Response to the Basel Committee's consultative document - the new Basel accord
Felles brev fra Kredittilsynet og Norges Bank til Basel-komiteen 31. mai 2001
This consultative statement was prepared jointly by Norges Bank and Banking, Insurance and Securities Commission of Norway (Kredittilsynet). It includes views submitted by Norwegian banking organisations. Attached are copies of the statements from The Financial Services Association of Norway (FNH) and The Norwegian Savings Banks Association.
1. General observations
Norges Bank and Kredittilsynet are in favour of a revision being carried out of the current capital adequacy rules, so that the regulatory framework to a greater extent reflects the relationship between the capital requirement and the bank's economic risk. The proposal will provide incentives towards a continuous improvement of banks' internal systems for measuring and controlling risks. Norges Bank and Kredittilsynet support the proposal from the Basel Committee that the regulatory framework should be founded on a so-called "evolutionary approach". This entails that, upon recognition from the supervisory authorities, banks may choose different methods for calculating the capital requirements, depending on the complexity of the activities, and the quality of the risk management. The New Basel Capital Accord will, nevertheless, represent a reform so far-reaching and complicated that it is difficult at the present time to know all its effects. It will therefore also be important in future years to have both active follow-up on the implementation of the new regime, and a continual evaluation of its consequences. The New Basel Capital Accord will mean increasing demands as to qualifications and resources within the supervisory authorities and to some extent within institutions.
The need for harmonised international standards
It is of decisive importance to reach broad agreement concerning the capital adequacy guidelines. It is, furthermore, altogether central to ensure a responsible level for the capital adequacy. Dissimilar rules in the various countries may give rise to " supervisory arbitrage" with credit institutions deciding to set up in countries which have the most liberal regulatory framework. As the mobility of capital increases, it is important to have common rules in order to ensure stability. The combination of increasingly mobile capital, cross-border activities, and the effect of a general deterioration of capital adequacy resulting from weakening of capital requirements will heighten the risk of contagion effects spreading across national borders.
The introduction of the second pillar, the supervisory review process, will increase the need for greater harmonisation of international supervisory practices to ensure a level playing field among banks across borders.
Complexity and competitive conditions
Taken altogether The New Basel Capital Accord entails a regulatory framework substantially more complicated and comprehensive than the current Capital Accord. The complexity may partly be justified as the new framework can be seen as a reflection of the advancement and innovations in the financial market place and the need for a more risk-sensitive framework. A complex framework containing a series of options for implementation 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.
The proposal for a revised capital accord also means that the need for a revision of the numerator in the capital adequacy ratio will become more urgent. In our view the current framework entail an overly complex capital structure in institutions. A hierarchy of instruments in an institutions capital base could impede a speedy solution of an acute solvency problem. The main emphasis should be on the tier one capital / core capital which will constitute a de facto buffer in an emergency situation.
Calibrating the capital adequacy requirement
The remaining work as regards calibration of the various elements of the proposal from the Basel Committee, in the light of the outcome from the Quantitative Impact Study etc., will be of decisive significance to the final proposal from the Committee. In co-operation with FNH and Sparebankforeningen, Norges Bank and Kredittilsynet have conducted a survey of the impact of the standardised approach on a selected group of Norwegian banks. The outcome of this survey has been set out in paragraph 6. This survey shows that the capital adequacy requirement for operational risk contributes to a significant increase in the total requirement for the participated banks. In Norges Bank and Kredittilsynet point of view, this should be considered when calibrating the system.
The banking industry in Norway and in several other European countries has not been sufficiently robust to avoid a banking crisis. Norges Bank and Kredittilsynet support the intention of the Basel Committee that the overall solvency in the banking system should not be reduced as a result of the proposed reforms. Nevertheless, in practice the danger exists that the level of overall capital will be reduced as major financial groups will achieve a lower capital requirement. In the event that the released capital in these groups is used to make acquisitions of other banks, the level of overall capital could be reduced.
Any objective that the size of overall capital should remain unaltered will necessarily have to be based on an average consideration. This entails that for some institutions the total capital adequacy requirement might be higher or lower than under the current requirements. Banks intending to apply internal ratings to portfolios of high quality and who have well documented credit control procedures should, according to the intention of the Basel Committee, be subject to a capital adequacy requirement lower than under the standard method. An internal ratings based approach will, on the other hand, result in a stricter requirement for banks where the quality of the credit portfolios is poor. Those banks will, therefore, apply the standardised approach in calculating the capital adequacy requirement. In order to ensure transparency, as laid down in the third pillar, and consistency with the standardised approach, banks who apply internal ratings should also publish their capital ratio as based on the standard method. To ensure satisfactory monitoring of the banking and financial system in its entirety, calculations ought to be made according to the standardised approach at least twice annually for a transitional period. Also in the longer term for monitoring reasons, one should consider having annual calculations. A corresponding view is held by Sparebankforeningen.
