The main objectives of this new accord are to foment safety and soundness in the financial system, enhance the competitive quality of the banks, and include approaches to capital adequacy that are appropriately sensitive to the degree of risk involved in a bank’s position and activity. Although the new accord is primarily focused on internationally active banks, it will indirectly impact smaller, less complex institutions.
A major theme of the proposed accord addresses minimum capital requirements. Capital, defined as equity that provides a permanent source of revenue for shareholders and funding for the bank for further growth, ratios will remain at a minimum requirement of 8%. Capital is also used to bear risk and absorb losses; and it is used as an incentive that shareholders ensure that a bank is managed in a safe and sound manner.
For credit risk, a standardized approach building upon the 1988 accord and introducing the use of external credit assessments will be available for less complex banks. Banks with more advanced risk management capabilities can make use of internal ratings-based (IRB) approaches. Under this approach, key elements of credit risk such as the probability of default by the borrower, will be estimated internally by a bank. Allowing capital charges to be calculated based on internal risk ratings means that the use of internal ratings will not be restricted. Under the proposal, banks will be able to use a range of approaches, with increased sophistication and data quality potentially leading to lower capital charges. To be eligible to adopt an IRB approach, a bank will need to demonstrate that its internal rating system meets supervisory standards set by the Basel Committee.
In these cases, banks must have a rating that separately distinguishes borrower risk and transaction risk. Banks should have at least six grades for performing loans and two for problem loans, with a meaningful distribution of exposures across grades and no excessive concentration in any particular grade. Banks must have specific criteria for assigning borrowers a rating and documentation on how these criteria are established. Banks need to have robust systems in place to validate the accuracy and consistency of rating systems, processes and the quantification of internal ratings. And bank managers need to demonstrate that they themselves rely on these ratings for key internal processes and decisions.
The Basel committee is also proposing an explicit capital charge for operational risk. Varying degrees of sophistication in monitoring and controlling operational risk will be permitted. At the “basic indicator approach” level, the current proposal will require banks to hold capital equal to a fixed percentage of their gross income. This methodology is crude and simplistic and will only be used by the least sophisticated institutions. At a more sophisticated level, banks will need to track key risk indicators in seven predefined business lines and capital charges will be calculated based on these. The most complex option proposed (“the internal measurement approach”) allows banks more direct input into calculating the operational risk capital charge under each of the predefined business lines.
With respect to the overall level of capital, the committee’s primary goal is to deliver a more risk-sensitive methodology that on average neither raises nor lowers regulatory capital for banks, after including the new operational risk capital charge. Naturally, capital requirements may increase or decrease for an individual bank depending on its risk profile.
The Good and the Bad
Such changes could improve a Latin American bank’s risk management techniques. They would also foster equality within a very competitive environment. A bank will be obliged to maintain levels of capital in accordance to their risk appetite. However, smaller, less complex Latin American banks will have to comply with guidelines dictated by the regulatory body, which could become costly. Low-rated countries and borrowers in Latin America will be penalized as funding costs will increase and accessibility to bank financing will deteriorate as international banks will have to assign more capital (based on risk factor of 150%) to lend to these low-rated borrowers. Also, operational risk capital charges could be burdensome and will pose a readiness challenge to most institutions. Like the internal ratings, it is expected that banks will be able to choose from a range of approaches in calculating the capital charge for operational risk.
The Basel Committee expects that the operational risk charge would, on average, represent 20% of the minimum regulatory capital charge. Those institutions that have focused little attention on measuring operational risk in the past may find it very difficult to quickly establish systems and procedures necessary to avoid capital charges for operational risk calculated under the basic indicator approach.
The committee’s second proposed change encourages regulators to assess banks’ internal approaches to capital allocation and assessments of capital adequacy, and provide a means for supervisors to improve bank internal controls and risk management. Subject to the regulatory minimum, banks themselves will set appropriate internal capital targets to cover their particular risk profile. Supervisors will then be responsible for checking that the internal capital targets are suitable for the bank’s risk profile, and intervene at an early stage if capital levels become insufficient.
This proposal should positively affect Latin American banks by fostering cooperation with the regulatory body and could promote intervention by central banks at an early stage. However, smaller banks will have to rely on the regulatory body or third parties to fully understand and embrace these new changes, and the impact of these reforms depends on regulator discretion, which could introduce or reinforce competitive inequalities. It is clear that while some countries intend to apply the rules arising from this accord to all banks, others will apply them only to internationally active banks. This raises the prospect of an uneven playing field across different jurisdictions.
The Basel Committee is also proposing a much greater range of disclosure initiatives designed to make risk and capital positions of a bank more transparent. This will help promote transparency among Latin American banks, but may be cumbersome and costly for small and medium-sized banks. Greater disclosure could also involve the release of sensitive information. One factor that has not been addressed is the context of developing international accounting disclosure standards, nor has a distinction been made between disclosure to regulators and disclosure to the public.
The Basel Committee’s proposals are complex and will have far-reaching implications for Latin American banks’ capital requirements, risk management and financial disclosure. The complexity is likely to increase compliance costs, but the accord should be embraced since it rewards best banking practices. The accord emphasizes banks’ own assessment of risks in the calculation of regulatory capital. Capital incentives for the more advanced capital calculation methods are deliberately included and it is hoped this will motivate banks to continuously improve their risk management capabilities.