The Basel II Accord could be the biggest risk management project ever undertaken by Australia’s banks. Stuart Fagg investigates and discovers that better risk modelling is just one part of the jigsaw Basel has nearly come of age.
It's close to 20 years since the original Basel Capital Accord was published in 1988. It was the result of an agreement thrashed out by the central banks of the ten most powerful industrialised countries to apply minimum capital standards across their banking industries. The original Accord almost exclusively covered credit risk, but set the scene for Basel II, the final version of which was published in June 2004. It's a historically unique document - possibly the world's first global risk management standard - and one that thrust one of risk management's newer disciplines, operational risk management, into the spotlight.
Close to two years on, and two years shy of the deadline for implementation, Australia's largest banks are working feverishly on Basel II implementation. The majority of Australian Prudential Regulation Authority-regulated (APRA-regulated) entities will be pursuing the standard approach to Basel II, which costs less and delivers fewer benefits. Under the advanced approach, banks must be able to demonstrate that their risk management processes are such that they can absorb significant shocks.
According to APRA chairman Dr John Laker, six Australian banks have applied for accreditation from the regulator to pursue the advanced, or internal ratings-based, approach to Basel II. For the advanced banks, there are four key tasks. They must track internal loss data and use that data to directly build loss measures or to validate them. They must use relevant external data and have a systematic process for determining the situations for which external data must be used and the methodologies used to incorporate the data. They must use scenario analysis or expert opinion in conjunction with external data to evaluate exposures to high-severity events. And they must capture key business environment and internal control factors that can change a bank's operational risk profile.
However, for leading banks, it's not a case of building the new risk framework from scratch. For banks like ANZ, which, according to Morris Batty, the bank's Basel II programme executive, has been using sophisticated modelling to support decisions and model risks, it is more a case of refining existing practices.
"Basel II is a good fit with ANZ's existing risk management framework," said Batty. "The use of rating tools and processes commensurate with the Basel II Accord were already in place. The risk estimates generated by the rating process for both credit and operational risk form the basis of a sophisticated economic capital modeling framework linked to the performance management process."
But there are issues with the validation of models. Regulators are concerned that the increasing use of quantitative models for risk measurement brings with it the risk of over-reliance on the integrity of those models. Indeed, one of Australia's larger banks lost billions due to problems associated with an incorrect model used for valuing mortgage servicing. Basel II requires that models be subjected to independent internal validation before implementation and use of the models in different processes, and Australian banks are grappling with the issue.
"The number one item on most banks' agenda is the challenge of model validation," said Rachael Phelan, a partner at KPMG who is advising banks on implementation.
"With our clients it's definitely number one on their list. The issue is how to physically get through the validation of existing models and how to establish a validation framework that is going to satisfy APRA's requirements, Basel's requirements and their own requirements. Independence of that validation function is a key concern. The meaning of independence is something that has to be interpreted and different organisations have different interpretations."
According to Rodger McArthur, chief executive, group functions, at HBOS Australia, which operates BankWest, availablilty of default data on which to base risk models has been a thorn in the side of Australian banks. "One of the biggest challenges for an Australian bank choosing to pursue the advanced approaches to credit or operational risk management is the availability of default data required to support the development of predictive risk models," he said. "The adoption of practices to collect better data to support future modelling activities will stand us in good stead."
Beyond the issue of models, technology is the major source of work for Australia's banks.
"Technology is one of the largest components of the Basel II framework," said ANZ's Batty. "As ANZ already uses rating systems and processes (both credit and operational risk) that are closely aligned with the key Basel II requirements (although some further analysis was required to meet the long run estimate requirements of Basel II), emphasis has focused on improving the linkages between systems and the requisite data requirements. Many new systems have also been developed, including a new operational loss data repository and new rating tools and collateral systems to support the Basel II initiative."
Indeed, increasing demand for Basel II technology has been identified as a major factor behind massive increases globally in spending on operational risk technology. According to a recent study, that reached more than $16 billion last year.
As Basel II program directors battle with these issues, executives tightly gripping the purse strings want to hear about return on investment. While there are no exact figures on how much is being spent on Basel II programs in Australia, APRA estimated in late 2004 that Australian banks implementing the advanced approach would spend between $50 and $100 million.
