T H E N EW BASEL CAPIT AL ACCO RD
REPLY O F T H E EU RO PEAN CEN T RAL BAN K T O
T H E T H IRD CO N SU LT AT IVE PRO PO SALS (CP3)
O n 29 Apr il 2003 the Basel C ommittee on Banking Super vision (BC BS) issued its thir d consultative pr oposals (C P3) on the N ew Basel C apital Accor d asking for comments fr om all inter ested par ties by 31 July 2003. T his note, which benefited fr om comments pr ovided by the Banking Super vision C ommittee, contains the contr ibution of the Eur opean C entr al Bank (EC B) on the matter .
In line with its pr evious contr ibutions,1 the
EC B remains very supportive of the work being
under taken by the BC BS and reiterates its
endorsem ent of the gener al thr ust of the pr oposed fr amewor k. In gener al, the EC B notes that the thir d consultative pr oposals mar k significant pr ogr ess r elative to the
pr evious pr oposals of the BC BS. T he improvements include, inter alia, the flattening of the r isk weight cur ves for inter nal r atings based (IRB) appr oaches, the tr eatment under Pillar II for banks using the IRB appr oach to addr ess pr o-cyclicality concer ns, the tr eatment of banks’ exposur es to small and medium-sized enter pr ises (SMEs) and r etail exposur es, and the r evised pr oposals for operational risk for banks or banking systems experiencing high credit margins.
T his note is or ganised in two par ts. T he fir st part contains remarks of a general nature mainly fr om the viewpoint of financial stability, while the second addr esses specific technical issues.
General remarks
T he gener al comments ar e divided into thr ee par ts. Fir st, issues war r anting consider ation when finalising the N ew Accor d. Second, issues war r anting enhanced monitor ing in the fir st phase of implementation of the new fr amewor k. T hir d, suggestions for topics r elated to the N ew Accor d on which the BC BS could wor k in the futur e.
(I)
Issues warranting consideration
when finalising the N ew Accord
First, the EC B considers it to be of the utmost impor tance that the cur r ent schedule for finalisation and implementation of the N ew Accor d be str ictly followed. A timely finalisation by the end of this year would maintain confidence in the N ew Accor d and the cr edibility of the pr ocess. In addition, once agr eed upon and published, the N ew Accor d should not be subject to major r evisions until at least the implementation of the r ules, envisaged at the end of 2006. T his is consistent with the prudent policy followed by the BC BS so far and will also allow banks
to develop their investment plans and r isk management pr ocedur es in view of the implementation of the N ew Accor d.
Second, the EC B welcomes the pr oposals to tackle the potential pr o-cyclical effects of the new capital adequacy r egime. In addition to the flattening of the r isk weight cur ve, the pr oposed intr oduction of str ess tests and the development of capital buffer s above the minimum capital r equir ements within Pillar II ar e steps in the r ight dir ection. T he EC B has suppor ted the need for consider ing the potential pr o-cyclical impact of the N ew Accor d since the ear ly stages of the BC BS’s proposals.2 In this context, the EC B and other
eur o ar ea centr al banks have consistently contr ibuted to the super visor y debate by complementing the discussion with a
1 The ECB provided comments on the first and second consultative proposals released by the BCBS in June 1 9 9 9 and M arch 2 0 0 1 respectively.
macr oeconomic dimension to super visor y tools and pr actices. C oncer ns about pr o-cyclicality of the N ew Accor d might be incr eased in an envir onment of deeper economic and financial integr ation since vulner abilities and cycle swings could become mor e synchr onised. H owever , the EC B also r ealises that pr o-cyclical effects cannot be r educed at the cost of a major misalignment between r egulator y and economic capital and of a loss of integrity and “signalling power” in inter nal r isk-management systems. W ith r egar d to the latter , the EC B under stands that one of the major innovations of the new r ules is to pr ovide r egulator s with a new information tool through IRB systems. Against this backgr ound, the EC B sees mer it in str engthening possible steps to alleviate the potential pr o-cyclical impact of the N ew Accor d. Mor e specifically:
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T he cur r ent text concer ning thesupervisory review of stress tests for banks under the IRB approach (paragraph 724) could be impr oved. In par ticular , the super visor y r eview of banks’ str ess tests would appear to be optional under the pr oposed wor ding, which states that “super visor s may wish to r eview how the str ess test has been car r ied out”. A fir mer statement that “super visor s should r eview how the str ess tests have been car r ied out”, namely when r eviewing lar ge systemically r elevant banks, would thus be welcomed. T his is also consistent with the agr eement r eached in the BC BS on 10 July 2002. In par ticular , the public r elease on the afor ementioned agr eement states in the section on str ess testing that “banks and super visor s will use the r esults of the IRB str ess tests as a means of ensur ing that banks hold a sufficient capital buffer under the IRB appr oach”. T he EC B consider s the super visor y r eview of pr ofound impor tance for ensur ing a prudent application of this requirement.
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T he EC B continues to support thebuilding-up of additional financial buffer s3 in
favour able economic times which can be used in less favour able economic
conditions when, inter alia, equity financing may be mor e difficult to obtain on the markets. T he counter-cyclical effect of such methods could be acknowledged by making an explicit r efer ence to them in the text of Pillar II.
