BY Prakash Shrestha

Prakash Shrestha

Although Basel II is primarily intended for “internationally active banks” among the G–10 countries, many countries have announced their intention to adopt the Basel II Capital Accord. Bank regulatory bodies around the world have been studying how Basel II can be incorporated into national regulations and are developing implementation guidelines and timeframes for compliance. Given the regulatory imperative, banking institutions are expected to face significant challenges to achieving Basel II compliance in a timely manner. These challenges include project management and system issues, data availability, technical interpretation, institutional awareness and training.

Asia has a relatively unique situation from the perspective of banking regulation, both in a regional and a global context. The region comprises a range of vastly different financial markets spread out across the development spectrum. Furthermore, and unlike Europe, no pan-regional regulation framework exists. These unique circumstances have and will shape how Basel II is implemented by the countries in this region. Asian countries can be basically categorised into three groups in view of adopting the Basel II perspective. The first group consists of countries with well-developed banking markets such as Japan, Hong Kong, South Korea, Singapore and Taiwan. These countries intend to preserve and strengthen their positions as leading financial centres and are well underway with respect to the process of incorporating Basel II guidelines into national regulations. The second group comprises countries with emerging financial markets such as China, India, Thailand, Malaysia, Sri Lanka and Indonesia. These countries have indicated their commitment to implement Basel II, but within less aggressive timeframes compared to those targeted by the more developed markets. And the third group comprises the least developing countries mostly South Asian countries such as Nepal, Bangladesh, Bhutan, Afghanistan, Maldives and some Southeast Asian countries. Adoption plans among these countries vary, and implementation is expected to be phased within a few years after the intended Basel Committee implementation date of 2006-end.

Due to the extensiveness and complexity of Basel II, most of the Asian banks are now facing many challenges and hurdles in implementing the requirements for operational risk. KPMG surveyed banking clients around the world last year on the status of their Basel II implementations and found that 16 per cent of Asian financial institutions surveyed had no Basel II implementation plans and they were also slowest in their preparations. US regulators require additional time to understand why the new Accord leads to an “unacceptable drop” in bank capital and are delaying their issue of Basel II implementation plans. This will have global implications since the US implementation timetable has influenced the work timetable by the Basel Committee. Hence there is the possibility that implementation timeframes may be deferred in other countries including those in Asia. Most regulators in the more-developed Asian countries are not prescribing or mandating their banks to adopt specific approaches under Pillar I for credit risk except that their choice must commensurate with their risk profile. Most countries are showing similar flexibility in relation to operational risk approaches regardless of the credit risk approach selected. Only Hong Kong is offering an additional approach to the Standardised and IRB approaches for credit risk calculations.

Another roadblock for Asian banks is: even if many desire to select the more sophisticated IRB approach, they lack the information required to build the databases for the credit risk models. Banks need enough historical information to gauge a customer’s statistical probability of default. Collecting enough material to produce reliable Probability of Default is particularly bad in Asia, where it’s common for banks to have long-standing relationships with companies not known for their transparency. Besides these, in most Asian countries, credit assessment, particularly among small to medium-sized enterprises, are still based on the relationship between the loan officer and the customer, not a very systematic tool. That is why many second-tier banks are trying to avoid full-blown cost of compliance, the buying of tools, and the restructuring needed, until there’s an absolute regulatory requirement to do so. Moreover, Asian banks may not really be equipped to accurately assess their own risks. Sophisticated risk measurement systems are new to most of the Asian countries and their reliability has not yet been demonstrated. Asian regulators may not have the resources, especially the necessary number of staff with sufficient technical expertise, to conduct effective monitoring of Basel II compliance.

What about least developed countries like Nepal?

It seems that the major aim of Basel II is to prevent Western governments from having to bail out the large consolidated Western private banks in case they fail. Also, the Basel Committee, which negotiated and designed the Basel II Accord, did not have the representatives of developing countries among its members. The Committee held regular consultations with a group of 13 non-member countries, but Basel II ultimately failed to take into account the interests of developing countries, who have no decision-making power in the design.

