Implementation of Basel II—Implications for the World Bank and the IMFPrepared by Staffs of the International Monetary Fund and the World BankJuly 22, 2005
Glossary Executive Summary
Box
|
Glossary
Executive Summary1. The New Capital Adequacy Framework (Basel II)1 proposes a significant refinement of regulatory and supervisory practice and encourages increased attention to risk management practices in supervisory agencies and financial institutions and improved disclosure and market discipline. 2. In all countries, a strong financial sector infrastructure including effective risk-based banking supervision, is critical for financial stability and development and is a necessary precondition for implementation of the Pillar 1 capital requirements of Basel II. As FSAP experience has shown, important elements of this infrastructure are still lacking in many countries. Safe and sound banking are key to financial stability which in turn facilitates economic development, and supports the Bank's and the Fund's mandates. 3. While much of the debate on Basel II has centered on the complexity and resource requirements of the advanced approaches to minimum capital requirements under Pillar 1, countries may benefit more, in the medium term, from implementation of Pillars 2 and 3, addressing supervisory practices and expanded market discipline and disclosure. 4. Large numbers of countries have expressed an interest in adopting Basel II for their banking systems. This interest of countries to implement Basel II may be leveraged to upgrade the quality of their banking supervision through better compliance with the Basel Core Principles (BCPs) and an increased focus on risk-based banking supervision and market discipline. The Bank and the Fund should be ready to provide assistance to achieve this. 5. Adoption of Basel II by member countries will affect the surveillance, technical assistance (TA) and financial sector development agendas of the Bank and the Fund. Surveillance of banking supervisory systems may become more complex in countries that have implemented Basel II, and cross-country comparisons will become more difficult, as countries choose different implementation options. 6. Meeting demands for Basel II oriented financial sector surveillance and provision of Basel II related technical assistance to member countries will require:
I. Introduction7. This paper informs the Executive Boards of the World Bank and the Fund of the main features and implications of the Basel Committee on Banking Supervision (BCBS)'s new "International Convergence of Capital Measurement and Capital Standards—A Revised Framework" ("Basel II"). At the Fund, the Executive Board has been briefed with regard to the main expected implications of Basel II, and staff have formulated and publicly disclosed policy guidance on the position of Fund staff with regard to some of the key elements of Basel II.2 The final text of the Basel II framework has not necessitated significant shifts in staff's position. In particular, the paper discusses its potential significance for Bank and Fund financial sector surveillance and technical assistance, as well as its potential impact on financial sector development, which is a key factor in economic growth and poverty reduction. 8. This paper is structured as follows: After the Executive Summary and the Introduction, Section II will discuss the key elements of the new Framework. Section III discusses the main implications of Basel II for Bank and Fund membership, including issues related to countries' readiness for Basel II and cooperation between home country and host country supervisory authorities. Section IV explores the implications for Bank/Fund work in surveillance and technical assistance, including the need to build expertise and to assure the availability of resources to fulfill these mandates. Section V makes recommendations relating to the work of the Bank and the Fund. 9. Staff views Basel II as an important step forward in an evolving process toward improved banking supervision in countries. It encourages increased attention to operational risk and risk management practices in financial institutions and supervisory agencies as well as improved disclosure and market discipline. 11. Basel II attempts to incorporate many aspects of these advances in risk management and has thus raised the bar for banking supervision in countries. In particular, it: (i) provides a more risk-sensitive approach to capital adequacy; (ii) underlines banks' own responsibility for ensuring they maintain sufficient capital; (iii) provides guidance for better supervisory practices; and (iv) provides a stronger basis for the role markets can play in identifying and discouraging excessive risk-taking by banks. 12. A 2004 survey by the BIS's Financial Stability Institute (FSI) revealed that of the 107 countries that participated in the survey, 100 planned to adopt Basel II over time. In countries that have decided to implement Basel II, the Bank and the Fund should be prepared to monitor the quality of implementation of Basel II, and assist them in strengthening their supervisory systems. 13. The thirteen BCBS member countries3 expect to begin implementation of Basel II starting end-2006,4 with implementation of the more advanced approaches at the end of 2007. Other supervisory authorities worldwide have been encouraged by the Basel Committee to "consider adopting this revised framework at such time as they believe is consistent with their broader supervisory priorities." The Committee acknowledges—and Bank and Fund staff concur—that Basel II may not be a first priority for all non-G-10 supervisory authorities in terms of what is needed to strengthen their banking systems and banking supervision. 14. While much of the debate on Basel II has centered on the complexity and resource requirements of the advanced capital approaches in Pillar 1 of the Framework, countries may benefit more, in the medium term, from implementation of Pillars 2 and 3.5 Implementation of the more sophisticated Pillar 1 capital adequacy methodologies may be too resource intensive, and unnecessary for many countries, given the current level of development of their banking systems. Premature adoption of Basel II in countries with limited capacity could inappropriately divert resources from more urgent priorities. This may ultimately weaken rather than strengthen supervision in these countries. Focusing on building supervisory capacity may avoid many of these risks. The Bank and the Fund have advocated that jurisdictions address inadequacies in their financial sector infrastructure and make risk-based supervision, a strong supervisory foundation, and improved market discipline the top priorities.
