Norges Bank

Brev

Basel Committee's proposal for a new capital adequacy framework

Felles brev fra Kredittilsynet og Norges Bank av 31. mars 2000 til Basel-komiteen for banktilsyn

0. Introduction and summary

This consultative statement has been jointly prepared by Norges Bank and Kredittilsynet. It includes views submitted by Norwegian banking organisations. A copy of the statements from the Norwegian Bankers Association and the Norwegian Savings Banks Association is enclosed.

The Capital Accord of 1988 represented a very significant step forward in capital adequacy regulation both in terms of methodology, with its introduction of a risk based system that captures off-balance sheet items, and because it led to a harmonised international standard. Although it was at the outset intended to apply exclusively to the large international active banks, it has with great authority been given effect for all groups of credit institutions.

Although the Capital Accord has functioned well, we have become increasingly aware of its flaws. The chief objection is that it fails to measure credit risk precisely, i.e. the risk weights fail to reflect the actual likelihood of default on the part of the debtor. This can lead to mispricing and misallocation of credit, and may also impair banks' competitive position vis-à-vis the securities market as a source of finance.

Norges Bank and Kredittilsynet are concerned about the design of future capital adequacy rules in view of the need for financial stability. The stability of the banking system is crucial to the stability of the financial system. The banks are at the heart of the payments system, they are the principal funding source for a large number of enterprises and are an important saving vehicle for large sections of the population.

The capital adequacy framework affects bank's behaviour. It should therefore be designed to provide banks with appropriate incentives and to establish a capital buffer of a size adequate to protect the system. The protection afforded by the capital adequacy rules constitutes the first line of defence against unforeseen future losses that could threaten the stability of the financial system.

Norges Bank and Kredittilsynet agree on the need for changes in the current capital adequacy regulation, and support the main features of the Basel Committee's proposal as set out in "A New Capital Adequacy Framework". Until a more detailed version of the proposal is available, it will be difficult to take a view on all aspects of the proposed framework. The Bankers Association supports the proposal, whereas the Savings Banks Association is more critical of the proposal as it now stands.

It is crucially important to achieve a broad consensus on capital adequacy guidelines. Differences in rules from country to country can encourage regulatory arbitrage with credit institutions opting to establish themselves in countries offering the most liberal regulatory framework. Given the increasing mobility of capital, a common set of rules is important in the interest of stability. Higher capital mobility combined with the effect of a general deterioration of capital adequacy resulting from competitive weakening of capital requirements will heighten the risk of contagion effects spreading across national borders.

In aggregate the proposed new guidelines entail a far more complex and far-reaching framework than the one currently in effect. Possibilities for simplification should be looked into ahead.

Where Pillar I is concerned, it is difficult from a Norwegian and European perspective to see that a further developed standard method based on external rating would do much to rectify the deficiencies of risk weighting under the current regulation as long as so few borrowers in Europe are rated. Capital adequacy calculations based on banks' internal rating systems would probably ensure better correspondence between capital charges and the individual bank's risk profile, but would make it difficult to achieve a level playing field. With the long-term evolution of capital markets in Europe in mind, we would not oppose the use of external rating in the standard method. Assuming the Basel Committee is in a position to arrive at precise and operational criteria that ensure uniform competitive conditions, we support the use of internal rating systems for capital adequacy purposes. We believe this method should not be confined to the most sophisticated banks.

