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THE NEW BASEL CAPITAL ACCORD REPLY OF THE EUROPEAN CENTRAL 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 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 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 (ECB) on the matter. exposures, and the revised proposals for 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 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 , 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. Although more recently the First, in drawing up the agreement, the US authorities have demonstrated a positive emphasis has been rightly placed on the attitude towards exploiting options for implications of the New Accord for risk resolving implementation issues for foreign management and financial stability. The New banks operating in the United States,6 this Accord, however, is also set to have flexibility has not been reflected in the important structural implications for banks Advance Notice of Proposed Rulemaking and banking systems through changing bank (ANPR) released in July 2003 for consultation behaviour. The very diverse effects on capital by the US authorities. It is expected that some options for resolving implementation issues for foreign banks operating in the 5 QIS 3 – overview of global results, Table 1 on world-wide results – overall percentage change in capital requirements. United States will be introduced in the final 6 See, for example, “Basel II – scope of application in the United rules. Second, there is the breadth of States”, a speech given by Mr. Roger W. Ferguson Jr., Vice Chairman of the Board of Governors of the US Federal Reserve implementation of the New Accord in non- System, before the Institute of International Bankers in New G10 countries. If the New Accord is intended York on 10 June 2003. In the speech it is stated that “the US supervisors are prepared to explore the possibility of allowing US to remain as an international standard for subsidiaries of foreign banks to use conservative estimates of capital adequacy around the world, it is LGD and EAD for a finite transitional period”. 7 Both as overseers of the well-functioning of supervisory standards crucial that the new framework, and and codes in the context of the Financial Sector Assessment especially the simpler approaches of the Programs.

ECB • The New Basel Capital Accord • August 2003 3 requirements for individual banks triggered debt. In addition, the particularly low capital by the New Accord8 are likely to influence requirements for revolving retail exposures their business strategies through, for example, relative to similar types of unsecured personal mergers and acquisitions, a reallocation of consumer loans may have structural their loan books (e.g. through credit risk implications as banks could be induced to transfers or a restructuring of existing structure retail banking in the form of transactions), an increased specialisation on revolving exposures.10 This may hold true in products and/or counterparties with a particular in EU countries where unsecured particular risk profile and a restructuring of consumer loans and other similar types of retail banking activities in the form of exposures are widely used in addition to revolving exposures. These structural changes credit cards. An expansion of the latter type will also have to be monitored closely from a of credit could have implications for banks’ central bank perspective. as the mix of their could change (note the relative importance Second, pro-cyclicality concerns could be of operational risk for credit card based particularly relevant in the first phase of the exposures). Also, the low loss rates and implementation of the new framework when subdued volatility for credit cards seem to be banks are adjusting to the new setting9. This a characteristic of the more mature US may require closer monitoring by central market. All the above elements suggest a need banks and supervisory authorities so that for enhanced vigilance and close co-operation potential problems can be detected and between central banks and supervisory addressed in a timely fashion. Enhanced authorities in the implementation phase. corporate governance by banks will also be an important complement to the activities of public authorities in ensuring a smooth (III) Future work on issues related to the transition to the new regime. New Accord

Third, in the area of real estate lending the The revision of the capital adequacy regime, ECB has no objection to the new and more put forward by the BCBS, has focused on flexible treatment proposed under both the improving risk measurement. In order to standardised and IRB approaches. However, maintain the effectiveness of the overall it cautions that the extended recognition of approach in the long run, it will be necessary real estate collateral should not lead to for the BCBS to initiate work at some stage excessive real estate lending and an on other related issues. With a view to overheating of property markets. This entails contributing to the definition of the future a need for prudent valuation by banks to work programme of the BCBS, the ECB sees prevent increases in credit availability from priorities in the following areas: fuelling asset price bubbles for residential and commercial properties. • Accounting and provisioning. The pursuit of greater consistency in accounting and Fourth, in the area of credit cards, the proposed reduction in regulatory capital is 8 On the basis of the QIS 3, the impact of the IRB approach on significant and, for some banks at least, will individual banks varies significantly from a 46% increase in capital requirements to a 36% decrease. determine a level of regulatory capital well 9 For the calibration of absolute capital requirements for the New below the economic one. Under these Accord a full business cycle should preferably be taken into account. Notwithstanding the fact that the current state of circumstances, it is emphasised that excessive development in banks’ rating systems would not technically lending to retail customers via credit cards, allow the pursuit of capital requirements from a full business cycle perspective, it cannot be disregarded that the capital especially in periods of booming economic requirements that resulted from the QIS 3 were affected by the activity, may lead to undesirable “point-in-time” ratings that tend to prevail in many banks’ internal ratings assessments, and thus by the particular phase of macroeconomic effects, such as increased the economic cycle. consumer spending and increased household 10 This is acknowledged by the BCBS (overview paper, paragraph 76).

