Ba se l I I a t a Gla nce
I m pr ove d St a nda r d for Ca pit a l Ade qua cy
A bank provides an int erm ediat ion funct ion for funds received from cust om ers. Failure of a bank will result in widespread im pact affect ing ret ail and inst it ut ional cust om ers who hold funds at t he bank. This could t rigger m ult iplier im pact s on t he dom est ic and int ernat ional m arket . The im port ance of t he banking role dem ands proper regulat ion, in which t he prim ary obj ect ive is t o m aint ain cust om er confidence in t he banking syst em . An essent ial part of t he regulat ory fram ework for t he banking syst em involves t he regulat ions governing bank capit al, which funct ions as a buffer against losses.
I n view of t he im port ance of capit al t o banks, BI S issued a capit al fram ework concept m ore com m only known as t he 1988 accord ( Basel I ) . This syst em was designed as a fram ework for m easurem ent of credit risk and est ablished a m inim um capit al st andard at 8% . The Basel Com m it t ee designed Basel I as a sim ple st andard requiring banks t o disaggregat e t heir exposures int o broader cat egories reflect ing debt or sim ilarit ies. Exposures t o cust om ers of t he sam e t ype ( such as exposures t o all corporat e cust om ers) are subj ect t o t he sam e capit al requirem ent s wit hout t aking account of differences in loan repaym ent capacit y and specific risks associat ed wit h t he indi vidual cust om er.
More t han a decade lat er, prom pt ed by t he evolut ion of banking worldwide and t he realit y t hat t he best m et hod for calculat ing, m anaging and m it igat ing risks would be different from bank t o bank, t he Basel Com m it t ee em barked on t he init iat ive for revision of Accord 1988. The growing diversit y and sophist icat ion of product s in t he banking syst em led BI S t o int roduce im provem ent s t o t he capit al fram ework in t he 1988 accord wit h t he launching of a new capit al concept known as Basel I I . The first proposal was released in 1999 and was slat ed for im plem ent at ion at end- 2006. The revised capit al accord—Basel I I —is a com prehensive agreem ent t hat est ablishes a spect rum of m ore risk - sensit ive capit al allocat ion and incent ive for im provem ent s in t he qualit y of risk m anagem ent at banks. This was achieved by adj ust ing capit al requirem ent s t o credit risk and operat ional risk, and int roducing changes in calculat ion of capit al t o cover exposures t o risks of losses caused by operat ional failures. I n addit ion t o t he calculat ion of m inim um bank capit al, Basel I I also provides for a supervisory review process t o ensure t hat banks m aint ain a level of capit al com m ensurat e t o t heir risk profile and prom ot es m arket discipline t hrough disclosure requirem ent s.
The obj ect ive of Basel I I is t o st rengt hen t he securit y and soundness of t he financial syst em by reinforcing t he em phasis on risk - based calculat ion of capit al, t he supervisory review process and m arket discipline. The Basel I I Fram ew ork is based on a
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looking approach t hat enables im provem ent s and changes t o be m ade over t im e. I n t his way, t he Basel I I fram ework is able t o keep pace wit h changes in t he m arket place and developm ent s in risk m anagem ent .
At first glance, Basel I I involves various com plexit ies and precondit ions t hat are difficult for banks t o m eet . However, t he ext ra effort is well j ust ified in view of t he benefit s t o banks from m ore econom ic use of capit al in covering t heir risks. Banks also benefit from t he int ernat ional recognit ion of t he Basel I I st andards, which enables a bank int ending t o operat e globally t o be readily accept ed on t he int ernat ional m arket , provided t hat t hese st andards are m et .
M a x im isin g t h e Be n e fit s of Ba se l I I
Basel I I calculat es t he capital requirem ent according t o t he bank risk profile and cont ains incent ives for im provem ent in risk m anagem ent wit hin t he banking syst em . By using various approaches t o m easure credit risk, m arket risk and operat ional risk, t he result obt ained is m ore risk- sensit ive allocat ion of bank capit al. I n Basel I I , t he calculat ion of bank capit al is prescribed in Pillar 1 – t he Minim um Capit al Requirem ent . The alt ernat ive approaches can essent ially be aggregat ed int o t wo m aj or groups: t he st andardised m odels t hat apply t o all banks and t he m ore sophist icat ed int ernal m odels developed as appropriat e t o t he nat ure of business and risk profile of t he individual bank.
A com parison bet ween t he t wo m aj or approaches reveals t hat int ernal m odels can generally be expect ed t o generat e m ore precise capit al adequacy calculat ions appropriat e t o t he risks faced by t he bank. This will offer banks an incent ive t hat is expect ed t o prom ot e sust ained effort s t o build t he qualit y of risk m anagem ent . I n t his way, over t im e, banks will m axi m ise t he benefit of t he m ore sophist icat ed approaches in calculat ing t heir capit al requirem ent .
