December 04, 2006	Monday	Ziqa'ad 12, 1427

THE Basel II Accord is regarded by some as the biggest challenge faced by the global banking industry in quite a long time. Almost everyone in the banking community is now familiar with buzzwords such as the three pillars of Basel II, the various methods for measuring capital charge for credit, market and operational risks etc.

Although initially meant for adoption by the member countries of the Basel Committee on Banking Supervision (BCBS) These include Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States, most regulators across the globe have mandated that their banks comply with this Accord.

In September 2006, the Financial Stability Institute (FSI) published a report on the summary of responses to a follow-up questionnaire on Basel II implementation. This questionnaire was targeted specifically for non-BCBS member countries across Asia, Africa, the Caribbean, Latin America, Middle East and Europe. As per the report, out of the 98 respondents, 82 jurisdictions have specific plans and timelines for the implementation of Basel II.

In the Asian region, supervisory authorities of 16 jurisdictions responded to the questionnaire, with all respondents indicating their desire to adopt Basel II. Out of these, 14 jurisdictions plan to complete the implementation of Standardized Approach (SA) for credit risk by the end of 2008. The same number of respondents will also ultimately permit the adoption of Foundation Internal Ratings Based (FIRB) Approach; however on a region-wide basis, this transition process is not expected to be fully completed until 2015. The Advanced Internal Ratings Based (AIRB) Approach has been offered by 10 supervisory authorities. On the operational risk side, the Basic Indicator Approach (BIA) will be initiated by 13 respondents, out of which 12 will eventually move on to the Standardized Approach (SA) for calculating capital charge for operational risk. The Advanced Measurement Approaches (AMA) will be implemented by seven Asian jurisdictions.

The State Bank of Pakistan (SBP) is among those Asian supervisory authorities that plan to adopt Basel II in a phased manner. In June 2006, SBP issued a detailed circular containing the implementation timeline of Basel II in the country, as well as elaborate instructions on the various methodologies under Pillar I, based on the original Basel II document of the BCBS.

According to the timeline, the parallel run for Standardized Approach for credit risk has already been initiated from July 1, 2006, while its complete adoption will be in force from January 1, 2008. The SBP has envisaged the adoption of IRB approaches from January 1, 2010, with its parallel run starting from January 1 2008. Banks have been given a choice between the adoption of BIA or SA for operational risk from January 1, 2008; however, the AMA has not yet been offered by the central bank.

The FSI questionnaire results suggest a high level of preparedness in the Asian region with regard to the adoption of Basel II. This makes sense as far as the Standardized Approach for credit risk is concerned, which is conceptually and computationally quite straightforward. However, the biggest challenge lies in moving toward the more complex and sophisticated IRB approaches.

Although there are a number of technical issues involved in the computation of capital charge for credit risk under these approaches, the building block is undoubtedly the collection of reliable and transparent data. Under the FIRB approach, banks need enough historical information (three years initially and eventually five years) to gauge a client’s statistical probability of default (PD), which is the key component needed for the calculations. Even if data availability is ensured, the estimation of PDs requires a robust IT infrastructure to handle this large amount of data and produce the desired results.

Above all, technical expertise with regard to the statistical processes involved in the estimation/modelling is of critical importance. The AIRB approach goes even further by allowing banks to compute their own estimates of loss given default (LGD) and exposure at default (EAD), two other variables used in the calculation of capital charge.

Under the IRB approaches, banks will basically be calculating the capital requirements for their credit exposures based on their own analyses. The first step in this regard is for banks to develop their own internal credit risk rating system, for assigning an internal risk rating to each of their exposures.

Most banks in Pakistan do have their own rating systems; however, the Basel II document puts down some stringent requirements for a rating system to be qualified for IRB approaches. One of these requirements is to rate the customer and the facility separately. The design of a rating system that conforms to all the requirements is in itself a compelling task; assigning ratings to each exposure would mean that banks will essentially be doing the job of a full-fledged rating agency. Since these ratings and the subsequent modelling of PDs, LDGs and EADs will eventually determine the capital requirements for credit risk, their authenticity, reliability and transparency is of utmost importance.

By their very nature, banks will always be looking to minimize the amount of capital they set aside so as to have more deployable funds available. Since banks will be using their own data to determine their capital requirements, there is a possibility that a little biasness may creep in at some level. This will put a lot of pressure on the SBP to ensure the integrity of all the underlying assumptions, models, procedures etc., so that the resulting capital charge is a true reflection of the level of credit risk undertaken by a particular bank.

This a monumental task, to say the least. It would require personnel from the SBP to acquire the technical and analytical skills required to not only assess the systems, procedures, resources and expertise of the banks at the time of granting approval for adopting the IRB approaches, but also to monitor these areas on a continuous basis.

Furthermore, the SBP needs to gather data and develop its own systems for estimating the LGD and the EAD, which under the FIRB are to be provided by the supervisory authorities. Any errors or loopholes in this process, whether on part of the banks or the SBP, will result in either overestimating or underestimating the capital requirements, which will actually put the banks and ultimately the entire banking system at higher risks. This will end up negating the basic premise of the Basel II Accord, which is to strengthen the risk management of banking institutions.

Hence, all material aspects of granting this level of autonomy and discretion to banks must be carefully deliberated, so as to ensure that this does not come at the expense of the depositors and other common stakeholders in the banking system.

Adoption of Basel II by banks operating in Pakistan requires a great deal of investment in human resource, IT software, systems and procedures. But most of all it requires all concerned to understand the crux of this Accord.

No matter how simple or complex an approach is, the basic aim is to improve the risk identification, management and mitigation function of the banks. In most banks across Pakistan, the risk management function is still being regarded as a requirement imposed by the SBP. In order to manage risk in the true spirit, banks need to dispense with this compliance-oriented mind frame, and start considering risk management as an essential and integral part of their overall business process.

Basel II and risk management should not be looked at separately; rather, instilling a prudent and proactive risk management environment will inevitably lead towards a smooth transition to Basel II compliance. The important things for both the banks and the supervisor is not to jump on the Basel II bandwagon and prematurely rush into the more advances approaches of the Accord, without first ensuring that all pre-requisite details are in place, both in letter and spirit.