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The New Basel Capital Accord Reply to the European Central Bank to The

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The New Basel Capital Accord Reply to the European Central Bank to The THE NEW BASEL CAPITAL ACCORD REPLY OF THE EUROPEAN CENTRAL BANK TO THE THIRD CONSULTATIVE PROPOSALS (CP3) On 29 April 2003 the Basel Committee on previous proposals of the BCBS. The Banking Supervision (BCBS) issued its third improvements include, inter alia, the flattening consultative proposals (CP3) on the New of the risk weight curves for internal ratings Basel Capital Accord asking for comments based (IRB) approaches, the treatment under from all interested parties by 31 July 2003. Pillar II for banks using the IRB approach This note, which benefited from comments to address pro-cyclicality concerns, the provided by the Banking Supervision treatment of banks’ exposures to small and Committee, contains the contribution of the medium-sized enterprises (SMEs) and retail European Central Bank (ECB) on the matter. exposures, and the revised proposals for operational risk for banks or banking systems In line with its previous contributions,1 the experiencing high credit margins. ECB remains very supportive of the work being undertaken by the BCBS and reiterates its This note is organised in two parts. The first endorsement of the general thrust of the part contains remarks of a general nature proposed framework. In general, the ECB mainly from the viewpoint of financial notes that the third consultative proposals stability, while the second addresses specific mark significant progress relative to the technical issues. General remarks The general comments are divided into three to develop their investment plans and risk parts. First, issues warranting consideration management procedures in view of the when finalising the New Accord. Second, implementation of the New Accord. issues warranting enhanced monitoring in the first phase of implementation of the new Second, the ECB welcomes the proposals to framework. Third, suggestions for topics tackle the potential pro-cyclical effects of the related to the New Accord on which the new capital adequacy regime. In addition to BCBS could work in the future. the flattening of the risk weight curve, the proposed introduction of stress tests and the development of capital buffers above the (I) Issues warranting consideration minimum capital requirements within Pillar II when finalising the New Accord are steps in the right direction. The ECB has supported the need for considering the First, the ECB considers it to be of the utmost potential pro-cyclical impact of the New importance that the current schedule for Accord since the early stages of the BCBS’s finalisation and implementation of the New proposals.2 In this context, the ECB and other Accord be strictly followed. A timely euro area central banks have consistently finalisation by the end of this year would contributed to the supervisory debate by maintain confidence in the New Accord and complementing the discussion with a the credibility of the process. In addition, once agreed upon and published, the New Accord should not be subject to major 1 The ECB provided comments on the first and second consultative proposals released by the BCBS in June 1999 and March 2001 revisions until at least the implementation of respectively. the rules, envisaged at the end of 2006. This 2 See the ECB comments on the CP2 which can be found at the website of the ECB (http://www.ecb.int) under publications “The is consistent with the prudent policy followed New Basel Accord: comments of the European Central Bank”, by the BCBS so far and will also allow banks June 2001. ECB • The New Basel Capital Accord • August 2003 1 macroeconomic dimension to supervisory conditions when, inter alia, equity financing tools and practices. Concerns about pro- may be more difficult to obtain on the cyclicality of the New Accord might be markets. The counter-cyclical effect of such increased in an environment of deeper methods could be acknowledged by making economic and financial integration since an explicit reference to them in the text of vulnerabilities and cycle swings could become Pillar II. more synchronised. However, the ECB also realises that pro-cyclical effects cannot be • There could be cases in which supervisors reduced at the cost of a major misalignment might require banks opting for the between regulatory and economic capital and standardised approach to hold additional of a loss of integrity and “signalling power” in buffers against pro-cyclical fluctuations. internal risk-management systems. With The risk weights currently proposed under regard to the latter, the ECB understands the standardised approach may render the that one of the major innovations of the new capital requirements more sensitive to rules is to provide regulators with a new cyclical conditions. One “extreme case information tool through IRB systems. Against scenario” can be represented by the this background, the ECB sees merit in example of a bank with highly concentrated strengthening possible