Altered methodology of supervision
Norges Bank and Kredittilsynet would point out that the second pillar entails a substantial change in supervisory methods. The proposal will mean that the supervisory authorities will be taking a more active role in evaluating and recognising the risk management systems used by the banks, as well as assessing the overall risk, the level of the capital adequacy, and the access to intervene. It must nevertheless be clear that it is the management and the owners of the bank who are responsible for proper risk management and for taking appropriate action if and when problems arise.
It is currently being debated whether the capital adequacy rules have the effect of being pro-cyclical and whether the new framework will enhance the sensitivity of capital requirements to the economic cycle, hence reinforcing the tendency of banks to act in a pro-cyclical manner. One important prerequisite for avoiding any such effects is that the rating systems used by banks are based on credit assessments of a more forward-looking nature that are well anchored in sufficiently long records of loss experience. In more general terms it is important to emphasise the time-dimension associated with evaluations of risk and the way the risk picture varies over time. Although one cannot in an economic upswing time precisely estimate when the downturn will occur, all experience warrants that it will indeed come, and that losses will normally rise. In principle, therefore, financial strength should be built up during times of economic expansion when bank profits are sound and loan losses are low.
In general it may often be the case that risk is underestimated in times of economic boom and overestimated in times of recession. This may be a significant reason why banks act pro-cyclically, and it underlines why the time-dimension related to risk is so important. To contribute to a situation where risk assessments are based on a forward-looking and long-term perspective, is a more general challenge which will concern both banks and the supervisory authorities in applying the new system. The question of pro-cyclicality must also be viewed in the context of how the regulatory framework for loan loss provisions has been designed. In future it will be important that the Basel Committee continues its work of analysing possible pro-cyclical effects of the new capital adequacy regime. One should also consider how the regulatory framework for loan loss provisioning might most appropriately be designed in order to abate such unfortunate effects.
The third pillar, market discipline, represent an important part of the totality of the new aggregate system for capital adequacy. Measures to ensure both increased transparency and harmonisation of standards for external reporting are important in order for market disciplinary mechanisms to function. Greater transparency and access to information about the capital and risk exposures of banks will not least be of major significance when a capital adequacy system is in place which is considerably more complicated and comprehensive.
Implementation time and consultation deadline
The New Basel Capital Accord will mean increasing demands as to qualifications and resources both within institutions and with the supervisory authorities. The short implementation deadline set in 2004 will mean that both banks and the supervisory authorities will be facing great challenges.
FNH is of the opinion that both the scope of the proposals and the major changes being proposed in the regulatory framework of the new Basel Accord, will mean that preparing comments will be time consuming. In view of this it would seem that the time period for presenting remarks is too short.
2. Scope of application
The Basel Committee proposes a widening of the definition of institutions to be included in the consolidation so as to apply also to securities firms and bank holding companies. Norges Bank and Kredittilsynet support this proposal. Securities firms and banks compete to some extent within the same markets and will largely be exposed to similar risks. Consolidation of holding companies will provide a more correct picture of overall risk exposure while reducing the extent of dept-financed capital in subsidiaries/ associated companies.
We furthermore endorse the Committee's proposal that the capital requirement must be complied with both at company level, at sub-group level and at group level. The consolidation provisions will thus help ensure that the capital is being allocated in proportion to the degree of risk in various parts of the group. This will be necessary to avoid contagion effects within financial conglomerates.
Norges Bank and Kredittilsynet support the Committee's proposal for full consolidation of a subsidiary which is a credit institution or a securities enterprise. With regard to the treatment of minority interests, we are, however, of the opinion that a deduction should be made from the capital of the group for the share of the minority interests in any surplus of total capital in a subsidiary beyond the minimum requirement.
The Committee also proposes that until further notice a deduction shall be made from the total capital for a subsidiary which is an insurance company. In Norway the requirements as to capital adequacy for credit institutions and securities firms have also been made applicable to insurance companies, at company as well as at group level. We take a positive view of continuing the work to develop capital standards for financial conglomerates. The trend which entails that a financial services group is no longer made up exclusively of banks, and the overlapping of activities in banking and insurance, will increase the need for supervision of mixed groups.
3. The first pillar - minimum capital requirements
3.1 The Standardised Approach
The standardised approach as it is presented in The New Basel Capital Accord, is founded on the same principles as the current capital requirement for credit risk. The most significant changes proposed are the possibility of using external ratings of counterparts for the purpose of determining risk weighting on claims.
It is furthermore proposed in The New Basel Capital Accord to introduce a new risk weighting of 150 per cent for those assets with the lowest rating, as well as for non-performing loans. Non-rated counterparts will as a main rule be given a weighting of 100 per cent. We would note that as far as those counterparts are concerned to whom the highest risk attaches, there will be a definite incentive to avoid being rated so long as they are able to obtain a lower risk weighting by not being rated. This must be deemed an unfortunate aspect of the proposal. Norges Bank and Kredittilsynet are, however, in favour of the proposal that non-performing assets be given a risk weighting of 150 per cent for any part exceeding any loan loss provision made against the commitment.