First of all, International banks get a more competitive advantage than the domestic banks in developing countries. The international banks that use their own risk assessment system must apply it to all the loans they provide in all countries. The costs of introducing and operating one's own risk assessment systems are more expensive and only feasible for top international banks. Consequently, the banks that operate in a particular developing country might each use different risk assessment approaches with different capital reserve requirements. Those international banks that use their own risk assessment system (IRB approach) which require less capital requirements would be given a competitive advantage over domestic banks that use a standardised approach requiring higher loan reserves.

Secondly, governments, banks and corporations in developing countries will probably face higher costs for loans due to Basel II. Developing country entities generally receive low ratings by rating agencies, Export Credit Agencies, and by the banks' own risks assessment systems; many companies or governments from developing countries have no rating at all. These lower or non-existing ratings do not always reflect actual creditworthiness of the corporations or governments and can reflect some bias in capital markets. According to the IRB approach in Basel II, banks need to put more capital aside for such lower or non-rated lenders, meaning banks will charge relatively higher interest rates for many loans to developing countries. Further, it is argued that interest rates charged to the developing world as a whole could be too high because Basel II has chosen not to include diversification in its risk assessment mechanism. Loans to developing economies are relatively risky, but banks can partially offset these risks with high-quality loans to developed countries. Although tools exist to assess the impact of diversification on credit portfolio risks, Basel II does not take them into account. As a result, the estimated credit risk for developing country loans could be high and, consequently, the interest rates charged to developing countries could be much too high as well.

A final potential danger to financial stability lies in the possible pro-cyclical effects of using external rating agencies for risk assessment. If a country is facing adverse macroeconomic circumstances, and rating agencies suddenly lower credit ratings, this would only aggravate the situation, creating financial crisis rather than stability.

Compliance & implementation schedule
	Japan	- electrification of affected villages of the 3 VDCs;
	Hong Kong	- construction of rural road and bridges in affected VDCs; Changes to the Bank Ordinance by the Hong Kong Monetary Authority
	Singapore	- All Singapore-incorporated banks are required to comply by March 2007
	South Korea	- All domestic and foreign banks operating in South Korea are required to comply by December 2007 - Domestic banks are expected to complete their credit risk rating systems for the new accord by early 2005- Regulators aim to announce draft guidelines on Pillar II and Pillar III in mid-2005
	Taiwan	- Intends to implement Basel II for all banks in Taiwan by 2006 end - Established a New Basel Capital Accord Taskforce to assess the impact of Basel II on Taiwan banks and propose capital requirements suitable for Taiwan
	China	- China Banking Regulatory Commission intends to have banks adopt the Basel II Capital Accord in full by 2010 - By 2007, all banks are required to meet the Basel I 8% CAR- By 2009, it is estimated that ten banks will have implemented the IRB Approach in Basel II
	India	- Reserve Bank of India plans to, at a minimum, have all banks in India adopt the Standardized approach for credit risk and the Basic Indicator Approach for operational risk with effect from end of March 2007
	Indonesia	- Bank of Indonesia expects Indonesian banks to implement the Basel II Capital Accord by 2008 - Phase 1: In January 2008, all banks are to adopt the Standardised Approach for credit risk and Basic Indicator Approach for operational risk. Bank Negara Malaysia may allow banks to remain on Basel I if they intend to adopt the IRB Approach instead - Phase 2: By 2010, implementation of the IRB Approach is completed for banks that choose this approach. Banks on the Standardised Approach are not mandated to migrate to the IRB Approach
	Thailand	- Bank of Thailand intends to have banks adopt Basel II in full by 2009- By end of 2007, local banks will be required to be ready for Basel II compliance testing and implementation
	Sri Lanka	- All the banks are expected to calculate all the market risks by the end of 2005 - During 2006, parallel capital adequacy calculations will be made under Basel II as well as Basel II - In 2007, All the banks are expected to fully comply with Basel II capital adequacy calculations
	Nepal	- By 2010, all banks are required to fully comply with three pillars of Basel II

Conclusion

The New Capital Accord (Basel II) encourages banks to assume a new role as information intermediaries, a role in which they collect and analyse customer-related data making use of systematic risk appraisal and classification processes and tools. Customers who can supply such information may choose to bypass a bank and go straight to the capital markets to obtain capital. Indeed, Basel II provides incentives for banks to transfer credit risks through instruments such as asset-backed securities or credit derivatives, while retaining the customer relationship. However, Basel II also affects financial institutions that do not have to comply with it. Such non-banks or near banks may not have to fulfill its potentially extensive disclosure requirements or make investments in managing operational risk. But, Basel II will raise the standard for risk management across the global market, and such institutions will likely seek to enhance their risk management techniques by adopting those described by the New Accord. The end result could be improvements in the global market stability.