4 ECB • The New Basel Capital Accord • August 2003 provisioning rules across countries has practices for accepting instruments with become an increasingly important goal in step-ups. the context of a risk sensitive capital framework. Greater consistency will • Supervisory practices. The new framework promote competitive equality, allow better entails increased emphasis on supervisory cross-border comparisons, reduce the convergence in order to assure a “level reporting burden and reinforce the playing field” between individual banks and effectiveness of Pillar III. In this context, it banking systems. In the EU, work on would be of interest to further align convergence has gained momentum in the International Accounting Standards (IAS) context of the new institutional setting with Basel II. The ECB therefore supports following a political agreement reached at the initiatives being undertaken by the the Council of Finance Ministers in BCBS to co-operate with accounting December 2002 to extend the so-called standard setters, namely the International “Lamfalussy framework”, which is already Accounting Standards Board (IASB), to in place in the securities field, to other ensure that supervisory concerns are taken financial sectors. In the EU banking sector, into due consideration in the shaping of work on the convergence of supervisory the new standards and that there will be practices has already been set in motion no need for divergent accounting and by the Groupe de Contact (GdC) and is regulatory standards. For the latter, anticipated to be a major responsibility of common standards for aspects such as the the forthcoming European Committee of definition of default and the assessment of Banking Supervisors (ECBS). At the G10 impaired assets are of primary importance level, convergence efforts are being made in order to reduce the reporting burden via the Accord Implementation Group of banks and to ensure consistency (AIG). Given that, at this juncture, the between accounting and risk management mandate of the AIG is mainly confined to procedures. the exchange of information among supervisors, merit is seen in encouraging the • Definition of own funds. There is room for AIG to intensify its efforts in pursuing a further harmonisation of the definition of coherent cross-border implementation of the own funds, especially for innovative capital New Accord. This effort would, of course, eligible as Tier 1 or Tier 2, and for greater have a positive impact on the corresponding consistency in current supervisory work carried out in the EU context.

Specific remarks

This section contains comments on more should be made clear whether the proposed technical aspects of the proposals to be taken deduction should follow the current rules into account mainly with a view to the (i.e. the deduction should take place after the finalisation of the New Accord. calculation of Tier 1 and Tier 2 components of capital) or should be applied before arriving at the final figures. Scope of application

The proposed deduction of investments, Standardised approach namely 50% from Tier 1 and 50% from Tier 2, should be clarified in the final proposals The proposed preferential treatment of by, for instance including an example in an claims on sovereigns, namely the lower risk annex, as is the case with Tier 1 limits in weight to be applied at the discretion of Annex 1 of the CP3. More specifically, it national authorities to banks’ exposures to