Norges Bank and Kredittilsynet are nevertheless of the opinion that it will be necessary to retain the standardised approach as an alternative for the banks. Many smaller banks will have neither the need for, nor be in a position to avail themselves of neither the simplified nor the more sophisticated version of internal rating. This should be viewed against the type of business conducted by these banks, and that many of these banks already maintain a high level of capital adequacy.
Weighting of claims on banks
Norges Bank and Kredittilsynet would point out that banks are subject to supervision, to capital requirements and to an underlying safety-net, something which taken together might justify a lower weighting for banks than for other commercial activities. There are two proposals for the weighting of claims on banks in The New Basel Capital Accord:
- Claims on banks are given a risk weighting corresponding to one risk category above the risk class pertaining to the sovereign. There is a cap of 100 per cent weighting, with the exception of banks in countries with the weakest rating. For these banks the risk weight is set at 150 per cent.
- The risk class is commensurate with the bank's individual rating, yet can never be below the risk class of the country where it is domiciled. Non-rated banks are given a risk weighting of 50 per cent.
One weakness of the alternative 1 is that it punishes the best banks while the weaker ones fare relatively better. Besides, that alternative will not offer any incentive for banks to further develop their risk management.
Although alternative 1 is not in accordance with the principles of risk based weightings there are considerable disadvantages to small countries with small banks under alternative 2. These banks will only to a minor extent be rated and will thus be allocated a risk weighting of 50 per cent. Furthermore this method can be justified since there is a close relationship between the country's economic situation and the credit-worthiness of its banks. Against this, Norges Bank and Kredittilsynet support alternative 1 which will entail that banks are allocated risk weightings according to the country's risk class. FNH and Sparebankforeningen also lend their support to that alternative.
The alternative 2 would allow claims with a maturity of three months or less to be given a lower risk weighting. Norwegian banks make use of borrowing at up to six months term in the interbank market. FNH and Sparebankforeningen are of the opinion that specifying the limit for short-term claims as a maturity of three months will offer strong incentives for banks to use shorter term funding. This will contribute towards a higher liquidity risk in banks. Norges Bank and Kredittilsynet endorse these points of view.
Weighting of claims secured by commercial property
As far as loans secured by commercial property are concerned, the Basel Committee points to that in many countries loan losses over time have been substantial, so that having a risk weighting of less than 100 per cent cannot be justified. Norges Bank and Kredittilsynet share that opinion. Norwegian experience has also shown that the risk of loss related to such commitments is considerable, hence a risk weighting of 100 per cent should be applied.
Recognition of rating agencies
Using external ratings of counterparts in determining the risk weighting could mean that capital requirements become more sensitive to risk. The proposal furthermore provides opportunities for the supervisory authorities in the individual countries to allow the use of so-called "unsolicited ratings" along the same lines as "solicited ratings". A number of countries, however, have established neither rating agencies nor "unsolicited ratings". In particular where many smaller banks in such countries are concerned, very few of their counterparts will possess a rating, and the change compared with the existing regulatory framework will therefore not be significant. These banks will, moreover, suffer a competitive disadvantage vis-á-vis countries where rating is more widespread, since they will need to allocate a risk weighting of 100 per cent to corporate claims.
The advantage of allowing "unsolicited ratings" to be recognised is that a larger number of commitments can be given a risk weighting based on external rating. It is, however, of the utmost importance to impose very strict requirements on these companies, for instance with regard to the quality of the data and methods which form the basis for the rating.
3.2 The internal rating based approach
Norges Bank and Kredittilsynet take a positive view of allowing banks' internal rating systems to be used because this will contribute to a closer relationship between the capital requirement and the actual risk inherent in the portfolio of each institution. The proposal will furthermore contribute to making banks more competitive in providing finance to large and sound enterprises. A possible lowering of the capital requirement for exposures towards these will assist in making financing through banks a real alternative to borrowing directly in financial markets for such enterprises.
The proposal goes far in providing useful guidelines with a view to implementation. Also in this respect it will be important to exercise the second pillar. Should the supervisory authorities find that a financial institution has a portfolio composition with risk elements that deviate clearly from what has formed the basis for calibrating the capital requirement, then the consequence should be a higher individual capital requirement.
The length of data series
The Basel Committee has posed a minimum requirement as to the length of the historical material for calculating the "Probability of Default" (PD) of 5 years. Norges Bank and Kredittilsynet would point out that 5 years appear to be rather a short time for capturing fluctuations across the economic cycle. Ideally one should therefore have longer time series in order to calculate credit risk . If Norwegian banks had taken the previous 5 years as their basis in estimating credit risk, the capital adequacy would probably have been too low, because during that period of time Norway's economy has largely been marked by economic expansion and small credit losses. Like the Basel Committee Norges Bank and Kredittilsynet hold that banks will need to use conservative assumptions and assessments in adapting the elements which form part of the internal ratings systems in banks.
