Weighing risk Basel II and the challenge for mid-tier...

Weighing riskBasel II and the challenge for mid-tier banks

A white paper from the Economist Intelligence Unitsponsored by Oracle

© The Economist Intelligence Unit 2004 1

WEIGHING RISKBASEL II AND THE CHALLENGE FOR MID-TIER BANKS

Weighing risk: Basel II and the challenge for mid-tierbanks is an Economist Intelligence Unit white paper,sponsored by Oracle.

The Economist Intelligence Unit bears soleresponsibility for this report. The EconomistIntelligence Unit’s editorial team executed the survey,conducted the interviews and wrote the report. Thefindings and views expressed in this report do notnecessarily reflect the views of the sponsor. Alison Reawas the author of the report.

Our research drew on two main initiatives:

We conducted a global online survey in September2004 of 102 senior executives in midtier banks andother financial institutions on the topic of the Basel IIaccord.

To supplement the survey results, we also conductedin-depth interviews with senior executives at a numberof banks.

Our thanks are due to all survey respondents andinterviewees for their time and insights.

October 2004

Preface

2 © The Economist Intelligence Unit 2004


As the provisions of the Basel II accord beginto take effect in 2007 in many parts of theworld, bankers are scrambling to respond.They are being called upon to make major

changes in the way they measure risk, report theirappetite for risk and manage their capital. The stakesare high. Those firms that adopt sophisticatedmethods for determining risk-adjusted capital underBasel II could be rewarded with higher credit ratings,stronger earnings and higher stock prices. The othersrisk falling behind.

The guidelines of Basel II are not compulsory unlessstipulated by local country regulators and will not beadopted uniformly. Basel II is primarily aimed atcommercial banks. The largest mid-sized banks(US$100bn in assets is our dividing line between top-tier institutions and mid-tier) will be under particularlystrong pressure, since many will have the option toadopt the most sophisticated approach that they canafford and be qualified for by regulators. Overall, somemid-tier banks will decide it is worth the huge effortand cost; others will gradually upgrade methods overtime; still others will stick with the simplestalternatives. But all will have to determine how tocompete with those financial giants that will be usingthe most advanced risk options available under Basel II.

To prepare this briefing paper, the EconomistIntelligence Unit interviewed risk officers at eightmid-tier banks around the world and conducted aglobal survey with 102 mid-tiered banks and otherfinancial services firms. Among the main conclusions:● Many mid-tier banks expect to come under

increasing pressure from regulators, investors andcompetitors to adopt Basel II or more advanced

approaches to risk measurement under Basel II.● Mid-tier banks see better risk management as the

greatest benefit by far, followed by the possibilityof higher credit ratings, greater transparency, theability to price products to reflect risk moreaccurately and the chance to gain a competitiveadvantage.

● While a large number of mid-tier banks are stillmulling adoption, most of those pushing ahead areaiming for the simplest of the three possible creditrisk methods, at least initially. In addition, moreplan to adopt the middle level of complexity foroperational risk, instead of either the simpler or themore complex choices.

● High costs emerged as the main challenge,followed by a lack of consistent, standardised data,integrated firm-wide IT systems, skilled people, andthe right computer models and analyticalframework.

● At many mid-tiered banks, estimates of the cost ofadopting Basel II range from US$10m to as much asUS$500m, depending in part on the size of the bankand the choices selected.

The Basel II guidelines come from the Basel Committeeon Banking Supervision, which is comprised ofbanking regulators and central bankers from 13 majorcountries who meet in Basel at the Bank forInternational Settlements. The aim is to achievegreater safety and soundness in the global financialsystem, more sophistication and harmonisation of riskmanagement by banks across national borders, andcapital levels more finely attuned to actual risks. BaselII offers a big incentive for those that comply with its

Executive summary



The Basel I and Basel II accords, from theBasel Committee on Banking Supervision,both offer guidelines, aimed mainly at com-mercial banks, on how to compute risk-adjusted assets against which a fixedpercentage of capital must be set aside forregulatory purposes.

The 1988 Basel I proposal requires thatbanks post ratios of 4% Tier I capital (mostlycommon and other types of stock), and 8%Tier II capital (common and other types ofstock) against their assets after adjustingthem for risk using a myriad of assigned riskweightings for most asset classes. Laterprovisions were added to allow banks tocalculate market risk weightings usinginternal value at risk (VaR) models.

Over the past decade, the BaselCommittee has been working to updateBasel I to allow the use of some internalmodels and frameworks for weighting creditand operational risk so that risk weightingsfor assets can vary by actual risk rather thanbeing charged a flat risk weight regardlessof such things as collateral. The resultingBasel II accord also spells out the principlesthat should guide improved regulation andtransparency in three so-called pillars. Thefirst offers new guidelines for measuringcredit risk more precisely and operationalrisk explicitly; the second concerns

regulatory oversight; and the third demandsgreater transparency in reporting riskexposures and the methodologies used tocalculate those risks.

