X / Chapter Description

The Basel II Capital Framework in Australia

In June 2004, the Basel Committee on Banking Supervision1 released a new global capital regime for banks, known as the Basel II Framework. This article provides background to the Framework and discusses some of the issues surrounding its implementation in Australia. In particular, it discusses the implementation timetable and the sorts of adjustments APRA will make within the Framework to accommodate local conditions.

A stable and efficient banking system2 is crucial to the growth and performance of the economy due to its effect on, and links to, the wider economy. When a manufacturing company (for example) poorly manages its risks, the negative consequences are typically limited to that company with little contagion to the broader economy. Banking is different. Banks play a crucial role in the financial system. Problems in one bank may be transmitted to other financial institutions and changes in banks capacity to lend affect the broader macro economy. In addition, a large proportion of banks funding is from depositors, many of whom are not sophisticated investors. For these reasons, governments generally seek to minimise the risks incurred by banks through some form of regulation and to protect the interests of depositors through depositor preference or insurance arrangements. Prior to the mid 1980s, bank risk-taking was constrained by direct controls on pricing, lending and foreign currency transactions. Since then, deregulation around the globe accompanied by a switch to implementing monetary policy through open market operations has prompted a move to risk-based prudential supervision. This has allowed banks much greater latitude in how they conduct their businesses and how they manage risk. But it has also meant that supervisors, counterparties and owners must take far greater responsibility for monitoring the financial health of banks.

The Committee, which comprises central banks and bank supervisory agencies from G-10 countries, operates under the auspices of the Bank for International Settlements (BIS) and consults widely with supervisory agencies in other countries and with industry on prudential matters. In the Australian context, the banking system comprises banks, building societies and credit unions, which are described as authorised deposit-taking institutions or ADIs. The Basel II Framework uses the word bank while Australian legislation is expressed in terms of ADIs. In referring to the Australian environment this paper uses the term ADI, but in the more general global context uses bank.

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The Basel II Capital Framework in Australia

A bank funds itself from equity and debt. Assuming there is sufficient equity or capital funding, a banks capital is the buffer which absorbs losses, for example from default by counterparties. Reflecting the risk-reward equation, debt is cheaper for banks to raise than equity. The challenge for bankers is getting the right mix of capital and debt - ensuring there is adequate protection against losses while achieving the optimum level of gearing. Initially, bank supervisors developed their own nationally based capital standards. However, many banks compete in the global marketplace. The 1988 Basel Capital Accord, developed by the Basel Committee, was borne out of a desire to align the capital requirements of banks that compete across national boundaries. It provided a global methodology and set minimum capital requirements. The methodology defined eligible capital and measures for on-balance sheet credit risk, off-balance sheet credit risk and, in a later version, traded market risk. It also set a minimum capital ratio of eight per cent, with supervisors having the discretion to apply a higher ratio. For over a decade in Australia, and in over 100 countries around the world, the Accord has provided a benchmark for assessing the capital adequacy of banks and other ADIs, not just those operating across national boundaries. However, since the Accord was released, the world of banking has become more complex and institutions have increasingly adopted more advanced risk measurement and management practices. The Accords relatively broad-brush methodology for setting bank capital requirements has become less attuned to these methodologies. The June 2004 Framework reforms the 1988 Accord, replacing it with a more risk-sensitive set of requirements. The Framework has evolved substantially from the original proposals released in mid-1999, benefiting from an extensive consultation process with industry and supervisors internationally.
FIGURE 1:

The objective of the Basel II Framework is to develop capital adequacy guidelines that more accurately align with the individual risk profiles of banks, lessen regulatory arbitrage opportunities and offer greater flexibility for supervisors, where appropriate, to encourage the use of more sophisticated risk management techniques. In being more sensitive to risk, the Framework rewards banks for stronger and more accurate risk management, better aligning the capital requirements of banks to their risk appetites. The resulting stronger risk management practices should enable banks to take on greater risks prudently, thereby improving profitability.

Structure of the Basel II Framework

The new Framework consists of three mutually reinforcing pillars. Pillar 1 sets out the mechanics of the revised minimum capital adequacy calculations and is the direct replacement of the existing Accord. Pillar 2 relates to the internal assessment of capital adequacy and the supervisory review process that should complement the black letter Pillar 1 requirements. Pillar 3 sets out market disclosure standards aimed at strengthening the role of market discipline in supporting prudential objectives.

Pillar 1
Pillar 1 provides the detailed requirements for assessing a banks minimum capital adequacy position, consisting of the sum of internationally agreed mandatory capital components for credit risk, traded market risk and operational risk. A hierarchy of methods is available for each of these risk areas ranging from simple to more sophisticated calculation approaches, with the latter relying to varying degrees on an institutions internal risk measures. These approaches are outlined in Figure 1.