The introduction of Pillar II, the supervisory review process, is a logical consequence of the fact that different institutions have different risk profiles and that the authorities wish to ensure that institutions are capitalised according to their risk profile and strategy. Establishing harmonised rules for authorities' intervention vis-à-vis institutions in a deteriorating capital position is a clear improvement. Putting in place harmonised rules that empower supervisory authorities to impose capital charges on an individual institution in excess of the minimum requirement that is established generally in the respective country, is also a step forward. However, Pillar II will make heavier demands of the expertise and resources possessed both by most institutions as well as supervisory authorities. We assume that Pillar II can be applied in a simple manner to institutions of minor significance to the financial system and/or whose capital strength is well in excess of minimum requirements. Moreover, in our view Pillar II raises issues related to the distribution of responsibility between institutions and supervisory authorities. The proposal will assign to supervisory authorities a more active role in assessing and approving banks' risk management systems, overall risk, capital levels and power of intervention. This must not be allowed to undermine that it is the responsibility of bank management and owners to ensure prudent risk management and for taking appropriate action should problems arise. For its part, the banking industry is concerned about the higher costs of supervision entailed by Pillar II.

The advantage of the present standard is its simplicity and the ease with which it allows institutions to be compared within and between countries. A complex framework containing a series of options for implementation, including supervisory criteria for setting individual capital ratios, could easily breach the basic principle of a level playing field. Moreover, a complicated regime could mean that only a few persons employed by institutions and the supervisory authorities are familiar with the rules and with key factors bearing on the individual institution's capital adequacy. There may also be a possible conflict here between Pillar I (minimum capital requirements) and Pillar III (market discipline/transparency).

The proposed revision of the Capital Accord retains the existing regime in respect of market risk and the composition of the capital base. The changes refer primarily to credit risk, but also entail a substantial elaboration of guidelines and methods for supervising banks' financial soundness. Norges Bank and Kredittilsynet believe that such a comprehensive review of the quantitative aspects of regulation should not be confined to the calculation base, but should be accompanied by a similarly thorough and necessary review of the regulation of capital structure. In our view the present framework will entail an overly complex capital structure at institutions. A hierarchy of instruments in an institution's capital base could impede a speedy solution of an acute solvency problem. Norges Bank and Kredittilsynet agree that there is no reason to amend the regulation of market risk at the present time.

We agree with the Basel Committee that a necessary premise for revising the framework must be to ensure that it does not result in impairment of overall capital adequacy. We agree with the banking industry that risk management and lending practices have improved appreciably since the Accord was introduced in 1988. However, experience gained both in Norway and several other countries in the intervening period shows that the banking system was insufficiently robust to meet the losses that arose.

1. General observations

The Capital Accord is in all essentials incorporated in various EU directives in the capital adequacy area. In Norway these directives are implemented in relevant legislation as part of the EEA agreement. Should the EU choose to amend the capital adequacy directives, we expect the changes to be built into the EEA agreement, thereby requiring Norway to adapt to the EU rules. In Norway the capital adequacy rules on credit risk also apply to insurance companies and on a consolidated basis to mixed groups.

A comprehensive review of the capital adequacy framework should be based on the objectives of the regulation. The main intention of the capital adequacy regulation is to cushion institutions against the risk of unforeseen losses on their operations. Anticipated losses will be covered by ordinary loss provisions. In addition to acting as a buffer and as protection for depositors and other creditors, the capital adequacy rules form part of the safety net established to secure financial stability. Since the owners of capital are the first to take losses, there is a strong incentive for long-term owners to ensure prudent conduct of business. For major, professional investors operating in the money and securities markets, bank's capital is a base for granting credit. In addition, the minimum requirements enable the authorities to intervene in the operations of a bank before the entire capital is lost. The earlier intervention takes place, the greater the chance of finding a solution other than liquidation. In this way the spread of contagion effects to other institutions and an economic setback can be avoided or contained. This protection of depositors and creditors also reduces the likelihood of panic responses to otherwise solid institutions.

In recent years a number of objections have been raised against the existing rules. Above all it has been pointed out that the rules neither enable sufficiently precise measurement of credit risk (i.e. risk weights fail to reflect the actual likelihood of default on the part of the debtor) nor recognise the value of modern risk management techniques. The consequences of these flaws could be mispricing and misallocation of credit.

