A guide to Basel II ?

new capital adequacy standards for

lenders
Last reviewed 30/03/2007 : any recent updates in this colour .

Introduction

In the late 1980s it was decided that, as banks were becoming increasingly international in their operations, there
was a need for a uniform regime to set minimum levels of capital that banks must hold across the developed
countries. An international regime was deemed necessary to ensure that a level playing field operated and that
banks had adequate capital to ensure their soundness and thereby protect the global financial system and their
depositors. The Bank for International Settlements, based in Basel in Switzerland, was the body charged with
establishing a framework for setting a minimum level of capital each bank should have to hold.

It was decided that this minimum level of capital would be determined with regard to the riskiness of the assets banks
held. Each asset on the balance sheet of a bank was given a weighting between 0% and 100%, where 0%
represented the safest assets such as sovereign bonds and 100% the riskiest exposures such as corporate debt
and unsecured personal loans. Loans secured on residential property were given a 50% risk weighting. Banks would
be required to hold tier 1 capital of at least 4% of risk weighted assets (RWA) and total capital of at least 8%. Tier 1
capital is the purest form of capital, comprised of shareholders funds and preference shares. Total capital also
comprises capital/debt hybrids such as subordinated debt (which counts as capital because it is at risk before
deposits and other bonds).

By the late 1990s, banks had become much more sophisticated in their operations and risk management and were
increasingly able to find ways to reduce a bank's risk weighted assets in ways that did not reflect lower real risk
(what has become known as regulatory capital arbitrage). It was therefore decided that a new capital standard was
required and work began on Basel II. The aim of Basel II is to better align the minimum capital required by regulators
(so-called regulatory capital) with risk. This inevitably requires a more complex regime, given that some of the
greatest anomalies in the first Basel Accord stemmed from its simplicity ? for example all unsecured corporate
exposures were weighted 100% whether the company was a highly profitable global giant or a struggling small
business.

But the outcome of the discussion on the form of Basel II is an Accord which is far more complex than Basel I and
goes far beyond Basel I is its scope.

Basel II came into effect in the European Union on 1 January 2007 under the Capital Requirements Directive (CRD)
and all lenders covered by the CRD will have to implement it from the beginning of 2008.

Structure of Basel II

Basel II consists of 3 'pillars' which enshrine the key principles of the new regime. Collectively, they go well beyond
the mechanistic calculation of minimum capital levels set by Basel I, allowing lenders to use their own models to
calculate regulatory capital while seeking to ensure that lenders establish a culture with risk management at the
heart of the organisation up to the highest managerial level.

Pillar 1 sets out the mechanism for calculating minimum regulatory capital. Under Basel I this calculation related only
to credit risk, with a calculation for market risk added in 1996. Basel II adds a further charge to allow for operational
risk.

Credit risk

While Basel I offered a single approach to calculating regulatory capital for credit risk, one of the greatest
innovations of Basel II is that it offers lenders a choice between:

1.The standardised approach. This follows Basel I by grouping exposures into a series of risk categories.
However, while previously each risk category carried a fixed risk weighting, under Basel II three of the categories
(loans to sovereigns, corporates and banks) have risk weights determined by the external credit ratings assigned to
the borrower. Amongst the other categories that continue to have fixed risk weights applied by Basel II, loans
secured on residential property will carry a risk weight of 35% against 50% previously, as long as the loan-to-value
(LTV) is up to 80%. This lower weighting is a recognition of the historically low rate of losses typically incurred on
residential mortgage loan portfolios across different countries and over a range of economic environments.

2. Foundation internal ratings based (IRB) approach . Lenders will be able to develop their own models to
determine their regulatory capital requirement using the IRB approach. Under the foundation IRB approach, lenders
will estimate a probability of default (PD) while the supervisor provides set values for loss given default (LGD),
exposure at default (EAD) and maturity of exposure (M). These values are plugged into the lender's appropriate risk
weight function to provide a risk weighting for each exposure or type of exposure.

3. Advanced IRB approach. Lenders with the most advanced risk management and risk modelling skills will be
able to move to the advanced IRB approach, under which the lender will estimate PD, LGD, EAD and M. In the case
of retail portfolios only estimates of PD, LGD and EAD are required and the approach is known as retail IRB.