The broad outline is in place. For creditand operational risk, there are threechoices for calculating risk-adjustedregulatory capital requirements that rangein complexity. The simplest uses setformulas provided by regulators, while themore advanced ones allow banks to relyincreasingly on internal risk models andanalytic frameworks. Credit risk optionsstart with the standardised approach,followed by the Internal Ratings-Based(IRB) foundation and the IRB advancedapproaches. IRB models measure such

things as the probability of default (thechance that a borrower won’t repay) andloss given default (the actual loss likelyafter considering factors such as recoveriesand collateral). The operational risk optionsare the basic indicator, standardised andadvanced measurement approaches (AMA).Models here are augmented by tools such asweighted score cards.

For market risk, Basel I guidelinesallowing the use of VaR models to assignregulatory capital remain in place. Thesemodels are already well established at mostbanks in regions such as the US and Europe.Elsewhere, some banks remain locked indeveloping and testing mode, pendingregulatory approval.

Basel primer

1. How would you describe your institution's management of market risk? (% respondents)

Mostly compliant with Basel I 17

Fully compliant with Basel I 17

Not sure 11

Just starting to work on compliance with Basel I 9

Half compliant with Basel I 7

Basel I does not apply to us 40



provisions: the promise that over time capital costscould drop since capital can be calibrated more closelyto actual risk than the one-size-fits-all approach ofBasel I. (See box: Basel primer.)

The goals are worthy, but in practice Basel II islikely to be difficult to put into effect since the rules,implementation details and timetables remain in flux.The Basel Committee is still refining definitions andacceptable procedures. And regulators in each countrycontinue to debate how and when the guidelines willgo into effect and to whom they will apply. Many

regulators have made no decisions, while others haveissued only preliminary rulings. “It’s not easy. It’s liketrying to fix your engine while you’re driving your car,”says James Liu, executive vice-president of riskmanagement at Hua Nan Financial Holdings, aUS$42bn-asset bank based in Taiwan.

This paper focuses on the response of mid-tieredbanks globally to the Basel II accord with its complexand still-evolving principles. It will describe thebenefits, the obstacles, and the actions that will helpdeliver value.



Given the complexity of Basel II and the factthat the guidelines are unfinished, manymid-tier banks are debating what course totake, even as deadlines loom. This quandary

is not faced either by the largest, internationallyactive players (who are likely to have to use the mostsophisticated techniques of risk management) or bythe smallest (those that are likely to be encouraged tostick to basics).

Each mid-tier bank will have to conduct its owncomprehensive cost-benefit analysis. “Basel II is notnecessarily right for everyone. Each institution has to

make its own fair assessment,” says Kevin Blakely,executive vice-president of risk management atKeyCorp, based in Cleveland, Ohio, which has aboutUS$85bn in assets.

Nowhere is this truer than in the US where mid-sizedbanks, like KeyCorp, have an all-or-nothing choice. Theycan stick with Basel I, or, if they go for Basel II,regulators will only allow the most advanced approachesfor credit and operational risk. (See box: Keycorp.) Atthe same time, in Europe, Basel II will be mandated forall financial services firms except insurance companies,but all three credit and operational risk options will be

The mid-tier bank dilemma

KeyCorp is waiting to decide whetherto stick with Basel I or adoptadvanced IRB and AMA approachesto credit and operating risk. “We fallbelow the radar screen of mandatorybanks and can opt in,” says KevinBlakely, executive vice-president ofrisk management. “Right now, weare proceeding as though we want tobecome Basel II compliant, but weare holding off the decision on whenand if we actually want to join upuntil we know all the final rules andexpectations.”

KeyCorp wants to fully understandall the implications, see if there are

any significant changes andunderstand better the competitivelandscape, he says. The bank still hasquestions about what kind of data itmust keep, how inputs into modelsshould be calculated and whatrequirements will be there for creditrisk in its retail operations, whichcomprises about half its business, saysAshish Dev, executive vice presidentfor enterprise-wide risk solutions

Mr Blakely believes non-mandatory institutions are likely tomake their decisions once they haveseen how the largest banks, whichmust apply Basel II, are faring. Since

US mandatory adoptors have to havetheir systems as ready as possible byJanuary 1st 2007 and then run themparallel with their existing systemsfor a year before going live, this willgive regulators and rivals a chance toevaluate the merits of theirapproaches. “That’s the periodwhere you’ll probably start seeing alot more opt-in banks jump in. Thefeeling in the industry is, ‘Let’s seewhat happens in 2007. Let’s let themget the bugs worked out, and thenlet’s give serious contemplation tojumping in sometime shortlythereafter’,” says Mr Blakely.

KeyCorp: Wait and see



When the Basel Committee on Bank-ing Supervision conceived Basel II, itfocused on larger banks in the so-called G10 countries, whose skill incalculating risk weightings had out-grown Basel I’s broadbrushapproach. The surprise, therefore,has been the enthusiastic receptionof Basel II by banks in many coun-tries outside the G10. (The so-calledG10 countries represented by regu-lators on the Basel Committeeinclude Belgium, Canada, France,Germany, Italy, Japan, Luxembourg,the Netherlands, Spain, Sweden,Switzerland, the UK and the US.)

Many regulators in Asia, LatinAmerica and in other parts of theworld are taking their cues from theBasel Committee, which hasencouraged non-G10 countries totake a practical approach to the newaccord—implementing what is mostfeasible to their particularcircumstances. As Simon Topping,executive director of banking policyat the Hong Kong MonetaryAuthority, said in a speech in May,“So the field would seem to be clearfor countries to pick and choose fromthe menu of Basel II and to assesswhat particular pieces of the jigsawshould be given priority.”