Norges Bank and Kredittilsynet would emphasise that a conservative emphasis will be particularly important if the historical material has a relatively short span. For banks as well as the supervisory authorities it will be an important task to ensure that such a conservative approach will be adopted as the basis for evaluating risk. Norges Bank and Kredittilsynet would emphasise how important it is that banks should be requested to complete necessary stress tests for the purpose of assessing the impact of unforeseen events.
Taking as the basis an evaluation of the fact that the historical material which is to become part of the banks' rating systems will not be completely satisfactory, it is moreover of significance to assess how important the requirement as to historical depth is as compared with the other requirements made of internal rating systems. To apply an internal rating system will for instance require that it must be possible to divide the portfolio into classes both by customer category and risk, and that no risk class (grade) within one single customer category may have a proportion of more than 30 per cent of the total exposure for that customer category. It is a further requirement that the internal rating must at regular intervals be subjected to reviews and re-evaluation by an independent body. The minimum requirement as regards the time horizon for estimating the probability of default is 12 months. Weighing the various requirements against each other will, as viewed by Norges Bank and Kredittilsynet, also be of significance as to when Norwegian banks may start using internal rating systems in calculating their capital requirement.
Definition of default
The Basel Committee outlines four different alternative occurrences as definition of a "default" situation. Norges Bank and Kredittilsynet are of the opinion that these are events which are mainly practised today in evaluating the probability of default. It is nevertheless the point of view that the definitions outlined are not necessarily sufficiently clear and unambiguous to ensure common standards and a common understanding of the concept among institutions. This is also important from the point of view of the supervisory authorities whose responsibility is to approve each bank's "PDs".
It has been proposed in the new Capital Accord that maturity should be one of the parameters included when calculating the capital requirement. The probability of insolvency increases with the length of the time horizon. A capital requirement which reflects this fact is therefore, in the opinion of Norges Bank and Kredittilsynet, well justified and consistent with the objective to tie the capital requirement with actual risk.
When using the "Foundation Approach" the Basel Committee proposes that the effective maturity should be set at three years for all types of loan. Norges Bank and Kredittilsynet have no view as to whether three years is a correct estimate, or whether applying this estimate could contribute in changing bank's behaviour as regards the maturity of the portfolios within the various categories. It is furthermore the opinion that the average maturity in a credit portfolio might increase considerably in an emergency situation. Consequently, the requirements as to maturity should to the greatest extent possible be tied to real maturities, as the requirement is when using the "Advanced Approach". Banks' calculations must, however, be presumed to be adequately documented so that disloyal adaptations to the regulatory framework may as far as possible be averted.
Within the "Retail-market" the Basel document contains several proposals for segmentation. Norges Bank and Kredittilsynet have no particular comments on the proposal, but the opinion is that segmentation according to type of product or type of debtor (using scoring systems) is what has so far been the most relevant. Developments both as regards products and systems will, however, mean that the segmentation will constantly need to be changed.
Expected and unexpected losses
The capital adequacy requirement for the IRB approach has been calibrated on the basis of Probability of Default (PD) in the various risk categories, and under an assumption of Loss Given Default. It has been taken as a further basis that the variance in "PD"-values remains constant across all risk categories, a fact which may prove to deviate from the actual state of affairs in various countries and market areas. The calibration has also been based on an assumption of an average remaining maturity of loans of three years.
Equity capital should cater for losses beyond expected losses. By relying on expected losses when determining the capital requirement, one can argue that there is an inclusion in the calculations elements which may be covered by operating earnings which will consequently not be charged against the equity capital. The calculations may therefore result in a capital requirement slightly too high. Experience nevertheless warrants that the regulatory framework concerning loan loss provisions in many countries are not designed in a way which adequately capture expected losses. It may also be the case that banks have insufficient risk pricing so that margin mark ups to cover expected losses are not being carried out in full. Under those conditions it will be more likely that banks will need to charge the equity capital in years with negative results. This would warrant a conservative calibration of the capital requirement. An additional argument in favour of a conservative approach is that many countries permit banks to include in the total capital reserves allocations which have the character of being provisions for expected losses.
Requirements for recognition of internal rating
Recognition of internal rating systems entails, among other things, ensuring that the quantitative and qualitative requirements have been met. In our view it is important to emphasise that model analytics only represents one part of the recognition process. It is furthermore important to ensure that the rating system covers the business areas of the institution, and that it captures the risk associated with those business areas.
Equally cardinal to the recognition procedure will be to review and evaluate the control environment surrounding the model, and to establish an understanding of the risk inherent in the activities comprised by the model. An important part of the recognition procedure will be to ensure that rating systems form an integral part of the credit assessment process and the internal risk management with implications for the pricing of individual credits and the composition of the lending portfolio.
