedures, but seeks to encourage consistent supervisory practice. It is hoped that supervisory authorities will share experiences as regards implementation of Pillar 2. Particularly the increase in the number of cross-border activities calls for international rules and cooperation to ensure smoothly operating supervisory processes. A major change in relation to the Basle Committee's initial consultative document from 999 is that capital requirements for interest-rate risks for non-trading-book items (banking book) has been moved from Pillar to Pillar 2 2. This gives the supervisory authorities greater powers to assess the capital-adequacy requirement. If the supervisory authorities deem that a bank does not have adequate capital reserves to cover its 2 The discretionary powers bestowed on the supervisory authorities in connection with the determination of the individual capital requirements have been somewhat criticised. The Basle Committee assesses that there are such great differences in the ways interest-rate risks are calculated and managed by banks that it is most expedient to deal with interest-rate risk under Pillar 2. If national supervisory authorities deem that sufficient homogeneity has been achieved within the national banking sector as regards the approaches to monitoring and measuring interest-rate risks, a minimum capital requirement in this respect may still be introduced under Pillar.
4 interest-rate risks, they may demand that the interest-rate risk be reduced or the capital reserves increased (or a combination of both). The Basle Committee notes that the supervisory authorities should be particularly attentive to "outlier banks", i.e. bank which are exceptionally sensitive to interest-rate risks for banking-book items. "Outlier banks" are defined as banks whose economic value declines by more than 20 per cent of the sum of Tier and Tier 2 capital as a result of an interest-rate shock of more than 200 basis points. In addition to interest-rate risk it would also be natural to include the following areas under Pillar 2: other risks not fully covered by Pillar (e.g. bank-specific risks not comprised by the capital requirement for operational risks) and risks related to external factors (e.g. the effects of economic trends). MARKET DISCIPLINE (PILLAR 3) The objective of Pillar 3, market discipline, is that banks should provide the market with more detailed information on risks, capital structure and capital reserves, risk management, etc. Pillar 3 is expected to promote self-discipline in the financial markets. As the new rules are to a great extent based on the banks' own internal methods for assessing capital adequacy, the Basle Committee believes that there is a need for extensive disclosure of information about the banks, so that the relationship between banks' risk profiles and capital base is more visible. A distinction is made between primary and secondary (supplementary) disclosures. The latter are not relevant for all banks. Large international banks are encouraged to disclose all types of information 2. As a main rule, it is recommended to disclose information at least half-yearly (and quarterly for large international banks). However, it is deemed to be sufficient to disclose information relating to e.g. banks' risk-management framework once a year. CONSEQUENCES OF THE NEW CAPITAL REQUIREMENTS The Basle Committee evaluates that it is not yet possible to calculate the overall effect on the banks' capital base of the new capital requirements, 2 It could be argued that it is expedient to manage the interest-rate risk on an integrated basis instead of applying the "outlier approach". That would mean including all items when calculating the interest-risk-related capital requirement (possibly with a petty limit, however, so that banks with little/no exposure for non-trading-book items are exempt from the administrative burden). Managing the interest-rate risk on an integrated basis will provide the highest degree of transparency and support the principles that disclosing accurate and reliable information will lead to better market discipline and thus increased confidence in the financial system. The Basle Committee seeks to achieve consistency between its recommendations for disclosure of information (cf. Pillar 3) and International Accounting Standards, IAS.
42 but the calibration efforts will continue in parallel with the consultation process. Work has still to be done in such areas as operational risk, credit risk mitigation and internal rating in relation to retail portfolios, project finance and equity in the banking book. In general the Basle Committee seeks to avoid (average) changes in the aggregate regulatory capital when the standardised approach is used (taking into account the capital requirements for operational risks). For the individual banks, large deviations in their loan portfolios (the ratio between customers with high/low credit ratings or between business customers and retail customers) in relation to the average may, however, result in major changes in the capital requirement vis-à-vis the present rules. As regards the internal rating-based approaches, the Basle Committee seeks to achieve a minor relaxation in comparison with the standardised approach in order to increase the incentive for more precise risk management in banks and its application to capital adequacy. The Basle Committee believes that such a relaxation is possible, considering that the minimum capital requirements are supplemented with the introduction of Pillars 2 and 3. As regards the internal rating-based approaches, the Basle Committee emphasises that banks should not be too optimistic when using these approaches in a booming economy. The Basle Committee thus deems it necessary for banks to collect customer-segment data over a longer period. This will enable them to better assess a borrower independently of the business cycle and via Pillar 2 to build up a capital buffer during economic upswings. The new rules are therefore generally expected to contribute to greater coherence between capital requirements and the actual risk profile of the banks, and to increase the incentive for the banks to improve their risk management. For example, the introduction of explicit capital requirements for operational risks is expected to increase the awareness of such risks and thereby promote the development of smoothly operating internal systems. Disclosure and transparency, as well as the explicit recommendations as to the supervisory review process, are also expected to contribute to sound financial systems and to increase financial stability. As previously stated, the proposed new capital-adequacy rules do not affect to banks only. The role of the supervisory authorities will also be changed. Pillar 2, relating to the supervisory review process, gives the supervisory authorities certain discretionary powers which they do not have at present. In general the Basle Committee encourages a more active dialogue between the supervisory authorities and the banks.