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Impact of the New Basel proposals on Traded Markets

Most of the readers of this publication will not have read the 500-plus pages of the New Basel Accord published for consultation in January this year, and are unlikely to read all of it even before its scheduled implementation date in early 2004. Hopefully, most will have read the executive summary and will be looking at the many comments and articles that have, and are, appearing in the press concerning its importance and the new style of supervision that goes hand in hand with its recommendations. All should, however, have a team or teams of people analysing the changes and innovations that it introduces and, above all, working out what it means for the capital adequacy of their bank.

There is far too much in the paper to try and cover how it is likely to affect the behaviour of banks in a short article, but over the months that I have seen it developing, I believe that it will bring about far reaching changes over the long run, which puts the focus even more firmly on the relationship between risk of all types and the capital that a bank will have to put up against them. This will, as it is intended, reverberate back as far as shareholders as well as management boards, who will have to make sure that they understand the risks that are being taken and make conscious decisions about their willingness to invest capital in those businesses associated with the risks. It is in this area that those of us involved in traded markets should look up and take notice.

In a nutshell, there will be two main effects of the new accord on the traditional markets of foreign exchange, interest rates and their underlying derivatives. First, as banks work out how the new credit ratings apply and how operational risk is calculated, there will be an ever greater focus on calculating how much capital is needed to support a product and therefore an increasing degree of importance attached to identifying the right return on equity to be expected from it. Secondly, given that risk is the pivotal point of today’s supervisory approach, dealing rooms will have to work more closely with their internal control functions to demonstrate that they are able to accompany their risk taking with the right type and culture of controls. In the best institutions, this means that controllers in banks (such as auditors, compliance officers and finance) will become the ‘friends’ of the front office rather than their adversaries, as has so often been the case in the past. In many banks, this has been happening for some time, but the new accord will bring risk analysis skills to the fore and create much more common ground between business generators and controllers.

It is worth asking why a new accord was deemed appropriate and what its main features are. Simply put, the 1988 Basel Accord (itself a response to the bad debt problems of the early 1980s and the weaknesses that they exposed in banks’ capital structures and controls) had become outdated in their treatment of types of credit risk and had not caught up with the changes in supervisory philosophy. True, the accord had been amended to cope with off-balance sheet business because of the growth in the derivatives market, and, along with the European Union’s Capital Adequacy Directive, had introduced the concept of traded model recognition.

There have also been refinements to the definition of capital. But it has been clear for a long while that it had not reflected true risk exposures and was prone to being exploited by regulatory arbitrage. The new paper defines a new set of credit risk weightings, and introduces a capital charge for operational risk and the concept of a supervisory review process.

The way in which Basel has approached the new accord should be well known. Regulators believe that the banking system should not, overall, have less capital supporting it than it does now. The result of implementing the new accord on the capital adequacy of each individual institution will almost certainly mean that some banks, which can demonstrate real understanding, measurement and control of risks, will not be expected to put up as much capital as they do at present, but those banks that are weak in risk measurement and control will be expected to put up more. If you are in a trading environment where you are charged for your capital use (which should by now be de rigueur) then it is in your interests to make sure that management and control functions understand what you are doing and apply accurate capital measures.

Basel is also keen that the market takes on board the three-pillar structure of the proposals. The first pillar enshrines the minimum regulatory capital requirements applied to risk types. The second introduces the overlay of a supervisory review process, the result of which will mean higher than minimum charges for banks for which supervisors believe that the minimum charges are not adequate to cover the risks undertaken. The third pillar requires banks to adopt a high standard of disclosure and transparency to reinforce market discipline.

Whilst the first of these needs detailed analysis and measurement, and the third means that banks will have to say more about what they are doing and how their activities are controlled, it is in the supervisory review process that many banks will feel the new approach. Supervisors also take on a new burden in that they will have to have in-depth knowledge of how banks operate and take their risks, and work more closely with them. For our markets, practitioners can be sure that, especially in the area of complex products, they carry their supervisors with them in their taking, measuring, reporting and controlling of the risks of their activities. This notion will be new in many financial centres (although not in the UK) and there are bound to be some tensions caused by this.

What should trading operations be doing to prepare them-selves for the implementation of the accord? The first step will be to ensure that they are integrally involved in the work being done in their own institutions, and that the work is being done in a way that supports the business. The formulation of Internal Ratings Based credit models and models to calculate operational risk certainly require front office input as well as that from database experts.

The next will be to agree internally on reporting and control methodologies. This will require banks to develop their middle office concept (many banks have different ideas about what MO’s should do) to ensure that all risks are captured, reported and priced in conjunction with front offices as well as finance. It is likely that as MO’s develop, new budgeting processes will emerge as the focus on risk/reward capital ratios increases.

Trading managers should also expect to see more of their supervisors and vice versa, and be prepared to discuss their risks and capital use very openly with them. As far as new products are concerned, it is likely that individual banks will adjust their product portfolios as they become better able to judge which are the most profitable in respect of how much capital they consume, and which new ones they might enter into. It is certain that there will be further growth in all types of credit markets as risk measurement becomes more sophisticated and the whole emphasis of the new accord speaks for the development of better credit understanding.

I have left out a considerable amount that is important about the Basel paper, including macro economic consequences. Having been able to see much of the development of the paper from the inside, I am struck by the radical nature of what our regulators want to achieve and how important it is for the global banking industry that capital is used efficiently, as well as to support the underlying integrity of the system.

When banks made Basel aware of how inappropriate the original accord had become, they triggered off a process that has become a challenge to regulators to get it right. That has been met and it is now up to the market to reply by optimising the management of their businesses. The new accord will bring real capital benefits for risk businesses if banks can demonstrate that they are good at running them. As always in our markets, there will be winners and losers, but the overall strengths and capacity of them will continue to offer rewards for the successful.

David Clark is honorary president of ACI, and holds a number of non-executive positions, including as a senior banking advisor to the UK’s Financial Services Authority and a non-executive director of Tullett & Tokyo Liberty.

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