The regulation may also impact on the relationship between banks and the securities market as a source of finance. So long as the banks are required to set aside 8% capital for loans to the financially soundest companies, direct borrowing in securities markets will probably be a cheaper form of funding for these companies. The fact that many banks in a number of countries have chosen to securitise assets is probably largely due to the capital requirements imposed on them. Moreover, the present rules do not explicitly cover risks other than credit and market risk.

The flaws in the present rules do not, in our view, impact equally on all types of institutions. Moreover, it will not be easy to put in place regulation that removes all the flaws mentioned and that at the same time fulfils the aims of the revision of the capital adequacy framework.

The banking system in Norway and several other European countries has not been sufficiently robust to avoid a banking crisis. Hence a central aim should be to ensure that the revision does not impair banks' overall financial strength. Leaving risk weights virtually unchanged while allowing greater recognition of risk mitigation techniques will make this aim difficult to achieve. The Basel Committee recommends the establishment of a separate capital requirement for other risks. These include operational risk, legal risk and reputational risk. In contrast to credit and market risk, these are not risks that banks assume in order to earn money. Norges Bank and Kredittilsynet support the establishment of a capital requirement to cover other risks. We would also point out that the capital adequacy rules do not take account of concentration risk and risk associated with large exposures. Concentration refers to the risk faced in concentrating the loan portfolio in particular sectors and/or geographical areas, while risk attending large exposures refers to risk concentration in relation to individual borrowers. We would point out that both these risks could be substantial for a bank. While it is true that the EU directives limit large exposures, these do not impose explicit capital requirements in respect of the risk involved.

1.1 Scope of the rules

The Basel Committee extends the definition of institutions to be included in consolidation to investment firms and bank holding companies. Norges Bank and Kredittilsynet support this extension and view the proposal as an important contribution to the evolution of international standards. Investment firms and banks often compete in the same markets and carry the same risks. Consolidation of holding companies will provide a more correct picture of overall risk exposure while reducing the extent of debt-financed capital in subsidiaries/associated companies.

The committee recommends adopting the Joint Forum's proposals for techniques and methods to prevent double-counting of capital in financial conglomerates which include banking, insurance and/or investment firms. In Norway the capital adequacy rules for credit risk are also applied to insurance companies and on a consolidated basis in mixed groups. We are in favour of the Basel Committee's intention to continue to develop capital standards for financial conglomerates. The trend for financial groups to include non-banking institutions, and to blur the distinctions between banking and insurance operations, will heighten the need for supervision of mixed groups. Importantly, the capital adequacy rules should not provide incentives for organising a group's operations with a view to exploiting the possibilities for double-gearing, achieving lower capital requirements or transferring risk to institutions in the group which are not subject to capital adequacy requirements. The capital requirements should be neutral in relation to where risk arises in a group.

1.2 Accounting rules

The valuation of assets and liabilities is based on accounting principles and valuation rules. Under the capital adequacy rules the same principles and rules underlie the calculation of statutory minimum capital requirements. Adequate, harmonised accounting principles are consequently a precondition for consistent calculation of equity capital. Flawed accounting principles could result in overvaluation of capital and could therefore weaken the stability of the financial system. Harmonisation of accounting rules must include the treatment of debt instruments eligible in the capital base as well as the institution's equity capital. A concrete example of an area where variations are likely in the international context is subordinated debt denominated in foreign currencies.

Harmonised accounting rules are also important in securing a level playing field across national borders. Differences in valuation rules may substantially affect the size of equity capital which could in turn lead to competitive distortions.

Individual countries' practice at implementation of the accounting rules could also affect the size of equity capital. Some countries, for example, apply depreciation and write-down rules less conservatively than others. Smaller depreciation and write-downs will entail higher book equity. Differing practice will impair cross-country comparability.

Continuous development of accounting rules and international harmonisation are crucial to ensuring proper calculation of statutory capital and to reducing undesired competitive distortions caused by national differences in accounting rules and their application. This is best done through existing agencies, including the Basel Committee, IASC and EU.