ECB • The New Basel Capital Accord • August 2003 5 the sovereign of incorporation denominated a level playing field in cases where different in domestic currency and funded in that jurisdictions adopt different options. currency, is not subject to any limitations. This leaves ample scope for national The eligibility criteria for external credit discretion. Accordingly, the current broad- assessment institutions (ECAIs) could be brush rules on claims on sovereigns further strengthened, making the denominated in domestic currency remain requirements more binding, while specific unaffected and the element of credit risk for considerations may need to be taken into domestic funded exposures is completely account when considering the structure of disregarded. A more stringent treatment at the highly concentrated rating business. The least for low credit quality sovereigns may interest of the ECB in this matter derives not encourage prudent lending policies by banks only from the fact that it follows its own to the sovereigns in question. In this context, policy with regard to the eligibility of it should be noted that the ECB pursues a collateral for monetary policy operations and policy of equal treatment of public and private of investments for asset management issuers in its own operations. operations, but also from its role in maintaining financial stability. First, the ECB With regard to claims on multilateral believes that the assessment of new ECAIs development banks (MDBs), the ECB should be done in a prudent fashion, taking supports the more flexible drafting of the into account the fact that some elements that second eligibility criterion and the underlying may affect the assessment process, such as argument that the criterion of relying on revenues and market share, may be valid for shareholders’ creditworthiness to repay the existing international ECAIs but could liabilities becomes less relevant when there create potential barriers to the entry of new is no leverage. However, as the evaluation of players. For new players, less emphasis should MDBs will continue to be made on a case-by- be placed on market coverage and more on case basis by the BCBS, it may be preferable criteria relating to the robustness and to list in the text11 (paragraph 33) the MDBs soundness of the assessment methodology currently eligible for a 0% risk weight, as in and rating procedure. In addition, for these the case of claims on international institutions players, ex-post accuracy and validity of (paragraph 30). More generally, an update of ratings cannot be fully assessed due to the the list of MDBs eligible for a 0% risk weight, lack of sufficiently long data series (a rigorous together with the eligibility criteria, would be and meaningful validation process would a more workable and practical solution than require many years of historical data). Second, the current exhaustive reference to the in the aftermath of recent financial events, eligibility criteria to be applied by the BCBS. the following issues may require further reflection in the context of the rules on Regarding the treatment of claims on banks, eligibility criteria (paragraph 61): the need to remedy possible implications of the existence of the two options requires • The assessment of the ECAI’s enhanced co-operation. Indeed, the freedom independence in respect of corporate which jurisdictions have to choose between governance issues may need to be more the two options to claims on banks contained specific, namely by making explicit in the standardised approach could have reference to the need to prohibit the staff undesirable consequences. For example, an and directors of rating agencies from being unrated or poorly rated bank operating in a members of the governing bodies or G10 jurisdiction which adopts Option 1 could supervisory bodies of rated firms. benefit from a lower risk weight than a highly rated bank in a jurisdiction, which adopts Option 2. Supervisory co-operation could therefore play an important role in ensuring 11 MDBs are mentioned in footnote 15 of the consultative proposals.

6 ECB • The New Basel Capital Accord • August 2003 • Rating agencies should implement capital-market driven transactions or (iii) procedures to manage potential conflicts secured lending would promote consistent of interest that arise, such as from ancillary implementation of the definition of holding fee-based business and direct contacts periods (paragraph 137). With regard to the between analysts and subscribers. minimum holding periods required for calculating own estimates of haircuts With regard to the implementation of the (paragraphs 128 and 138) with a daily mark mapping process (Annex 2) under the to market valuation or with daily remargining standardised approach, the proposed three- of the collateral, it is not clear why the year cumulative default rate (CDR) minimum holding period is dependent on the benchmarks appear to be too generous. transaction type (i.e. repo, other capital There is a need for further clarification of transaction or secured lending). The minimum the distribution assumptions made in the holding period should be independent of the Monte Carlo simulations performed to derive transaction type and, instead, be dependent the proposed trigger levels. Experience of on the liquidation characteristics of the recorded long-run average CDR from collateral involved (i.e. the time required to international rating agencies implies that sell the collateral in an orderly fashion in the levels should be lower than the ones market). proposed. However, it is acknowledged that the proposals are intended to provide Finally, the reference to “reasonable steps” guidance to supervisors and not additional that banks should take to ensure that the eligibility criteria for ECAIs. custodian segregates the collateral from its own assets (paragraph 97) should be either clarified or, preferably, deleted, in which case Credit risk mitigation the paragraph would simply require banks to ensure that the custodian segregates the The inclusion of non-rated debt securities as collateral from its own assets. eligible financial collateral requires market liquidity. In this context, the requirement set forth in paragraph 116 (d), which focuses on Internal ratings based approach supervisors having sufficient confidence about market liquidity, could be changed and made The proposed rules for adopting a phased consistent with paragraph 96, which roll-out by banks with a view to extending emphasises the liquidation properties of the the IRB approach across the entire banking assets and the liquidation procedures. book (paragraphs 225 to 231) include several exemptions subject to materiality conditions On the proposed standard supervisory which are not further defined. These haircuts (paragraph 122), the risk of collateral exemptions refer to non-significant business could be better reflected in the distribution units, asset classes or sub-classes in retail as of residual maturities by using more than well as equity exposures. The introduction of three buckets. This is especially true for the materiality thresholds, or at least a general bucket for maturities exceeding 5 years in indication in the final rules of the amounts which collateral with very diverse maturities that the BCBS would consider to be are lumped together. In this regard, it would potentially eligible for exemption, would be desirable to divide the maturity bucket promote consistency in implementation and into two buckets, one for maturities between a level playing field. In addition, a situation 5 and 10 years and another for residual could arise where an immaterial exposure at maturities of more than 10 years. the group level is significant within a local banking system. Hence, the exclusion of an Guidance on the criteria for classifying exposure could be made subject to prior transactions as (i) repo-style, (ii) other enquiry to the host country in order to