That is what Hong Kong and manyothers seem to be doing. Hong Kongbanks will have to adopt theguidelines but are not being toldwhich banks must adopt which

approaches, especially since internalrating systems for assessing the riskof borrowers are not wide-spread inthe region and banks havetraditionally relied on collateral tomitigate risk. That said, Mr Toppingnoted in the same speech that someof the smaller local banks are aimingto adopt Internal Ratings-Based(IRB) approaches for credit risk andthat many others, while unlikely totake the IRB approach, are buildinginternal ratings systems to help withgauging credit risk.

For operational risk, Hong Kongregulators will not make advancedapproaches a priority while theirefficacy is being ironed out. Instead,regulators will encourageimprovements in operational riskmanagement, and in stress testingfor all types of risks given thevolatility of the region.

In Taiwan, regulators havestipulated that banks at least adoptthe standardised method for creditrisk by the end of 2006. Hua Nan ison track for this timetable. (See box:Hua Nan.) “Basically, we are usingthis implementation of Basel II as achance to really implement our riskmanagement systems,” says JamesLiu, executive vice-president of riskmanagement at Hua Nan FinancialHoldings. For operational risk, thebank believes it will have thestandardised approach up andrunning in six months. “But we are

not going to stop there. We are goingto move forward until we can applythe advanced measurementapproach,” he says.

For most Mexican banks,regulators are likely to require thesimplest Basel II methods, with moreadvanced approaches optional, whilethe impact of volatility on models istested. About six banks are likely tobe allowed to apply to use moreadvanced approaches for credit risk,starting with IRB foundation.Banorte is already compliant with thestandardised approach, and, withfive years of the requisite historicaldata on hand, is confident it can starttesting the IRB foundation approachby June 2005, says Heliodoro Ruiz,head of credit risk at GrupoFinanciero Banorte. Mexican bankshave not been told the length of thetesting period before regulators letthem use their own models.

Banco do Brasil has also madegreat strides. For credit risk, the bankplans to adopt the IRB foundationapproach at the suggestion of itscentral bank while it gathers the datafor the more advanced method. Foroperational risk, it wants to startwith the standardised method, buthas plans to achieve the advancedapproach. “Implementing Basel IIwill allow us to manage better ourrisks and mitigate them,” says VitoriaVaz Morgado, executive manager foroperational risk at Banco do Brasil.

Basel II and non-G10 banks



available. By contrast, regulators in many other parts ofthe world, including Asia and Latin America, will takemany different approaches depending in part on howadvanced a particular banking sector is both in generaland in terms of risk management. (See box: Basel II andnon-G10 banks.)

The dilemma can be seen among respondents to theEconomist Intelligence Unit survey. A total of 38% saidthey plan to implement the Basel II guidelines, while24% remain undecided. (See chart 2). A further 38%said they did not plan to implement Basel II. (A total of40% of the 102 respondents said that Basel I market riskmeasurement methods did not apply to them. Thereasons for this include the fact that some respondents’

companies do not have significant trading operationsand that some work at insurance companies which don’thave to comply with Basel guidelines.)

Of those adopting the accord, 47% plan to start withthe simplest or standardised approach, 37% with theInternal Ratings-Based (IRB) foundation and 16% withthe IRB advanced approaches to credit risk. Foroperational risk, 63% plan to begin with the secondmost complex, or standardised, approach, 21% with thebasic indicator approach, and 15% with the advancedmeasurement approach (AMA). (See charts 3 and 4.)

In some countries, the timing is another unknownfactor, and, even if finalised, it could easily be delayeddepending on the preparedness of the bank. It should

2. Does your company plan to implement the Basel II guidelines?(% respondents)

Yes 38

Undecided 24

No 38

3. If your institution plans to implement Basel II, what approach will it initially take towards credit risk?(% respondents)

The standardised method 47

The IRB advanced approach 16

The Internal Ratings-Based (IRB) foundation approach 37

4. If your institution plans to implement Basel II, what approach will it initially take towards operational risk?(% respondents)

The basic indicator approach 21

The advanced measurement approach (AMA) 15

The standardised approach 63



therefore come as no surprise that about half of theEconomist Intelligence Unit survey respondents arenot sure when they will be fully compliant with Baselguidelines for credit risk, operational risk andtransparency guidelines. More surprisingly, about 18of the 86 who replied to this question said theyexpected to be compliant for credit risk in 2007 andanother 13 expected to be ready in this area by 2008.(See chart 12– chart numbers correspond to numbersin the appendix.)

Many mid-tier banks will face growing pressure toadopt Basel II or a more advanced Basel II approach,as regulators demand more sophistication andcompetition intensifies from better-prepared rivals.According to our survey, 41% of respondents expectincreasing pressure to adopt Basel II or a moreadvanced Basel II approach. Of those who expect morepressure, 54% say the pressure will come fromregulators, 16% from more advanced competitors and10% from shareholders. (See charts 5 and 6.)