2. The first pillar - minimum capital requirements

The main objection to the existing rules is their failure to provide for sufficiently precise measurement of credit risk. An argument advanced against the introduction of a more risk-based regime is its tendency to be pro-cyclical: a cyclical downturn or the effect of external shocks may be magnified by a requirement for higher capital. Higher capital requirements prompt a reduction in lending by financial institutions which may bring about a credit crunch. The result is a higher rate of company liquidations forcing the economy in a downward spiral. Norges Bank and Kredittilsynet would point out that this problem may just as well be due to belated recognition of the increased risk as to insufficient initial pricing of credit risk and inadequate loss provisions. Nor will a regulation with capital charges that are less sensitive to risk (like the present one) have a stabilising effect in the somewhat longer term, as witnessed in previous financial crises. In our view harmonised, more dynamic loss provision rules are needed. We therefore support the establishment of a regime that provides a better alignment between risk and capital charges.

2.1 Standard method - external rating

External credit rating is used both in country risk assessments and in connection with the major banks' funding activities. In our view competition among rating agencies could mean that considerations other than assumed credit risk might influence the individual rating agencies' risk classification, and that borrowers seeking a better rating will be able to indulge in a form of rating shopping. Criteria for classifying borrowers who have been rated by more than one rating agency also need to be established. The Bankers Association points out that the Basel Committee possibly has unjustified faith in the major international rating agencies' desire and ability to set aside the resources needed to carry on rating activities in a small economy such as Norway, and that it would be highly detrimental if financial and non-financial companies in a small economy were to be burdened with an extra risk premium by rating institutions owing to these institutions' insufficient insight into the workings of the economy in question.

Given the significant role that rating agencies are given in the capital adequacy context according to the proposal, Norges Bank and Kredittilsynet would stress that these agencies' assessments should both be independent and of a high professional standard. The Basel Committee lists seven criteria which it considers must be met by rating agencies in order for them to be employed for the purpose. While we have little knowledge and sparse experience of rating agencies' activities, we view the proposal as a sound basis for establishing such criteria.

Moreover, the Committee contemplates opening the way for the introduction of a risk category with a higher weight than 150% for assets carrying the highest risk. Unrated counterparties generally attract a 100% weight. We would note that the proposal clearly encourages counterparties carrying the highest risk to refrain from being rated so long as they can achieve a lower risk weighting by not doing so. Moreover, it is not apparent that an external rating entails an obligation to employ the assigned classification. Hence the result may well be that the key premise of achieving rules that are more risk-based will only apply to assets attracting a lower weight as a result of the revision. This type of asymmetry will in our view be a major flaw in the regime.

Weighting of claims on sovereigns

Under the existing regulation the weighting of sovereign states depends on whether the state is an OECD member. Norges Bank and Kredittilsynet agree with the Basel Committee that such a distinction may serve little purpose when it comes to assessing the likelihood of default by states.

According to the Bankers Association it would be detrimental to dismiss the rating agencies' expertise in this field. For its part the Savings Banks Association considers that a possible alternative to the proposed arrangement is for rating to be done not by rating agencies but by a neutral authority which utilises all available information, including the rating agencies' assessments.

Although rating agencies have few and varying results to refer to as regards risk classification of states, we believe that in the absence of anything better, and so long as most states are rated, then using external rating to determine risk weightings for states is acceptable.

Weighting of claims on banks

Assuming that the weighting of sovereigns is revised in line with the proposal, Norges Bank and Kredittilsynet agree with the Basel Committee that the current weighting of claims on banks will no longer be meaningful.

Two alternative proposals are to hand. In relation to alternative 2 the Committee states that most claims on banks, including banks not subject to rating, will be assigned a 50% weighting. Only the most solid banks will achieve the current 20% charge.