steps to alleviate the exposures to corporate credits, where a potential pro-cyclical impact of the New downgrade by one notch4 from A- to BBB+ Accord. More specifically: would lead to a doubling of capital requirements. It may be argued that such • The current text concerning the cases would be limited in that supervisory review of stress tests for banks internationally active and other important under the IRB approach (paragraph 724) domestic banks would opt for the IRB could be improved. In particular, the approach or would hold diversified supervisory review of banks’ stress tests portfolios. would appear to be optional under the proposed wording, which states that Third, the ECB takes the view that some “supervisors may wish to review how the improvements could be still introduced in stress test has been carried out”. A firmer relation to the correct incentives for banks statement that “supervisors should review to opt for more sophisticated approaches. how the stress tests have been carried In the area of credit risk, as the Third out”, namely when reviewing large Quantitative Impact Study (QIS 3) results systemically relevant banks, would thus be indicate, the incentive structure has been welcomed. This is also consistent with the significantly improved relative to the second agreement reached in the BCBS on 10 July consultative proposals thanks to the 2002. In particular, the public release on recalibration of the IRB approach and the the aforementioned agreement states in revision of the risk weights. However, in the the section on stress testing that “banks case of lower quality credits, it is envisaged and supervisors will use the results of the that the capital requirements calculated IRB stress tests as a means of ensuring according to the standardised approach will that banks hold a sufficient capital buffer be substantially lower vis-à-vis the IRB under the IRB approach”. The ECB approach and, presumably, this gap is likely considers the supervisory review of to increase as the credit quality decreases. profound importance for ensuring a This might create incentives for banks with a prudent application of this requirement. higher risk loan portfolio to adopt the • The ECB continues to support the building- 3 One way of building such buffers is through the expanded use by up of additional financial buffers3 in banks and supervisors of pro-active provisioning methods such as “dynamic provisioning”. favourable economic times which can be 4 Examples are based on the ratings used by the BCBS in the used in less favourable economic proposed New Accord. 2 ECB • The New Basel Capital Accord • August 2003 standardised approach. This argument is consultative proposals, enjoys the support of reinforced by the more beneficial capital the vast majority of non-G10 supervisors as impact for the G10 international banks under well as of the International Monetary Fund the IRB approach versus the standardised (IMF) and the World Bank.7 In this regard, it approach, according to the last QIS 3 survey.5 may be deemed appropriate for non-G10 This issue might be addressed, for instance, countries to extend the implementation of by requiring additional capital requirements Basel II for developing countries beyond the for those banks whose capital is not end of 2006. However, possible delays in the commensurate with their risk profile. Also in implementation of Pillar I rules should not the field of operational risk there still seems prevent supervisors in these countries from to be scope for improvements in the incentive implementing key components of the structure, in particular in the calibration of supervisory review (Pillar II) and market the basic indicator and the standardised discipline (Pillar III). In addition, thorough approach (see also the specific remarks implementation guidance developed by the below). BCBS for non-G10 countries, to be endorsed by the IMF and World Bank, would be an Finally, two issues relating to the common efficient tool in facilitating the transition of implementation of the New Accord, these countries to the New Accord. effectively to ensure a level playing-field on a global scale. First, there is the need to ensure a harmonised implementation of the new (II) Issues warranting attention in the framework in G10 countries. For example, implementation phase the US authorities have made clear that they intend to apply the new rules only to the The New Accord is a complex framework in largest, internationally active commercial comparison with the current one. A full banks and will require them to use only the understanding of all its possible implications advanced methodologies for credit and will be possible only some time after operational risk. In this respect, in case the implementation. For this reason, close United States does not provide for the monitoring of the application of the new implementation of less advanced approaches, regime will be important. In this regard, four the treatment of EU banks operating in the issues can be highlighted. United States via subsidiaries should be further clarified.
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