15. Even in countries where Basel II may not be implemented for some time, the underlying framework of Basel II, with its emphasis on more sophisticated risk management, has encouraged countries to take a more risk-based approach to supervision. Many countries are focusing their attention on adoption of supervisory policies and systems that will enable them over time to move toward Basel II implementation. It is important that countries' roadmaps for implementation of Basel II be comprehensive, realistic and give appropriate attention to necessary preconditions. II. Key Elements of Basel II16. The Basel II framework is not a 'one size fits all' standard and offers a variety of options. The new capital adequacy framework has been crafted following a lengthy and inclusive consultation process, and offers several approaches of varying degrees of sophistication aimed at being applicable to diverse banking and supervisory systems. 17. Basel II consists of three "pillars:"
III. Implications of Basel II18. The following paragraphs discuss a number of issues related to Basel II implementation and possible implications for countries and for the work programs of the Fund and the Bank in strengthening countries' financial sectors. 19. Pressure to implement Basel II. Some countries report pressure from their major banks and from the market to adopt Basel II promptly. As Basel II is viewed by many as the new global capital standard, it may be difficult for countries to explain to market analysts why they are not immediately moving to implement it. Hurried implementation, however, may lead to weaker rather than stronger supervision. The more sophisticated variants of Pillar 1 require data, skills, and systems that are lacking in many developing countries; applying models with parameters that are borrowed from other countries could provide a misleading indication of required capital. Therefore, the BCBS has emphasized that Basel II "may not be a first priority for all non-G 10 supervisory authorities in terms of what is needed to strengthen their banking supervision, and should adopt Basel II only in a timeframe consistent with national priorities and capacities."7 20. A strong supervisory foundation should be a precondition for Basel II implementation. The IMF's "Gaps Paper"8 reports weak compliance with many of the BCPs across countries that are important to the effective implementation of Basel II.
21. Higher capital requirements likely for loans to emerging markets. For many emerging and developing countries, the increased risk sensitivity in Basel II may lead to higher bank capital requirements for loans to these countries. The BCBS' Third Quantitative Impact Study10 showed that banks lending to emerging and developing markets will face higher capital charges for credit risk and operational risk. This could result in higher borrowing costs as well as reduced capital flows to higher risk countries. The effect of Basel II on banks' lending rates, however, is not straightforward. Banks lending to emerging markets may already incorporate the higher risk in their current lending rates. Moreover, many other factors besides the cost of capital determine bank lending rates, including competitive pressures and strategic considerations. Even if bank-intermediated flows to emerging markets declined, nonbank flows might well offset some or all of the decline. 22. Portfolio adjustments arising from Basel II. The application of different capital charges based on the credit risk of a type of loan (e.g., residential mortgage loans) or borrower may lead banks to change the composition of their asset portfolios. Banks may tend to increase their holding of low risk assets (with lower capital charges) and may reduce their holdings of those assets, which under Basel II, generate a higher capital charge and put upward pressure on lending rates. These factors could shift the flow of credit from higher risk sectors (e.g., commercial real estate), to less risky sectors (e.g., residential housing). More work needs to be done to assess the likelihood of the occurrence of such portfolio shifts and their potential macroeconomic consequences. 23. Increased procyclicality. In addition to higher provisions against corporate loans, triggered by deteriorating corporate performance, Basel II may require banks to assign higher risk weights in an economic downturn. This raises banks' cost of extending credit, which may in turn have the effect of further restricting bank lending. While this is arguably an inherent part of a risk-based capital regime, and can lead to more accurate pricing of risk, it may also have the effect of exacerbating business cycles. A more risk-sensitive and forward looking capital framework may, on the other hand, also provide incentives for banks to better analyze risk and avoid excessive "herd behavior."11 24. Risk of selective implementation of Basel II. Basel II offers a large number of options, starting with legitimate choices between the simpler and the more advanced approaches to capital adequacy. However, some countries may wish to exercise national discretion to adopt lower risk weights for certain asset categories permitted under Basel II, without meeting the Basel II requirements of a safe lending environment and without taking into account the loss experience of their countries. Such practices, such as application of lower risk weights for residential mortgages, retail and SME lending should not be authorized by supervisors unless countries have the historical loss data and appropriate legal judicial and accounting environment to justify these lower risk weights. To do otherwise could lead to unwarranted reductions in bank capital and increased systemic vulnerability. 