The greatest challenge to moving forward with the Accord is understanding the implications of operational risk. Boards of directors and senior management will be held more responsible and accountable for operations. They will have to sign off and be accountable for the integrity of their operational risk-management systems and processes. They need to ensure that they stand up to regulatory scrutiny and the transparency implied by the disclosure requirements.

On the other hand, for some businesses the capital charge will depend upon operational risk measures for factors such as error rates, product complexity, asset risk, contract risk, volume risk, fraud, incompetence, information risk, programming errors, and control of the settlement process, among others. This presents a particular problem for large global groups, because the proposal requires a consistent global approach. Regulators will expect large institutions to meet various stipulations. If they do not, required capital reserves are likely to increase significantly.

Designed for developed banking applications, the straightforward application of the new regulations could lead to undesired consequences for economies like Nepal. There is no standardised accounting systems in the country, as well as it does not have enough tools for the diagnosis of excessive risk taking by small banks or cannot prevent manipulation of results via using incorrect data. The framework has shortcomings that may facilitate bank acquisitions and further credit squeeze for small borrowers.

Every economy has its specific conditions that have to be considered while setting standards and rules. Basel II, prepared for developed economies therefore is not going to be the only solution for the systematic problems of the Nepali financial system. If the presented regulations are to be applied then the supervisors in Nepal and similar countries have to take extra measures. For instance market discipline is a huge challenge to be addressed. One very important step is certainly decreasing the level of concentration that is a dominant characteristic of the Nepali financial system as well as other developing market economies. Decreasing customer loans, development of alternative loan products to small businesses and entering the mortgage market in order to benefit from the favorable capital requirements are some of the measures that can be considered. However, the most important determinant, the demand by retail borrowers is directly linked to the economic conditions and requires a healthy development and a fair distribution of wealth in the society. Without adopting the framework for Nepal, establishing the conditions for which these regulations are modeled, a step for strengthening the financial system may unexpectedly damage the banking sector seriously. Therefore without putting these measures in place for prevention of adverse impacts, it may not work as expected. Besides, treating it as a magic carpet that will take the financial system to safer lands is not realistic.

What is Basel II?

Basel Capital Accord II is an international agreement that sets minimum requirements for capital reserves held by creditor banks.It was drafted by the Basel Committee on Banking Supervision, comprises central bankers from the 13 biggest industrialised economies countries comprising G-10 countries plus Switzerland, China and Russia. The First Basel Accord had the objective of promoting world financial stability by coordinating supervisory definitions of capital, risk assessments, and standards for capital adequacy across countries and set the basis of a universal system of measurement of bank capital to the risk level of its activities, including various off-balance-sheet forms of risk exposure. But, it was restricted to measures of market risk and basic measures for credit risk. However, the Basel Committee believes that an improved capital adequacy framework is required to encourage a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities. So, the Basel Committee has revised the first Basel Accord, and has come up with what is known as Basel Capital Accord II (Basel II). The new Capital Accord (Basel II) prescribes calculation of capital requirements for protection of the banks from operational risk which could occur due to inadequate or incorrect internal processes, people or systems, or/and from external events.

Basel II introduces an array of sophisticated credit risk approaches and a new focus on operational risk. At the same time, by putting operational risk management on every bank’s agenda, it encourages a new focus on its management, and sound and comprehensive corporate governance practices. It is designed to be more flexible and risk-sensitive than its predecessor. It is set to improve the trustworthiness of the financial system by aligning capital adequacy assessment more closely with the fundamental risks in the banking industry. It provides a draft set of regulation that is to modify notably the way that banks are capitalised. Moreover, it will also provide incentives for banks to enhance their risk measurement and management capabilities. It will thereby augment market discipline.