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I n assessing bank capit al adequacy, it is not only necessary t o allocat e capit al on t he basis of Pillar 1, but also capit al t o ant icipat e losses from ot her risks, such as liquidit y risk, st rat egic risk, int erest rat e risk in t he banking book and ot her risks. This approach is capt ured in Pillar 2, t he Supervisory Review Process, and is referred t o as t he I ndividual Capit al Adequacy Assessm ent Process ( I CAAP) . I t will pose an im port ant challenge for banks and supervisors. Building of supervisor com pet ence and capacit y will be essent ial, as also t he support of t he regulat ory fram ework for bank supervision. Wit h t im e, supervisors will becom e effect ive in t he assessm ent of risks ot her t han t hose covered in Pillar 1 and m ay even order banks t o add t o t heir capit al if bank capit al is deem ed inadequat e.
Furt herm ore, t he act ive public role in scrut iny of banks is seen as crucial. From t he beginning, t he public will also be expect ed t o assess bank risks and ascert ain t he level of capit al adequacy as envisaged in Pillar 3 – Market Discipline. The synergy of t he t hree Pillars in Basel I I is int egral t o building a sound and st able banking indust r y and financial syst em .
I m pa ct of Ba se l I I on t h e Re silie n ce of t h e Ba n k in g Syst e m
1 . W ill Ba se l I I ca u se ba n k CAR t o dr op be low t h e 8 % m in im u m ?
Bank I ndonesia is now working t oget her wit h a num ber of banks on a periodical st udy of quant it at ive im pact t o assess t he consequences of Basel I I on bank capit al. For t his reason, the im pact of Basel I I should be exam ined on an individual basis. I t is necessary t o perform assessm ent s and im prove t he effect iveness of risk m anagem ent from an early st age in order t o gain m axim um advant age from t he available incent ives. A drop in t he CAR could well occur for banks wit h a higher risk profile. However, banks whose credit port folios are dom inat ed by ret ail loans and hom e m ort gages will see a reduct ion in t heir capit al requirem ent because of t he lower risk weight ings t hat will apply t o ret ail loans and hom e m ort gages.
2 . W ill Ba se l I I be im ple m e n t e d for a ll com m e r cia l ba n k s?
The focus of Basel I I in I ndonesia is developm ent and im provem ent in risk m anagem ent wit hin t he nat ional banking syst em . This was set out in Bank I ndonesia Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003 concerning Applicat ion of Risk Managem ent for Com m ercial Banks. These m easures will apply t o all banks regardless of size, given t hat t he risk m anagem ent cult ure should becom e st andard pract ice in t he banking business. Survey shows t hat banks would prefer Basel I I t o be im plem ent ed across t he board. The m ain reason is t o m inim ise t he negat ive im pact on com pet it ion t hat would arise from different iat ions by abilit y and readiness of banks t o im plem ent and develop risk m anagem ent and t he associat ed infrast ruct ure. Furt herm ore, all banks in I ndonesia will be able t o apply t he st andard approaches in Basel I I .
3 . Cou ld Ba se l I I h a m pe r t h e in t e r m e dia t ion pr oce ss?
Basel I I is not int ended t o ham per t he int erm ediat ion process current ly in operat ion in t he banking syst em . At t he m acro level, it also does not seek t o reduce t he dom inant role of t he banking syst em in financing econom ic act ivit ies. The overall t hrust of t he approaches put forward in Basel I I is int ended m ore as an effort t o reposit ion and redefine what has been achieved by t he banking syst em , wit h focus on im proving risk m anagem ent .
sect ors ( e.g. because of t he use of rat ings in lending t o corporat e ent ities) , on t he ot her hand it will also encourage increased exposures t o ot her sect ors, such as ret ail lending ( e.g. sm all- scale business credit , personal loans and so on) and housing m ort gages t hrough reduced risk weight ings. I t is underst ood t hat t his shift in exposures will bring som e shock t o banks, debt ors and t he econom y as a whole. Even so, t his effect is not expect ed t o last long, and will be no m ore t han a fine t uning cust om ary t o any econom y.
4 . W h a t w ill be t h e im pa ct for ba n k s cu r r e n t ly w or k in g on r a isin g t h e ir ca pit a l for t h e im ple m e n t a t ion of t h e I n don e sia n Ba n k in g Ar ch it e ct u r e ?