The Norwegian banking associations express a clear preference for alternative 1. Under this alternative exposures to Norwegian banks will attract a 20% risk weight. The Bankers Association would however point out that both methods have evident flaws as regards capturing bank's precise credit risk, which illustrates the need for an approach based on internal rating available to a large number of banks. The Bankers Association also considers that alternative 1 is an improvement on the present rules since it better reflects the general credit risk in the banking systems in different countries. The choice offered recognises the close link between the economy in which a bank operates and the bank's creditworthiness. The association also notes that most western countries have explicit or implicit safety nets for banks.

As regards alternative 2 the Bankers Association believes there are two problems. The first is the high risk weights proposed for banks with high creditworthiness coming under the two lowest risk categories. The second refers to the treatment of unrated banks. If alternative 2 is chosen the result will be higher weightings for almost all European banks. The association points out that almost no Norwegian banks are rated, and that for most of them, if not all, the risk weight would not reflect the low credit risk associated with them.

The Savings Banks Association considers that a capital adequacy framework entailing different funding costs based on whether or not a bank is rated by the major international rating agencies would be unreasonable. The association also considers that it would be detrimental for countries to opt for differing systems.

Norges Bank and Kredittilsynet would point out that since banks are subject to supervision and capital adequacy requirements and have access to a lender of last resort, they may warrant lower weights than other business activities. A weakness of alternative 1 is that it penalises the best banks, while the relatively speaking weaker ones fare better. Although alternative 1 does not conform with principles of "risk-based" weights, alternative 2 entails substantial disadvantages for small countries with small banks. Based on the advice offered by the Norwegian banking industry, Norges Bank and Kredittilsynet express support for alternative 1.

For short term claims on banks (a definition of 6 months proposed) a one-category lower risk weight than the weight applied to long-term borrowing is proposed. Hence as regards interbank financing there will be no difference for Norwegian banks between alternative 1 and alternative 2, apart from in the case of loans with a term between 6 and 12 months.

Norges Bank and Kredittilsynet would in all events call for harmonisation of the rules.

Weighting of claims on corporates

The Savings Banks Association considers a possible option to be the development of national systems in which loans to corporates are differentiated on the basis of accounting and prudential criteria.

The Bankers Association contends that the present 100% weighting of all corporates is a significant impediment to the banking industry's ability to develop sound risk management and that this impediment will continue to apply to Norwegian and European banks under the revised standard method. The association states that the proposal will merely serve to reduce the inequalities in competitive conditions for funding costs in countries with a tradition of external rating compared with countries without such a tradition. The association states that these weaknesses can be taken into account by developing a basic ratings approach in conjunction with the banking industry. Such an approach could incorporate both internal and external rating in a non-discriminatory manner and be applied to a large number of banks. The Bankers Association notes that the European Banking Federation is looking into such an approach.

Norges Bank and Kredittilsynet are in principle in favour of seeking approaches other than a further-developed standard method and the internal rating method, but find it difficult at present to take a view on the proposal from the European Banking Federation and the Bankers Association for a basic ratings approach until a concrete submission is put forward.

Weighting of loans secured by property

Loans fully secured by mortgage on a house which is or will be used by the owner or will be let out currently attract a risk weight of 50%. The Basel Committee proposes to retain this weighting. In view of the low losses associated with such loans, Norges Bank and Kredittilsynet consider that the favourable treatment of loans secured by property should continue.

To secure continued adequate treatment of loans secured by property, an alternative solution to the current credit risk weighting may be to reduce the capital requirement in conjunction with the deduction made in the calculation base when applying credit risk mitigation techniques.

Where loans to commercial property are concerned, the Basel Committee states that in many countries the losses incurred on such loans over time have been so large that a weight lower than 100% is not warranted. Norges Bank and Kredittilsynet share this view. The Norwegian experience shows that the loss risk associated with such loans is not sufficiently low to warrant their receiving treatment different from that applying under the general rule of 100% weighting.