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T her e could be cases in which super visor smight r equir e banks opting for the standardised approach to hold additional buffer s against pr o-cyclical fluctuations. T he risk weights currently proposed under the standardised approach may render the capital r equir ements mor e sensitive to cyclical conditions. O ne “extr eme case scenar io” can be r epr esented by the example of a bank with highly concentrated exposur es to cor por ate cr edits, wher e a
downgrade by one notch4 from A- to BBB+
would lead to a doubling of capital r equir ements. It may be ar gued that such cases would be limited in that inter nationally active and other impor tant domestic banks would opt for the IRB appr oach or would hold diver sified por tfolios.
T hir d, the EC B takes the view that some impr ovements could be still intr oduced in r elation to the cor r ect incentives for banks to opt for mor e sophisticated appr oaches. In the ar ea of cr edit r isk, as the T hir d Q uantitative Impact Study (Q IS 3) r esults indicate, the incentive str uctur e has been significantly impr oved r elative to the second consultative pr oposals thanks to the r ecalibr ation of the IRB appr oach and the r evision of the r isk weights. H owever , in the case of lower quality cr edits, it is envisaged that the capital r equir ements calculated accor ding to the standar dised appr oach will be substantially lower vis-à-vis the IRB appr oach and, pr esumably, this gap is likely to incr ease as the cr edit quality decr eases. T his might cr eate incentives for banks with a higher r isk loan por tfolio to adopt the
3 One way of building such buffers is through the expanded use by banks and supervisors of pro-active provisioning methods such as “dynamic provisioning”.
standar dised appr oach. T his ar gument is r einfor ced by the mor e beneficial capital impact for the G 10 inter national banks under the IRB appr oach ver sus the standar dised approach, according to the last Q IS 3 survey.5
T his issue might be addr essed, for instance, by r equir ing additional capital r equir ements for those banks whose capital is not commensur ate with their r isk pr ofile. Also in the field of oper ational r isk ther e still seems to be scope for improvements in the incentive str uctur e, in par ticular in the calibr ation of the basic indicator and the standar dised appr oach (see also the specific r emar ks below).
Finally, two issues r elating to the common implementation of the N ew Accor d, effectively to ensur e a level playing-field on a global scale. Fir st, ther e is the need to ensur e a har monised implementation of the new fr amewor k in G 10 countr ies. For example, the U S author ities have made clear that they intend to apply the new r ules only to the lar gest, inter nationally active commer cial banks and will r equir e them to use only the advanced methodologies for cr edit and oper ational r isk. In this r espect, in case the U nited States does not pr ovide for the implementation of less advanced appr oaches, the tr eatment of EU banks oper ating in the U nited States via subsidiar ies should be fur ther clar ified. Although mor e r ecently the U S author ities have demonstr ated a positive attitude towar ds exploiting options for resolving implementation issues for foreign
banks oper ating in the U nited States,6 this
flexibility has not been r eflected in the Advance N otice of Pr oposed Rulemaking (AN PR) released in July 2003 for consultation by the U S author ities. It is expected that some options for resolving implementation issues for for eign banks oper ating in the U nited States will be intr oduced in the final r ules. Second, ther e is the br eadth of implementation of the N ew Accor d in non-G 10 countries. If the N ew Accord is intended to remain as an international standard for capital adequacy ar ound the wor ld, it is cr ucial that the new fr amewor k, and especially the simpler appr oaches of the
consultative pr oposals, enjoys the suppor t of the vast major ity of non-G 10 super visor s as well as of the Inter national Monetar y Fund (IMF) and the W orld Bank.7 In this r egar d, it
may be deemed appr opr iate for non-G 10 countr ies to extend the implementation of Basel II for developing countr ies beyond the end of 2006. H owever , possible delays in the implementation of Pillar I r ules should not pr event super visor s in these countr ies fr om implementing key components of the super visor y r eview (Pillar II) and mar ket discipline (Pillar III). In addition, thor ough implementation guidance developed by the BC BS for non-G 10 countr ies, to be endor sed by the IMF and W or ld Bank, would be an efficient tool in facilitating the tr ansition of these countr ies to the N ew Accor d.
(II) Issues warranting attention in the
implementation phase
T he N ew Accor d is a complex fr amewor k in compar ison with the cur r ent one. A full under standing of all its possible implications will be possible only some time after implementation. For this r eason, close monitor ing of the application of the new r egime will be impor tant. In this r egar d, four issues can be highlighted.
Fir st, in dr awing up the agr eement, the emphasis has been r ightly placed on the implications of the N ew Accor d for r isk management and financial stability. T he N ew Accor d, however , is also set to have impor tant str uctur al implications for banks and banking systems thr ough changing bank behaviour . T he ver y diver se effects on capital
5 QIS 3 – overview of global results, Table 1 on world-wide results – overall percentage change in capital requirements. 6 See, for example, “Basel II – scope of application in the U nited
States”, a speech given by M r. Roger W . Ferguson Jr., Vice Chairman of the Board of Governors of the U S Federal Reserve System, before the Institute of International Bankers in N ew York on 1 0 June 2 0 0 3 . In the speech it is stated that “the U S supervisors are prepared to explore the possibility of allowing U S subsidiaries of foreign banks to use conservative estimates of LGD and EAD for a finite transitional period”.
r equir ements for individual banks tr igger ed by the N ew Accor d8 ar e likely to influence
their business strategies through, for example, mergers and acquisitions, a reallocation of their loan books (e.g. thr ough cr edit r isk tr ansfer s or a r estr uctur ing of existing tr ansactions), an incr eased specialisation on pr oducts and/or counter par ties with a par ticular r isk pr ofile and a r estr uctur ing of r etail banking activities in the for m of revolving exposures. T hese structural changes will also have to be monitor ed closely fr om a centr al bank per spective.