3.3 Credit Risk Mitigation (CRM)
One objection to the current Capital Accord is that only to a limited extent does it consider the use of risk mitigation techniques in calculations of capital requirements. Norges Bank and Kredittilsynet are in principle in favour of greater acceptance of the use of risk mitigation techniques in the capital adequacy context. We consider it important to create incentives in the form of capital relief for the use of such systems and techniques.
The overall objective must be to ensure that the transfer of risk is real and irrevocable when such methods are employed. One cardinal issue is how the rules are to be designed in order best to take these techniques into account upon calculating the capital requirement and to achieve a harmonised implementation in order to secure a level playing field.
The Basel Committee proposes that general principles shall be applied which may be used across the various techniques and instruments within the categories collateral, on-balance sheet netting, guarantees and credit derivatives. 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. At the same time such an approach would mean that instruments with similar risk reducing effects would be dealt with in a consistent manner. Norges Bank and Kredittilsynet would nevertheless point out that the proposal will cause considerably more work in the form of interpretation of the regulatory framework, both as far as the institutions are concerned, and the supervisory authorities. Moreover, a more complex body of rules will also necessitate increasing the complexity and scope of administration and oversight of compliance. Norges Bank and Kredittilsynet want to stress that the continued efforts relating to these issues should endeavour to find ways of simplifying matters.
Norges Bank and Kredittilsynet support the Committee's evaluations regarding legal aspects and requirements as to risk management. The complexity of the risk mitigation techniques is generally of a nature that makes it necessary to have sufficient focus on the management and control of operational risks occurring when such techniques are employed. Of core importance here will be risks associated with legal matters and documentation.
3.4 Asset Securitisation
Securitisation entails a re-distribution of risk from financial institutions to investors who must be expected to be capable of evaluating the risk and therefore demand to be compensated accordingly. This may also be used as a tool in managing risk since it is possible to sell unwanted assets or assets that are overrepresented in the portfolio. In the same manner, an institution may acquire assets that are underrepresented in the portfolio, thus achieving a lessening of the risk through wider diversification. When loans are being removed from the balance sheets of financial institutions, it is possible to handle the same volume of credit with a smaller amount of equity capital without adversely affecting the stability of the system. To achieve these effects, however, a number of prerequisites will have to be met.
In the context of capital adequacy securitisation transactions ought to be dealt with from various points of view. On the one hand banks are involved in the process in that they sell loans to a Special Purpose Vehicle (SPV) and/or in that they act as managers, provide credit support or liquidity support to the SPV. It is moreover a question how the claims should be risk weighted after having been securitised.
There is reason to assume that the capital adequacy regulatory framework has motivated a large number of the securitisation transactions until now. Banks' desire to reduce the capital requirement has in many instances been the main objective. Nevertheless it ought to be an objective that the regulatory framework regarding capital adequacy should have a neutral effect where such transactions are concerned.
The new Basel Capital Accord defines clear terms and conditions for ensuring a "clean break" between the portfolio sold and the lender bank. This is a precondition if the bank no longer is to be required to calculate a capital requirement for the sold portfolio. As the proposal has been presented it will be a contribution towards a harmonisation of the regulatory framework for securitisation in the various countries, and Norges Bank and Kredittilsynet regard this as a positive aspect.
Reputational Risk and Cherry Picking
It may appear, however, that there are two sets of problems that have been inadequately resolved in the proposal. One concerns the handling of reputational risk to the originating bank. Even when all terms and conditions warranting a "true sale" have been met, it may still be conceivable that the bank will deem it expedient to provide some support to the SPV if it should turn out that there are major loan losses in the portfolio. The problem with this kind of risk is that it only becomes visible afterwards. It may nevertheless seem like the proposal might contribute in aggravating the consequences upon the originating bank of any such act.
In addition there is the problem relating to cherry-picking. When the originating bank transfers the best loans to a SPV, the claims on the SPV will obtain a high rating. At the same time the average quality of the portfolio remaining with the bank will be lowered. Especially in the case where the seller bank calculates its capital adequacy requirement according to the standardised approach, this will not necessarily have any effect on the capital ratio.
Risk weighting of securitised claims
The proposal from the Basel Committee has been drafted so that the risk weightings of securitised claims are lower than if the bank carries a direct claim in its balance sheet. The proposal may perhaps be justified by the fact that the loan portfolios underlying the securitised claims are more widely composed and for that reason entail less risk. At the same time, a lower risk weighting of securitised claims will represent a further incentive to offloading from the balance sheet of the bank. Norges Bank and Kredittilsynet regard it as unfortunate that the capital adequacy regulatory framework should provide such an incentive.
