Basel II

Kevin Davis, Journal of Banking + Financial Services, June/July 2005

The author discusses the driving forces behind the new Basel Accord, its inherent risks and benefits, and sets out the view that even smaller economies (such as New Zealand) need to take note of the underlying developments.

Key messages

This article explains that Basel II was driven by the considerable growth in the activities of large international banks in highly developed financial markets, and advances in risk management practices.

It is one method for national regulators to ensure that such practices are improved, although the author expresses the view that "for many economies, Basel II may, at this stage, involve too large a step to be taken in the near future". However, the broad objectives of Basel II may be able to be achieved in other ways.

According to the article, the pace of developments behind Basel II, including new financial instruments and advances in technology, is a critical consideration for bankers. In particular, banks that are able to adopt the most modern risk-identification techniques will be at the forefront of efficient pricing and product development (leaving behind their competitors).

However, the expense of the most sophisticated risk management systems will be prohibitive for smaller players. Unfortunately, this also means that the incentive of lower capital charges available to banks that are able to achieve the status of an internal ratings based (IRB) bank(1) under Basel II will not be feasible for many smaller banks or for banks in smaller economies.

Inherent risks

Mr Davis contends that the principal risks of Basel II are:

1. its effect on the relative competitive position of banks (for instance, the lower capital charges available to IRB banks may be significant, and IRB-based pricing may allow IRB banks to operate more effectively in certain markets than banks using the standardised model);
   
   
2. an increase in compliance costs (especially in order to achieve IRB status);
   
   
3. the potential that, if its standardised risk weighting schedules for different types of customers are not correct, the availability and cost of funds for those customers are distorted; and
   
   
4. possible "pro-cyclical macroeconomic effects", e.g. the situation where banks' customer ratings decline in a recession and capital charges are therefore increased with the result that banks cut back on new lending, which in turn aggravates the economic downturn.

He also notes that the particular attention paid by Basel II to securitisation risks will be of interest to APEC countries.

However, the article goes on to say that these risks do not mean that Basel II should not be welcomed in the Australia-Pacific area, just that "there is much to be done in assessing how the new Basel Accord needs to be implemented in the region to achieve the benefits of a more risk-sensitive capital-based supervisory process". In particular, attention should be paid to:

1. developing risk management skills and capacity within the banking sector (potentially involving challenging cultural changes);
   
   
2. Pillar Two of Basel II, which emphasises an effective supervisory process (e.g. the ability to require banks to hold capital buffers above minimum requirements, the ability to intervene early, the ability to assess bank management capacity and governance requirements) - this article points to the various different approaches currently adopted by countries in the APEC region; and
   
   
3. Pillar Three of Basel II (market discipline), including information disclosure and other checks and balances designed to protect stakeholder interests - Mr Davis believes that there is significant scope for institutional changes to be made to increase the ability of "at risk" stakeholders to monitor and influence bank behaviour.

The article's conclusion is that, while work continues to implement Basel II, it is important to remember that the ultimate objective is a safer and more efficient financial system, rather than simply the adoption of a new model for banking supervision.

(1) Under Basel II, IRB banks are able to determine customer ratings internally, as opposed to non-IRB banks that use standardised customer risk weighting schedules

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