Second, pr o-cyclicality concer ns could be par ticular ly r elevant in the fir st phase of the implementation of the new fr amewor k when banks ar e adjusting to the new setting9. T his
may r equir e closer monitor ing by centr al banks and super visor y author ities so that potential pr oblems can be detected and addr essed in a timely fashion. Enhanced cor por ate gover nance by banks will also be an impor tant complement to the activities of public author ities in ensur ing a smooth tr ansition to the new r egime.
T hir d, in the ar ea of r eal estate lending the EC B has no objection to the new and mor e flexible tr eatment pr oposed under both the standar dised and IRB appr oaches. H owever , it cautions that the extended r ecognition of r eal estate collater al should not lead to excessive r eal estate lending and an over heating of pr oper ty mar kets. T his entails a need for pr udent valuation by banks to pr event incr eases in cr edit availability fr om fuelling asset pr ice bubbles for r esidential and commer cial pr oper ties.
Four th, in the ar ea of cr edit car ds, the pr oposed r eduction in r egulator y capital is significant and, for some banks at least, will deter mine a level of r egulator y capital well below the economic one. U nder these circumstances, it is emphasised that excessive lending to r etail customer s via cr edit car ds, especially in per iods of booming economic activity, may lead to undesir able macr oeconomic effects, such as incr eased consumer spending and increased household
debt. In addition, the par ticular ly low capital r equir ements for r evolving r etail exposur es relative to similar types of unsecured personal consumer loans may have str uctur al implications as banks could be induced to str uctur e r etail banking in the for m of revolving exposures.10 T his may hold tr ue in
par ticular in EU countr ies wher e unsecur ed consumer loans and other similar types of exposur es ar e widely used in addition to cr edit car ds. An expansion of the latter type of cr edit could have implications for banks’ r isk management as the mix of their r isks could change (note the r elative impor tance of oper ational r isk for cr edit car d based exposur es). Also, the low loss r ates and subdued volatility for cr edit car ds seem to be a char acter istic of the mor e matur e U S market. All the above elements suggest a need for enhanced vigilance and close co-operation between centr al banks and super visor y author ities in the implementation phase.
(III) Future work on issues related to the
N ew Accord
T he r evision of the capital adequacy r egime, put for war d by the BC BS, has focused on impr oving r isk measur ement. In or der to maintain the effectiveness of the over all appr oach in the long r un, it will be necessar y for the BC BS to initiate wor k at some stage on other r elated issues. W ith a view to contr ibuting to the definition of the futur e wor k pr ogr amme of the BC BS, the EC B sees pr ior ities in the following ar eas:
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Accounting and provisioning. T he pursuitof greater consistency in accounting and
8 On the basis of the QIS 3 , the impact of the IRB approach on individual banks varies significantly from a 4 6 % increase in capital requirements to a 3 6 % decrease.
9 For the calibration of absolute capital requirements for the N ew Accord a full business cycle should preferably be taken into account. N otwithstanding the fact that the current state of development in banks’ rating systems would not technically allow the pursuit of capital requirements from a full business cycle perspective, it cannot be disregarded that the capital requirements that resulted from the QIS 3 were affected by the “point-in-time” ratings that tend to prevail in many banks’ internal ratings assessments, and thus by the particular phase of the economic cycle.
pr ovisioning r ules acr oss countr ies has become an increasingly important goal in the context of a r isk sensitive capital fr amewor k. G r eater consistency will promote competitive equality, allow better cr oss-bor der compar isons, r educe the r epor ting bur den and r einfor ce the effectiveness of Pillar III. In this context, it would be of inter est to fur ther align International Accounting Standards (IAS) with Basel II. T he EC B ther efor e suppor ts the initiatives being under taken by the BC BS to co-oper ate with accounting standar d setter s, namely the Inter national Accounting Standar ds Boar d (IASB), to ensure that supervisory concerns are taken into due consider ation in the shaping of the new standar ds and that ther e will be no need for diver gent accounting and r egulator y standar ds. For the latter , common standards for aspects such as the definition of default and the assessment of impaired assets are of primary importance in or der to r educe the r epor ting bur den of banks and to ensur e consistency between accounting and risk management pr ocedur es.
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D efinition of own funds. T her e is r oom for fur ther har monisation of the definition of own funds, especially for innovative capital eligible as T ier 1 or T ier 2, and for gr eater consistency in cur r ent super visor ypr actices for accepting instr uments with step-ups.