6. If yes, where do you expect the pressure will come from?(% respondents)

Regulators 54

Competitors that have adopted Basel II guidelines or more 16advanced Basel II guidelines

Shareholders 10

Board of directors 5

5. Do you expect to come under pressure to adopt Basel II or a more advanced Basel II approach in the future?(% respondents)

Yes 41

Not sure 27

No 31

12. If your institution is adopting Basel II, when do you expect to be fully compliant with its guidelines? (Number respondents)

2007 2008 2009 2010 2011 Later than Not sure2011

Credit risk 18 13 5 6 1 1 41

Operational risk 11 14 7 6 1 1 45

Transparency guidelines 15 11 6 5 1 1 46



10. Apart from regulatory compliance, what benefits do you expect or would you expect to achieve by adopting Basel II? Select up to three benefits. (% respondents)

Better risk management 52

Better competitive position 16

Less volatile earnings 9

Higher profits 8

Better credit ratings 28

Higher share price 4

Pricing of products to reflect risk better 23

Lower capital levels 4

Greater transparency 25

Improved efficiency 12

Not applicable: I do not/would not expect any benefits 33

Other 1

The argument in favour of Basel II is thatimproved risk management will result in fewerlosses and therefore stronger, less volatileearnings. Capital charges may fall over time,

particularly for less-risky activities, enabling betterpricing and allocation of resources. Credit-ratingagencies would hopefully respond by raising ratings,which would lower the cost of funding and enablebusiness expansion and/or a higher capital cushion.All this, when combined with the greater transparency

demanded by Basel II, would probably make a bankmore attractive to investors, improve earnings andconfer a competitive edge.

Indeed, our survey shows that many bankers expectto gain by adopting Basel II, with 52% viewing betterrisk management as the main advantage, 28% hopingfor improved credit ratings, 25% for greatertransparency, 23% for the ability to price moreaccurately for risk and 16% for a better competitiveposition. (See chart 10.)

The benefits of Basel II



Interviews with risk managers mirror these themes.While respondents expect multiple benefits, a fewstand out:

Improved risk management. At the very least, simplygearing up for Basel II should improve the quality ofrisk management. “We see Basel II very positively asan enhancer for risk management and businesseffectiveness, because you have to discuss thepotential for risk in every area and create a culture ofrisk throughout the bank,” says Vitoria Vaz Morgado,executive manager for operational risk at Banco doBrasil. She notes that Banco do Brasil is alreadyreporting global operational risk on a monthly basisusing both the basic indicator and standardisedmethod, although it is not yet using the information toassign regulatory capital.

The US$80bn bank has taken additional steps toembed risk awareness into its daily regimen by testingthe use of risk-adjusted return on capital in somebusiness lines, as a precursor to using it across theentire bank. This measure ties decision-making moreexplicitly to risk. “Risk management needs to be in ourday-to-day thinking,” says Vilmar Gongora, executivemanager for credit risk at Banco do Brasil.

Business expansion and better allocation ofresources. Basel II should facilitate wiser businessdecisions since bankers can focus on the mostprofitable areas, using models to determine what areaprovides the best return on a risk-adjusted, oreconomic capital, basis. “We can choose which sub-portfolios need to be grown because they create ahigher economic value-added than others”, saysHeliodoro Ruiz, head of credit risk at Grupo FinancieroBanorte. “That’s a main advantage of this model.”

Even though the US$20bn Mexican bank cannot yetuse Basel II models to assign regulatory capital, theyhave already aided strategic decision-making when,

several years ago, Banorte decided to launch fixed-rate mortgages, an innovative product for Mexico. “Wewere able to get a competitive advantage because,using these models, we were able to calculateexpected losses as well as unexpected losses, theeconomic capital necessary to cover the risk, the loanloss reserves to cover the risk, and establish a fixed-rate loan for mortgages. So for the last 2 1/2 years, wehave been number one in mortgages and making a lotof profits,” says Mr Ruiz.

More rational pricing. Basel II should produce pricingthat is better aligned with risk, since the ability toquantify risk more precisely is crucial to being able toprice adequately to cover that risk. Basel II will alsohelp lenders explain to borrowers why costs are risingfor weaker credits and falling for stronger credits, saysUlrich Richter, chief credit officer of US$40bn IKBIndustriebank. “So we are working together toimprove credit quality, not just selling loans,” he says.

Higher credit ratings. Credit-rating agencies, intheory, should reward stronger risk management withhigher credit ratings and, consequently, lower fundingcosts. “To an organisation like Alliance & Leicester, ifwe can demonstrate clearly, using the Basel IIframework, that our risk profile really is quite low, itshould benefit both our cost of equity and cost ofdebt,” says Michael Thomas, director of group risk atAlliance and Leicester, a US$86bn UK bank.

Lower capital charges. While credit-rating agenciesand regulators are unlikely to permit an immediatedrop in overall capital levels, capital charges are likelyto fall over time for those customers, businesses andactivities that are shown by models to be less risky. “If,by using models, you can prove to your regulators thatindeed a borrower is less risky than what is indicatedby the standardised approach, then you can ask for a



lower risk weight. In the end you will save capital,”says Mr Liu of Hua Nan. He believes that any savingscould come gradually over the next five to ten years.

Even in the shorter term, Northern Rock thinks itlikely that Basel II will reduce capital charges becausemodels will require less capital for mortgage loansthan is currently the case using Basel I. “We believeBasel II will reduce the capital charge,” says IanWallace, director of risk at the US$66bn UK mortgagelender. “As primarily a lender of lower-risk mortgageassets, we should gain capital efficiencies followingthe implementation of Basel II. In terms of costs, weare already well placed because of the nature of ourbusiness and the systems we have in place.”