ECB • The New Basel Capital Accord • August 2003 7 ascertain the relative significance of the to demonstrate prudent use of human exposure. Furthermore, the data used in judgement in their models’ ratings whenever order to determine the banks’ own estimates requested to do so by supervisory authorities (, or in the context of periodic reviews. and ) may be relevant at the group level but not at the local level. The time horizon used in probability of Hence, it may be useful to ensure the default (PD) estimations is set at one year relevance of the characteristics of the own (paragraph 376). A reference to the fact that estimates by imposing the condition that the BCBS will monitor developments in risk banks’ own estimates used locally should modelling and banking practice with respect reflect local characteristics. to the assessment horizon would be desirable. A sentence could be added in the text stating There seems to be an imbalance between the that the BCBS may revisit its requirements exhaustive but necessary list of minimum on the assessment horizon. This would also requirements that banks should comply with put the aforementioned references to in order to be eligible for the IRB approach prudent PD valuations into context. (paragraphs 349 to 500) and the assessment and action to be taken in cases of The use of stress tests (paragraphs 396 to non-compliance. With regard to the latter, 399) is welcomed as a step towards ensuring only very general references to situations capital adequacy under adverse economic, that might lead to supervisory action, market and liquidity conditions. The ECB using phrases such as “not in complete would support a reference to the fact that, in compliance”, “timely return to compliance addition to the already mentioned follow up plan” and “duration of non-compliance”, are at the national level (paragraph 399), the found in a single paragraph (paragraph 355). BCBS will monitor developments in the field More guidance on these issues would of stress tests and may come up with more promote consistent implementation. concrete guidance, if required. In the same Alternatively, the AIG should address these vein, an explicit reference to the results of issues. stress tests could be made in the context of the internal rating reporting to senior There are some elements of the proposals management (paragraphs 401 and 402, section that make sense from a functional point of on corporate governance and oversight). view to ensure that banks’ practices are properly taken into account when laying The proposed treatment of specialised down the rules on compliance with minimum lending and its five sub-classes (paragraphs requirements. However, these elements need 187 to 196, 218 to 220 and 244 to 253), enhanced monitoring to ensure a level playing although detailed, seems to leave open issues field and a prudent outcome when estimating such as the assessment of restructuring by capital charges. Against this background, the banks in distressed situations, which may in permission for banks to use human judgement turn have level playing field implications as to correct the rating outcome of credit the risk weights of the “weak” and “default” scoring models (paragraph 379) or to categories differ significantly (350% versus override the outputs of the rating process 625%, respectively, for all sub-classes). (paragraph 390) is welcomed as a potential means to improve the overall process. In this The reference to the application of the default context, a reference would be welcomed to rate for retail exposures at the level of the the need for a periodic review by internal facility rather than at the level of obligor, and and/or external auditors of the practices of to the fact that a default by one borrower on banks where human judgement has been one obligation does not require a bank to allowed to override the rating generated by treat all other obligations to the banking the model. In addition, banks should be ready group as defaulted (paragraph 417), makes