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Supervisory practices. T he new frameworkentails incr eased emphasis on super visor y conver gence in or der to assur e a “level playing field” between individual banks and banking systems. In the EU , wor k on conver gence has gained momentum in the context of the new institutional setting following a political agr eement r eached at the C ouncil of Finance M inister s in D ecember 2002 to extend the so-called “Lamfalussy framework”, which is already in place in the secur ities field, to other financial sector s. In the EU banking sector , wor k on the conver gence of super visor y pr actices has alr eady been set in motion by the G r oupe de C ontact (G dC ) and is anticipated to be a major r esponsibility of the for thcoming Eur opean C ommittee of Banking Super visor s (EC BS). At the G 10 level, conver gence effor ts ar e being made via the Accor d Implementation G r oup (AIG ). G iven that, at this junctur e, the mandate of the AIG is mainly confined to the exchange of information among supervisors, merit is seen in encouraging the AIG to intensify its efforts in pursuing a coherent cross-border implementation of the N ew Accord. This effort would, of course, have a positive impact on the corresponding work carried out in the EU context.
Specific remarks
T his section contains comments on mor e technical aspects of the proposals to be taken into account mainly with a view to the finalisation of the N ew Accor d.
Scope of application
T he pr oposed deduction of investments, namely 50% from Tier 1 and 50% from Tier 2, should be clar ified in the final pr oposals by, for instance including an example in an annex, as is the case with T ier 1 limits in Annex 1 of the C P3. Mor e specifically, it
should be made clear whether the pr oposed deduction should follow the cur r ent r ules (i.e. the deduction should take place after the calculation of T ier 1 and T ier 2 components of capital) or should be applied before arriving at the final figur es.
Standardised approach
the sover eign of incor por ation denominated in domestic cur r ency and funded in that cur r ency, is not subject to any limitations. T his leaves ample scope for national discr etion. Accor dingly, the cur r ent br oad-br ush r ules on claims on sover eigns denominated in domestic cur r ency r emain unaffected and the element of cr edit r isk for domestic funded exposur es is completely disr egar ded. A mor e str ingent tr eatment at least for low cr edit quality sover eigns may encour age pr udent lending policies by banks to the sover eigns in question. In this context, it should be noted that the EC B pur sues a policy of equal treatment of public and private issuers in its own operations.
W ith r egar d to claims on multilater al development banks (M D Bs), the EC B suppor ts the mor e flexible dr afting of the second eligibility cr iter ion and the under lying ar gument that the cr iter ion of r elying on shar eholder s’ cr editwor thiness to r epay liabilities becomes less r elevant when ther e is no lever age. H owever , as the evaluation of MD Bs will continue to be made on a case-by-case basis by the BC BS, it may be pr efer able to list in the text11 (par agr aph 33) the MD Bs
cur r ently eligible for a 0% r isk weight, as in the case of claims on international institutions (paragraph 30). More generally, an update of the list of MD Bs eligible for a 0% r isk weight, together with the eligibility cr iter ia, would be a more workable and practical solution than the cur r ent exhaustive r efer ence to the eligibility cr iter ia to be applied by the BC BS.
Regar ding the tr eatment of claims on banks, the need to r emedy possible implications of the existence of the two options r equir es enhanced co-oper ation. Indeed, the fr eedom which jur isdictions have to choose between the two options to claims on banks contained in the standar dised appr oach could have undesir able consequences. For example, an unrated or poorly rated bank operating in a G 10 jurisdiction which adopts O ption 1 could benefit fr om a lower r isk weight than a highly r ated bank in a jur isdiction, which adopts O ption 2. Super visor y co-oper ation could ther efor e play an impor tant r ole in ensur ing
a level playing field in cases wher e differ ent jur isdictions adopt differ ent options.
T he eligibility cr iter ia for exter nal cr edit assessment institutions (EC AIs) could be fur ther str engthened, making the r equir ements mor e binding, while specific consider ations may need to be taken into account when consider ing the str uctur e of the highly concentr ated r ating business. T he inter est of the EC B in this matter der ives not only fr om the fact that it follows its own policy with r egar d to the eligibility of collateral for monetary policy operations and of investments for asset management oper ations, but also fr om its r ole in maintaining financial stability. Fir st, the EC B believes that the assessment of new EC AIs should be done in a pr udent fashion, taking into account the fact that some elements that may affect the assessment pr ocess, such as r evenues and mar ket shar e, may be valid for the existing inter national EC AIs but could cr eate potential bar r ier s to the entr y of new players. For new players, less emphasis should be placed on market coverage and more on cr iter ia r elating to the r obustness and soundness of the assessment methodology and r ating pr ocedur e. In addition, for these player s, ex-post accur acy and validity of r atings cannot be fully assessed due to the lack of sufficiently long data ser ies (a r igor ous and meaningful validation pr ocess would require many years of historical data). Second, in the after math of r ecent financial events, the following issues may r equir e fur ther r eflection in the context of the r ules on eligibility cr iter ia (par agr aph 61):
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T he assessment of the EC AI’sindependence in r espect of cor por ate gover nance issues may need to be mor e specific, namely by making explicit r efer ence to the need to pr ohibit the staff and directors of rating agencies from being member s of the gover ning bodies or super visor y bodies of r ated fir ms.
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Rating agencies should implement procedures to manage potential conflicts of interest that arise, such as from ancillary fee-based business and dir ect contacts between analysts and subscr iber s.W ith r egar d to the implementation of the mapping pr ocess (Annex 2) under the standar dised appr oach, the pr oposed thr ee-year cumulative default r ate (C D R) benchmar ks appear to be too gener ous. T her e is a need for fur ther clar ification of the distr ibution assumptions made in the Monte C arlo simulations performed to derive the pr oposed tr igger levels. Exper ience of r ecor ded long-r un aver age C D R fr om inter national r ating agencies implies that levels should be lower than the ones pr oposed. H owever , it is acknowledged that the pr oposals ar e intended to pr ovide guidance to super visor s and not additional eligibility cr iter ia for EC AIs.