Greater transparency. More extensive disclosure ofrisk exposures and methodologies under Basel IIshould improve the perceptions of customers,employees and investors about banks with better risk

profiles. “Our company will be better received. Itshould make our business more profitable and morecompetitive,” says Mr Wallace. Mr Ruiz at Banorteagrees. “Down the road, there will be greatertransparency that will allow your shareholders andbondholders to see that you might be more stable nextto your competitor,” he says.

Stronger competitive position. Basel II may confer acompetitive advantage since its practitioners couldoperate with less capital and price more favourably. Ata minimum, Basel II should protect mid-tier banksfrom being hurt by larger competitors that adoptsophisticated models and thrive. “It’s a way ofshowing the market that National Bank has the samestandard in risk management as the big five Canadianbanks,” says Nicolas Delisle, director ofimplementation of Basel II at the US$65bn NationalBank of Canada.”



Those banks embracing more advanced Basel IIapproaches are likely to face steep challenges.Whether large or small, they will need to makesubstantial investments just to gather and

store the right data. They will have to develop or buyrobust models and information technology (IT)systems and hire skilled staff and train them. Banksmust combat cultural resistance to new riskprocedures and avoid needless spending that mightarise as banks navigate a thicket of new rules.

Most mid-tier banks lack the resources of theirlarger brethren to shoulder these costs. “For me, aUS$2m project is quite expensive. For one of the bigfive Canadian banks, that is the same as a US$500,000

project is for me because it is six times bigger. But atthe same time when you buy software from an externalvendor, it is not going to sell it to you for a fraction ofthe price at which it can sell it to a larger bank. So werun into these problems,” says Mr Delisle of theNational Bank of Canada.

Staffing can also be a problem. “The resourcesrequired to implement Basel II are similar for all banksirrespective of size. The challenge for smaller banks isthe timely realization of the project, which can takeyears, with a smaller number of employees,” says MrRichter at IKB.

Respondents to the Economist Intelligence Unitsurvey ranked high costs as the biggest barrier,

Obstacles to overcome

9. What are the biggest obstacles to implementing Basel II at your institution? Select up to three obstacles. (% respondents)

High cost 31

Lack of consistent, standardised data 25

Lack of skilled people 18

Unclear processes 19

Lack of integrated institution-wide IT systems 25

Cultural resistance 5

Lack of top-level support 9

Resulting higher capital levels 13

Lack of the right models and analytical framework 22

Not applicable: There are no obstacles 35

Other 3



followed by a scarcity of standardised data, a lack ofintegrated firm-wide IT systems, a dearth of the rightmodels and analytical frameworks, unclear processesand not enough skilled people. (See chart 9.)

High costs. Depending on the starting point, advancedapproaches can run into the tens and even sometimesinto the hundreds of millions of dollars. And even iffirms start with the simplest methods, many willdevelop models that they can use initially to makebetter internal decisions and then upgrade over time.

According to our survey, many companies areunable to estimate the total cost of implementingBasel II. Those that can say it will cost as much asUS$500m. (See chart 13.) Estimates from riskmanagers also depend upon the scope of theirprojects. Mr Ruiz at Banorte puts the bank’s Basel IIexpenses at 4-5% of annual general expenses, a figurethat includes salaries, training, software, hardwareand databases.

Hua Nan expects developing a market risk programwith value at risk (VaR) models to cost US$8–9m,advanced credit risk initiatives to add another US$1m,and operational risk improvements to costUS$500,000 more. Included are the costs of internaldevelopment, external help with data, modelling, and

strategic risk decisions, as well as the purchase ofsoftware, models and IT systems from outside vendors.

There are many reasons for the lack, or widevariation, of spending estimates. For some, it is stilltoo soon even to guess. Others focus only on theincremental costs pertaining to Basel II beyond thenormal efforts taken to improve risk management.Others budget for one project at a time. Still others donot segregate costs that are purely related to Basel IIfrom those related to other risk initiatives.

Data, models and systems. Basel II requires hugeoutlays for data, models, IT systems and people.KeyCorp, which puts Basel II costs in the tens ofmillions of dollars, sees about 40% of that amountgoing to data gathering and storing, 20-25% to ITsystems, and the rest to staffing. Ashish Dev,executive vice-president in charge of enterprise-widerisk solutions at Keycorp, sees data warehousing aseasily the single largest expense. Many mid-tier firmslack this crucial ingredient for developing models.

It is an enormous task to gather the right data,enter it into a standardised format, store it in awarehouse where it can be accessed easily, and getenough historical data to fuel mathematical andanalytical models. Operational risk requires 3-5 years

13. How much do you expect your institution will spend on setting up systems, processes and procedures to be compliant with Basel II? (% respondents)

Less than US$10m 41

US$10m-50m 5

US$50m-150m 2

US$150m-500m 1

More than US$500m 1

No estimate yet 49



of data, while credit risk demands 5-7 years ofinformation on such items as payment history,collateral, defaults and recoveries to predict theprobability of default and loss given defaults. (Seebox: Hua Nan.)

Most mid-tier banks simply lack the requisitehistorical data, although some have started gatheringit in recent years.