Tiered structure of proposed capital changes

Aggregate capital

Credit risk Standardised approach

Traded market risk Standardised approach Internal model approach

Operational risk Basic indicator approach Standardised/alternative standardised approach Advanced measurement approach

Foundation internal ratings based approach Advanced internal ratings based approach

1988 Accord

Basel II Framework

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The Basel II Capital Framework in Australia

Credit risk
The simplest approach for determining the credit risk capital component is the standardised approach, which uses external credit ratings where available. The two more sophisticated credit risk approaches are collectively referred to as internal ratings based (IRB) approaches. The foundation IRB (FIRB) approach permits a bank to use its own estimates of the probability of customer default (the probability of default), while the advanced IRB (AIRB) approach allows a bank additionally to use its own estimates of its exposure at the time the customer defaults (exposure at default) and the loss it will incur if the customer defaults (loss given default). Both IRB approaches take into account the maturities of a banks credit exposures to corporate customers. The Framework does not provide a FIRB option for banks retail exposures.

Pillar 3
Pillar 3 complements the other two pillars by encouraging market discipline through the development of a set of disclosure requirements that allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes and ultimately the capital adequacy of the institutions.

Implementation and accreditation timetable

In Australia, all ADIs will be required to implement the Basel II Framework. Under the Framework the AIRB approach for credit risk and the AMA for operational risk are available to countries for implementation from year-end 2007. All other calculation approaches are available for implementation a year earlier. Institutions that adopt the more sophisticated credit and operational risk approaches are subject to a prior twelve-month settling-in period of parallel calculations using both the existing and new rules. The delayed start for institutions adopting the AIRB and AMA approaches allows banks and supervisors to benefit from an additional year of impact analysis. Originally, it was also intended to allow a period for supervisors internationally to gather actual data on which to base any recalibration of the new Framework. Recalibration may be required to meet the Basel Committees objective of not changing the overall level of capital in the banking industry. However, it is now likely that any recalibration will follow an impact analysis study to be conducted during the second half of calendar year 2005. ADIs in Australia that adopt either the foundation or advanced IRB approach for credit risk will also be required to implement the AMA for operational risk. The FIRB approach will therefore not be available in Australia before year-end 2007. Accordingly, only the standardised approach could potentially be implemented earlier. APRA is not attracted to the so-called staggered implementation approach, under which different approaches are adopted within different timeframes. Following industry consultation, APRA has decided on a common implementation date from year-end 2007 for all approaches. This allows institutions adopting the less sophisticated approaches an additional year to make the necessary system changes.

Traded market risk

The traded market risk charge remains essentially unchanged from existing requirements. It is calculated using either a standardised or an approved internal models approach.

Operational risk
In relation to operational risk, several relatively simple calculation methods are available including the basic indicator, standardised and alternative standardised approaches. The advanced measurement approach (AMA) is designed for banks with advanced operational risk management and modelling capabilities.

Pillar 2
Pillar 2 is referred to as the supervisory review process, but it imposes obligations on both supervisors and banks. It requires banks to have a process and strategy for assessing and maintaining their overall capital adequacy in relation to their risk profile. In addition, banks are expected to operate above minimum regulatory capital levels to cover additional risks not covered explicitly by Pillar 1. The banks strategies and capital assessments, as well as compliance with regulatory capital ratios, will be reviewed and evaluated by their supervisors. Where a supervisor judges that a bank is not holding sufficient capital to support its risk profile, the supervisor should intervene to address this.

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The Basel II Capital Framework in Australia

The development and implementation of the Framework is an immense challenge to supervisors, as is its implementation for those banks proposing to use the more sophisticated approaches. In contrast, for small institutions using the standardised approaches, the implementation is likely to be less burdensome. ADIs in Australia that propose to adopt any but the simplest of the available calculation approaches must be accredited by APRA. Institutions wishing to be accredited in time for implementation from year-end 2007 are required to lodge an application with APRA between July and September 2005. Institutions applying for accreditation at a later date will not be able to implement the IRB/AMA approaches until after year-end 2008, with the accreditation window re-opening from mid 2007. APRA will keep this timetable under review, especially in the light of decisions by other supervisors. APRA also recognises that the timetable will need to be applied flexibly to subsidiaries of foreign banks. It would make little sense to insist on an application from a subsidiary of a foreign bank before the parent had applied for accreditation, or was accredited by its home supervisor. An outline of the implementation and accreditation timetable is contained in Figure 2.
FIGURE 2:

National discretion
APRA will implement the Basel II Framework through its Prudential Standards. Draft standards for Pillar 1 will be issued for industry consultation in the first part of 2005. APRAs priority in developing the standards is to meet its legislative mandate. However, it is also cognisant of the advantages of, and the Basel Committees intent for, consistent global implementation of the Framework. APRA will only deviate from the internationally agreed Framework where there is a compelling reason to do so. Within the Framework, the Basel Committee has identified a number of areas where it believes home supervisors (such as APRA) should be able to tailor the rules to reflect local prudential views. These are referred to as national discretions. In these cases, supervisors must choose which available approach to implement in their particular jurisdictions. Many of these national discretion items relate to relatively technical aspects of the revised Framework. Several items likely to be of particular interest to Australian industry participants are detailed below. Under the standardised credit risk approach, the Framework permits a 75 per cent risk weight for other retail exposures. However, the proposed standardised and IRB risk weights pertain to large, diversified portfolios, but Australian ADIs likely to be using the standardised approach generally do not have a high degree of diversification. In addition, quantitative assessments of the Basel II proposals suggest that for Australian ADIs a 75 per cent risk weight offers an inadequate buffer for other risks that will be captured under the more sophisticated approaches but which are not captured in the same way by the standardised approach. The Basel Committee has proposed a 35 per cent standardised risk weight for housing exposures that currently attract a 50 per cent risk-weighting. In this case, the quantitative results indicate that the standardised risk weight does contain a buffer for risks not specifically captured by the less sophisticated Basel II approaches. Institutions adopting the IRB and AMA approaches will need to assess these other risks more robustly and comprehensively under Pillar 2. ADIs adopting the IRB approach in Australia must meet AMA requirements for operational risk. Other ADIs will use a less sophisticated approach. The so called basic indicator approach uses gross income as the risk indicator and produces wide variations in outcomes among ADIs that cannot be directly tied to differences in operational risk. Graph 1 shows the percentage increase in existing risk-weighted assets that is due to the addition of operational risk under the basic indicator approach and the alternative standardised approach, which uses an asset indicator for ADIs main business lines of retail and commercial banking. As can be seen, the variation is considerably dampened under the latter approach.

Implementation and accreditation timetable for Australia

Parallel run

12/03

12/04 Accreditation window open

12/05 Accreditation window closed for banks where APRA is the home supervisor Accreditation

12/06 Accreditation window reopened

12/07

Common implementation date

Draft prudential standards

12/08

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The Basel II Capital Framework in Australia

GRAPH 1:

Pillar 2 consists of four principles: 1. Banks (ADIs) should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
35

Operational risk contribution for credit unions, building societies and regional banks under the basic indicator approach and the alternative standardised approach

35

Per cent contribution to the overall change in risk - weighted assets

30

30

2. Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate action if they are not satisfied with the result of this process. 3. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. 4. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. Implicit in the first principle is that all material risks faced by a bank should be addressed in its capital assessment process. If a bank is not addressing in a robust and comprehensive way all the material risks to which it is exposed, under principles two and four it is incumbent on its supervisor to intervene to ensure that it does so. As Basel II is considered to be a step along the path towards full economic capital3 models, it would seem logical to utilise those models, at least as a starting point, within Pillar 2 to address those material risks. However, since in APRAs view, banks have yet to demonstrate the completeness and robustness of their economic capital models, an interim Pillar 2 model may be necessary. Such an interim model would need to be regularly reviewed and provide banks with incentives to improve their economic capital models and other means of assessing their capital adequacy. APRA is exploring the need to specify the significant risks it judges that banks face and, in the absence of banks own robust methodologies for measuring them, to assign a regulatory capital charge against each risk, or group of risks. A further aspect of the new Framework that Pillar 2 seeks to address is the so-called pro-cyclicality effect4. During economic downturns, a banks capital base may be eroded through loan losses while its existing (non-defaulted) borrowers also tend to be downgraded by the banks internal rating processes. Within the Basel II Framework (and under banks own internal modelling processes), this will lead to increases in banks capital requirements at a time when raising capital will potentially be more problematic and certainly more expensive. Banks unwilling or unable to raise capital will have no option but to further reinin their lending, exacerbating the economic downturn. Pillar 2 provides a mechanism for addressing this pro-cyclicality effect, but it does require the forbearance of the supervisor. Banks will be required to include in their Pillar 2 capital a buffer against a general downturn in the cycle. The buffer only

