By Anthony Rowley
The new international capital accord for banks known as Basel II presents emerging markets with what managing director of the Institute of International Finance (IIF) Charles Dallara says will be a ?significant challenge?. For this reason, he says, bankers and regulators in these markets ?need to get in gear for Basel II sooner rather than later?. The market will ?reward those that get it right and penalize those that miss the opportunity?, he stresses.
?Basel II is poised to become the worldwide standard, but its implementation is complex,? says Dallara in an interview with Emerging Markets. ?Banks and supervisors alike have to make some serious choices and investments, and they have to train a lot of people fast. On the other hand, there's a unique opportunity to upgrade risk management and governance across whole banking sectors.?
The new framework, designed to replace the Basel I Accord introduced in 1988, seeks to bring banking regulatory capital requirements into line with specific (credit and operational) risks taken on by each bank, and to provide incentives for better risk management. Basel II, as rating agency S&P puts it, allows banks to ?apply more nuanced risk adjustments for determining their capital adequacy?.
Risk management has become an integral part of the business culture in most advanced nations, and with the coming into force of Basel II (from the end of 2006), it will become deeply imbedded in the banking culture too. But the concept of risk management remains alien to many emerging market economies ? in banking, business or government ? and this means that adoption of the new Basel principles is not going to be easy in these markets.
Flexibility
Recognizing this, the Basel Committee on Banking Supervision (of the Bank for International Settlements), which drew up the accord, is being flexible about the timing of implementation. Ryozo Himino, secretary-general of the Basel Committee on Banking Supervision, and Cesare Calari, financial sector vice-president of the World Bank, said in a recent joint statement they ?urge all countries to evaluate carefully their readiness for Basel II. We do not urge its adoption until they are ready.?
Basel II, they added, ?provides an excellent opportunity for banks to improve their risk management and for authorities to upgrade supervisory practices. However, a newly designed house must have strong foundations. Likewise, Basel II must be built on solid foundations such as sound accounting standards and practices, effective legal and judicial systems and adequate supervisory resources and powers. In the absence of such foundations, regulatory and supervisory resources should be devoted to infrastructure improvement.?
Central bank governors and regulatory heads from the G10 industrial nations approved the sweeping rewrite of global bank safety rules in late June. Basel II ?will enhance banks' safety and soundness, strengthen the stability of the financial system as a whole, and improve the financial sector's ability to serve as a source for sustainable growth for the broader economy,? Jean-Claude Trichet, chairman of the G10 central bank group, suggested at that time.
The intention, however, is to move Basel II out beyond the limited circle of the G10 quite quickly. ?We're glad to see that the Basel Committee's Accord Implementation Group is making non-G10 implementation a priority,? says Dallara. ?That can make a real difference. But emerging markets' supervisors should not allow themselves to take too much comfort from the Basel Committee's flexibility about non-G10 implementation schedules.?
First task
Emerging market banking regulators' first task should be ?to do a full assessment of their current regulatory infrastructure?, Dallara suggests. ?They need to establish clear and actionable priorities for reform. Ultimately, this process should conclude with the adoption of the New Framework, perhaps beginning with the simpler approaches, but facilitating the transition to the more complex approaches as soon as bank and supervisory capabilities develop.?
The proposed new capital accord, which the Basel Committee began studying in 2001, will replace the 1988 accord, which set simple ratios for determining bank capital adequacy in relation to risk assets. Basel II is based on what the IIF calls three ?mutually reinforcing pillars? that allow banks and supervisors to evaluate in a more sophisticated way the risks that banks face. It focuses on minimum capital requirements, a supervisory review of an institution's capital adequacy and internal assessments of risk.
Central bank governors argue that Basel II, which will help to promote global economic growth by letting capital flow around the world more readily and safely, still has to secure legislative approval in the nations that adopt the accord. But first bank regulators need to convince politicians that the new code will make financial systems more robust without imposing heavy financial and administrative burdens.
Evolution
The accord promotes the concept that regulations should evolve in line with advances in risk control practices. Publication of the 239-page accord is just the start of a long road to full implementation. It will be phased in between the end of 2006 (when the code's ?simpler approaches? are introduced) and the end of 2007 (when the ?advanced approaches? switch in). Some regulators fear that a banking crisis could erupt before then, in advanced or emerging market economies where banks have exposed themselves heavily to real estate and consumer financing during a long period of record low interest rates.
Even in advanced economies, banks have complained about the cost and complexity of the new system, although Jaime Caruana, chairman of the Basel Committee, has rejected as ?overdone? a widely-held view that the new Basel accord will add to pressure for banks to consolidate. The IIF has warned, however, that ?the accord could become costly and
perhaps difficult to manage if banks are subjected to inconsistent interpretations, duplicative requirements for information or repeated validation exercises by regulators.?
However, the lobby group hopes that ?over time an increasing number of jurisdictions will embrace Basel II, but only in a way consistent with their readiness. Banking supervisors will find several alternative approaches in the Basel II framework, from simpler to more advanced paths.?