sign in sign up
<<
Home , Basel Accords, Basel II, Basic indicator approach, Tier 2 capital

What II Means for Unions In June of 2004, the Basel standards and to ensure had a Committee on Banking sound amount of capital. It required Supervision issued its participating financial institutions to “International Convergence maintain a minimum capital-to- of Capital Measurement weighted asset ratio of eight percent. and Capital Standards: A Revised Framework,” also The importance of sufficient capital known as Basel II. While levels was summed up by Jaime implementation of the Caruana, chairman of the Basel standard will vary from Committee, during World Council’s one credit union system (WOCCU) conference in Rome this to another, and the long- past summer. “No institution can term impact of the Accord maintain the public’s trust for long if is only conjecture at this it is not properly managed or lacks point, one thing is nearly sufficient capital. Since capital is certain: Basel II will com- the last line of defense against pel credit union systems insolvency, regulatory capital require- to do an even better job of ments are one of the fundamental analyzing risk and adopt- elements of financial supervision.” ing processes to mitigate it. was implemented in over History of the 100 countries and applied to both large and small banks and several credit union movements. As financial The Basel Committee on industry regulation has been con- Banking Supervision (Basel solidated in many countries, credit Committee) of the Bank for unions have become increasingly International Settlements subject to the capital standards of (BIS) is comprised of bank- the BIS. Credit union movements ing regulators in the Group in Australia, Ecuador, Bolivia, the of 10 (G-10) countries. It Dominican Republic and four prov- develops banking regu- inces of Canada have been subject to latory best practices and a risk-based capital standard that is coordinates the activities based on Basel I for many years, and of banking regulators in many European cooperative banks, G-10 countries, Spain and which are ancestral relatives of credit Luxembourg. unions, have been operating under Basel I for over a decade. The first Basel Capital Accord (Basel I) was issued From 2000 to 2004, the Basel in 1988 to provide interna- Committee worked to create a stan- tionally active banks in G- dard that better served the Accord’s 10 countries with a level playing field on capital ~ 2 ~

cuworldv7i2.indd 2 11/14/05 10:30:43 AM mandate to create meaningful capital to-asset ratio and introduced new requirements. World Council played Pillar one risk mitigation techniques. Some of an active role in these discussions the most relevant changes for credit to ensure that the credit union voice unions in Basel II are: was heard. • Moving from a one-size-fits-all As mentioned earlier, the minimum methodology for deriving the capi- Defining Capital acceptable capital-to-risk weighted tal ratio to a menu of three choices: The definition of capital has changed asset ratio was eight percent under the Standardized Approach, the only minimally from Basel I to Basel Basel I and remains the same for Internal Ratings-Based Approach II. Capital is still comprised of two Basel II. (IRB) and the Advanced Internal types, or tiers. Tier one capital is Rating-Based Approach (AIRB). comprised of permanent share- Basel II differs from Basel I in that The main difference between the holder equity (issued and fully-paid it takes a broader, more flexible approaches is that the Internal ordinary shares/common stock and approach to monitoring and man- Ratings-Based approaches allow perpetual non-cumulative prefer- aging risk and introduces two new very large institutions to rely on ence shares) and disclosed non- tools or pillars that increase oversight their own internal estimates of distributable reserves that are created and decrease reliance on the capital- risk components in determining or increased by appropriations of to-asset ratio (the capital-to-asset the for an retained earnings, capital donations ratio is known as pillar one). These exposure, which will likely result or other surpluses. two new pillars are: in different risk weightings. • The inclusion of Tier two capital is comprised of in the capital-to-assets ratio. less secure sources of capital and Pillar two therefore may not account for more • A regulatory review process (pillar • Much greater specificity in the risk than 50 percent of the total capital two) to assist supervisors in ana- weights and additional asset types of an organization. Tier two capital lyzing risk. in the Standardized Approach. includes undisclosed reserves, asset • The inclusion of external credit revaluation reserves, general pro- assessments from ratings agencies visions/general loan loss reserves Pillar three • A market discipline framework for loans and claims on govern- (loan loss reserves are not appli- ments, businesses and other finan- cable under the internal rating based (pillar three) that dictates what information should be disclosed cial institutions in the Standardized approaches), hybrid (/equity) Approach. capital instruments and subordinat- to the public regarding the capital ed debt, which cannot exceed 50 structure of the institution. • Greater allowance and recogni- percent of total capital. In those tion of mitigation tech- instances where credit unions have Basel II also made substantial chang- niques (e.g., collateral, guarantees converted their ownership shares es to the risk weights of the capital- and credit derivatives). from being withdrawable to perma- Continued on Page 14 nent sources of capital in line with International Accounting Standard Overview of the key differences for credit unions 32—which provides guidance on how to characterize shares of coop- between Basel I and Basel II eratives—these shares cannot com- Issue Basel I Basel II - Standardized prise more than 50 percent of capital. Capital ratio 8% risk-weighted assets No change As is the case under Basel I, if the Composition of capital Tier 1 & No change ownership shares in credit unions Supervisory review Not included New guidance on supervisory review process are unencumbered and fully with- Market discipline Not included Introduced in new Accord drawable, the shares cannot be con- Operational risk Implicit within ratio Specific formula of 15% of average gross income in the sidered part of either tier one or tier Risk weighting of assets One-size-fits-all 3 approaches (standardized, IRB foundation and two capital in Basel II. IRB advanced) Retail exposures 100% Treated separately with 75% risk weighting for (Standardized Approach) qualifying exposures What’s new in Basel II? Residential mortgages 50% risk weighting 35% risk weighting Basel I defined a standard method (Standardized Approach) Loans 90 days past due 100% 150% if specific provisions are less than 20% for calculating the acceptable capital- (Standardized Approach) of outstanding loan amounts; 100% if specific to-asset ratio of a financial institution: provisions are at least 20% of outstanding loan amounts; 100% if specific provisions are at least 50% of outstanding loan amount with supervisory discretion to reduce risk weight to 50%