25. Incentives to develop credit rating agencies. Basel II may create an incentive for countries to facilitate the development of credit rating agencies and foster an improved credit culture. For instance, implementation of the Standardized Approach under Pillar I allows the use of borrower ratings issued by rating agencies to determine asset risk weights. This is only feasible, however, in countries with sufficient rating agency penetration. If rating agency penetration is low, and ratings are not available for major borrowers, then the standard risk weights of Basel I will be applied. For ratings to qualify for use under Basel II, supervisors are expected to assess the quality of the rating agencies, based on criteria of objectivity, independence, availability to foreign and domestic institutions, disclosure of methodologies, adequacy of resources and credibility.12 Such evaluations will require additional resources and expertise. 26. Increased resource pressures to build financial infrastructures. Supervisors and banks wishing to implement Basel II, and particularly the IRB approaches, may need to build considerable additional infrastructure, i.e., data and reporting systems, and verification and validation capacity. The advanced approaches to measuring credit risk require a minimum of reliable five-year data sets on credit performance, according to the Basel Committee. Other experts argue that five years is insufficient to obtain an accurate estimation of risk; if the time series of data available is less than that of a typical business cycle, then the models will exacerbate cyclical swings more than an approach that looks at risk over the entire cycle. Such data sets are currently only partially available in many countries. Where neither banks nor supervisors have developed their own databases, credit registries or data pooling arrangements can be used. 27. Shortage of trained supervisors. To build their supervisory capacity, countries will need to recruit additional specialized staff, and provide extensive training to existing staff on Basel II. The FSI Survey on Implementation of the new capital adequacy framework estimates that responding countries could require training of over 9,000 supervisors. Demand for expertise in risk-based supervision, credit and operational risk management is likely to increase significantly in the next few years. In most countries, supervisory agencies, operating under government pay scales, will be disadvantaged in competing against the private sector for these skills. The prospect of a "brain drain" of Basel II-trained supervisors to the private sector is very real, further challenging the ability of supervisory agencies to build the necessary capacity to implement Basel II. 28. The role of the host supervisor. For foreign banks operating under the more advanced versions of Basel II, host supervisors are responsible for deciding to what extent they wish to rely on home country supervisors to validate the systems and policies of the parent banks' major foreign subsidiaries. For instance, if a home supervisor authorizes one of its large international banks to operate under advanced-IRB, it will expect the bank to operate all of its major subsidiaries, both domestic and foreign, under Advanced-IRB. Such arrangements could raise a number of home-host issues. For instance, is it feasible for the supervisors in every country in which that bank has major subsidiaries to require each subsidiary to go through an approval/validation process? Alternatively, should the host supervisor of a foreign bank subsidiary rely, in essence, on the home supervisor to judge the adequacy of that subsidiary's capital adequacy? In the event that the foreign subsidiary encountered capital problems, what would be the accountability of the home supervisor to the host authorities and legislature? These are difficult questions that are being discussed between a number of home and host regulators, and the banks operating in their jurisdictions. Ultimately, the host supervisory agency has the responsibility for maintaining a safe and sound banking system in its country and can be expected to retain the authority to impose the "rules of the house" upon foreign banks' local subsidiaries. Host supervisors will in any case need to develop resources to dialogue effectively with home supervisors on Basel II implementation, and will in this context, where applicable, also need to be able to assess the quality of implementation of more advanced Basel II systems in the host country. 29. Home-host supervisory cooperation. Effective working relationships, including agreements on information sharing, need to be formed between home and host authorities.13 The challenge will be to strike an appropriate balance between efficient home country consolidated supervision, host country responsibility, and avoidance of duplicative and overlapping regulation/supervision of foreign banks. These agreements should take account of the differences between home and host supervisory systems and capabilities and between the capital frameworks used by foreign banks and domestic banks. The Accord Implementation Group (or AIG, a subgroup of the BCBS), has developed guidance for the development of mechanisms for home-host cooperation, and is compiling materials on current arrangements between home and host regulators ("case studies"). In countries where foreign banks control a substantial portion of the banking assets, the national authorities will need to work very closely with the foreign banks' home supervisors to develop an effective supervisory process and will need staff with sufficient expertise to be able to conduct a meaningful dialogue with the home supervisors of these foreign banks. In the EU, renewed efforts are underway to address issues of home-host supervisory cooperation, in the form of multilateral arrangements with regard to conglomerate supervision and crisis management, to supplement an extensive system of bilateral MOUs among EU supervisory authorities. 