Will Basel II work for consumers?

The Revised Framework became necessary as the banking system became more and more sophisticated in the 1990s.  The first framework (known as the Basel Accord) was agreed in 1988 and introduced capital requirements for banks in order to support the level of exposure to the customer default risks that they were running.  Over time, this first framework was felt to be lacking in sensitivity to the overall risks faced by a bank.  In 1996 the Market Risk Amendment was published which also required banks to hold capital against their exposure to risks arising from the fluctuations in the value of assets that they held, such as shares.  However, a rising tide of banks losses (e.g. BCCI, Barings) forced the Basel Committee to consider other risks to which banks are exposed and to enhance the credit risk part of the 1988 Accord.

The Revised Framework has been endorsed by the Central Bank Governors and Heads of Banking Supervision of the Group of 10 countries (actually 13 countries) and should therefore be a powerful force in developing banking supervision to common minimum standards around the world and in protecting the integrity of the international banking system.  Although the Basel Committee has no powers to actually make regulations, the endorsement mentioned above gives it considerable weight in the international world of banking.  The new framework contains many items that should lead to the consumer being better protected.  But will it work in practice?

While the earliest that parts of it will be implemented is 31 December 2006, the Revised Framework is already driving considerable effort and expenditure in the global banking community and generally in the financial services industry in the UK.  The financial services regulator for the UK (the Financial Services Authority) has chosen to interpret and implement the new framework in concept for all banks and investment companies, although the detail will vary depending on the type of organisation.

The Revised Framework contains three, so-called, pillars each of which will give more information to consumers, if they know where to look and how to interpret it.

The first pillar sets out (sometimes in considerable detail) how a bank should calculate the minimum capital it should hold against all the risks that it runs. 

The second pillar relates to the supervision and review of banks and includes principles of supervisory review, risk management guidance and supervisory transparency and accountability.  It is intended to encourage banks to develop and use risk management techniques in monitoring and managing their risks, such as improving internal controls and strengthening the level of provisions and reserves.

The third pillar is intended to encourage further market discipline in banking through the introduction of (generally) semi-annual public disclosures on, inter alia, the capital, risk exposures and risk assessment process of a bank.  However, some of the disclosures are only annual, whilst others are quarterly.

Pillar 1 gives the calculations required for the total minimum capital to be held by a bank for its market, credit and operational risks.  Many of these calculations can be extremely complex and, even within regulators, the most advanced methods are only understood by a few specialist staff.  Whilst the more intricate calculations are more sensitive to the risks bourn by a bank, they are impenetrable to even the most informed consumer and in general are unlikely to be available for public review.  This may be to the consumers’ benefit because the complex and unique mathematical models used by a bank may give a competitive advantage to that particular bank and therefore better pricing on a product for consumers.  The simple options for capital calculation are likely to be of little, if any, benefit to the consumer as they do not reflect the ‘riskiness’ of a bank and therefore give very little information on that bank.  However, under Pillar 3 there will be considerable data available (see Pillar 3 paragraph).

By contrast, Pillar 2 is concerned with supervisory transparency and accountability and therefore should be of significant interest to and more easily accessible by the consumer.  It is clear that the quality of the supervisory review is important and that the regulators in each country should be uniquely placed to properly and formally assess a bank’s approach to the risk that it takes on.  A central supervisor can encourage a bank, through moral suasion or through fines and other actions, to develop internal processes and to set capital targets that are commensurate with a bank’s risk profile and control needs.  The Basel Committee has identified four key principles of supervisory review:

• Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for monitoring their capital levels.

• Principle 2: Supervisors should review and evaluate a bank’s 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 particular bank and should require rapid remedial action if capital is not maintained and/or restored.

The principles are supported by considerable detail and should be welcomed as providing clear guidance for supervisors. However, only general criteria will be publicly available rather than specific information. The transparency to the consumer will therefore be very limited as there will only be clarity between the regulators and the bank concerned rather than the bank and its stakeholders.

Pillar 3 is specifically concerned with the public disclosure of information relevant to the particular bank and should therefore be of considerable benefit to the consumer.  Although the implementation of Pillar 3 is still a couple of years away, there is considerable detail available on what will be disclosed.  Unhappily, in some areas (for example credit risk, which is the exposure that a bank has to it not being paid back for money that it has lent)  there will be many pages of facts and consumers will have to work hard in order to ascertain which pieces of information are key.  Any consumer able to plough through the details will have to be both very capable in interpreting complex financial information and very motivated.  Generally, consumers will rely on financial analysts to perform a considerable amount of work for them.  Whilst this will be useful in some ways as the average consumer does not have the detailed knowledge necessary to interpret sometimes complex data, it will mean that many consumers will not be able to make decisions on which institutions to bank with from first-hand information and by themselves.

However, there will be at least one area where consumers will find accessible information.   This will be in disclosures relating to a bank’s view of its operational risk exposure.  (Operational risk is defined by the Basel Committee as the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events.  The Revised Framework has excluded strategic and reputational risk from the definition.)  Given that operational risk is relatively easy to understand (as we are all exposed to it every day in our lives) consumers will be particularly able to judge for themselves the ‘riskiness’ of a bank to this wide ranging risk.  It is the first time in banking regulation that there has been a focus on operational risk and it is to be welcomed as many banking failures in the past have been the direct result of an operational risk crystallising.

Although the boards of directors in banks are given considerable discretion in what they have to make public there are a number of prescribed areas in which reporting is required.  For operational risk, these relate to:

• the bank’s operational risk management objectives and policies, including:

• strategies and processes;
• the structure and organisation of the operational risk management function;
• the scope and nature of operational risk reporting and/or measurement systems;
• policies for mitigating operational risk and strategies and processes for monitoring the continuing effectiveness of mitigants;

• the approaches for operational risk capital assessment [Pillar 1 calculations] for which the bank qualifies;
• a description of the AMA [complex Pillar 1 calculation], if used by the bank;
• for banks using the AMA, a description of the use of insurance for the purpose of mitigating operational risk.

While the language used in the disclosures is expected to be somewhat technical, it is to be hoped that many banks will use the operational risk area to explain in ordinary language how they approach a topic that can be fundamental to all stakeholders in a bank. 

Overall, the Revised Framework will give consumers far more information than they have ever had on which to base their banking choice decision.  Some of this information will be complex but some has the capability of being accessible to all.  Banks have a golden opportunity to show that they are open and transparent to consumers.  But will they grasp the chance or hide behind technical obfuscation?

This article was published in Global Consumer Initiatives in January 2006.