8 ECB • The New Basel Capital Accord • August 2003 sense from a functional point of view. The rule stating that a bank cannot assign an However, a default by a borrower on one adjusted PD or LGD to the guaranteed obligation may in practice also signal defaults exposure if the adjusted risk weight would on other obligations across the banking be lower than that of a comparable direct group. Thus it is proposed that there be an exposure to the guarantor (paragraph 444) explicit reference to recognise the fact that may be overly stringent. A prudent move banks will be allowed to make their own towards a more risk-sensitive approach could assessments and that supervisors will review be considered in this context, based on them. further research on the risk mitigation of “double default”. The treatment of previously defaulted exposures as non-defaulted and their possible The wide recognition of types of eligible subsequent reclassification as second guarantors13 which is unlimited for banks defaulted exposures (paragraph 419) could under the advanced IRB approach (paragraph be complemented by a reference to the need 445), including the recognition of conditional for prudent internal procedures by banks, guarantees (paragraph 446), may warrant including reviews by the internal or external attention, given the fact that the application auditors and their ability to demonstrate of the “w” factor, which may in practice limit prudent treatment to their supervisors. In the number of potential guarantors other the same vein, the re-ageing of facilities and than financial institutions, is no longer found granting of extensions, deferrals, renewals under Pillar I. An undue proliferation of and rewrites to existing accounts (paragraph guarantees provided by non-banks, and 420) may require guidance from the BCBS especially by non-regulated entities which are with a view to promoting consistency in not subject to capital requirements, may banks’ practices.12 require close monitoring, as it may have an adverse impact on the level playing field and With regard to the length of the underlying could give rise to reputational risks historical observation period (i.e. 5 years), it concerning the provision of guarantees in is stated that, if the available observation general. The ECB would welcome close period spans a longer period, the latter must monitoring by the BCBS of the possible be used (paragraph 425). However, it is not implications of such wide recognition of clear that long series of historical data would guarantees by non-regulated entities and a always be more appropriate because of possible future review of the proposals. The changes in the portfolio base, rating introduction of limitations may also be seen methodologies or economic circumstances. from a point of view of overall consistency, A bank should not have to give equal as the provision of insurance as a mitigant for importance to historical data if it is possible operational risk is limited to insurance to demonstrate that recent data are more providers (which already are regulated useful for the estimation of risk parameters. financial institutions) with minimum credit rating of “A” or equivalent. On the mitigating effect of guarantees (where own estimates of LGD are used) two options With regard to the recognition of other are given, an adjustment of the PD estimate physical collateral, it is stated that each or an adjustment of the LGD estimate (paragraph 442). It is not clear why the 12 The current text (paragraph 420) makes reference to the fact adjustment should concern the PD, or the that some national supervisory authorities that may issue specific borrower’s specific risk. The adjustment requirements. 13 The range of eligible guarantors/protection is also generous should be confined to the LGD, which takes under the standardised and foundation IRB approaches and into account transaction-specific risks. This includes sovereigns, Public Sector Entities, banks and securities would also make the adjustment consistent firms with a lower risk weight than the counterparty and other entities (including corporates and insurance companies) rated with paragraphs 359 and 393. “A” or better.

ECB • The New Basel Capital Accord • August 2003 9 supervisor should determine whether or not to one year or more than one year collateral meets certain standards, such as respectively (paragraph 56). By contrast, a the existence of well-established liquid consistent treatment for short-term self- markets and publicly available market prices liquidating trade letters of credit is proposed (paragraph 484). Although supervisors are in under both approaches (paragraphs 58 a privileged position to assess the liquidity of and 284). The reasons, if any, for applying markets, this may not always be feasible given lower CCFs for commitments under the the nature of some types of collateral (e.g. standardised approach than under the IRB inventories such as raw materials, goods, approach, should be explained. etc.). Accordingly, a reference could be added that banks should utilise available information The use of the word “may” in paragraph 216 from other competent bodies and authorities is misleading. It should be made clear that and should be able to demonstrate to their banks that use the advanced IRB approach supervisors that their analysis is based on a “must” provide own estimates of PD, LGD prudent evaluation of such information. and EAD. Although the heading of paragraph 208 reads “definition”, the terms “retail With regard to the supervisory slotting receivable” and “corporate receivable” are criteria for specialised lending (SL), banks are not in fact defined in paragraphs 209 and 210. expected to map their internal ratings based on their own criteria according to five categories (paragraph 374). Annex 4 provides Securitisation general assessment factors for each sub-class of SL exposure. With a view to promoting a The ECB acknowledges the substantial level playing field, further guidance on the progress that has been achieved in the area way this mapping should be performed seems of securitisation in particular, although some to be warranted for two reasons. First, there issues may warrant further consideration. is the complexity of the mapping process, as With respect to the incentive structure, the the proposed tables with supervisory rating proposed framework does not always yield grades introduce numerous indicators (e.g. the desired results. For example, low rated 18 indicators for object finance) that are to tranches (i.e. BB and BB-) attract a be classified according to four assessment substantially lower capital charge under the categories, namely strong, good, satisfactory, standardised approach than under the IRB and weak. Second, there is the generalised approach.14 This uneven relation between nature of some of the elements against which capital charge and degree of risk sensitivity is the assessment is to be performed. For even more pronounced when the proposed example, in the case of object finance simplified standardised approach (Annex 9) is exposures, the difference between used in the assessment. Adverse incentives satisfactory and fair mitigation instruments may therefore prevail and high risk exposures for assessing the political and legal may be taken on through innovative and environment or between satisfactory and fair complex instruments by banks that have insurance coverage for assessing insurance relatively less sophisticated risk management against damages may require further systems. This argument is reinforced by the clarification. fact that securities markets offer a much more flexible platform to react to such incentives Under the foundation IRB approach, the when compared to the general choice of the proposed (CCF) for approach to adopt (i.e. the IRB versus the commitments is set at 75% regardless of the standardised approach), which may be more maturity of the underlying facility (paragraph of a strategic decision. Cases where the 281). This compares with CCFs under the

