A Head Start on Basel II

Ahead of the introduction of the International Convergence of Capital Measurement and Capital Standards, commonly known as Basel II, Chile’s banking industry and its regulatory authorities have been looking closely at the implications of the new recommendations. During that process, we have arrived at three main conclusions: that Chile is well-positioned to move into line with the new accord, that it can afford to do so at the pace that best suits its own interests, and finally, that it has a great deal to gain and little or nothing to lose from Basel II. 

On its own initiative, Chile is already treading a road that points in the direction of Basel II. It has, for example, introduced a new model of bank supervision that focuses on the quality of each bank’s risk-management policies, rather than on monitoring risk levels as such. This model – which includes not only credit risk, but also market and operational risk – is very much in line with the second of Basel II’s three pillars, which seeks to promote an effective supervisory review of banks’ internal assessments of their overall risks. 

Similarly, at the end of last year, Chile launched an initiative that will gradually align the industry’s accounting practices more closely with internationally accepted principles. At the same time, disclosure requirements on banks have been increased along lines similar to those suggested in Basel II’s third pillar, which refers to market discipline.

In January, Chile also launched a new system of credit risk classification and provisioning. By permitting greater flexibility, this gives the country’s banks more freedom to establish their own procedures but, at the same time, places the responsibility for these decisions more firmly where it should be – on the banks themselves and their boards of directors.

This new system is based on a scale of ten categories that provides sufficient options for the classification of debtors with different risk profiles.  Although the scale is mandatory banks have sufficient flexibility in setting and applying their own methodologies for assigning borrowers to each category. Provisioning follows as a result of this process and summarizes the first publicly disclosed results of the new system, which refers to March 2004.

Perhaps Chile’s single most important advantage in the transition to Basel II, however, is the prudential approach it has taken to the capital adequacy requirements established by the original Basel Accord.  For example, in the case of small banks with a capital base of less than $20 million, Chile requires a minimum capital ratio of 10% of risk-weighted assets and, in some special cases, this can rise to 12%. Moreover, 10% has, in practice, become the market standard since this is the percentage ratio generally required by institutional investors in order to hold bank securities.

All Chile’s banks participated in a simulation last year of Basel II’s implications for capital requirements, using the same methodology suggested by the Basel Committee. This showed that, on the basis of data for December 2002, banks’ capital requirement for operational risk would have to rise an average 10.3%, while capital allocated for credit risk would drop 13.3%, giving a net decrease of 3%.

A Cautionary Lesson
It has become a cliché that Chile holds a leading position among emerging economies, particularly regarding banking and financial development. However, in terms of the country’s readiness for Basel II, this cliché contains a great deal of truth. 

According to studies by the International Monetary Fund and the World Bank, compliance in developing countries with the Basel Committee’s Core Principles of Effective Banking Supervision reaches an average of only 60%. In developed countries compliance reaches, an average 90%.  Chile’s performance comes closer to that of industrialized countries than of emerging markets.

These virtues are the result of a hard lesson – the collapse of the country’s banking system in the early 1980s. It was in response to the lessons of this crisis that a far-reaching reform of the country’s banking legislation was implemented in 1986, introducing strict regulatory and supervisory controls.

This reform laid the foundations of the solid and well-capitalized banking system that Chile now boasts. However, as conditions have evolved and the industry has acquired increased expertise, greater degrees of flexibility have gradually been introduced. In 1997, a second major reform of the industry’s legal framework was enacted.  In a bid to correct the excessive rigidities that had become apparent over the years, this reform opened up new areas of business to the country’s banks, both at the national and international level.

This gradual approach, which has ensured the maintenance of the industry’s solid fundamentals, means that, unlike many other emerging market countries, Chile has little or nothing to fear, and a great deal to gain from Basel II.  There is no market pressure on Chile to hasten its compliance and no risk that its cost of capital will rise.

In fact, according to several studies, implementation of Basel II should actually reduce the cost of capital for Chile, mainly for medium and long-term transactions for which regulatory restrictions can at present be binding. Although Chile’s macroeconomic stability is widely recognized it is not yet a member of the OECD. For overseas banks that carry Chilean debt, this means that capital adequacy requirements would diminish with the implementation of the Basel II recommendations.

At Its Own Pace
In the second half of this year, the Superintendency of Banks and Financial Institutions (SBIF) plans to publish a road map for compliance with Basel II, drawn up in collaboration with the industry. However, a word of warning is appropriate here. Chile’s head start on Basel II has triggered expectations that it will move ahead rapidly, and adopting the more advanced approaches from the start and setting an example to other emerging markets.

That is not necessarily our intention. On the contrary, we see Chile’s readiness as a major asset that will allow us to adopt Basel II at our own speed, guided by the country’s own best interests.

That principle is, of course, also valid for emerging market economies around the world. They should be allowed flexibility not only as regards to the speed at which they adopt Basel II, but also in choosing between different approaches and setting their own priorities along the road to compliance.

In Chile, for example, we initially plan to adopt what has been termed the “standardized” approach to credit-risk management.  This is, we believe, right for a country such as Chile in which most banks target the domestic market. In this first stage, we expect banks to gain experience with modeling provisions under the rules set in place earlier this year. Managing provisions adequately under the new mechanism will be a good preparatory exercise for later moving on to the more sophisticated methodologies envisaged in Basel II – the internal ratings-based approaches.

Similarly, we believe that small banks – for which the costs of Basel II may initially outweigh the advantages – should be allowed to proceed more slowly towards compliance, particularly because they are currently subject to higher capital adequacy requirements than their larger counterparts.

From our perspective, it is also crucial that the country’s banks – irrespective of whether they are locally- or foreign-owned – should all face the same rules of the game. That is vital in order to ensure the maintenance of a level playing field and is particularly important in a country like Chile where overseas banks account for around 40% of the market, and some of the largest players are subsidiaries of international banks.

Moreover, despite Chile’s macroeconomic stability, country risk remains a concern and in this regard the solvency of the banking industry and its capital indicators are key issues. A significant reduction in capital allocation, even if it is justified on Basel II grounds, could have a negative impact on market perception and Chile’s country risk indicators.

The solution here is coordination and cooperation among supervisors. In our continent, the Association of Bank Supervisors of the Americas (ASBA), which brings together most countries of the region as well as Spain, constitutes a prime vehicle for this type of collaboration.

Of course, implementing Basel II will not be easy but every country will do so eventually. For Chile, the benefits are clear and speed will be of the essence – not in the sense of simply putting our foot on the gas pedal, but of finding the right cruising speed that maximizes those gains, while minimizing the costs. That is our key challenge. LF

* Enrique Marshall is Chile’s Superintendent of Banks and Financial Institutions, the country’s bank regulatory and supervisory authority.