Volume 11 March, 2001 Number 2

The New Basel Capital Accord

Last month, the Basel Committee on Banking • The first pillar sets minimum capital requirements
Supervisions (‘BCBS’) issued a proposed revision to the for all supervised banks. It is the most direct
1988 Basel Capital Accord, commonly known as the BIS replacement for the current ‘BIS’ capital regulations.
capital rules. This New Accord represents the culmination The central requirement remains unchanged: banks
of a great deal of thoughtful work by the members of the must hold capital equal to 8% of Risk Weighted
BCBS, national banking supervisors, and the industry in Assets, of which at least half must qualify as Tier I
the 19 months since the first consultative paper was capital. The bulk of the Risk Weighted Assets remain
released in June 1999. It will significantly affect not just based on the credit risk of the bank’s assets;
the amount of capital that banks will be required to hold, however, there is now an explicit capital requirement
but the relationship of government supervisors to the for operating risk.
supervised institutions and the incentives in the financial
markets. Consistent with our impression of the earlier For credit risk, the New Accord introduces three
consultative paper, we view the New Accord as a major options for how banks can calculate their Risk
step (if not a giant leap) forward – which should Weighted Assets:
significantly improve the basis for international bank
capital regulation. – Standard Approach: For banks wishing to
minimise the impact of the New Accord, there is
a standard approach which works very much like
Three Pillars the current rules. In particular, most commercial
The central concept of the New Accord is that there are to lending will continue to have a 100% risk
be three separate pillars working together to ensure weighting. Some changes have been made to
capital adequacy. align the Risk Weightings more with market
economics, particularly for sovereigns, banks,
and publicly rated borrowers.

New
NewBasel
Basel Capital Accord
Capital Accord

1 Minimum Capital 2 Supervisory Review of 3 Market

Requirements Capital Adequacy Discipline

• Sets minimum acceptable capital • Based on 4 principles • Increased disclosure of capital

• Enhanced approach for credit – Banks must assess structure
risk tied to ratings solvency relative to their • Increased disclosure of risk
– Public ratings risk profile measurement and management
– Internal ratings – Supervisors should review practices
• Explicit treatment of Operational bank’s own assessments + • Increased disclosure of risk
(‘Event’) Risk capital strategies profile
– Still ‘under development’ – Banks should hold in • Increased disclosure of capital
excess of minimum level of adequacy
– Excludes ‘Business Risk’
capital
• ALM Risk not treated, but – Regulators will intervene at
included in Pillar 2 an early stage if capital
levels deteriorate

Copyright © 2001 Oliver, Wyman & Company

New York London Frankfurt Madrid Paris Toronto Singapore
L099-89-118 -1-
 – Internal Ratings Based (‘IRB’) Approach – riskier end of the quality spectrum. The result has
Foundation: Banks which have developed and been bad both for the safety and soundness of the
fully implemented a system for internally rating banking system, and for the optimal allocation of
borrowers may, with approval from their capital within the economy.
supervisor, use a formula which bases the risk
weighting on the default probability predicted by • Recognises the Advances in Risk Measurement
the internal rating. Technology

– Internal Ratings Based Approach – Advanced: Working with many of the G10’s leading banks,
Banks whose internal ratings systems Oliver, Wyman & Company has been at the forefront
incorporate a rigorous analysis of facility level of the development of sophisticated risk
risk factors, such as collateral, covenants, and measurement tools and internal economic capital
maturity, will be able to further adjust their risk frameworks. We are pleased to see that the New
weightings to take account of loss given default Accord proposes to make use of many of these tools
and exposure factors. and the concepts underlying economic capital. In
particular, rigorous credit rating is now deservedly at
• The second pillar calls for the supervisory review the heart of the capital requirements for credit risk.
of banks internal capital adequacy and planning. This We are also pleased to see that the Internal Ratings
serves to ensure that bank management is paying Based approach is built around the Default
appropriate attention to risks which may be neglected Probability X Loss Given Default X Exposure at
or understated by the Pillar I minimum capital Default framework we have advocated for over 10
requirements. It is also intended to encourage years.
supervisors to intervene early if a bank’s risks are
growing dangerously relative to its capital. • Provides Incentives for Continued Improvement in
Risk Measurement and Management
• Finally, the third pillar promotes the role of market
discipline on bank’s risk taking activity by greatly The three pillar approach found in the New Accord
increasing the public disclosure of risks. provides incentives for almost all banks to improve
their risk measurement in order to advance to the
Step in the Right Direction next level of sophistication and take advantage of the
more rational capital requirements. The strict
In our view, the New Accord is a major step in the right requirements for operational controls and reporting,
direction. It moves towards a regulatory capital regime necessary to apply the more advanced methods, will
that is truly risk-based, and attempts to reflect – insofar as also encourage banks to drive measures into day-to-
possible in a rules-based system broadly applicable to a day business practices.
large number of banks – the economic risks undertaken
by a financial institution. • Increases Role of the Market