30. Commercial bank implementation. Basel II has reinforced the need for commercial banks to focus more on risk management and to better align capital and risk. Large, internationally active banks in developed countries have already begun to take steps to implement Basel II according to the Basel timetable. Medium-income countries have adopted a variety of approaches depending on the degree of sophistication of their banks and resources available to the supervisory authorities. Banks in lower-income countries are the most challenged by implementation of the advanced approaches under Pillar 1, as are their supervisors. IV. Implications of Basel II for Bank/Fund Financial Sector Surveillance and Technical Assistance31. The Fund and the Bank's surveillance work, in particular through the FSAP, and the demands for technical assistance (TA), will be significantly affected by Basel II. A large majority of countries can be expected to implement one of the variants of Basel II over time. To meet the demand for technical assistance to countries implementing Basel II and to be able to conduct surveillance of financial sectors under the changing environment, the Fund and the Bank will need to build expertise on the various aspects of risk-based supervisory frameworks within their own organizations. A. Surveillance 32. The Bank and the Fund have an interest in safe, balanced and carefully sequenced implementation of Basel II. Countries should be advised to avoid overly ambitious schedules and the diversion of resources away from core supervisory and regulatory functions. For those countries that choose to adopt Basel II, the conditions for effective implementation of Basel II can be assessed as part of the FSAP, and to some extent, during the Fund's Article IV consultations, when the necessary expertise is available, either from MFD staff or outside experts. The number of specialized staff or expert resources needed to perform this aspect of surveillance cannot be estimated at this time, as it is insufficiently clear which countries intend to implement advanced options under Basel II, nor when they intend to do so. It is assumed that this form of surveillance will not be required before 2007, and in the case of many countries, at least some years after 2007. In the meantime, candid assessments will need to be made of country readiness, including sufficient implementation of the BCP, and the feasibility and comprehensiveness of roadmaps to Basel II. The Bank and the Fund have received requests by countries to evaluate their roadmaps for Basel II implementation and have provided comments. In the context of surveillance, countries will not be assessed on whether or not they have implemented Basel II, but on the basis of the quality of their supervision of banks' capital adequacy.14 33. For countries that are implementing Basel II, preparing assessments of their supervisory and regulatory systems will become more complex. There will be a need to assess the quality of implementation and the capacity to effectively exercise Basel II-based supervision. A surveillance and assessment methodology, and supporting guidance materials, will need to be developed by the Bank and the Fund, based on the text of the Basel II framework, to serve as a basis for an assessment whether supervisors are monitoring effectively the quality of Basel II implementation by banks. Furthermore, comparability of assessments, while not the primary objective of assessments, will become more difficult, as countries exercise a wide variety of implementation options. While the Fund has in the past urged convergence in the use of these options, only the EU has undertaken efforts toward convergence. Convergence is not a requirement, and Basel II implementation is likely to remain diverse across countries. 34. Basel II has two potential effects on stress testing. First, there will be a need to assess, in the context of surveillance or BCP assessments, the quality of stress testing practices of banks and its monitoring by supervisors, as required under the advanced approaches under Basel II. Techniques currently applied to stress test banks and banking systems in the context of FSAP, will probably not undergo much change, even if the data provided by the authorities as inputs to stress tests is produced differently under Basel II. 35. As banks implement Basel II and the risk weights are adjusted as a result of the new capital framework, the reported capital position of individual banks will change. These changes to a bank's reported capital ratios may occur even when the banks' portfolio and risk profile remain unchanged. In addition, Basel II provides countries with more than 40 options of national discretion, leading to variations in the actual frameworks among countries. As a result of such variations, assessments and comparisons of banking systems' capital positions over time will become very difficult. The Fund and Bank have suggested to the BCBS that the Committee set up a database of countries' implementation of Basel II, in particular with a view to compiling information on countries' use of the different areas of national discretion. 