Given that a key objective of Basel II is to improve risk management culture, it is unsurprising that the regime
encourages lenders to move towards the IRB approach and ultimately, the advanced or retail IRB approach. To this
end, it is expected that banks will see a modest release of regulatory capital in moving from the standardised to
foundation IRB approach and on to the advanced or retail IRB approach.

Operational risk

The Accord defines operational risk as 'the risk of loss resulting from inadequate or failed internal processes, people
and systems or from external events'. In keeping with the approach to credit risk, it provides three mechanisms for
computing operational risk of rising complexity to suit lenders' varying characteristics.

Pillar 2 is meant to identify risk factors not captured in Pillar 1, giving regulators discretion to adjust the regulatory
capital requirement against that calculated under Pillar 1. For most lenders, the Pillar 2 process is expected to result
in a higher regulatory capital requirement than calculated under Pillar 1. Pillar 2 requires banks to think about the
whole spectrum of risks they might face including those not captured at all in Pillar 1 such as interest rate risk.

Pillar 3 is designed to increase the transparency of lenders' risk profile by requiring them to give details of their risk
management and risk distributions. Information is likely to be released through the normal mandatory financial
statements lenders are required to publish or through lenders' websites.

Timetable

All lenders covered by the CRD will be required to have fully implemented Basel II from the beginning of 2008.

Implications of Basel II

There has been a considerable amount of debate concerning the potential impact of Basel II. Perhaps the most
obvious effect will be to alter the percentage return on regulatory capital by altering the denominator (the amount of
regulatory capital required). For residential mortgages, the release of regulatory capital under both the standardised
and retail IRB approaches should be considerable. Many commentators see this as the basis for significant changes
in industry pricing, which they believe could alter the competitive landscape and drive consolidation.

However, there are a number of reasons why the impact on market pricing might not be as dramatic as some
suppose:
Many of the largest financial institutions already set their pricing on the basis of economic rather than
regulatory capital. For them Basel II should not lead directly to a desire to reappraise their pricing.
Non-deposit taking lenders face different regulatory capital requirements under which they are required to
hold much lower levels of capital, so the introduction of Basel II should have no direct impact on their pricing.
The fact that non-deposit taking lenders have not come to dominate the lending industry is testament to the
competitive importance of factors other than capital (like access to a stable retail deposit base).
Lenders routinely hold capital well above the regulatory minimum. Even where the minimum level of
regulatory capital alters significantly, a lender may choose not to alter its actual capital profile in response.
Lenders hold capital for a number of reasons, such as to enhance their credit rating or allow for future
possible acquisitions, and not just to satisfy the regulator.
Lenders face a risk/reward trade-off: The higher their capital ratio, the lower the perceived risk, other things
being equal. This provides lenders with an incentive to hold more capital independent of the requirements of
the regulator.

The conclusion from the above must be that the impact of Basel II on pricing may not be particularly large, especially
in markets like mortgages served by a heterogeneous group of lenders including non-deposit taking institutions.
Therefore, this may not be much of a force driving industry consolidation.

The other possible drivers of mortgage market consolidation from Basel II that have been discussed are the cost of
compliance and the lower capital requirement of the retail IRB as opposed to the standardised approach. Here again
there is a risk of overstating the impact. The reason for a three tier approach to credit and operational risk is to allow
for the fact that smaller lenders are not going to be able to devote the same resources as the larger ones. And
although a move from standardised to retail IRB should see a reduction in regulatory capital for mortgage lenders,
the move to Basel II could see much larger changes driven by relative portfolio mix. As a result, the pressure that
Basel II will create for further consolidation may not be as great as some commentators claim.

The other area where Basel II will be felt is in firms' 'risk culture'. A key objective of the Accord is to promote a more
rigorous approach to risk management. It will require increasingly sophisticated risk management and greater senior
management engagement in issues relating to risk. The requirement for public disclosure outlined in Pillar 3 and the
expected regulatory capital relief for IRB banks against those on the standardised approach support this objective.

Summary

In summary, Basel II aims not only to align regulatory capital more closely with risk but to promote a more
sophisticated approach to risk management and to create a 'risk culture' inside lenders, whereby the organisation,
and senior management in particular, understand risk and remain alert to risk as a core issue. As lenders begin to
gear up for its introduction, they are discovering just how substantial a change the move to Basel II really is.