Risk classification of off-balance sheet exposures

Under the current regime granted but unutilised general loan facilities with an agreed term exceeding one year attract a conversion factor of 50%, while those with a term shorter than one year are not subject to a capital charge. Experience show that banks often adjust to the rules by structuring products with a term of less than one year and subsequently rolling the commitments. The Basel Committee points out that some risk also attaches to short-term loans and proposes raising the conversion factor to 20% for terms below one year.

Given that there is empirical support for the contention that losses on general loan facilities are lower for short maturities, it would be sensible to continue to provide incentives for banks to grant this type of loan on short terms. If not, Norges Bank and Kredittilsynet believe that the conversion factor should be independent of term.

Securitisation

Tranches of securitised loans issued in the international capital market are generally rated, and risk classification by external rating agencies should therefore be well suited to fixing capital charges on such assets. As the Basel Committee's proposal now stands, the weights on securitised claims could turn out to be lower than if the bank has a direct claim in its balance sheet. The proposal can probably be justified in terms of the fact that the loan portfolio underlying the securitised claims is broader based and therefore carries lower risk. At the same time a lower risk weighting of securitised claims will encourage asset sales by banks.

2.2 Internal rating

As an alternative to a further developed version of the standard method (external rating), the Basel Committee proposes that the most sophisticated banks be permitted to employ their own classification systems as a basis for calculating capital adequacy. The justification is that using the internal ratings based approach (IRB) will more correctly reflect the individual bank's risk profile than the current system which is comparatively risk-neutral.

A material difference between the present capital adequacy rules and the IRB approach and use of external rating agencies is that the standard method takes the individual claim or exposure as the basis for calculating capital adequacy, while IRB and external rating generally take a basis in the overall customer relationship.

Norges Bank and Kredittilsynet share the Basel Committee's view that permitting use of the IRB approach for capital adequacy purposes could help to fulfil the basic premise that capital requirements should to a greater degree reflect the individual bank's risk profile.

Most Norwegian banks currently employ classification systems when evaluating their customers. We assume that only a few of these systems will satisfy the necessary requirements likely to be set to systems applied for capital adequacy purposes. Norges Bank and Kredittilsynet share the view that banks normally have a broader and deeper knowledge of customers than do external rating agencies. A number of qualitative factors play a part in assessing an exposure which rating agencies are not necessarily able to capture in their analyses. Norwegian banks can also be assumed to have a deeper knowledge of macroeconomic and sector-specific factors in Norway than do international rating agencies, and that the same will apply in the majority of small economies. Credit assessment of customers is likely to be more thoroughly grounded and documented by the banks than by external agencies, and the IRB approach will in all probability provide a more correct picture of the customer's credit risk than will external rating.

Another advantage of the IRB approach compared with external rating is that the bulk of the corporate loan portfolio is classified.

In Norges Bank's and Kredittilsynet's judgement a natural step would be to adapt a regime that lays a basis for capital adequacy calculation based on internal rating to all categories of banks, not only the most sophisticated ones. The question that has to be asked is to what extent the systems must be further developed in order to be applied for capital adequacy purposes.

The IRB approach is also intended to cover functions other than simply monitoring and following up on credit risk, for instance in dealing with credit cases, pricing and profitability management. If the same systems can serve the basis for several purposes, this would in itself appear to be rational. A potential problem is that institutions may be tempted to establish IRB systems whose primary purpose is to minimise the capital requirement rather than to give as correct a picture as possible of the credit risk attending the individual customer.

In order for the IRB approach to be applied when calculating capital charges, it is particularly important to define precisely what is meant by an internal rating system and to establish clear-cut, strict minimum requirements which must be met in order for the authorities to give their approval. The authorities must also be entitled to impose penalties on banks that systematically understate their risk. A central issue is whether use of internal rating should be confined to risk classification of claims on corporates, parts of the banking book or the entire banking book. Another important concern when formulating a set of rules is the relationship between quantitative and subjective assessments in the system, and how a level playing field should be secured both nationally and between countries. The aim must be to ensure that an internal rating regime produces the same capital requirements for the same debtor in all banks. If such standards are not achieved, the result will be differing national implementation of the rules with associated distortion of competitive conditions between institutions. Moreover, complex calculation systems do not automatically guarantee higher quality than simplified solutions.