3.5 Operational risk
The New Basel Capital Accord proposes a separate capital requirement to cover the operational risk of banks. Three alternative methods of varying degrees of sophistication are set out in the proposal; "The Basic Indicator Approach", "The Standardised Approach" and "The Internal Measurement Approach". The Committee's proposals for The Basic Indicator Approach and The Standardised Approach provide a simple approach to the quantification of operational risk. Norges Bank and Kredittilsynet would nevertheless suggest that this is an acceptable approach since the institutions' own systems as of today are probably not sufficiently well developed for calculating the capital requirement. We are, moreover, of the view that the proposal may be expected to draw attention to these risks and to provide incentives for better control and management. In time, more advanced institutions may be capable of developing systems that will meet the requirements in "The Internal Measurement Approach".
Although the capital requirement for operational risk is anchored in the first pillar, we hold it to be important that sufficient attention is given to these risks when individual capital requirements are set within the second pillar. The manner in which the two most simple proposals have been designed, highlighting internal control etc. which might reduce operational risk, will have no direct effect in the form of a reduced capital requirement under the first pillar. Consequently, the supervisory authorities ought to have the opportunity to adjust the capital requirement relating to operational risk following closer supervisory evaluation. An individual capital requirement that is lower for institutions where efforts to reduce the operational risk have been implemented will provide additional incentives for institutions to reduce such risks.
FNH and Sparebankeforeningen also consider that the current proposal for operational risk fails to provide sufficient incentives for banks to allocate resources to internal controls. Both organisations are of the view that the requirement is more appropriately placed under the second pillar where a more thorough and overall review is made of the relationship between financial strength and risk.
4. The second pillar - supervisory review process
The purpose of the second pillar is to review the capital situation of banks and their strategy for capitalisation as well as to ensure that the size of the total capital is consistent with the risk profile of the bank. The supervisory authorities shall be assured of a legal basis for determining individual capital requirements in cases where they consider that a bank is insufficiently capitalised. The reason for individual minimum requirements is that the risk profiles of banks are dissimilar, and that the general minimum requirements fail to take account of that dissimilarity.
Norges Bank and Kredittilsynet are basically in favour of the principles set out in the second pillar. The proposal may contribute to greater solvency in the banking industry by means of a more efficient supervision of banks at the same time as the banks are given an incentive to develop and improve their risk management systems. Since banks to a greater extent will use their own risk assessments, it is reasonable that the supervisory authorities conduct a more active follow up and evaluation of the risk profiles of banks as well as their risk management and internal control systems, and that, based on an overall assessment, they have the opportunity to impose a higher minimum capital requirement.
Resources needed and the scope of the second pillar
The New Capital Accord will mean that the overall system for capital adequacy will become substantially more complicated for banks as well as for the supervisory authorities. Where the latter are concerned, there will thus be a need for both an upgrading of competence and an increase of the resources available for handling a system that is considerably more comprehensive and complicated.
The New Basel Capital Accord, and in particular Pillar 2, contains strong elements of risk based supervision, and this would warrant that supervisory resources should be channelled to those institutions which represent the greatest risk to the financial system and/or where the system risk is the greatest. Norges Bank and Kredittilsynet therefore deem that it would be natural for the second pillar to be principally directed towards that type of institutions. In our view, institutions that represent a lesser degree of risk to the financial system could mainly be monitored by means of off-site supervision. The problem concerning the scope of the second pillar is in our view of particular relevance in connection with principle 3, which relates to the determination of individual capital requirements.
Changes in the supervisory methodology
Norges Bank and Kredittilsynet would point to the fact that Pillar 2 entails a material change in the methods of supervision. The proposal will mean that the supervisory authorities will be given a more active role in evaluating and approving the risk management systems of banks, the assessment of overall risk and the level of the capital adequacy as well as the power of supervisory intervention. It is nevertheless a cardinal fact that it is the management and owners of the bank who are responsible for proper risk management and for taking appropriate action if and when problems arise.
The need for harmonised supervisory practice
In the "Supporting document to the New Basel Capital Accord" relating to the second pillar, it follows that it is not the purpose to harmonise the supervisory process in member and non-member countries, as different legal regimes, powers and styles of supervision will persist. As viewed by The Basel Committee, it is intended that the second pillar will encourage consistency in supervisory approaches and that supervisors will share their experience in implementing and practising Pillar 2.
Sparebankforeningen deems that both the supervisory authorities and banks will find it to their advantage that relatively precise standards are issued for the implementation of the second pillar. The Association considers that, unless definite standards have been established, it will be difficult for the supervisory authorities to command the requisite authority among banks when banks are ordered to increase their capital adequacy.
Norges Bank and Kredittilsynet are of the opinion that the new pillar will increase and highlight the need for international supervisory practices which are harmonised to the greatest possible extent in order to ensure that competitive conditions for banks are as equal as possible across national borders. We would therefore welcome the Basel Committee to draw up further guidelines on implementation and practising of the second pillar. Norges Bank and Kredittilsynet would here refer to the work done under the auspices of Group de Contact of Banking Supervisors in the EEA-area on "supervisory convergence" and "high level principles on supervisory review".
