Basle II unsettles banks
If you talk to Greek bankers about the new Basle II capital adequacy rules, expected to come into effect for most banks at the end of 2006, you get the sense that some simply do not like them. This is for a simple reason: Mindful that their banks still have a long way to go on risk management, especially credit risk, they are not happy to see another hurdle put in front of them. Unfortunately, there is no escape and the sooner they realize it and proceed with the implementation of the new regulations, the better for their shareholders and their good customers. Of course, local bankers are not alone. Unlike the first accord on capital adequacy, dubbed Basle I, which was hailed by the financial community as an important step in banking regulation, the new accord appears to have raised eyebrows abroad as well, but for an entirely different reason. It is regarded as very complicated and there is confusion about the implementation of credit-monitoring procedures. Indeed, unlike the first accord, with its one-size-fits-all approach dating back to 1988, the new the Basle II accord, approved in June by central bankers and regulators of the Group of the 10 industrialized countries, is more complicated. According to Basle I, all a bank had to do was to set aside 8 percent of its capital in relation to loans extended to customers. The first accord distinguished between OECD and non-OECD members, regardless of their credit rating. This meant that OECD countries, like Turkey, enjoyed a comparable advantage over non-OECD countries, like Cyprus, with superior credit ratings when it came to borrowing. Banks did not have to put aside any capital when they were extending loans to the OECD because of their zero weighting status, but had to do so when lending to non-OECD countries because the latter were weighted at 100 percent. All this is going to change under the new Basle II accord, which has to be approved by politicians in different countries. In calculating minimum capital requirements, banks will have to assign different risk weights to assets and take into account the credit risk profile of each customer. Moreover, unlike the Basle I rules, banks will have to measure and take into account the so-called operational risk, the type of risk associated with credit card fraud, errors in money transfers, penalties from the central bank and others. New pricing system «The implementation of the new regulations will help banks manage their resources in a more efficient way and bring into focus the concept of risk adjusted return,» says Aris Protopapadakis, CEO at Systemic Risk Management SA in Athens. «The new rules will reduce the cost of borrowing for good customers but increase it for customers with a poor credit rating profile. Basle II will lead to an entirely new pricing system of banking services.» Despite taking steps toward the rationalization of their lending pricing practices, it is known that some local banks take into account other determinants, such as friendly relationships and the customer’s other business with the bank, when it comes to loaning an amount. This helps explain why spreads on loans to Greek unrated companies are cheaper than loans extended to rated foreign firms outside Greece and a major reason behind the failure of the local corporate bond market. Things are getting more complicated of course. A few local corporations are rated by well-known international credit rating agencies, such as Moody’s and Standard & Poor’s. ICAP is rating local corporations based on their balance sheets and relevant data but will have to be certified by the central bank before banks can adopt its ratings for measuring capital adequacy, say market participants. Interestingly enough, under the new Basle II rules, loans falling under the retail banking category, such as mortgages, consumer and perhaps small-and-medium enterprise (SME) loans, will be weighted at a lower risk weighting, that is, 75 percent, than before (100 percent). This will enable banks to lower the interest rates charged on them but it is unclear whether all will choose to pass on the benefit to their clients. Banks will be able to employ either one of two methods in calculating their minimum capital adequacy requirements: the standardized approach, which resembles the Basle I method, and the IRB approach which is more complicated and is based on internal ratings. Protopapadakis says the standardized approach is simpler but sends the wrong message to the market in the sense that «it shows either the bank does not have the proper infrastructure to support it or its loan portfolio is of poor quality.» So, he believes banks will try to adopt the IRB method, which requires a database. In addition, Protopapadakis points out that banks will have to incorporate into their calculations of capital adequacy requirements an entirely new factor, operational risk. «This is going to be a considerable burden because banks will have to set aside 15 percent of their average profits of the last three years, resulting in a significant reduction in their return on capital (ROE) and will have to look into ways to compensate for that,» he says, adding that the collapse of venerable and mighty Barings in the mid-1990s was due to a failure that fell under operational risk. Protopadakis noted that the extra burden from the inclusion of the operational risk factor may eliminate fully or partly some of the benefits for bank customers with a good credit profile. It is no secret that there is a shortage of experts on risk management in Greece, especially in the area of credit risk but not so much in the area of market risk. Although different banks are at different stages in building and implementing risk management systems and procedures, there is little doubt that the adoption of the new Basle II regulations on capital adequacy require more effort and resources than previously thought. Some local banks appear to have grasped this but others appear to take it more lightly and will pay the price when the time comes.