Credit risk mitigation
T he inclusion of non-r ated debt secur ities as eligible financial collater al r equir es mar ket liquidity. In this context, the r equir ement set for th in par agr aph 116 (d), which focuses on supervisors having sufficient confidence about mar ket liquidity, could be changed and made consistent with par agr aph 96, which emphasises the liquidation pr oper ties of the assets and the liquidation pr ocedur es.
O n the pr oposed standar d super visor y haircuts (paragraph 122), the risk of collateral could be better r eflected in the distr ibution of r esidual matur ities by using mor e than thr ee buckets. T his is especially tr ue for the bucket for matur ities exceeding 5 year s in which collater al with ver y diver se matur ities ar e lumped together . In this r egar d, it would be desir able to divide the matur ity bucket into two buckets, one for matur ities between 5 and 10 year s and another for r esidual maturities of more than 10 years.
G uidance on the cr iter ia for classifying tr ansactions as (i) r epo-style, (ii) other
capital-mar ket dr iven tr ansactions or (iii) secur ed lending would pr omote consistent implementation of the definition of holding periods (paragraph 137). W ith regard to the minimum holding per iods r equir ed for calculating own estimates of hair cuts (par agr aphs 128 and 138) with a daily mar k to mar ket valuation or with daily r emar gining of the collater al, it is not clear why the minimum holding per iod is dependent on the tr ansaction type (i.e. r epo, other capital transaction or secured lending). T he minimum holding per iod should be independent of the tr ansaction type and, instead, be dependent on the liquidation char acter istics of the collater al involved (i.e. the time r equir ed to sell the collater al in an or der ly fashion in the mar ket).
Finally, the r efer ence to “r easonable steps” that banks should take to ensur e that the custodian segr egates the collater al fr om its own assets (par agr aph 97) should be either clar ified or , pr efer ably, deleted, in which case the par agr aph would simply r equir e banks to ensur e that the custodian segr egates the collater al fr om its own assets.
Internal ratings based approach
ascer tain the r elative significance of the exposur e. Fur ther mor e, the data used in or der to deter mine the banks’ own estimates (Pr obability of D efault, Loss G iven D efault and Exposur e At D efault) may be r elevant at the gr oup level but not at the local level. H ence, it may be useful to ensur e the r elevance of the char acter istics of the own estimates by imposing the condition that banks’ own estimates used locally should r eflect local char acter istics.
T her e seems to be an imbalance between the exhaustive but necessar y list of minimum r equir ements that banks should comply with in or der to be eligible for the IRB appr oach (par agr aphs 349 to 500) and the assessment and action to be taken in cases of non-compliance. W ith r egar d to the latter , only ver y gener al r efer ences to situations that might lead to super visor y action, using phr ases such as “not in complete compliance”, “timely r etur n to compliance plan” and “duration of non-compliance”, are found in a single paragraph (paragraph 355). M or e guidance on these issues would pr omote consistent implementation. Alter natively, the AIG should addr ess these issues.
T her e ar e some elements of the pr oposals that make sense fr om a functional point of view to ensur e that banks’ pr actices ar e pr oper ly taken into account when laying down the r ules on compliance with minimum requirements. H owever, these elements need enhanced monitoring to ensure a level playing field and a pr udent outcome when estimating capital char ges. Against this backgr ound, the permission for banks to use human judgement to cor r ect the r ating outcome of cr edit scor ing models (par agr aph 379) or to over r ide the outputs of the r ating pr ocess (par agr aph 390) is welcomed as a potential means to impr ove the over all pr ocess. In this context, a r efer ence would be welcomed to the need for a per iodic r eview by inter nal and/or exter nal auditor s of the pr actices of banks wher e human judgement has been allowed to over r ide the r ating gener ated by the model. In addition, banks should be r eady
to demonstr ate pr udent use of human judgement in their models’ r atings whenever requested to do so by supervisory authorities or in the context of per iodic r eviews.
T he time hor izon used in pr obability of default (PD ) estimations is set at one year (par agr aph 376). A r efer ence to the fact that the BC BS will monitor developments in r isk modelling and banking pr actice with r espect to the assessment horizon would be desirable. A sentence could be added in the text stating that the BC BS may r evisit its r equir ements on the assessment hor izon. T his would also put the afor ementioned r efer ences to pr udent PD valuations into context.
T he use of str ess tests (par agr aphs 396 to 399) is welcomed as a step towar ds ensur ing capital adequacy under adver se economic, mar ket and liquidity conditions. T he EC B would suppor t a r efer ence to the fact that, in addition to the alr eady mentioned follow up at the national level (par agr aph 399), the BC BS will monitor developments in the field of str ess tests and may come up with mor e concr ete guidance, if r equir ed. In the same vein, an explicit r efer ence to the r esults of str ess tests could be made in the context of the inter nal r ating r epor ting to senior management (paragraphs 401 and 402, section on corporate governance and oversight).