Initially, according to APRA, banks were clamouring for a reduction in the amount of regulatory capital they would need to hold as a benefit. "We hear arguments that the cost of the systems and infrastructure necessary to implement these approaches cannot be justified unless they lead to significant reductions in regulatory capital," APRA's program director Bernie Egan said in 2004.
Most bankers agree that while a reduction in capital requirement would be welcomed, it is not the endgame of Basel II. "There is certainly potential for the industry to focus on capital relief but we feel that doing so misses the point of Basel II - adoption of more robust risk management disciplines will provide the organisation with a competitive edge," said McArthur.
Since Egan's comments APRA has said there will be a slight reduction in capital requirements, but bankers insist the return on investment debate has moved on. "While not losing sight of this [capital reduction] issue, ANZ's focus has been on ensuring that systems and processes will meet Basel II requirements, and on benefits derived from the system enhancements," Batty said.
Indeed, experts argue that the benefits of the massive investment in Basel II are becoming clearer. "For the advanced banks, there are five core benefits. The first is definitely better risk measurement capability - the ability to assess business lines on a risk/return basis much more effectively," said Phelan. "Secondly, Basel allows for an enhanced risk and governance framework. It gives greater focus from the top down, as well as from the bottom up. Risk management has previously really been at a transactional level going up, but now there's a focus going down too."
The third benefit concerns the management of customer information; the timeliness of information, and having centralised, well-maintained data that can be used in the ongoing enhancement of risk measurement models.
The fourth is better pricing capability through the improved risk measurement process. "ANZ already has a strong quantitative approach to risk measurement. Statistical models support credit decisioning and economic capital modeling of key risks, linking to performance management - in place since the mid '90s," said Batty. "Nonetheless, the Basel II implementation has resulted in a number of refinements to existing rating tools and processes and improved models in some areas. We can expect to see benefits resulting from this improved risk measurement capability."
The final benefit, however, may not be realised by all. A perusal of the various studies, surveys and analyses of Basel II reveals frequent of use of the word 'compliance'. While Basel II is centered on banking supervision, thinking of it in terms of a compliance projects is a mistake, according to Phelan.
"There is the potential to streamline existing processes using risk," she said. "This is a really big benefit that only the really clever banks will see; there is the potential to streamline existing processes using risk. They've invested in all this risk measurement capability, but smart guys need to grab onto that and turn it into a business benefit. It seems quite obvious. The main reason is that a lot of banks have approached this as a compliance initiative. As soon as you do that, the status it gets in the organisation, the focus and the resources that are applied to it all take a certain bent. There are some organisations that are recognising now that its cost them an awful lot, and they need to think about what benefit they get out of it other than just being a good corporate citizen and complying. That's a big ask to turn that situation around and introduce some of those benefits."
While Basel II will not come into effect until 2008, there is already expectation that its principles could be applied outside banking and financial services. "Basel provides a fabulous platform for better risk management," said Phelan. "Its principles could be very easily applied to other industries."
Additionally, the key advances in measuring and managing operational risk could also find wider application. "The key credit risk requirements and risk measurement standards have obvious application to other credit providers," said Batty. "Similarly, approaches to the management of operational risk have broader application."
Banking clients may also be interested in the wider applications of Basel II. "The first thing corporates will ask is 'why is my banker treating me differently?'" said Phelan. "In order to understand that they will need some recognition of Basel and how they are being assessed in terms of a risky asset for their bank. That will bring awareness. More sophisticated corporates may look outside their industries to enhance their risk management capability."
But for now, the feverish activity surrounding Basel II continues. According to a study released earlier this month, the majority of banks globally are working intensively on Pillar 1. Pillar 2 implementation and improvements are in their infancy while most are only planning Pillar 3 work.
"Perhaps the biggest challenges between now and the start of 2008 will be related to the Pillar II aspects of the Basel Accord," said HBOS Australia's McArthur. "The other critical aspect which is not a barrier but requires strong leadership and focus is the need to ensure that Basel II principles are firmly embedded into business as usual activities, reporting, day to day language and at board level."
News