Any guidelines on how to practise Pillar 2 should also contain further provisions regarding the determination of individual capital requirements. As far as the supervisory authorities are concerned, it may be difficult to determine how risk profiles or shortcomings in the risk management procedures may result in an explicitly higher capital requirement. Any shortcomings in the risk management procedures will require a qualitative assessment that cannot be directly translated into a quantitative charge. At the same time persuasive arguments will be 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.
Interest rate risk in the banking book
The Basel Committee cites that there is considerable heterogeneity between internationally active banks with regard to the "nature of underlying risk" and the processes for managing and monitoring such risk. Against this background the Committee considers that interest rate risk in the banking book should be dealt with in Pillar 2. The Basel Committee nevertheless mentions that an explicit minimum requirement may be relevant provided that the banks are sufficiently homogenous.
Norges Bank and Kredittilsynet would refer to the fact that interest rate risk in the banking book can for certain institutions represent a considerable risk. For competitive reasons it is therefore essential to ensure consistent treatment of such risk among the supervisory authorities in various countries. In our view, therefore, the main rule ought to be that interest rate risk in the banking book should be dealt with under the first pillar, and that only in exceptional cases should it be dealt with in the second pillar. An explicit capital requirement will also reduce the possibilities for arbitrage between the banking book and the trading book.
FNH and Sparebankforeningen also take the view that this risk should have been included in the first pillar and cite amongst others that well tried methods exist for the calculation of interest rate risk.
5. The third pillar - market discipline
Norges Bank and Kredittilsynet consider that the third pillar ("market discipline") is important to ensure both greater transparency and harmonisation of standards for external reporting. This may in turn be important for enabling market disciplining mechanisms to function. This is also founded on a reasonable trade-off, since banks to a greater extent will be using their own assessments of risk and capital adequacy, it is reasonable that this should be balanced by stricter requirements for transparency and the disclosure of information.
Degree of disclosure
The third pillar imposes very extensive disclosure requirements that are to be published as part of the financial reporting by the institution (annual accounts). IASC has prepared standards for supplementary disclosures that must be assumed to coincide in many respects with the Basel proposal. In the view of Kredittilsynet and Norges Bank, a co-ordination of the IASC and the Basel proposal on the subject of supplementary disclosures would be desirable.
The Basel proposal furthermore distinguishes between requirements and recommendations. Norges Bank and Kredittilsynet are of the opinion that it is unfortunate to regulate by means of recommendations since the legal standing of any such provisions will be be uncertain. In Norway corresponding recommended requirements were previously included in the regulations concerning annual accounts. That provision has now been amended to be an order because of the uncertain situation to which it gave rise to.
Sparebankforeningen deems it important that the information requirements and recommendations should not be so comprehensive that they may lack focus. One possible solution to this problem may be, according to the Association, that a set of requirements to be prepared for all banks, while those banks that use IRB will be subject to additional disclosure requirements.
Disclosure of individually determined capital requirements
The second pillar enables the authorities to impose on an institution a capital requirement above the minimum requirement. It is a cardinal issue whether the institution should disclose this through the third pillar or whether such information should not be made available to the markets. One objection to making individually determined capital requirements public may be that institutions with a low capital requirement might want to make that information public in order to gain a competitive advantage.
Norges Bank and Kredittilsynet will, however, refer to the fact that the institutions´ capital ratio in general is information available for the public (e.g. through reports and accounts). If details of individually determined capital requirements are not to be published, it might imply that these these institutions - in publishing seemingly higher capital ratios - will give the impression of being more financially sound compared with institutions not subject to such higher capital requirement. In our view this may undermine the main objective of market discipline, as the disciplinary functions of the market will be distorted by misleading information about capital ratios. We would, consequently, support a requirement for institutions to make public through Pillar 3 whether they have been subjected to a higher capital requirement by the supervisory authorities. Therefore, we will support a requirement that institutions via Pillar 3 have to disclose their capital requirements regularly. This will also be relevant for the stock exchange and securities markets.
Particular circumstances might imply that the timing of the disclosure is in itself of great significance, something which the supervisory authorities in certain cases will have to emphasise in their assessments.
6. Consequences for the capital adequacy ratio in Norwegian banks
In co-operation with Sparebankforeningen and FNH, Norges Bank and Kredittilsynet have carried out a study of 12 selected commercial banks and savings banks relating to the impact of the Basel Committee's proposal on the capital ratios. A more detailed presentation of these calculations is given in appendix 3 to this consultation statement. The calculations are limited to the Standardised Approach for calculating the capital requirement for credit risk and to the Basic Indicator Approach for calculating the capital requirement for operational risk. There is some uncertainty attached to the figures, and the figures for the various banks are not directly comparable, as some of the banks have taken group figures as their basis for the calculations, while other banks have used figures from the parent bank.
The main conclusion is that the capital requirement for operational risk will have the greatest implications for the banks' capital adequacy. The calculations show a weakening in the tier 1 capital ratio (in total) of the selected banks of around 1 to 2 percentage points with the "Basic Indicator Approach". In these figures no account has been taken of Credit Risk Mitigation (CRM) in the standardised approach.