T he pr oposed tr eatment of specialised lending and its five sub-classes (par agr aphs 187 to 196, 218 to 220 and 244 to 253), although detailed, seems to leave open issues such as the assessment of r estr uctur ing by banks in distr essed situations, which may in tur n have level playing field implications as the r isk weights of the “weak” and “default” categor ies differ significantly (350% ver sus 625%, r espectively, for all sub-classes).
sense fr om a functional point of view. H owever , a default by a bor r ower on one obligation may in pr actice also signal defaults on other obligations acr oss the banking gr oup. T hus it is pr oposed that ther e be an explicit r efer ence to r ecognise the fact that banks will be allowed to make their own assessments and that super visor s will r eview them.
T he tr eatment of pr eviously defaulted exposures as non-defaulted and their possible subsequent r eclassification as second defaulted exposures (paragraph 419) could be complemented by a r efer ence to the need for pr udent inter nal pr ocedur es by banks, including r eviews by the inter nal or exter nal auditor s and their ability to demonstr ate pr udent tr eatment to their super visor s. In the same vein, the r e-ageing of facilities and gr anting of extensions, defer r als, r enewals and r ewr ites to existing accounts (par agr aph 420) may r equir e guidance fr om the BC BS with a view to pr omoting consistency in banks’ practices.12
W ith r egar d to the length of the under lying histor ical obser vation per iod (i.e. 5 year s), it is stated that, if the available obser vation per iod spans a longer per iod, the latter must be used (par agr aph 425). H owever , it is not clear that long ser ies of histor ical data would always be mor e appr opr iate because of changes in the por tfolio base, r ating methodologies or economic cir cumstances. A bank should not have to give equal impor tance to histor ical data if it is possible to demonstr ate that r ecent data ar e mor e useful for the estimation of r isk par ameter s.
O n the mitigating effect of guar antees (wher e own estimates of LG D ar e used) two options ar e given, an adjustment of the PD estimate or an adjustment of the LG D estimate (par agr aph 442). It is not clear why the adjustment should concer n the PD , or the bor r ower ’s specific r isk. T he adjustment should be confined to the LG D , which takes into account tr ansaction-specific r isks. T his would also make the adjustment consistent with paragraphs 359 and 393.
T he r ule stating that a bank cannot assign an adjusted PD or LG D to the guar anteed exposur e if the adjusted r isk weight would be lower than that of a compar able dir ect exposure to the guarantor (paragraph 444) may be over ly str ingent. A pr udent move towards a more risk-sensitive approach could be consider ed in this context, based on fur ther r esear ch on the r isk mitigation of “double default”.
T he wide r ecognition of types of eligible
guar antor s13 which is unlimited for banks
under the advanced IRB approach (paragraph 445), including the r ecognition of conditional guar antees (par agr aph 446), may war r ant attention, given the fact that the application of the “w” factor , which may in pr actice limit the number of potential guar antor s other than financial institutions, is no longer found under Pillar I. An undue pr olifer ation of guar antees pr ovided by non-banks, and especially by non-r egulated entities which ar e not subject to capital r equir ements, may r equir e close monitor ing, as it may have an adver se impact on the level playing field and could give r ise to r eputational r isks concer ning the pr ovision of guar antees in gener al. T he EC B would welcome close monitor ing by the BC BS of the possible implications of such wide r ecognition of guar antees by non-r egulated entities and a possible futur e r eview of the pr oposals. T he intr oduction of limitations may also be seen fr om a point of view of over all consistency, as the pr ovision of insur ance as a mitigant for oper ational r isk is limited to insur ance pr ovider s (which alr eady ar e r egulated financial institutions) with minimum cr edit rating of “A” or equivalent.
W ith r egar d to the r ecognition of other physical collater al, it is stated that each
1 2 The current text (paragraph 4 2 0 ) makes reference to the fact that some national supervisory authorities that may issue specific requirements.
super visor should deter mine whether or not collater al meets cer tain standar ds, such as the existence of well-established liquid mar kets and publicly available mar ket pr ices (paragraph 484). Although supervisors are in a pr ivileged position to assess the liquidity of mar kets, this may not always be feasible given the natur e of some types of collater al (e.g. inventor ies such as r aw mater ials, goods, etc.). Accordingly, a reference could be added that banks should utilise available infor mation fr om other competent bodies and author ities and should be able to demonstr ate to their super visor s that their analysis is based on a pr udent evaluation of such infor mation.
W ith r egar d to the super visor y slotting cr iter ia for specialised lending (SL), banks ar e expected to map their inter nal r atings based on their own cr iter ia accor ding to five categories (paragraph 374). Annex 4 provides gener al assessment factor s for each sub-class of SL exposur e. W ith a view to pr omoting a level playing field, fur ther guidance on the way this mapping should be per for med seems to be war r anted for two r easons. Fir st, ther e is the complexity of the mapping pr ocess, as the pr oposed tables with super visor y r ating gr ades intr oduce numer ous indicator s (e.g. 18 indicator s for object finance) that ar e to be classified accor ding to four assessment categories, namely strong, good, satisfactory, and weak. Second, ther e is the gener alised natur e of some of the elements against which the assessment is to be per for med. For example, in the case of object finance exposur es, the differ ence between satisfactor y and fair mitigation instr uments for assessing the political and legal envir onment or between satisfactor y and fair insurance coverage for assessing insurance against damages may r equir e fur ther clar ification.