The Basel document points to the need for consistency between banks' use of risk categories and the standard method (cf. risk weightings). Norges Bank and Kredittilsynet are of the view that the Committee must be particularly aware that use of both the standard method and the IRB approach as a basis for calculating capital charges could lead to wide variations from bank to bank without this necessarily reflecting the actual risk profile or difference in risk between banks. Applying the IRB approach will in our view make it more difficult to compare banks, both nationally and internationally.

It is also important to ensure that the approval process does not put the authorities in a "position of responsibility" which could influence any subsequent review they may carry out. The introduction of the IRB approach as a basis for calculating capital charges will require more resources to be made available to supervisory authorities, both in terms of specialist expertise and financial resources. Monitoring of institutions will need to be more thorough and tailored to the individual institution than is the case today.

It is also important to ensure that institutions establish control and approval entities staffed by highly qualified, "independent" personnel.

2.3 Credit risk models

The Basel Commitee has also considered the possible use of credit risk models in setting regulatory capital requirements, but has concluded that this for the time being is premature. Norges Bank and Kredittilsynet support the Committee's conclusion as regards use of credit risk models for capital adequacy purposes.

2.4 Risk mitigation techniques

Norges Bank and Kredittilsynet are in principle in favour of greater acceptance of the use of risk mitigation techniques in the capital adequacy context, and consider it important to create incentives in the form of capital relief for the use and further development of such systems and techniques. The key issue is how the rules should be designed so as to accommodate the techniques as far as possible. Norges Bank and Kredittilsynet would point out that the rules will become more complex as a result of this proposal. We find it difficult to give a definite response to the proposal since it is dealt with in a summary manner in the consultative document. Definite feedback will have to wait until further studies of the various issues involved are to hand.

Norges Bank and Kredittilsynet would point out that if banks are permitted to apply internal rating systems, and collateral backing is included in the classification of exposures in such a system, it is important not to grant double relief in the sense of the customer being assigned both a low weighting upon classification and a reduced capital charge based on sound collateral.

The question of whether general rules should be applied establishing general principles for dealing with the various hedging instruments, or whether, alternatively, more product-specific provisions should be applied, is left open. Norges Bank and Kredittilsynet recognise the ability of general rules to cover a wide range of hedging instruments and techniques and their robustness to new methods. On the other hand general rules entail a risk of regulatory arbitrage since such rules might in our view inevitably gravitate towards those implemented in the most liberal country. Moreover, Norges Bank and Kredittilsynet believe that the task of interpreting general rules will necessitate substantial extra work both for institutions and the supervisory authorities. We base this view on the considerable effort put into interpreting the current simple regulation of risk mitigation. Moreover, a more complex body of rules will also necessitate increasing the complexity and scope of administration and oversight of compliance.

Of vital importance in the further work in this field is to secure a level playing field.

2.5 Capital requirements for other risks

The Basel Committee proposes applying a capital charge to interest rate risk in the banking book of banks where such risk is substantially higher than the average, in addition to an explicit charge for other risks, principally operational risk. The proposal is based on the increased emphasis placed on these risk areas.

Norges Bank and Kredittilsynet agree with the Basel Committee on the advisability of imposing a capital charge for interest rate risk in the most exposed institutions. Key issues that need to be clarified are which institutions this special capital charge should apply to, i.e. identification of outliers, and how the charge should be determined, i.e. the appropriate method applied. The final rules should set out a standard calculation method, for example the duration method, and state how wide a deviation from the average is acceptable before provisions have to be made by the institution.

The current capital adequacy rules in respect of credit risk are relatively crude, and are assumed to implicitly cover other risks. A more precise measurement of credit risk, as entailed by the proposed revision of the capital adequacy framework, may lead to the reduction of the buffer in the existing regime.