Basel II addresses all these emerging issues, requiring banks to reserve capital to cover all risks. As per the Basel committee, the Basel II emphasises the objectives for:

	promoting safety and soundness in global financial markets;
	closer alignment of capital levels to actual risks in business;
	more competitive equality among institutions
	a more comprehensive approach to risks.

To achieve these objectives, Basel II is based on three mutually reinforcing pillars:

Pillar 1

Minimum capital requirements seek to ensure that financial institutions hold enough capital to cover their exposure to credit, market and operational risk.

Pillar 2

Supervisory review defines the process for supervisory review of an institution’s risk management framework and, ultimately, its capital adequacy and internal assessment process. It sets out specific oversight responsibilities for the board and senior management, thus reinforcing principles of internal control and other corporate governance practices established by regulatory bodies in various countries worldwide. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks such as liquidity risk, interest rate risk etc.

Pillar 3

Market discipline sets out a framework for public disclosures and tries to encourage safe and sound banking practices through effective disclosure. Effective disclosure is essential to ensure that market participants can better understand the banks’ risk profiles and the adequacy of their capital positions.

Core Principles for Effective Banking Supervision

The Basel Core Principles comprise 25 basic principles that need to be in place for a supervisory system to be effective. The Principles relate to:

	Objectives, autonomy, powers and resources
	CP 1 is divided into six parts:
-	more competitive equality among institutions
-	CP 1 is divided into six parts:
-	CP 1.1 deals with the definition of responsibilities and objectives for the supervisory agency;
-	CP 1.2 deals with, skills, resources and independence of the supervisory agency;
-	CP 1.3 deals with the legal framework;
-	CP 1.4 deals with enforcement powers;
-	CP 1.5 requires adequate legal protection for supervisors;
-	CP 1.6 deals with information sharing.
	Licensing and structure
	CP 2 deals with permissible activities of banks;
	CP 3 deals with licensing criteria and the licensing process;
	CP 4 requires supervisors to review, and have the power to reject, all significant transfers of ownership in banks;
	CP 5 requires supervisors to review major acquisitions and investments by banks.
	Prudential regulations and requirements
	CP 6 deals with minimum capital adequacy requirements. For internationally active banks, these must not be less stringent than those in the Basel Capital Accord;
	CP 7 deals with the granting and managing of loans and the making of investments;
	CP 8 sets the requirements for evaluating asset quality, and the adequacy of loan loss provisions and reserves;
	CP 9 sets rules to identify and limit concentrations of exposures to single borrowers or to groups of related borrowers;
	CP 10 sets rules for lending to connected or related parties;
	CP 11 requires banks to have policies to identify and manage country and transfer risks;
	CP 12 requires banks to have systems to measure, monitor and control market risks;
	CP 13 requires banks to have systems to measure, monitor and control all other material risks;
	CP 14 calls for banks to have adequate internal control systems;
	CP 15 sets out rules for the prevention of fraud and money laundering.
	Methods of ongoing supervision
	CP 16 defines the overall framework for on-site and off-site supervision;
	CP 17 requires supervisors to regularly contact the bank management and staff, and to fully understand the banks’ operations;
	CP 18 sets the requirements for off-site supervision;
	CP 19 requires supervisors to conduct on-site examinations, or to use external auditors for validation of supervisory information;
	CP 20 requires the conduct of consolidated supervision.
	Information requirements
	CP 21 requires banks to maintain adequate records reflecting the true condition of the bank, and to publish audited financial statements.
	Remedial measures and exit
	CP 22 requires the supervisor to have, and promptly apply, adequate remedial measures for banks when they do not meet prudential requirements, or are otherwise threatened.
	Cross-border banking
	CP 23 requires supervisors to apply global consolidated supervision over internationally active banks;
	CP 24 requires supervisors to establish contact and information exchange with other supervisors involved in international operations, such as host country authorities;
	CP 25 requires that local operations of foreign banks are conducted to standards similar to those required of local banks, and that the supervisor has the power to share information with the home country supervisory authority.