~ 3 ~

cuworldv7i2.indd 3 11/14/05 10:30:45 AM Continued from Page 3 ments, other standards might not. “People who think How Does Risk Weighting Work? that Basel II will create significant competitive inequities should realize there are multiple reasons why a bank The following example (see figure 1) might carry a certain level of capital on its balance illustrates how risk weighting differs sheets, say to meet the standards of a rating agency. from a leverage ratio (where capital This won’t change because of Basel II,” said Gary is divided by total assets). Rogers, chief financial officer of Credit Union Central of Canada. How Basel II Will Affect Credit Unions Although implementation of Basel II will be determined at the provincial level in Canada, Rogers feels that the Countries and leagues where credit Accord is likely to benefit credit unions whether they’re unions are required to implement required to implement it or not. Basel II will feel the most immediate impact. In Australia, where banks “In any case, Basel II will have at least an indirect impact and credit unions share a common on credit unions,” said Rogers. “The standards raise regulator, Basel II will be imple- the bar on what constitutes safe and sound business mented across the board. practices and . Basel II is not just about calculating capital requirements; it’s about knowing “There is some concern that this your business and using the most up-to-date analysis will give banks an advantage over techniques to help you make effective decisions. It can credit unions. The larger banks are only benefit credit unions to adopt standards that force investing in expensive, sophisticated them to learn more about their business.” systems that allow them to take advantage of the highly complex By their very nature and structure, credit unions will risk analysis methods of Basel II; not be affected by some sections of Basel II: many of the typical credit union doesn’t have Basel II’s pillar three disclosure requirements are geared the resources to do this,” said John toward publicly traded banks and are not relevant for Gilbert, chief executive officer, Credit credit unions. As privately held, not-for-profit financial Union Services Corporation Australia, cooperatives, credit unions do not openly issue stock on Ltd. (CUSCAL). public exchanges, and those that do issue subordinated debt generally do so under more restricted conditions A number of recent studies lend than banks by limiting or targeting debt to members. credence to this concern. They sug- gest that decreases in absolute levels of capital by institutions that utilize Recommendations more sophisticated approaches to Credit unions are neither banks nor micro-credit non- Basel II may be significant enough governmental organizations and should not be regulated to enable these organizations to or supervised as such. Around the world, credit unions translate these savings into lower vary in size and relative importance in their respective priced products.1 financial markets. Consequently, credit unions should be prudentially regulated by competent financial sector This advantage may be somewhat regulators who understand the financial, operational, offset by the changes in risk weight- structural and social differences of credit unions relative ing for home loans. “We understand to other deposit-taking institutions. Credit union supervi- that this will be reduced from 50 sion should be implemented and enforced based on the percent to 35 percent, subject to the credit unions carry. loans meeting certain criteria,” said Gilbert. “This could have a positive As cooperatives, credit unions do not obtain or seek impact on capital requirement levels, outside investment capital to start their organizations, because home loans typically make but rather grow capital internally over time from retained up 65-70 percent of a credit union’s earnings. This can have the effect of providing credit assets in Australia, but this might be unions with a more stable capital base than a bank, offset by higher capital requirements which is oftentimes funded by revalued assets, and sub- for operational risk.” ordinated and hybrid debt. However, in many countries, credit unions have historically been overly reliant on Keep in mind that while Basel II withdrawable member share capital. Credit unions often standards might allow financial insti- lack access to conventional capital markets, making it tutions to lower their capital require- vitally important that they build financial strength and ~ 14 ~

cuworldv7i2.indd 14 11/14/05 10:33:01 AM adequate reserves to ensure sound operation. Equally Calculating the Capital-to-Asset Ratio important is regulatory recognition that credit unions, as in Basel II (pillar one) retail-oriented institutions, often present little systemic figure 1. risk to a financial system.