A capital charge for other risks could in general help to instil in banks a more conscious approach to their work on such risks. However, several problems attach to setting a special capital requirement, among them the fact that other risks constitute a highly complex group of risk sources. Moreover, it may be difficult to draw a clear distinction between other risks on the one hand and credit and market risk on the other. Major challenges attend quantification of other risks. It should also be kept in mind that other risks can vary widely in significance between different areas of activity.

A capital charge for other risks raises important issues. If such a charge is too static, as a straightforward mark-up probably would be, it may lead to incentive problems. If banks are unable to achieve capital relief via tighter risk management they could be discouraged from improving their risk management. Norges Bank and Kredittilsynet agree that other risks constitute a significant source of risk which should be countered by maintaining a solid financial position and should therefore be taken into account in a future capital adequacy framework.

Norges Bank and Kredittilsynet would also point out that residual operational risk may attend asset securitisation. Capital requirements could reasonably be imposed for such risk, and we would request the formulation of a harmonised standard with this in mind. The absence of an international standard governing the operational aspect of securitisation has resulted in a variety of rules among countries. In our view harmonisation is needed to ensure a level playing field and to reduce the risk of regulatory arbitrage.

3. The second pillar - supervisory review of capital adequacy

Norges Bank and Kredittilsynet broadly support the principles contained in Pillar II. The proposal could contribute to increased financial strength in the banking industry through more effective banking supervision at the same time as it gives the banks an incentive to develop and improve their risk management systems.

Norges Bank and Kredittilsynet would none the less point out that implementation of Pillar II will be resource- and competence-demanding both for the supervisory authorities and for banks under supervision. The resources needed will in part depend on the number of institutions under supervision and their complexity.

Further, the supervisory authorities may find it difficult to determine how risk profiles or possible flaws in the risk management process can be assigned higher capital charges. Flaws in the risk management process require a qualitative assessment which cannot be directly translated into a quantitative charge. At the same time persuasive arguments will required of the supervisory authorities if a capital charge higher than the minimum is to be imposed on banks operating well-founded, complex risk management systems.

The Bankers Association notes that since supervisory authorities may have differing approaches to Pillar II, banks' competitive conditions may differ based on their nationality. The Bankers Association consequently calls for detailed criteria governing cases in which the supervisory authorities should require banks to hold capital in excess of the minimum requirement. Norges Bank and Kredittilsynet support this view.

Norges Bank and Kredittilsynet would point out that Pillar II entails a significant change in supervisory method. The proposal entails a more active role for the supervisory authorities in assessing and approving banks' risk management systems, overall risk, level of capital adequacy as well as power of supervisory intervention. This must not be allowed to undermine that it is the responsibility of banks' owners and managers for proper risk management and for taking appropriate action should problems arise.

4. The third pillar - market discipline

Norges Bank, Kredittilsynet and the banking associations support the proposed introduction of Pillar III. Greater transparency will promote better information to decisionmakers, and will benefit the financial system as a whole. It may be noted that the information requirement in Norway in all essentials is in conformity with the proposal. Some information will, however, be confidential or market-sensitive and will not be publishable.

The Bankers Association requests that consideration be given to requiring all banks to publish their capital adequacy ratio based on the standard method as well as based on the method employed by the bank itself. The justification for this request is to facilitate comparison between banks.

If the rules otherwise empower the supervisory authority to impose capital charges in excess of the statutory minimum, the issue of whether such information should be published is, in the view of Kredittilsynet and Norges Bank, a pivotal and difficult one. Although it will promote greater market control, such publication could trigger an accelerating negative effect on the bank's financial position.

Sincerely,

Bjørn Skogstad Aamo

Svein Gjedrem
General Director
Governor
Kredittilsynet
Norges Bank
 
Publisert 31. mars 2000 09:19