Once the data are available to estimateprobabilities of default and loss given default, banksmust build mathematical models to support thestratification of portfolios along these twodimensions. Models have been well developed foryears for consumer lending, and progress is beingmade on corporate and middle market loans. It will beharder to grade more esoteric credits, such asconstruction and asset-based loans, which have

unique characteristics that do not easily fit intogeneric grading models. For an asset-based loan, thevalue of collateral, often inventories or receivables,must be gauged on a weekly basis. This requires a backoffice with strong monitoring processes.

Another key challenge for mid-tiered banks is toinstall the right IT systems for Basel II and make surethat they connect seamlessly with IT, accounting andreporting systems across the enterprise. This isespecially tricky for those struggling with disparatelegacy systems that have not been fully integratedfrom past bank mergers. Banks must also demonstratethat their Basel II risk methods work before beingallowed to use them.

Skilled people. Workers with the quantitative andqualitative skills to grapple with Basel II are in short

For Hua Nan Financial Holdings,combing through and standardisingthe five years of credit data it needsto drive IRB models is a dauntingtask, because the requisite informa-tion is often either lacking or hard tofind in the same format, accordingto James Liu, executive vice-presi-dent of risk management at the Tai-wan bank, for which credit riskaccounts for about 60% of its busi-ness.

Missing data must beextrapolated from existing data orestimated using external sources, he

says, noting that even gathering theright data for launching thestandardised approach can be achore. “The main problem is thereconfiguration of our data systemsso that every instrument – forexample, loans and collateral – willbe matched on an individual loanbasis,” says Mr Liu. Moreover, onceHua Nan has gathered the requisitehistorical data on a consistent basis,it will devise an internal ratingsystem to apply across the entireorgnaization. This will require that itchange its credit approval processes,

performance measurement systemsand incentive compensation models.

Hua Nan’s aim will be to startwith the standardised approach,which its regulators stipulate mustbe adopted by the end of 2006. Thenit will work towards developing IRBmodels initially for managementpurposes. Perhaps by 2009, Hua Nanwill have sufficient data to makepreliminary estimations on theprobability of default demanded bythe foundation method, and by 2010it hopes to qualify for advanced IRB,says Mr Liu.

Hua Nan Financial Holdings: The data challenge for credit risk models



supply given the growing demand. Staff must beconversant with models and able to format datameticulously while also being able to communicatecomplicated risk processes to co-workers in order toenlist their support and promote execution. GoodEnglish is another advantage, since risk managersmust understand the often arcane, cryptic andevolving Basel regulations. “It’s a competitive gamefor a limited talented pool,” says Mr Liu at Hua Nan.

Larger banks can afford to pay more for talent.However, many mid-tiered banks are located awayfrom major urban centres that are stocked with peoplewith the right skills. “Resources can be stretched thinas firms make do with the staff on hand, who mustoften work on demanding Basel II tasks while

satisfying their normal IT or risk functions,” says MrRichter.

Regulatory complexity, inconsistency anduncertainty. Many express frustration with thecomplexity of Basel II and with the fact that manyspecifics are still being hammered out, especially foroperational risk which lacks universal standards andmodels. Regulators are debating within countries andacross borders over what constitutes optimumcompliance, while banks, especially the giants, areweighing in with preferences and protests.

In practice, assumptions must be made about howguidelines will be finalised and how implementationwill pass muster with regulators.



Attaining the benefits of Basel II withoutstumbling requires using limited resourceswisely. Mid-tier banks will have to choose themethodology that fits their strategy,

business mix and abilities. Trying to do too much toofast could hurt morale, strain technical infrastructuresand drain the budget without achieving desiredresults.

A number of actions promote success. They include:● Winning the support of the board and top

executives;● Creating a culture of risk management with support

from all employees;● Integrating Basel II into existing risk processes

and other risk initiatives; ● Working as a team across business, product and

customer lines;● Embedding incentives for compliance; and● Building flexibility into all initiatives.

Top-down support. The board and CEO must givemore than lip-service by showing to all employeesthat Basel II and better risk practices are a priority. “Ifyour CEO doesn’t want to commit the resources andthe money and doesn’t think it’s important to comply,you’re never going to accomplish anything,” says MrDelisle.

Naming a chief risk officer (CRO), who reports to theCEO and has access to the board, should also helpemphasise the importance of Basel II and give the riskgroup the clout to get the job done. “I talk to my CROevery week, and if I have some problems, she can talkdirectly to the CEO quite quickly. Having a direct

contact with top management helps a lot in movingthings forward,” says Mr Delisle.

Create a firm-wide culture to manage risk. A lack ofsupport from employees at all levels can underminesuccess. Resistance to change must be overcome andnew, more rigorous risk habits instilled. “The difficultpart is to persuade your colleagues that this is aworthwhile project. A lot of credit people have beenusing a judgmental approach all their lives, so theyhave a deep suspicion of model-based approaches.You have to try to come up with a compromise thatcombines both elements. We have to work with theveteran credit people to win them over,” says Mr Liu.