U nder the foundation IRB appr oach, the pr oposed cr edit conver sion factor (C C F) for commitments is set at 75% r egar dless of the matur ity of the under lying facility (par agr aph 281). T his compar es with C C Fs under the standardised approach of 20% or 50% for commitments with or iginal matur ities of up
to one year or mor e than one year r espectively (par agr aph 56). By contr ast, a consistent tr eatment for shor t-ter m self-liquidating tr ade letter s of cr edit is pr oposed under both appr oaches (par agr aphs 58 and 284). T he r easons, if any, for applying lower C C Fs for commitments under the standar dised appr oach than under the IRB approach, should be explained.
T he use of the word “may” in paragraph 216 is misleading. It should be made clear that banks that use the advanced IRB appr oach “must” pr ovide own estimates of PD , LG D and EAD . Although the heading of paragraph 208 r eads “definition”, the ter ms “r etail r eceivable” and “cor por ate r eceivable” ar e not in fact defined in par agr aphs 209 and 210.
Securitisation
T he EC B acknowledges the substantial pr ogr ess that has been achieved in the ar ea of secur itisation in par ticular , although some issues may war r ant fur ther consider ation. W ith r espect to the incentive str uctur e, the proposed framework does not always yield the desir ed r esults. For example, low r ated tr anches (i.e. BB and BB-) attr act a substantially lower capital char ge under the standar dised appr oach than under the IRB
appr oach.14 T his uneven r elation between
capital char ge and degr ee of r isk sensitivity is even mor e pr onounced when the pr oposed simplified standar dised appr oach (Annex 9) is used in the assessment. Adver se incentives may therefore prevail and high risk exposures may be taken on thr ough innovative and complex instr uments by banks that have r elatively less sophisticated r isk management systems. T his ar gument is r einfor ced by the fact that securities markets offer a much more flexible platfor m to r eact to such incentives when compar ed to the gener al choice of the appr oach to adopt (i.e. the IRB ver sus the standar dised appr oach), which may be mor e of a str ategic decision. C ases wher e the
capital char ge is not commensur ate with the r isk sensitivity and sophistication may need to be r evisited in or der to ensur e that the appr opr iate incentive str uctur e is in place.
T he pr oposed r ules on secur itisation have become ver y detailed. T his is due par tly to the need to establish a compr ehensive fr amewor k as well as the complexity of secur itisation tr ansactions. In this context, the complexity of these r ules could be r educed by r elying less heavily on income and expenses stemming fr om assets, namely “excess spread”, as defined in paragraph 512, and “futur e mar gin income” (FMI), as defined in par agr aph 203. W ithin the fr amewor k of secur itisation, FMI shall be deducted fr om T ier 1 capital (par agr aph 523) and is explicitly excluded from calculating a “cap” (paragraph 554), which sets upper limits for capital char ges. In contr ast, the tr eatment of qualifying r evolving r etail exposur es allows FM I to effectively cover 75% of expected losses (par agr aph 300). In addition, the secur itisation fr amewor k intr oduces the notion of “excess spr ead”, which is r elevant for the cr edit conver sion factor (C C F) of specific r evolving secur itisation tr ansactions and those that include contr olled ear ly amor tisation pr ovisions. Although the impor tance of futur e income and expenses in a compr ehensive assessment of r isk is, of cour se, acknowledged, ther e may be benefits in limiting the technical details when addr essing these aspects until a mor e compr ehensive and consistent tr eatment can be intr oduced that applies to all exposur e classes.
T he pr oposals for a capital tr eatment of secur itisation tr ansactions ar e closely linked to those on cr edit r isk mitigation (C RM ) techniques and this is welcomed as such linkages tend to enhance the consistency of the overall framework. H owever, in individual cases, such cr oss-r efer ences may r equir e fur ther consider ation. W ithin the fr amewor k of securitisation, paragraph 544 refers to “the standar dised appr oach for C RM ” for a definition of the eligible r ange of collater al in a secur itisation tr ansaction. T his could be
under stood to mean that equities and bonds of the originating bank or claims against firms that for m par t of the secur itised asset pool would also be acceptable. H owever , a narrower recognition of collateral may be justified. T he value of collater al might be questioned in par ticular in tr ansactions that use claims against a given company both as collater al and as an under lying asset. In another context, the wording in paragraph 517 (c) concer ning eligible guar antor s for synthetic secur itisations r efer s to par agr aph 142 and appear s to mean that the downgr ade of a financial institution (e.g. an insur ance company) to “single A” would r ender void any pr otection that is pr ovided. T his could entail substantial changes to the capital requirements of banks whenever an insurance company is downgr aded. At the same time, banks may have limited scope to r eact if the pr otection seller cannot be for ced to pass on the exposure to an eligible guarantor.
U nder the IRB appr oach a bank would be per mitted to take into consider ation possible over laps fr om duplicated cover age given the pr ovision of sever al types of facilities, and to hold capital only once for the position cover ed by the over lapping facilities (par agr aph 602). Similar flexibility should be provided for under the standardised approach and for overlapping exposures.