The proposal from The Basel Committee affects the risk-weighted exposures. The level of total capital will not be changed as a result of the proposal.
The impact study is based on data as of 31 December 2000.
All the banks will be subject to a stricter capital requirement as a result of the standardised approach. When the 12 banks are viewed together there is a reduction in the tier 1 capital ratio from 7.8 per cent under the current regulatory framework to 7.6 per cent under alternative 1 for risk weighting of non-central government public sector entities (PSEs) and banks. The capital ratio is similarly reduced from 11.1 per cent to 10.8 per cent. Under alternative 2 there is a reduction of the tier 1 capital ratio and the capital ratio to 7.3 per cent and 10.5 per cent, respectively. The difference in the tier 1 capital ratio and the capital ratio between alternative 1 and alternative 2 reflects the fact that only very few of the PSEs and the banks are rated. These figures do not take CRM into consideration. Most of the banks reported that the extent of such techniques is limited at present, and that it has been difficult to provide data for calculating the effect on the capital requirement.
The following tabulation shows how the various parts of the Basel Committee's proposal is going to affect the total risk-weighted exposures in the three largest banks; Den norske Bank, Christiania Bank and Gjensidige NOR Sparebank (a savings bank):
The figures are a combination of group figures and parent bank figures. In addition, for one of the banks the figures only represent a fraction of the risk-weighted exposures. Although the figures are not directly comparable, the tabulation nevertheless provides a certain indication of the changes in risk-weighted exposures.
It will be seen from the tabulation that the exposures where the counterpart is an institution1 or a PSE provide the largest changes in the risk-weighted exposures of NOK 16.5 billion under the alternative 2. The other types of claim shows corresponding changes under the alternative 2.
With regard to changes that are not associated with alternative 1 and alternative 2 for risk weighting of PSEs and banks, risk-weighted exposures will increase as a result of the introduction of capital requirements for business commitments with an original maturity up to one year. The removal of the 50 per cent ceiling on counterparty risks weightings of OTC derivatives also contributes significantly. The effect on risk-weighted exposures of these proposals for business commitments and OTC-derivatives represents around NOK 9 billion and NOK 3.1 billion, respectively.
According to the proposal from the Basel Committee the capital requirement for operational risk should constitute around 20 per cent of the current capital requirement. Based on this it is possible to calculate the value of alpha in the Basic Indicator Approach and the values of beta in the Standardised Approach.
Basic Indicator Approach
The capital requirement under the Basic Indicator Approach is defined as gross income (as defined in the proposal from the Basel Committee) multiplied by alpha. Given that the capital requirement is to constitute 20 per cent of the current capital requirement, the Basel Committee has given a preliminary estimate of the alpha of 30 per cent. Based on the data collected from the Norwegian Banks the alpha looks in average to be somewhat over 30 per cent. The estimated alpha values vary from 19 to 50 per cent. Since the selection of banks is limited and that there is uncertainty attached to the figures, the estimates should be interpreted with every caution.
The capital requirement for operational risk will come in addition to the capital requirements for credit risk and market risk. If the basis to be taken is an alpha of 30 per cent, as the Basel Committee implies, there is a reduction in the tier 1 capital adequacy for the 12 banks together, from 7.8 per cent under the current regulatory framework, to 6.5 per cent. The capital ratio for the same banks is reduced from 11.1 per cent under the current regulation, to 9.3 per cent. The calculations assume alternative 1 for risk weighting of PSEs and banks.
The Standardised Approach
The Standardised Approach has seven "business lines", each with a belonging beta factor. The beta factor may be calibrated according to the assumptions given in annex 3 of "Operational Risk - Supporting Document to the New Basel Capital Accord", at page 21.
Several of the banks have not reported data under the Standardised Approach. At the same time none of the remaining banks reported data for all of the seven "business lines". It is therefore difficult to obtain a reliable estimate of the beta factors, and the figures have not been stated here. Even though the figures are uncertain and show considerable variation within each "business line", the estimates appear to be in line with preliminary studies from Basel. It will be necessary to have a larger number of banks in order to be able to provide a more exact estimate of the beta factors. The small number of banks means that including or excluding one single bank could result in substantial changes in the estimated beta values. In view of this, no calculations have been made of how the Standardised Approach might affect the capital ratio.
This impact study shows that the capital requirement for operational risk contributes to a significant increase in the aggregate (credit risk, market risk and operational risk) capital requirement for the participating banks. Norges Bank and Kredittilsynet are of the opinion that this should be taken into consideration in the further calibration of the capital requirement.
The Quantitative Impact Study
Three Norwegian banks also participate in "The Quantitative Impact Study" under the auspices of The Basel Committee. These results will be forwarded to the Committee by the end of June 2001.
1Institutions include credit institutions, investment firms and insurance companies. Claims on insurance companies are in Norway under the current regulation subject to a 20 per cent risk weight.