standardised approach of 20% or 50% for 14 At the other end of the spectrum, high rated tranches attract a commitments with original maturities of up relatively higher weight.

10 ECB • The New Basel Capital Accord • August 2003 capital charge is not commensurate with the understood to mean that equities and bonds risk sensitivity and sophistication may need of the originating bank or claims against firms to be revisited in order to ensure that the that form part of the securitised asset pool appropriate incentive structure is in place. would also be acceptable. However, a narrower recognition of collateral may be The proposed rules on securitisation have justified. The value of collateral might be become very detailed. This is due partly to questioned in particular in transactions that the need to establish a comprehensive use claims against a given company both as framework as well as the complexity of collateral and as an underlying asset. In securitisation transactions. In this context, another context, the wording in paragraph the complexity of these rules could be 517 (c) concerning eligible guarantors for reduced by relying less heavily on income synthetic securitisations refers to paragraph and expenses stemming from assets, namely 142 and appears to mean that the downgrade “excess spread”, as defined in paragraph 512, of a financial institution (e.g. an insurance and “future margin income” (FMI), as defined company) to “single A” would render void in paragraph 203. Within the framework of any protection that is provided. This could securitisation, FMI shall be deducted from entail substantial changes to the capital (paragraph 523) and is explicitly requirements of banks whenever an insurance excluded from calculating a “cap” (paragraph company is downgraded. At the same time, 554), which sets upper limits for capital banks may have limited scope to react if the charges. In contrast, the treatment of protection seller cannot be forced to pass on qualifying revolving retail exposures allows the exposure to an eligible guarantor. FMI to effectively cover 75% of expected losses (paragraph 300). In addition, the Under the IRB approach a bank would be securitisation framework introduces the permitted to take into consideration possible notion of “excess spread”, which is relevant overlaps from duplicated coverage given the for the credit conversion factor (CCF) of provision of several types of facilities, and to specific revolving securitisation transactions hold capital only once for the position and those that include controlled early covered by the overlapping facilities amortisation provisions. Although the (paragraph 602). Similar flexibility should be importance of future income and expenses in provided for under the standardised approach a comprehensive assessment of risk is, of and for overlapping exposures. course, acknowledged, there may be benefits in limiting the technical details when addressing these aspects until a more Operational risk comprehensive and consistent treatment can be introduced that applies to all exposure The incentive structure associated with the classes. calibration of the capital requirements for the basic indicator and the standardised The proposals for a capital treatment of approach could be improved. Although the securitisation transactions are closely linked basic indicator and the standardised approach to those on credit risk mitigation (CRM) represent progressive approaches within the techniques and this is welcomed as such range of the proposed treatments, which is linkages tend to enhance the consistency of also reinforced by the fact that eligibility the overall framework. However, in individual criteria are, quite rightly, not used in the cases, such cross-references may require ,15 there are no built- further consideration. Within the framework in capital incentives since both approaches of securitisation, paragraph 544 refers to “the have been calibrated to lead to roughly the standardised approach for CRM” for a definition of the eligible range of collateral in 15 By contrast, eligibility criteria are used in the standardised a securitisation transaction. This could be approach (paragraph 624).

