Basel II: Vintage 2003

Journal of Financial Regulation and Compliance

Volumn 12, Issue 1, 2004, Pages 22-35

  Cornford, Andrew ^a  

^a United Nations Conference on Trade and Development   (Switzerland)

Author keywords

Bank capital; Basel committee on banking supervision; Credit risk; Internal controls; Risk weights; Supervisory review; Transparency

Indexed keywords

EID: 84993080106     PISSN: 13581988     EISSN: 17400279     Source Type: Journal    
DOI: 10.1108/13581980410810650     Document Type: Article

References (16)

1. See BCBS, A New Capital Adequacy Framework (Basel, 1999) and The New Basel Capital Accord (Basel, January 2001), which is accompanied by seven specialised supporting documents. For the author’s commentary on these documents see Cornford, A. (2000) ‘The Basel Committee’s proposals for revised capital standards:rationale, design and possible incidence’, G-24 Discussion Paper Series No. 3 (New York and Geneva:UNCTAD and Center for International Development Harvard University, May) and Cornford, A. (2001) ‘The Basel Committee’s proposals for revised capital standards:Mark 2 and the state of play’, UNCTAD Discussion Paper No. 156, September.
2. There are reports of many banks allocating 8-15 per cent of their budgets for information technology and operations to Basel II compliance. See ‘Basel II a new competitive landscape’, supplement to The Banker, October 2003, p. 4.
3. The USA is proposing to permit any bank meeting the requirements of Basel II’s most advanced approaches for credit and operational risk (discussed below) to follow Basel II. The expectation is that this will include about 20 institutions with about 99 per cent of the foreign assets held by US banks. See, for example, Ferguson, R. W. (2003) ‘Basel II-scope of application in the United States’, speech before the Institute of International Bankers, 10th June (reprinted in BIS Review 26/2003).
4. See editorial in the Financial Times, 15th September, 2003 and ‘Basel II 2007 deadline unlikely’, The Banker, September 2003.
5. As in the 1988 Basel Capital Accord, offbalance-sheet exposures are converted to on-balance-sheet equivalents by multiplication of nominal amounts by factors specified for different categories of such exposure.
6. In a total return swap the seller of risk/buyer of protection pays to the buyer of risk/seller of protection the cash flows of a reference asset (appreciations in capital value as well as coupon payments) in return for its cost of funding plus a sum to cover losses on the asset in response to a ‘credit event’ triggering them. In a credit default swap the buyer of risk receives a premium in return for the obligation to pay to the seller of risk a sum linked to losses due to a ‘credit event’.
7. For the purpose of estimating risk weights CP3 also distinguishes the separate category of ‘purchased receivables’. These are then classified as retail or corporate and, subject to certain adjustments reflecting the specific features of receivables, are assigned risk weights on the basis of the methods used for corporate and retail exposures under the IRBA.
8. The somewhat daunting formula for K in its algebraic form (before particular values are specified for its parameters) can be derived relatively simply from a model in which the asset value of a claim on a borrower (and thus the corresponding exposure) is a linear combination of a systemic factor affecting all borrowers and a factor depending on the borrower’s idiosyncratic risk, and in which default is triggered if this asset value hits a threshold. The parameter values for K and the expression giving the adjustment for maturity are set by the BCBS, presumably in consonance with certain benchmarks and on the basis of statistical evidence. For a lucid discussion of the derivation of the analogous formula in CP2 see Resti, A. (2002) ‘The New Basel Capital Accord: Structure, possible changes and micro-and macroeconomic effects’, CEPS Research Report No. 30, Centre for European Policy Studies, Brussels, September.
9. In Germany, a country whose SMEs provide about 70 per cent of employment and are highly dependent on bank financing, estimates of the effects of the IRBA in CP2 indicated that on average SMEs would incur an interest rate 1.5 per cent higher than larger firms. This led Chancellor Schrö der to declare that the New Basel Capital Accord would be unacceptable without major changes, and in mid-2001 an all-party motion passed by the Bundestag specified minimum conditions to be met by the Accord. These were directed not only at the cost of loan financing but also at flexible transition periods for the application of the IRBA, the broadening of the definition of eligible collateral and rules to ensure that the risk weights for equity holdings in the banking book were not excessive. In mid-2002 Schrö der declared that a compromise had been reached with changes sufficient for Germany to withdraw its objections. See Engelen, K. C. (2002) ‘Why Schrö der is ready to shoot down Basel II’, Central Banking, Vol. XII, No.3, February, and Imeson, M. (2002) ‘SMEs mind the financing gap’, The Banker, October. Under the standardised approach to credit risk the BCBS assigned a relatively low risk weight to unrated corporations precisely because of its concern to avoid an unwarranted increase in the cost of financing for SMEs. However, the German banking sector has been experiencing strong competitive pressures to adopt the IRBA.
10. Countries typically classify problem loans into a number of different categories such as substandard, doubtful and loss, each of which is linked to rules as to the corresponding amount of specific provisions to be set aside. Only loss loans are assigned an extremely low probability of collectability. But loans in other categories applied in several countries would be classified as in default under the definition of CP3. For variation in the classification of problem loans in some Asian countries and recent moves towards greater convergence see Golin, J. (2001) ‘The Bank Credit Analysis Handbook: A guide for analysts, bankers and investors’, John Wiley and Sons (Asia), Singapore, chapter 10.
11. National supervisors are permitted to opt for an alternative standardised approach which for the business lines, retail and commercial banking, would substitute a fixed factor times a three-year average of outstanding loans and advances.
12. See BCBS (1997) ‘Core principles for effective banking supervision’, Basel, September and BCBS (1999) ‘Core principles methodology’, Basel, October.
13. For a fuller account of the problems likely to be associated with assessment under IMF surveillance see Cornford (2001) Core principles for effective banking supervision (ref. 1), pp. 11-12.
14. A major difficulty here is that of defining the maturity of a bank’s total core deposits. In legal terms this is treated as very short or sometimes as subject to some conventional but arbitrary amortisation process but in practice is better classified as more or less unlimited outside periods of high financial uncertainty. Interest rate risk is typically managed and hedged as part of asset and liability management (ALM) which relies heavily on analysis of possible future scenarios for assets, liabilities and interest rates. Banks’ ALM is a subject suitable for supervisory review.
15. ‘Each issuer shall disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, … as the Commission [SEC] determines is necessary or useful for the protection of investors and in the public interest’ (sec 409, Real Time Issuer Disclosures).
16. See BCBS (1996) ‘Amendment to the Capital Accord to Incorporate Market Risks’, Basel, January.