From Andrew Liegel, Risk & Reporting Specialist at FRSGlobal:
Basel II faced its first global challenge when the credit markets began to implode in early 2008. With foreclosures mounting and loan-to-value ratios in banking books reaching disastrous levels, many are wondering why the Basel II Accord did not do a better job of preventing such a meltdown across the financial services industry. Partial implementation is probably the best explanation for the lack of Basel II effectiveness. Only a few regions have fully implemented Basel II and of those countries that have, far more attention was paid to the minimum capital requirements than to the supervisory review. The partial implementation approach that took place from both the geographic and reporting framework has left many regulators scrambling to change things quickly.
From a geographic standpoint, if one region is using Basel II capital adequacy standards, those banks are not immune to the problems that its non-Basel trading partners in another region may encounter with weak capital adequacy measures under Basel I (or no Basel at all). When countries set up their own time frames some years apart regulators were ignoring just how much todays financial institutions are interconnected across national borders. The international exposures are very evident when looking at the holdings of the major custodial banks such as Bank of New York Mellon, RBC Dexia, Northern Trust, and State Street, all of whom have foreign exposures greater than $10bn, pushing them into the Advanced Basel II classification.
While New York, London, and Tokyo have remained the keystones of the financial world, most of the growth in banking and trading operations came in second world and developing countries that have much weaker capital adequacy standards. The biggest impediment to the effective operation of Basel II is that the worlds largest economy, the US, still has not implemented the measures as of the fourth quarter 2008. Now that the credit crisis and recession are taking hold, there may be more ‘revisions’ to the US Basel framework before it is finally put in place for either Advanced (those with $250B in total assets or $10B in foreign) or Standardized banks (banks that can voluntarily opt-in).
While the geographic adoption of Basel II was incomplete, even those countries that adopted the Basel II framework did not adopt all the metrics equally. As previously mentioned, far more attention was paid to the minimum capital requirements in Pillar I (particularly the credit risk requirements) while far less attention was paid to the Pillar II (Supervisory Review) process, particularly the liquidity and concentration risk. These two areas are perhaps the greatest contributors to todays financial turmoil. With defaults rising in the housing sector during 2007 and 2008, many questioned the effectiveness and validity of PD metrics and calculations. In hindsight, those systems functioned very well. Financial institutions began taking heavy losses, because they did not accurately assess the correlations between market and credit risk metrics exactly the issues that many of todays liquidity risk models emphasise.
What will be the short-term changes to Basel II?
1. Liquidity and concentration risk will have reporting metrics with levels of detail comparable to credit risk metrics in the minimum capital adequacy requirements. Currently, liquidity and concentration risks are part of the Internal Capital Adequacy Assessment Process (ICAAP) of Basel II. Even though regulators in different countries are requiring stress test results to be submitted as part of the Pillar II requirements, far more emphasis needs to be placed on different stress testing results so that they have a level of detail that is similar to the PD and LGD disclosures found in the minimum capital requirements.
Expect to see regulatory report templates released in the next few months for these measures.
2. Much more detail is required for Pillar III (Public Disclosure). Currently, the 11 tables that most regulators around the world have adopted are very vague with regards to the how the qualitative information will augment the required quantitative information. Few of the European qualitative disclosures that have been released so far offer any substantial information see the instructions below for proposed capital adequacy disclosure in the Basel II Accord.
Table 11.3 Capital Adequacy
Qualitative disclosures
(a) A summary discussion of the bank holding companys approach to assessing the adequacy of its capital to support current and future activities.
The CFO and risk managers within a financial institution are left to their own interpretations to decide what they need to disclose in this section. Is it one or two short paragraphs or a much more robust explanation of why risk assumptions were chosen and what would have been the required capital adequacy levels if assumptions were modified to different levels? Most banks have elected to disclose the least amount of information possible and this has left investors will little information from which they can evaluate capital adequacy levels.
For the last few months of 2008, most investors have shunned all types of financial stocks, and the drastic declines in equity prices are evident. The biggest change in transparency demands from investors will center on the assumptions that have been used to calculate economic capital, regulatory capital, and corresponding liquidity cushions. A tremendous amount of emphasis was placed on reporting the amount of risk-based capital relative to the risk weighted assets, but there is little, if any, disclosure around the assumptions that went into the risk models and banking/trading books. Among the biggest culprits:
How will the demand for securitized mortgages change in the secondary market as interest rates and subsequent default rates change?
What will be the range of LTV ratios given a 100 basis point increase in interest rates?
What were the resulting risk-capital requirements when the current assumptions for the calculated and reporting capital requirements were shocked by X or Y per cent above and below the chosen threshold?
When many investors are looking at the risk-based capital holdings of financial institutions that failed in the second part of 2008, they are finding that the capital amounts calculated were sufficient given the chosen assumptions around the credit and market risk calculations. The problem is that few people agree that the proper assumptions were selected, which in turn, led to inadequate amounts of risk-based capital. With little confidence left in the global banks’ abilities to select the correct assumptions from which to calculate capital requirements, expect investors to demand that the details of the proposed ICAAP are released to the general public, instead to the regulators.
The recent meetings of the G-20 in Washington DC in November of 2008 reiterated the global standards rhetoric that was supposed to have taken place years ago. While some are predicting drastic changes in required capital levels or leverage ratios, the biggest change will be the amount of information that is released to the investing public, rather than just confined to the eyes of the regulators and senior executives at financial institutions. The regulators may not impose new capital requirements, but the investing public certainly will when they use the increased transparency into financial institutions to move capital in and out of those that have demonstrated that they are utilizing the most dynamic risk systems in the industry to protect their customers, revenues, and investors.