The entering into force of the New Basel Capital Accord (BIS II) is intended to promote a stable financial system through the adequate capitalization of institutions and a leveling out of the competitive playing field.
BIS II affords great importance to comprehensive risk management. Far from being a new formula for calculating regulatory capital (more in tune with the reality of the risks managed), the New Accord invests the institutions themselves with greater responsibilities, encouraging them to use the most advanced techniques in the management and control processes relating to all risks incurred.
Progress in risk management at an institution is a necessity. BIS II clearly indicates the strategic objectives to be accomplished, although the path to their achievement requires an increased effort by all areas involved at each organization.
Within this context, Management Solutions, an International Consultancy Services Firm, has considered it necessary to hold a Convention of experts on the matter to allow the sharing of its vision of the impacts of Basel II.
Organized from a regional perspective, the Convention was held last month in four venues: Mexico City, Sao Paulo, Santiago de Chile, and Buenos Aires. The opinions of national supervisors, the main (domestic and international) financial institutions and independent experts were heard in all of these, making it the one framework for sharing experiences on the Impacts of Basel II in terms of risk management at Financial Institutions.
The purpose of this document is to summarize the main matters addressed throughout the referred Convention, covering such aspects as the advantages posed by this new norm for management models, sharing current experiences in implementation processes, and analyzing how the role of the supervising authority will be modified.
The perception of risk has existed since the beginning of time. Mankind has always tried to cast away such perceptions by delegating or sharing risks. In 20 B.C., the Hammurabi Code in Babylonia already established the sharing of losses from (naval) working accidents and commercial losses. Later, with the Greek Rhodes law or the Roman Mutuum contract (mutual credit), some progress was achieved along these lines. In the first century, the bulk loan was established, whereby a ship owner received cash before the ship sailed and returned it upon its arrival at port, with interest, but such money would be kept if the ship did not arrive. These precedents have a characteristic in common: cash venture capital, equivalent to the maximum loss.
A key element for the progress in the theory of risk lies in probability. The origin of the wheel seems to be found in Babylonia (thirty-fifth century B.C.) and the roulette wheel along with it; dice initially showed up in Egypt (twenty-seventh century B.C.), with cards appearing later during the fifteenth century, all key elements in understanding the concept of probability. It is not until the sixteenth century that Pierre de Fermat and Blaise Pascal established the theory of probabilities during an exchange of letters, when assessing the price of the risk being assumed by a friend in common. During the seventeenth century, gambling houses implemented a fundamental advance in the theory of risk by introducing a distinction between Cash Capital and Gambling Capital (cash + probability): everyone must bet against the house and the house has no need to cover the sum of the capitals of the gamblers.
Pierre de Fermat and Blaise Pascal did not formalize the concept of economic capital. Its origin lies in insurance and, more specifically at Lloyds. During the seventeenth century, this institution was a famous tavern that brought in a fashionable beverage (coffee), and where its patrons, to quench their gambling fever, would bet on the success in the arrival of the coffee ships. The ship owners took advantage of this situation by betting against their own ships, to thus somehow insure the arrival of their cargo.
A few years later, after the London fire, Jacob Bernoulli established the law of large numbers: frequency tends asymptotically to probability when cases approach infinity (e.g. heads/tails).
Early in the eighteenth century, Abraham de Moivre established the Central Limit Theorem in 1734 and Daniel Bernoulli (nephew of Jacob), formulated the classic Theory of risk in 1738, introducing the concept of confidence level in normal distributions and proposing convolution processes.
Later, in the nineteenth century, Filip Lundberg simplified convolution and introduced the concepts of frequency and intensity (severity) in a compound Poisson variable.
Bruno de Finetti, now in the twentieth century, closed the circle by relating capital to price plus a safety coefficient (shared risk).
London goldsmiths of the seventeenth century introduced the concept of fractional reserve (liquidity risk) when lending part of the gold they kept and playing with the terms of the loans. This concept is later embraced by certain banks (the Riskbank of Sweden and the Bank of England). In parallel, Isaac Newton and Gottfried Leibnitz established differential calculations (the use of derivatives).
In the twentieth century, Frederick Mackaulay and Frank Redington introduced the concepts of duration and convexity, and along with these concepts, that of immunization: Immunization: Same Duration, Convexity of Assets > Convexity of Liabilities
Market and Credit
The origins of modern statistics lie in the nineteenth century, with the introduction of the concepts of correlation and regression between variables made by Francis Galton. Harry Markowitz and William Sharpe later established the theory of portfolios (assets immunized by other assets). In the twentieth century, Fisher Black, Myron Scholes and Robert Merton established the formula for the valuation of options (two equations with three unknowns) and introduce the concept of portfolio replication (setting up risk-asset portfolios that are risk free for a given period of time).