Extensive communications and training programsare vital to teaching requisite skills and motivatingpeople to grapple with the detail of mapping risk andimposing proper safeguards. Mr Liu says he constantlyextols Basel II’s value and educates his team througharticles and internal and external conferences.Northern Rock encourages people from each functionto attend meetings where operational risk issues arediscussed and future problems identified. According toMr Wallace at Northern Rock, “This is not a statisticalapproach, but a way to get businesses to realise thatthey do know how to be proactive on managing risk.”

Banorte has invested at least five years in thetraining and education necessary to enable people tounderstand and be able to apply and developadvanced models, and has sent employees to getmasters degrees and specializations in riskmanagement at universities in the US, Spain and theUK. Banco do Brasil has also engaged in intensivetraining programs.

Steps for successful implementation



Integrate with other risk initiatives. A carefulinventory of existing risk processes and procedures tosee what can be adapted to Basel II can help mid-tierbanks avoid the temptation to spend too much onseemingly attractive but unnecessary new solutions.“The key is to integrate rather than insert processes.We have built wherever possible on existing structuresand data so as not to incur major overhead. This is oneof the reasons that we have such a low cost base,” saysMr Wallace.

When seeking external solutions for data, modelsand IT, off-the-shelf models or systems must becompatible with the bank’s customers and productlines and with existing technology platforms.Eliminating differences later could add money andtime. Moreover, new risk-rating systems will be uselessunless they are linked with the origination platform inthe branches and other business areas.

Additional economies of scale can be wrung out bycombining work for Basel II where possible with otherrisk-related projects such as compliance with theSarbanes-Oxley Act. There may also be cost savings asimplementation efforts highlight redundancies.

Incentives count. Under Basel II, those businessgroups that use less risk-adjusted capital should getrewarded by reporting higher returns and, in somecases, by being allocated more capital with which togrow their revenue. Higher earnings should bereflected in higher bonuses. Such incentives shouldspur managers to support Basel II initiatives.

To this end, Hua Nan is working to develop a scorecard approach to operating risk so that it can link eachdepartment’s risk performance more closely to theamount of capital that it is allocated. To monitor

performance, risk committee members will meet everysix months to reassess each department’s risk scoreand then reassign risk capital accordingly. “We aretrying to internalise this process so that safeguardingthe bank’s safety is not only the job of the auditors orthe risk management department. Business lineswould have the internal incentive to do it right. If theydon’t, they will be penalised,” says Mr Liu.

Breaking down silos. Rigorous risk managementcannot be won without co-operation betweenmanagers across risk categories. This may soundsimple, but traditionally market risk and credit risk aremanaged separately since the two require differenttools. Nevertheless, there is a growing need toimprove operational risk controls, and different kindsof risk increasingly cohabit in one instrument oractivity. This means that working as a team acrossdisciplines can help to manage risks and improveefficiency.

Risk managers must also work well with people in thebusiness lines and IT. “You really have to have peopleworking in the same direction. Sometimes that’sdifficult because priorities are different. But, if youwant to make sure that it all comes together at the gatewhen the door opens, you have to be sure that there isco-ordination between groups,” says Mr Delisle.

Flexibility is king. Given the complexity and fluidity ofBasel II, models and procedures must have theflexibility to be modified as rules change over theyears. Those banks that get too far ahead ofthemselves and implement models that cannot adaptto these rule changes could spend a lot of moneyunnecessarily.



As global uncertainty grows, so will pressuresto adopt best practices for risk managementas embodied in Basel II, particularly its mostsophisticated methods. Regulators will goad

banks to ever-higher standards. Investors andcustomers will gravitate towards those exhibiting thegreatest transparency of risk and an appropriatereturn for the risk taken. In theory, a virtuous circlewill emerge with leaders gaining an ever-wideningcompetitive advantage.

European mid-tier financial firms are likely to takethe lead in implementing Basel II, since they arefarther along than most emerging markets banks andEU rule-makers will require the accord for everyonebut insurers. The choice is likely to be the toughest forthe largest mid-tier banks, especially in the US andCanada, because they will be under the strongestpressure to follow the lead of the top-tier banks intheir markets. Elsewhere, and especially in thedeveloping world, regulators are likely to allow mid-tier banks to follow simpler approaches to riskmeasurement while encouraging them to worktowards developing internal models and more-streamlined processes.

Compliance will not come cheap. Mid-tier banks willhave to marshal limited resources to gather data intoexpensive warehouses, create the right models andanalytical frameworks, install the right IT systems andhire the right people. Support from the board and top

management will help, as will buy-in from every levelof the company.

Nevertheless, not every mid-tier bank will be ableto make the leap to internal risk models that couldlower their pricing and funding costs compared withcompetitors. Instead, over time, a perception of weakrisk practices could reduce funding from waryinvestors and lead to a wave of consolidation.Likewise, regulators in some parts of the world may bestretched thinly by the demands to monitorcompliance with Basel II. The different standardsacross borders could result in inconsistency inmonitoring, reporting and compliance.

As Basel II changes the way that banks view risk,business mixes are likely to shift towards activitiesthat require less risk-adjusted capital, such asmortgage lending, and away from those that demandmore, such as private equity. In addition, riskierborrowers may find it more expensive or tougher toobtain loans from more risk-conscious lenders.

Even so, many mid-tier banks will migrate over timetowards adopting Basel II. As Mr Blakely at KeyCorpsays, “The greatest criticism of Basel II is that it’s toocomplex and too costly. But the question is, in this dayand age, can a financial services institution reallychoose to avoid the complexity of the industry in whichit operates, and can it really afford not to build the kindof risk management systems necessary to adequatelyunderstand that complexity?”