The New Accord will help create appropriate incentives We believe that, generally, the financial markets can
for risk taking, risk management, risk mitigation and risk provide the most accurate, timely and bias-free
pricing. At the same time, it generally strikes a good assessment of risk and value. However, in the case
balance between a desire to advance the state of of large complex financial institutions, current
regulatory capital with an understanding of the practical disclosure practices provide the market with a very
limitations of current technology and the business opaque, rear-window view of risk-taking. Thus the
environment. need for government supervision. Nevertheless, the
New Accord, has an important section, in Pillar III,
We see five key areas in which the New Accord which recommends far reaching extensions to the
represents a significant improvement on the current state amount of risk information banks should publish.
of capital regulation: Years from now, increased market disclosure may
well be seen as the most significant change in the
• Removes the Worst Perverse Incentives of the Old 2001 Accord.
System
• Flexibility of Supervision
The existing capital regulations, due to their
simplicity, contain many arbitrary distinctions which Although we feel that the BCBS has done as good a
have led capital requirements for some activities to job as could be expected in setting minimum capital
differ greatly from the true, economic risks. An requirements, no set of rules, even running over 400
obvious example is lending to high-quality, pages, can capture every possible type of risk. Even
investment grade borrowers, for which the current if it could, the pace of innovation in today's financial
equity requirement far exceeds the true level of markets means that the rules would soon be
economically-implied capital. This has led banks to incomplete. That is why we think Pillar 2 of the New
reduce lending to the highest quality borrowers – and Accord – the supervisory review of banks’ internal
worse, to overlend (and underprice) – loans at the

Copyright © 2001 Oliver, Wyman & Company

New York London Frankfurt Madrid Paris Toronto Singapore
L099-89-118 -2-
 capital measurement – is also of considerable made to assess both the system-wide effect on bank
importance. While the rulebooks may be slow to capital and the effects on individual classes of
accommodate change, responsible banks must not institutions.
be.
• Complexity of Regulation Poses Challenges
Oliver, Wyman & Company also approves the BCBS’s
decision not to take several steps which have been The complexity of the Internal Ratings Based capital
suggested. These include: approaches will present even relatively sophisticated
banks with implementation challenges. As noted
• Adoption of internal credit portfolio models below, most banks will have to devote significant
resources to validating rating systems in order to be
• Mark-to-market accounting and risk measurement for eligible for either the foundation or advanced IRB
credit approaches.

• Full recognition of many credit risk mitigation tools • Preliminary Treatment of Consumer Credit Risk and
Operating Risk Treatment Require Further
• Reliance on capital market solutions Refinement

The current proposed approaches for consumer

While we support the development of these techniques, credit and operating risk are tentative. They will
we agree with the BCBS that they are not sufficiently require further development to accurately link
evolved at this time to serve as a foundation for a broadly- regulatory capital assignments to risks in the
applicable regulatory framework. To the extent that business. In particular, for retail credit risk the risk
particular applications are robust within individual weight function should be differentiated to reflect
institutions, we hope that supervisors will give them variations in risk – particularly, in diversification levels
appropriate credit in the Pillar II review. In the future, and correlation factors – across diverse consumer
these techniques should play an increasingly important credit portfolios globally.
role in internal risk management and capital setting.
• Disclosure Requirements
Unfinished Business
Although we support the principle of increased
While the proposed new Accord, with its Overview and
disclosure – and think that ultimately market
seven supporting documents, represents a great
discipline may have the greatest impact on bank
accomplishment, even more work is on the horizon. The
capital management – as a practical matter many of
documents frequently state where the BCBS is still
the specific information requirements proposed under
deliberating and soliciting input from the industry on the
Pillar III will necessitate significant internal IT and
details of the rules. Open areas include the definition of
MIS efforts. It is unclear that the external gain in
retail and project finance credits, the calibration of the IRB
market knowledge from each of the requirements
risk weight formulae, the role of maturity, and the
justifies the internal costs.
parameters for operating risk. We have already begun to
work with the BCBS, national supervisors, and others in
Banks Have A Lot of Work Ahead of Them
the industry on contributing our perspective on these
issues. Although the regulators still need to take care of the
unfinished business, the bulk of the effort required must
We also want to highlight a number of significant issues now come from the regulated banks. Bankers need to
and gaps in the proposal that should be considered in the examine their current practices and capabilities in regard
comment period. to each of the three pillars. They need to know:

• System-wide Capital Impact and Individual Financial • What they absolutely must do to meet the minimum
Institution Impact is Unclear reporting requirements

The stated desire of the BCBS is that there be no net • Whether they will be advantaged by using the more
impact on the system-wide level of capital held by the sophisticated options, and what is needed to qualify
banking industry. Yet given the complexity of the
regulations it is not yet clear if the proposed accord • How the New Accord will affect their competitors, and
achieves this objective. This is true not only at the thus the markets in which they do business
system-wide level but also for individual institutions.
The unspecified nature of some elements of the Even The Most Sophisticated Fall Short
framework (such as Operating Risk) and uncertainty
over how other elements (e.g. Pillar II) will be applied The most noticeable area where banks will need to work
in practice, make it difficult for individual banks to is on the IRB approach for credit risk. Banks whose
estimate the net impact of the proposals on their expected credit losses are less than the industry average
capital requirements. Significant efforts should be will benefit from reduced minimum capital requirements if

Copyright © 2001 Oliver, Wyman & Company

New York London Frankfurt Madrid Paris Toronto Singapore
L099-89-118 -3-
they are able to use internal ratings. Even if their overall which are either unrated, or which use a much less
capital requirements do not significantly change, banks rigorous approach.
may wish to use the internal ratings based approach for
the benefit of those business units that have low credit • Demonstrating sufficient historical data to validate
risk. We expect that most large banks will be using the internal ratings systems, and, in particular, the default
IRB approach, and that this will significantly affect the probabilities they assign to each rating.
more competitive markets, such as syndicated lending.
Banks not using IRB will find themselves at a • Improving Risk IT systems to be able to meet the
disadvantage, especially with the best borrowers. disclosure requirements, especially in relation to
collateral.
In order to take advantage of the more risk sensitive, and
possibly lower, capital minima allowed by the IRB, banks • More broadly, incorporating credit risk measures in a
will have to show that they have met quite strict bank-wide internal economic capital framework that
requirements. These cover the design of internal risk is sufficiently comprehensive and robust to satisfy
measures, the controls around the application of those Pillar II.
measures and the completeness of their implementation.
Banks will need to show empirical evidence to justify the These issues are all compounded for banks that wish to
calibration of their internal ratings systems. They need to take advantage of the advanced IRB approach. Although
show that these risk measures have not been adopted billed as the more sophisticated option, the impact of the
solely for setting regulatory capital, but are used by bank advanced approach will likely be greatest in some more
management in business decision making. Finally, they traditionally run businesses, such as middle market
will need IT systems capable of providing the regulatory lending. This is because the advanced approach allows
and public disclosures required. banks to receive recognition for their ability to reduce the
losses they experience once credits have already
Based on our experience working with many of the largest defaulted, an aspect of banking where conservatively run
financial institutions around the world, we think that even local banks are often better than their more aggressive
the most sophisticated institutions will have a lot of work rivals. Banks that make heavy use of commercial
to do to meet these requirements. The documents collateral (e.g. receivables, inventory and equipment)
released with the New Accord – and conversations with stand to see the greatest reductions in risk weights from
national supervisors – hint that the supervisors expect the advanced IRB approach.
large, international banks to meet the more advanced IRB
standards as soon as the Accord takes effect, likely in The IRB rules are only part of the changes in the New
2004. While most of these banks have well-developed Accord. Banks will also need to address the impact of,
internal ratings, bank management may still be surprised and their readiness for, other aspects including
at the gaps between their current capabilities and the operational risk, supervisory review, and disclosure
minimum requirements of the New Accord. Key areas reporting. Although the expected implementation date,
where even the most sophisticated banks may fall short 2004, may seem far off, the process of planning,
include: designing, piloting, validating, accepting, and fully
implementing a new risk system can easily take several
• Ensuring complete internal ratings coverage of the years from start to finish. Banks thus have little time to
credit portfolio. Many banks with sophisticated waste.
internal ratings systems will find they have pockets

Produced by:
Locations Telephone
New York: 99 Park Avenue, New York, NY 10016 (212) 541-8100
London: 1 Neal Street, Covent Garden, London WC2H 9QL 44 (20) 7333-8333
Frankfurt: Ruesterstrasse 1, 60325 Frankfurt 49 (69) 955-1200
Madrid: C/ Serrano 32-2E, 28001 Madrid 34 (91) 426 2700
Paris: 91, rue du Faubourg Saint Honoré, 75008 Paris 33 (1) 44.71.36.60
Toronto: 25 King Street West, Suite 1450, Toronto, Ontario M5L 1E2 (416) 360-4363
Singapore: 290 Orchard Road, #17-01 Paragon, Singapore 238859 (65) 838-5289

L099-89-118 -4-