O perational risk
T he incentive str uctur e associated with the calibr ation of the capital r equir ements for the basic indicator and the standar dised appr oach could be impr oved. Although the basic indicator and the standardised approach r epr esent pr ogr essive appr oaches within the r ange of the pr oposed tr eatments, which is also r einfor ced by the fact that eligibility cr iter ia ar e, quite r ightly, not used in the basic indicator approach,15 ther e ar e no
built-in capital built-incentives sbuilt-ince both appr oaches have been calibr ated to lead to r oughly the
same capital charge (12% of current minimum capital). T hus, incentives may only stem fr om the types of activity a bank under takes, as the betas of the standar dised appr oach r ange between 12% and 18%, depending on the business line, compar ed with an alpha of 15% proposed for the basic indicator approach. T he lack of incentives may lead to capital arbitrage and opportunities for cherry picking. Banks with higher r isk pr ofiles engaged in activities for which a higher beta is pr ovided will be induced to opt for the basic indicator appr oach, wher eas banks with lower r isk pr ofiles will be induced to opt for the standar dised appr oach. T he latter may be desir able in the case of small banks concentr ated in low oper ational r isk activities, such as r etail banking. H owever , unless they fulfil the qualifying cr iter ia for the standar dised appr oach, banks with low oper ational r isk pr ofiles will be obliged to apply the basic indicator appr oach. T his may become a fur ther obstacle to ensur ing that banks of higher r isk ar e confr onted with a higher capital char ge. Fr om a longer -ter m per spective, the EC B would ther efor e support further work on calibration to ensure that the appr opr iate incentives exist for choosing between the basic indicator and the standar dised appr oach, especially in view of the fact that the latter appr oach is expected to be used mor e widely in the EU than in other G 10 countr ies. In the shor t r un, anomalies der iving fr om the pr oposed incentive structure should be dealt with under Pillar II. T o this end, the EC B would welcome the inser tion of a specific r efer ence to the need to be pr o-active in dealing with such cases in the final r ules text, by expanding the relevant paragraph on operational risk under Pillar II (paragraph 723).
The reference to internationally active banks with significant risk exposures (paragraph 610) should be modified16 to make it clear that these
banks will be expected to use more advanced approaches. The corresponding reference in the CP2, which states that “while the basic indicator approach might be suitable for smaller banks with a simple range of activities, the Committee expects internationally active banks to use a
more sophisticated approach”, could also be used in the CP3.
T he definition of gr oss income (as cur r ently proposed in paragraph 613) is incomplete and may leave room for misinterpretation and diver gent implementation. It should be made clear that gr oss income is to be calculated befor e the deduction of oper ating expenses (gener al administr ative expenses in the EU context). It is pr oposed that a r efer ence to the main sub-components of gr oss income, as can be found in earlier documents,17 should
also be made in the final N ew Accord. In this context, gr oss income is defined as net inter est income (inter est r eceived minus inter est paid) + net non-inter est income (compr ising (i) fees and commissions r eceivable less fees and commissions payable, (ii) the net r esult fr om financial oper ations, and (iii) other income). T his reference would, on one hand, ensur e consistency with definitions of gr oss income given in ear lier BC BS documents and, on the other hand, pr event possible diver gent implementations owing to the unintended lack of clar ity in the cur r ent definition. Similar ly, the definition of gr oss income in the simplified standar dised approach (Annex 9, paragraph 64) should also be amended. G uidance is needed on the calculation of gross income for operational r isk pur poses in specific cases, such as mer ger s and de-mer ger s or when gr oss income is negative (which may be the case for a specific business line such as tr ading).
T rading book issues
T he use by banks of mar king to model methodologies in or der to deter mine their trading book positions should, in addition to the cr iter ia set in par agr aph 653, be subject to r egular r eview by the inter nal and exter nal auditor s.
1 6 The current draft makes a vague reference to being “appropriate for the risk profile and sophistication of the institution”. 1 7 E.g.: Consultative proposals on operational risk as a supporting
Pillar II
A clear er r efer ence to the limits on cr edit r isk concentr ation that should be defined in r elation to the banks’ capital, total assets or , wher e adequate measur es exist, to its over all r isk level (par agr aph 733) would be welcomed. T he EU tr eatment of cr edit r isk exposur es, such as in lar ge exposur es, may pr ovide useful guidance to the BC BS in this field.
T he var ious issues under the super visor y r eview (Section C of Par t 3) ar e not addressed in a balanced way. N otwithstanding the impor tance of having detailed r ules, ther e seems to be excessive detail on secur itisation and related elements (such as the supervisory action for banks found to have pr ovided implicit suppor t). G iven the impor tance of the issue, the r elevant text could be str eamlined by including a r efer ence to a mor e detailed technical suppor ting document (as in the case of inter est r ate r isk).
Pillar III
T he EC B agr ees with the pr oposed fr equency of information disclosure on a semi-annual basis (par agr aph 767), while T ier 1 capital, total capital adequacy r atios and r isk exposur es pr one to r apid changes ar e to be r epor ted on a quar ter ly basis. H owever , a r efer ence to a timefr ame within which the BC BS expects banks to disclose this infor mation may pr omote conver gence in the timing of disclosur e r equir ements.
T he disclosur e of capital buffer s, deter mined either thr ough str ess-tests under the IRB appr oach or thr ough other methods, accompanied by quantitative infor mation, would, as a means to combat pr o-cyclicality, provide useful additional information not only fr om a financial stability per spective but also for individual investor s.
Q uantitative information about banks’ phased r oll-outs and par tial use of appr oaches in the context of cr edit r isk and oper ational r isk should be accompanied by qualitative infor mation on the timefr ame within which the bank expects to r oll out the mor e advanced appr oaches acr oss all mater ial entities and business lines.
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