25

25

20

20

15

15

10

10

Alternative standardised approach

Basic indicator approach

Pillar 2
Through the reform process, the Basel Committee has held strongly to the view that the overall level of regulatory capital held by banks was appropriate and that the revised requirements should not greatly alter that outcome. APRA supports this view. APRA acknowledges, however, that ADIs in Australia tend to hold a higher proportion of residential mortgage loans on their books than most overseas banks. The Basel Committee has now assessed these loans to be less risky and has reduced the associated riskweight under the standardised approach from 50 per cent to 35 per cent. To the extent that Australian ADIs do hold a heavier proportion of residential mortgage loans, it is reasonable that they should benefit from a reduction in regulatory capital for credit risk. At the same time, however, the Basel II Framework is intended to be more risk sensitive, so those institutions taking on more risk than their peers will be required to hold more regulatory capital under both the standardised and advanced approaches. All ADIs in Australia currently hold capital in excess of the eight per cent minimum required under the existing Accord. At these current levels of capital, APRA is comfortable that ADIs are holding sufficient capital to provide a buffer against all but the most extreme unexpected losses. ADIs using the more sophisticated Basel II approaches under Pillar 1 will use a methodology that attempts to estimate the losses they may incur in respect of credit, traded market and operational risks. In doing so, these ADIs will effectively strip out the buffers that currently exist against all the other risks they face (such as strategic risk, business risk, credit concentration risk, liquidity risk, reputation risk and model risk). The challenge for both ADIs and regulators is to ensure the capital buffers ADIs hold remain adequate against the full range of risks they face. This, in part, is the role of Pillar 2.
3

Economic capital is a business own estimate of the capital it should set aside as a buffer against potential losses inherent in any of its business activities, or set of risks. In most countries financial systems are pro-cyclical. Credit to the non-financial private sector typically increases when output is expanding and contracts during recessions. Concerns have been raised that the Basel II Framework could potentially contribute to pro-cyclicality.

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The Basel II Capital Framework in Australia

mitigates against pro-cyclicality during a downturn if the supervisor allows the bank to run down the buffer. In effect, it would require the supervisor to agree to a bank reducing its capital relative to measured risk at the very time the supervisors instincts tell it that the bank should be holding relatively more capital, not less. For APRA, this issue is still work in progress. In its revised prudential standards, APRA will mandate a specific capital requirement for interest rate risk in the banking book (IRR) that must be met by all ADIs adopting the IRB and AMA approaches and by outlier ADIs adopting the standardised approaches. The former will be expected to seek APRAs approval to use an internal modelling approach, whereas ADIs adopting the standardised approaches will be able to utilise an APRA-defined standard calculation methodology. APRA is still to decide whether the IRR capital requirement will be included in Pillar 1 or Pillar 2.

Conclusion
The implementation of the Basel II Framework in Australia has generated interest around timing, APRAs exercise of its national discretion to reflect local conditions and its approach to Pillar 2 of the Framework. APRA has announced a starting point from year-end 2007 for all ADIs in Australia. Institutions seeking accreditation to adopt the IRB and AMA approaches from year-end 2007 must lodge an application during the third quarter of 2005. The accreditation window then remains closed until mid 2007. APRA is exercising its national discretions across various segments of the Basel II Framework and will release draft standards for consultation in the first part of 2005. Under Pillar 2, APRA will require ADIs to address robustly all significant risks they face. If they do not, APRA will specify a capital requirement. APRA will also require ADIs to hold capital against the pro-cyclicality effect stemming from rating downgrades during downturns in the credit cycle. As a practical matter, this will only apply to IRB institutions given the small proportion of externally rated exposures in other ADIs credit portfolios. Bernie Egan
Program Director Basel II, Policy Research and Statistics

Pillar 3
To date the focus of APRAs attention, and that of most other supervisors, has been on Pillars 1 and 2. In constructing its disclosure framework in Pillar 3, the Basel Committee has taken the view that disclosure by banks should be consistent with how senior management and the board of directors assess and manage the risks of the bank and that individual banks should decide which disclosures are relevant for it, based on a materiality concept. The Committee recognises that its disclosure framework should not conflict with requirements under accounting standards, which are broader in scope. It also recognises that general disclosure requirements are the preserve of other regulators - in Australias case, the Australian Securities and Investments Commission (ASIC). Prudential disclosure goes beyond the general disclosure requirements. It is an attempt to provide sophisticated market participants with additional information to enable them to better assess the prudential standing of financial institutions, strengthening the market discipline process. Finally, the Committee has sought to strike an appropriate balance between the need for meaningful disclosure and the protection of proprietary and confidential information. The implementation of Pillar 3 in Australia, which will result in APRA-mandated disclosure, will require some legislative amendment.5

5 See the article in the Quarter 2 2004 issue of Insight.

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