ECB • The New Basel Capital Accord • August 2003 11 same capital charge (12% of current minimum more sophisticated approach”, could also be capital). Thus, incentives may only stem from used in the CP3. the types of activity a bank undertakes, as the betas of the standardised approach range The definition of gross income (as currently between 12% and 18%, depending on the proposed in paragraph 613) is incomplete and business line, compared with an alpha of 15% may leave room for misinterpretation and proposed for the basic indicator approach. divergent implementation. It should be made The lack of incentives may lead to capital clear that gross income is to be calculated arbitrage and opportunities for cherry picking. before the deduction of operating expenses Banks with higher risk profiles engaged in (general administrative expenses in the EU activities for which a higher beta is provided context). It is proposed that a reference to will be induced to opt for the basic indicator the main sub-components of gross income, approach, whereas banks with lower risk as can be found in earlier documents,17 should profiles will be induced to opt for the also be made in the final New Accord. In this standardised approach. The latter may be context, gross income is defined as net desirable in the case of small banks interest income (interest received minus concentrated in low operational risk interest paid) + net non-interest income activities, such as retail banking. However, (comprising (i) fees and commissions unless they fulfil the qualifying criteria for the receivable less fees and commissions payable, standardised approach, banks with low (ii) the net result from financial operations, operational risk profiles will be obliged to and (iii) other income). This reference would, apply the basic indicator approach. This may on one hand, ensure consistency with become a further obstacle to ensuring that definitions of gross income given in earlier banks of higher risk are confronted with a BCBS documents and, on the other hand, higher capital charge. From a longer-term prevent possible divergent implementations perspective, the ECB would therefore owing to the unintended lack of clarity in the support further work on calibration to ensure current definition. Similarly, the definition of that the appropriate incentives exist for gross income in the simplified standardised choosing between the basic indicator and the approach (Annex 9, paragraph 64) should also standardised approach, especially in view of be amended. Guidance is needed on the the fact that the latter approach is expected calculation of gross income for operational to be used more widely in the EU than in risk purposes in specific cases, such as other G10 countries. In the short run, mergers and de-mergers or when gross anomalies deriving from the proposed income is negative (which may be the case incentive structure should be dealt with under for a specific business line such as trading). Pillar II. To this end, the ECB would welcome the insertion of a specific reference to the need to be pro-active in dealing with such Trading book issues cases in the final rules text, by expanding the relevant paragraph on operational risk under The use by banks of marking to model Pillar II (paragraph 723). methodologies in order to determine their trading book positions should, in addition to The reference to internationally active banks the criteria set in paragraph 653, be subject with significant risk exposures (paragraph 610) to regular review by the internal and external should be modified16 to make it clear that these auditors. banks will be expected to use more advanced approaches. The corresponding reference in the 16 The current draft makes a vague reference to being “appropriate CP2, which states that “while the basic indicator for the risk profile and sophistication of the institution”. approach might be suitable for smaller banks 17 E.g.: Consultative proposals on operational risk as a supporting document to the New Basel Accord (CP2), January 2001; with a simple range of activities, the Committee Working paper on the treatment of operational risk, September expects internationally active banks to use a 2001; and Operational risk rules paper, February 2002.

12 ECB • The New Basel Capital Accord • August 2003 Pillar II Pillar III

A clearer reference to the limits on credit The ECB agrees with the proposed frequency risk concentration that should be defined in of information disclosure on a semi-annual relation to the banks’ capital, total assets or, basis (paragraph 767), while Tier 1 capital, where adequate measures exist, to its overall total capital adequacy ratios and risk risk level (paragraph 733) would be exposures prone to rapid changes are to be welcomed. The EU treatment of credit risk reported on a quarterly basis. However, a exposures, such as in large exposures, may reference to a timeframe within which the provide useful guidance to the BCBS in this BCBS expects banks to disclose this field. information may promote convergence in the timing of disclosure requirements. The various issues under the supervisory review (Section C of Part 3) are not The disclosure of capital buffers, determined addressed in a balanced way. Notwithstanding either through stress-tests under the IRB the importance of having detailed rules, there approach or through other methods, seems to be excessive detail on securitisation accompanied by quantitative information, and related elements (such as the supervisory would, as a means to combat pro-cyclicality, action for banks found to have provided provide useful additional information not only implicit support). Given the importance of from a financial stability perspective but also the issue, the relevant text could be for individual investors. streamlined by including a reference to a more detailed technical supporting document Quantitative information about banks’ phased (as in the case of interest rate risk). roll-outs and partial use of approaches in the context of credit risk and operational risk should be accompanied by qualitative information on the timeframe within which the bank expects to roll out the more advanced approaches across all material entities and business lines.

© European Central Bank, 2003 Address: Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany Postal address: Postfach 16 03 19, D-60066 Frankfurt am Main, Germany Telephone: +49 69 1344 0, Internet: http://www.ecb.int, Fax: +49 69 1344 6000, Telex: 411 144 ecb d All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

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