In the view of the foregoing, it would seem logical to think that there would be a need to establish certain minimum standards to ensure adequate capital levels in the financial system. In 1913, the Federal Reserve established certain minimum capital requirements. In 1930, the Bank for International Settlements is created in Basel. The capital accords known as BIS I and BIS II were developed under that framework
Basel II (BIS II)
The new Basel capital accord II (BIS II) seeks to strengthen the stability of financial systems through the adequate capitalization of institutions and a leveling out of the playing field.
BIS II is intended to replace the previous capital accord, BIS I, which was issued in 1988 and which, in general terms, established the requirement of maintaining a minimum capital equal to 8% of the overall risk assumed. This capital, called "regulatory" capital, seeks to ensure banks' solvency from potential losses due to credit, exchange and market risk not covered by provisions.
Without a doubt, BIS I has helped to strengthen the international standards for determining capital requirements. However, BIS II represents a significant qualitative leap from the previous standard by:
- Enabling the complete coverage of the risks currently faced by the financial industry.
- Incorporating risks not considered by BIS I.
- Establishing a method for capital calculation that is more sensitive to the aforementioned risks.
- Reducing the gap between regulatory and economic capital requirements.
Additionally, all of this has been done while preserving the principle of capital neutrality, i.e., preserving the current capitalization levels of the financial system.
What is BIS?
Its three pillars make BIS II an immensely valuable tool for improving our current management models:
The first pillar refers to a method for calculating the regulatory capital necessary to adequately cover credit risk, market risk and operational risk. Application of this pillar encourages the use of the most advanced risk measurement techniques. The new regulation allows for two calculation methods for measuring credit risk:
- The standardized approach.
- The IRB (Internal Ratings Based) approach, in the case of using internal rating/scoring data to obtain the risk parameters (PD, LGD, and EAD).
In terms of market risk, Pillar 1 does not add anything new to the 1996 Basel 1 Amendment. Therefore:
- The "standardized" approach is used.
- Subject to supervisor approval - "internal models" based on value-at-risk (VaR) may be used.
Finally, Pillar 1 includes the new concept of calculating own capital consumption relating to operational risk. This risk can be measured using:
- A "basic" or "standardized" approach such as a percentage of annual income.
- An internal (AMA) approach based on operational loss models.
The second pillar of BIS II deals with the new role granted to the market regulating bodies. It gives greater authority to supervisors while increasing the capacity of institutions with an “economic capital" model properly incorporating all their risks to assess their own capital adequacy.
Therefore, Pillar 2 promotes a more effective relationship model among all the different players with the use of assessment mechanisms that are better adapted to each financial institution’s capital requirements according to their individual risk profiles.
The third and final pillar seeks to enhance disclosure to third parties. Looking toward the market, Pillar 3 requires institutions to provide clear information on their risk profiles as well as the actions and controls implemented to mitigate the risks they assume.
The request for regulatory information is also adapted to the new self-assessment possibilities granted, to ensure proper system supervision.
Without a doubt, this enhanced transparency will enable institutions to leverage the good practices developed in the framework of comprehensive risk management, and strengthen the stability of their market links.
- In having a more dynamic, reliable and objective approach for making decisions on accepting or rejecting transactions.
- In being able to calculate the profitability of their transactions and portfolios based on the risk incurred (RAROC models) and to determine a reference price for transactions (pricing).
- In being able to more efficiently allocate capital.
- And even — in certain cases, and always subject to supervisor approval — in being able to generate regulatory capital savings and improve income.
Most important, however, BIS II enables institutions to be fully aware of the level and nature of certain risks that are not being measured in the most adequate manner today.
Now, implementing BIS II in an institution is not an easy task, and requires a veritable change in culture. In fact, in those countries where BIS II is binding, regulatory bodies are requiring institutions to truly integrate the model into their overall risk management and control structures.
Therefore, effectively achieving such an implementation implies an ambitious, large-scale effort and the active participation of senior management and the different areas and departments affected.
In general terms, it will require:
- Adaptation of internal organizational structures.
- Redesign of all risk management process.
- A serious effort to develop and implement mathematical models.
- A significant investment in information systems and risk management tools.
Objectives of the Regional Convention on the Impacts of BIS II
In this context, Management Solutions has considered it convenient to gather a select group of specialists to share their vision on the impact of Basel II from their perspective as regulators, global institutions, local banks and independent experts.