Raising addit ional capit al for t he purposes of t he I ndonesian Banking Archit ect ure will not in it self provide t he m eans for a bank t o achieve full com pliance wit h Basel I I . However, an adequat e capit al base will enable a bank t o develop t he hum an resources and inform at ion t echnology capabilit ies essent ial for Basel I I . I n t his way, t he Rp 80 billion t ier 1 capit al requirem ent for com m ercial banks, t o be m et by t he end of 2007, and t he Rp 100 billion requirem ent for t he end of 2010 will not only expand t he econom y of scale in conduct ing operat ions, but also provide opport unit y for t he bank t o st rengt hen it s risk m anagem ent capabilit ies for im plem ent at ion of Basel I I .
5 . W ha t a r e t h e pr e r e qu isit e s for pr ope r im ple m e n t a t ion of Ba se l I I ?
Condit ions t hat m ust be sat isfied for proper im plem ent at ion of Basel I I include: - Applicat ion of risk m anagem ent pract ices in t he banking syst em as st ipulat ed
in Bank I ndonesia Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003 concerning Applicat ion of Risk Managem ent for Com m ercial Banks
- Adj ust m ent s in account ing st andards in keeping wit h int ernat ional account ing st andards ( I AS) , including but not lim it ed t o I AS 32 and I AS 39
- Consolidat ed calculat ion of bank capit al t o cover com panies in t he sam e group operat ing in t he financial sect or, wit h t he except ion of insurance com panies - Recognit ion of a rat ing agency t o enable obj ect ive rat ing of bank debt ors.
Roa dm a p for Ba se l I I in I ndone sia : W h a t Ba n k I n don e sia a n d t h e Ba n k in g Syst e m M ust D o t o Pr e pa r e
Basel I I st at es t hat each supervisory aut horit y m ust weigh priorit ies before adopt ing Basel I I . I n im plem ent ing Basel I I , Bank I ndonesia is essent ially seeking t o st rengt hen risk m anagem ent so t hat banks will becom e m ore resist ant t o dom est ic, regional and int ernat ional shocks. Bank I ndonesia has developed a realist ic form at t o be followed in t he im plem ent at ion of Basel I I t hat t akes account of t he current condit ion of t he banking indust ry. For t hi s reason, t he default m ode for im plem ent at ion will be t o t ake t he sim plest pat h, i.e. t he st andardised approach. This m eans t hat all banks will m ake adj ust m ent s t o t heir capit al adequacy calculat ions on t he basis of t he Basel I I guidelines. Basel I I also provides for nat ional discret ion, in which som e m at t ers are decided by t he local supervisory aut horit y. Judgem ent s can t herefore be m ade for t he condit ion of t he I ndonesian banking syst em and com plexit y of I ndonesia's banking product s.
Q2/2011
There have been widespread m isunderst andings am ong bankers t hat banks will be required t o adopt m ore advanced approaches dem anding heavier invest m ent in expensive I T and dat abases, a requirem ent t hat would obviously place banks under financial st rain. I n principle, banks are given flexibilit y t o adopt m ore advanced approaches, such as I RB, provided t hat t he necessary preparat ions in I T, hum an resources and syst em s are com plet e and t he bank risk profile offers assurance t hat t he use of a m ore advanced approach would offer benefit s for t he bank. I n t hese cases, banks m ay apply t o Bank I ndonesia for approval. The BI supervisors will validat e t he st at e of preparedness of t he bank before perm it t ing t he bank t o calculat e capit al adequacy using int ernal m odels. Bank I ndonesia is now providing special t raining t o bank supervisors who will becom e validat ors of m arket ri sk and validat ors of credit risk.
I m ple m e n t a t ion of Ba se l I I in Ot h e r Cou n t r ie s
I n cont rast t o t he G- 10 count ries, non G- 10 nat ions do not com e under any deadline for im plem ent at ion of Basel I I . This is consist ent wit h t he underlying nat ure of Basel I I , which does not const it ut e a legally binding docum ent im posing sanct ions on non -com plying count ries. Furt herm ore, assessm ent of a count ry’s financial sect or st abilit y will not be based on im plem ent at ion of Basel I I , but m ore on t hat count ry’s com pliance w it h t he 25 Basel Core Principles for Effect ive Banking Supervision ( BCP) . For t his purpose, I ndonesia has m ade st eady im provem ent s in com pliance wit h t he BCP in recent years.
I ndeed, t he sheer diversit y of preparat ions and policies m eans t hat each country will follow a unique pat h in im plem ent ing Basel I I . The condit ion, st ruct ure and business com plexit y of t he banking syst em and qualit y of bank supervision are t he m ain fact ors t hat will be t aken int o account in est ablishing t hese policies. I n t he Unit ed St at es, for exam ple, t he advanced I RB ( A- I RB) will be adopt ed by only t he 10 leading banking groups widely known for t heir int ernat ional operat ions. Ot her banks will apply a Basel I I form at known as Basel 1A.