36. For those countries with banks adopting the internal ratings-based approaches, judging the quality and effectiveness of the supervision of these banks will require assessors with a good understanding of underlying implications of implementation of Basel II, in particular the key aspects of risk management. Furthermore, in order to exercise adequate quality control, Bank and Fund staff will need a sufficient level of knowledge on Basel II and its implementation aspects. Because banks adopting the internal ratings approach are likely to be systemically important on a national if not global basis, it will be very important that the surveillance of these countries include a comprehensive review of the adequacy of Basel II implementation by the supervisory authorities. Given the likely demands for staff with Basel II expertise in member countries, availability of expert staff from cooperating institutions to use on surveillance missions may be limited. Internal training on the key aspects of Basel II and its implementation will need to be organized for Fund and Bank staff, as well as for assessors. B. Technical Assistance 37. Providing technical assistance related to improving supervisory capacity is an appropriate role for the World Bank and Fund in the long-term development of banking sectors and banking supervision in countries. A distinction can be made between, on the one hand, "pre-Basel II" assistance to help build the necessary basis without which implementation of Basel II should not be undertaken (i.e., BCP compliance and risk-based supervision) and, on the other hand, actual Basel II implementation. The Fund and the Bank are presently able to field programs of TA to help countries improve the quality of their banking supervision and establish the preconditions for effective banking supervision. 38. With regard to "pre-Basel II" technical assistance in strengthening supervisory systems, the Bank and the Fund—in accordance with their areas of expertise and availability of resources—will continue to collaborate closely in supporting member countries in the following areas: (i) improving supervision consistent with the BCP, Basel I, and risk-based supervision; (ii) training of supervisory staff; (iii) strengthening banking system infrastructure and legal framework; (iv) payment systems; and (v) advising on insolvency frameworks. 39. As part of its development mandate for countries' financial sector infrastructure, the Bank will continue its work in preparing supervisory development plans, credit bureaus, development of collateral registries and enhancing corporate governance. Within the Bank Group, expertise in the IFC could also be used to complement technical assistance to supervisory agencies with that to the private sector. 40. Countries are likely to request assistance in Basel II related areas on the following topics: (i) developing a roadmap for Basel II implementation; (ii) cost/benefit analyses of Basel II implementation; (iii) developing supervisory skills to assess the quality of banks' risk management models; (iv) development and analysis of data sets to analyze historical loss information; (v) development of disclosure related requirements; and (vi) qualification of external rating agencies. 41. Both the Bank and Fund will be able to assist countries in preparing for Basel II. The Bank and the Fund can assist countries in developing Basel II training programs for their staff. In addition to direct technical assistance through programs of the Bank and the Fund and the training institutes, the BIS's Financial Stability Institute (through its workshops and its FSI–Connect distance learning program for banking supervision), the Toronto Center and various other multilateral, regional and bilateral initiatives provide relevant training on Basel II. 42. With regard to more technical Basel II implementation, however, particularly with regard to the advanced options under Pillar 1, it will be essential to manage member country expectations. Neither organization is currently in a position to assist in developing highly technical risk management systems. Staff may be able to help build supervisory capacity to evaluate banks' Basel II implementation but it is likely that resources to provide these very technical services will need to be recruited from outside. This may prove to be difficult to achieve in light of the expected scarcity of such resources and the budgets to attract them. 43. In responding to TA requests, the Bank and Fund will need to coordinate carefully with Basel II related technical assistance activities of other bilateral and multilateral donors. Also, qualified supervisory authorities and internationally active banks will need to be called upon to assist other supervisory authorities in training and building of data infrastructure. V. Recommendations44. Bank and Fund technical assistance to countries should focus on strengthening financial sector infrastructure, core supervisory functions in line with the BCP and including risk-based supervision, as well as conditions allowing for the exercise of market discipline. These are essential prerequisites for countries seeking to adopt the Basel II framework. Bank and Fund staff should avoid conveying the perception that countries will be criticized by the Bank or Fund for not moving to adopt the Basel II framework. 45. Bank and Fund staff will provide assistance to host countries wishing to strengthen their supervision but should, at the same time, take a neutral position with regard to the question of whether host supervisors should permit foreign banks in their countries to operate under Basel II (particularly the advanced approaches), while domestic banks remain under Basel I. Host supervisors, however, should retain responsibility for the supervision of all banks operating under their jurisdiction. 46. Internally, the Bank and the Fund would need to allocate resources to continue to upgrade staff knowledge of all aspects of Basel II, including the more advanced elements of Pillar I, through secondments to supervisory agencies, through internal and external training of existing staff and through hiring staff familiar with Basel II. Although availability of resources in the area of Basel II will be scarce for the coming years, the Fund and the Bank will need to position themselves, within the existing resource envelope and using external funding where possible, to recruit outside short-term and long-term experts to assist in building the IFIs' own expertise and to participate in technical assistance activities. 1Basel, June 2004. |
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||