There is a broad base of support from international organizations2 to encourage regulators, especially in developing markets, to focus on a strong supervisory Sample Institution: ABC Credit Union regime as opposed to implementing Basel II carte blanche Assets Value on books Risk Weight Weighted Value without recognition of local conditions. “WOCCU has Cash on hand ...... $20 ...... 0% ...... $0 (in AA+ rated country) long recognized the important role that a strong regula- Financial investments in banks .... $40 ...... 20% ...... $8 tory system plays in the success of a credit union system. Mortgages ...... $150 ...... 35% ...... $52.5 Auto loans ...... $70 ...... 75% ...... $52.5 We believe that Basel II can be a valuable tool for regula- Personal loans ...... $30 ...... 75% ...... $22.5 tors to use when evaluating risk and appropriate capital Loans in default not provisioned .. $5 ...... 150% ...... $7.5 requirements,” said Pete Crear, WOCCU CEO. Securities ...... $0 ...... $0 Total Assets ...... $315 ...... $143 Gross Income - for Calculating Operational Risk Should a Credit Union System Adopt Basel II? Year 1 ...... $20 Year 2 ...... $4 The existence of prudential supervision should be the Year 3 ...... $12 first consideration when determining if credit unions Average Gross Income over 3 years ...... $12 Beta Factor in Basic Indicator Approach ...... 15% should apply Basel II. This is most typically a concern in Ave. Gross Income adjusted by Beta Factor ($12 x .15) ...... $1.80 non-industrialized countries. Equating operational risk to be 8% of risk weighted assets ($1.80 x 12.5 (reciprocal of 8%)) ...... $22.5 Apply Basel II if... Do Not Apply Basel II if... Capital Retained earnings ...... $11.8 • Strong, prudential • Credit unions are not Capital donation ...... $1.9 risk-based prudentially supervised. Total Capital ...... $13.7 supervision Resources are better exists spent on ensuring strong AND examination and oversight Capital-to-Risk Weighted Asset Ratio (ABC Credit Union) • Credit unions compete • Strong supervisory oversight $143 Risk Weighted Assets exists but: Credit unions/ directly with banks 100 8.28% Total Capital that adopt supervisory staff would have $13.7 $0 Asset Ratio Basel II a difficult time understanding, calculating and applying the $22.5 Operational Risk AND capital-to-asset ratio under • Credit unions/supervisors pillar one Capital to TOTAL Assets Ratio (ABC Credit Union) understand how to OR 100 4.35% calculate the capital $13.7 Total Capital $315 TOTAL Assets ratio under • Credit unions do not compete Asset Ratio pillar one directly with banks that use Basel II. Focus should be directed to strong risk- Do not apply Basel II if... based supervisory system. Do apply Basel II if... And while concerns about the impact 1 Emmons, William R., Basel II Will Trickle Down In the appropriate situations, implementation of Basel II of Basel II upon the competitive to Community Bankers marketplace may be valid, credit footnotesand Consumers, The may help establish regulatory neutrality and introduce a Regional Economist, April more risk-sensitive capital and management framework unions should also realize the 2005. Paletta, Damian, A benefits the Accord could bring to Tale of Two Fed Staffers in credit unions. Prior to the application of Basel II, the and a Paper on Basel II, credit union industry should be consulted by the regula- their systems. Maintaining a strong American Banker, January capital position can guard the insti- 14, 2005. Quantitative tory agency and a quantitative impact study should be Impact Study 3, Bank for completed to understand the ramifications of applying tution from catastrophic events and International Settlements. provide for better service and growth French, George, Estimating Basel II to credit unions. the Capital Impact of Basel of the credit union. Credit unions II in the United States, have always had strong community Federal Deposit Insurance Conclusion Corporation, December ties that bolster public trust for them 8, 2003. As regulators and lawmakers consider the application and a strong capital base will only of Basel II to credit unions, they should recognize that 2 See article titled Take deepen the foundation of trust. Time to Prepare for the there is not one approach that can be applied to all credit New Basel Rules. London unions worldwide, and that Basel II’s implementation –by Dave Grace Financial Times, August 12, 2004 by Cesare Calari, Vice should be made in the larger context of strengthening the Senior Manager, Association Services, WOCCU President, Financial Sector supervisory structure for the financial sector, including of the and Ryozo Himino, Secretary credit unions. General of the Basel Committee on Banking ~ 15 ~ Supervision.

cuworldv7i2.indd 15 11/14/05 10:33:03 AM