Conclusion



Appendix: Survey resultsSeptember 2004

Responses received: 102

Please note that not all answers add up to 100, because of rounding or because respondents could give multiple

answers to some questions.

1. How would you describe your institution's management of market risk? (% respondents)

Mostly compliant with Basel I 17

Fully compliant with Basel I 17

Not sure 11

Just starting to work on compliance with Basel I 9

Half compliant with Basel I 7

Basel I does not apply to us 40

2. Does your company plan to implement the Basel II guidelines?(% respondents)

Yes 38

Undecided 24

No 38


APPENDIX: SURVEY RESULTSWEIGHING RISKBASEL II AND THE CHALLENGE FOR MID-TIER BANKS

3. If your institution plans to implement Basel II, what approach will it initially take towards credit risk?(% respondents)




4. If your institution plans to implement Basel II, what approach will it initially take towards operational risk?(% respondents)


The advanced measurement approach (AMA) 15


5. Do you expect to come under pressure to adopt Basel II or a more advanced Basel II approach in the future?(% respondents)

Yes 41

Not sure 27

No 31

6. If yes, where do you expect the pressure will come from?(% respondents)

Regulators 54

Competitors that have adopted Basel II guidelines or more 16advanced Basel II guidelines

Shareholders 10

Board of directors 5

7. If your institution plans to continue using Basel I or a less advanced method of Basel II, what approach would be your ultimate goal for credit risk? (% respondents)




We plan to implement advanced approach immediately 7

We do not plan to implement Basel II or a more advanced 44method of Basel II


APPENDIX: SURVEY RESULTSWEIGHING RISK

BASEL II AND THE CHALLENGE FOR MID-TIER BANKS

8. If your institution plans to continue using Basel I or a less advanced method of Basel II, what approach would be your ultimate goal for operational risk?(% respondents)



The advanced measurement approach 19

We plan to implement the IRB advanced 2 approach immediately

We do not plan to implement Basel II or a more advanced 43methed of Basel II

9. What are the biggest obstacles to implementing Basel II at your institution? Select up to three obstacles. (% respondents)

High cost 31

Lack of consistent, standardised data 25

Lack of skilled people 18

Unclear processes 19

Lack of integrated institution-wide IT systems 25

Cultural resistance 5

Lack of top-level support 9

Resulting higher capital levels 13

Lack of the right models and analytical framework 22

Not applicable: There are no obstacles 35

Other 3

10. Apart from regulatory compliance, what benefits do you expect or would you expect to achieve by adopting Basel II? Select up to three benefits. (% respondents)

Better risk management 52

Better competitive position 16

Less volatile earnings 9

Higher profits 8

Better credit ratings 28

Higher share price 4

Pricing of products to reflect risk better 23

Lower capital levels 4

Greater transparency 25

Improved efficiency 12

Not applicable: I do not/would not expect any benefits 33

Other 1



13. How much do you expect your institution will spend on setting up systems, processes and procedures to be compliant with Basel II? (% respondents)

Less than US$10m 41

US$10m-50m 5

US$50m-150m 2

US$150m-500m 1

More than US$500m 1

No estimate yet 49

11. How compliant is your institution currently with Basel II for: (Number of respondents, degree of compliance)

0% 25% 50% 75% 100% Not sure

Credit risk 24 16 17 12 3 27

Operational risk 24 19 19 7 3 27

Transparency guidelines 21 15 17 11 2 32

12. If your institution is adopting Basel II, when do you expect to be fully compliant with its guidelines? (Number respondents)

2007 2008 2009 2010 2011 Later than Not sure2011

Credit risk 18 13 5 6 1 1 41

Operational risk 11 14 7 6 1 1 45

Transparency guidelines 15 11 6 5 1 1 46

14. To what subsector of the financial services sector does your institution belong? (% respondents)

Banking 36

Other 13 Insurance 23

Assetmanagement29


APPENDIX: SURVEY RESULTSWEIGHING RISK

BASEL II AND THE CHALLENGE FOR MID-TIER BANKS

15. Where is your institution headquartered?(% respondents)

United Kingdom 12

United States of America 12

India 7

Brazil 5

Australia 4

Indonesia 3

Israel 3

Italy 3

Mauritius 3

Other 49

16. Country of residence(% respondents)

United Kingdom 12

United States of America 12

India 7

Australia 5

Brazil 4

Indonesia 3

Israel 3

Italy 3

Netherlands 3

Other 49



18. Are you responsible for, or involved in, risk management at your institution? (% respondents)

Yes 74

No 26

17. Which of the following best describes your title? (% respondents)

Board member 10

CEO/President/Managing director 23

CFO/Treasurer/Comptroller 9

Chief Risk Officer 4

Other C-level executive 4

SVP/VP/Director 13

Head of Business Unit 4

Head of Department 11

Manager 15

Other 9

Whilst every effort has been taken to verify theaccuracy of this information, neither the EconomistIntelligence Unit Ltd. nor the sponsor of this reportcan accept any responsibility or liability for reliance byany person on this white paper or any of theinformation, opinions or conclusions set out in thewhite paper.

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