Banks Report Widespread Challenges Remain in their Basel II Preparations

Substantial numbers of banks surveyed remain uncertain over budgets, a lack of confidence in risk-management frameworks and economic capital systems, and insufficient progress in implementation of the credit-risk measurement tools required to meet the new regulation. Survey results indicate that U.S. and Asia-Pacific banks lag behind their European counterparts in several key areas of preparation for Basel II.
The survey of executives responsible for Basel II compliance at 97 of the world’s 200 largest banks in April and May was designed to gauge how major banks worldwide are responding to the challenges of the Basel II Accord just before the announcement of final rules in late June. Basel II updates and expands 1988 capital rules for risk-management practices that align capital more closely with operational, credit and market risks for banks operating internationally.
Other major survey findings include:

  • Uncertainty on the total cost of compliance is broad, with nearly a third of survey respondents saying they remain unsure of the total cost of their Basel II program. Of those banks providing estimates, most banks with assets under US$100 billion expect price tags of Euro 50 million or less while nearly two-thirds of larger banks project costs of more than Euro 50 million.
  • The majority of banks said they see significant benefits from Basel II, especially in improved capital allocation and better risk-based pricing.
  • More than 70 percent of banks surveyed are planning to adopt Basel II’s advanced regulatory approaches on both the credit risk and operational risk sides.
  • Common expectations of increased competition in retail and small-and-medium-enterprise (SME) lending, consolidation among corporate and specialized lenders, and more selective approaches to emerging-market credit.

Concerns remain

The survey indicates that many banks have significant work remaining to satisfy the requirements of two of the three major elements of Basel ll: setting up a risk-based supervisory structure within the bank and increasing market discipline through expanded disclosure. Nearly two-thirds (63 percent) of banks surveyed described their enterprise-wide risk management framework as poor or average. Just over 60 percent of respondents described their economic capital systems as poor or average. Basel II will also require banks to make significant changes to their business practices. Nearly 90 percent of survey respondents say change is likely in their operational risk management processes. In addition, almost eight in ten bank executives say that their credit risk management processes are likely to change.
“The survey confirms that a quick database and reporting fix was never going to work,” said Paul Cartwright, a managing director at Accenture. “Many banks now clearly see the need for combined information technology (IT), organizational and process change. Although budgeting was hurt by the last two years of worldwide cost-containment, banks are finding they face significant compliance challenges.” Survey results highlighted another area of focus for banks to achieve Basel II compliance: development of the tools necessary for internal credit ratings. More than half of the banks targeting the advanced internal ratings-based (IRB) approach – requiring rigorous guidelines in rating each credit exposure, impacting cost of capital and competitiveness – by 2007 have not yet entered the build-and-test phase of rating tool development. More than 20 percent of these banks are still performing early-stage gap analyses.

Regional differences

Three-quarters of European banks have completed strategic need assessments compared with only 12 percent of the banks surveyed in the U.S. and 22 percent in Asia-Pacific. More than 60 percent of European banks have progressed to implementation – compared with only 12 percent in the U.S. and 15 percent in Asia-Pacific. Analysis of the survey findings suggests that this disparity in progress may reflect, in part, a lack of confidence among American bankers in their existing credit-risk measurement systems. Asked their opinion of their rating model performance, model validation and use-test compliance, U.S. bankers responded that they do well in these areas at less than half the rates of their European counterparts. U.S. banker evaluations on capability related to three other credit-risk tools also lagged significantly.
“Banks need to be more confident in their assessment of risks, which will increasingly be incorporated into the day-to-day running of their businesses,” said Tom Garside, managing director and deputy head of the finance and risk practice of Mercer Oliver Wyman. “Risk will drive capital allocation, as well as tactical and strategic decision-making. But building the underlying risk measurement models is, at most, only half the battle. Banks must look beyond the build-phases of their Basel II programs, ensuring that ‘use-test’ initiatives will deliver both regulatory compliance and bottom-line benefits.”

Costs still uncertain for many banks

The survey indicated considerable uncertainty remains over the level of costs – 31 percent of survey respondents said they did not have a cost estimate for Basel II compliance. The level of uncertainty cited by respondents was highest among banks in the U.S. (59 percent) and Asia (54 percent), more than twice the rate of European banks (20 percent). Among those banks providing cost estimates, more than 90 percent of medium-size banks (those with assets of less than US$100 billion to US$25 billion) do not expect costs to exceed Euro 50 million. For larger banks (assets of at least US$100 billion) with multiple business lines, however, the complex implementation issues they face is reflected in their expected costs. Nearly two-thirds of large banks providing estimates still expect to spend over Euro 50 million, and 30 percent of these higher spenders project a cost of more than Euro 100 million.
Many banks surveyed are finding ways to lower their compliance costs. While nearly 60 percent of banks surveyed plan to implement new solutions to meet the new operational risk requirements, nearly half say they plan to take lower-cost routes by developing solutions internally or modify existing technology. In addition, centralizing credit data storage is on the agenda of 63 percent of banks. “Most banks will tell you that data management remains the greatest single Basel II challenge because you have to utilize detailed information from across the enterprise,” said Thomas Balgheim, senior vice president, financial services, SAP AG. “Increased centralization is a way to improve the likelihood of successful project delivery and cost reduction. Seventy percent of banks in North America, Asia and Australia seek centralized data management solutions, which should also boost their businesses in other ways.”

Benefits justify effort

The survey found widespread expectations that Basel II will significantly affect lending. Slightly over half of bankers in the survey said they expect to expand unsecured retail loans, while 48 percent projected increased retail mortgages and 45 percent predicted more SME credit. These results suggest that borrowers in these areas are likely to see lower costs. Conversely, bankers expected declines in corporate (22 percent), specialized (16 percent) and emerging markets (15 percent) lending – suggesting consolidation of these areas towards banks that can best price these risks. Banks surveyed in Europe, the Middle East and Africa expect Basel II to have the most influence on loan interest-rate pricing – 58 percent see significant impact compared with 41 percent in Asia-Pacific and only 7 percent in the Americas.
Banks also see significant business benefits from improved capital allocation (63 percent) and better risk-based pricing (53 percent), well above those expecting to benefit from reduced regulatory capital requirements (37 percent). Among the survey’s other key findings, over 80 percent of European and U.S. banks said they are targeting one of the IRB approaches for credit risk by 2007. For operational risk, while less than half of all banks surveyed are targeting the advanced measurement approach by 2007, 71 percent expect to attain that status by 2010. The incentives of lower capital costs and remaining competitive with peers appear to be spurring banks to take on advanced approaches.
The survey was conducted by London-based Financial Times Research Centre. A sampling frame of approximately 200 of the world’s quoted banking institutions was provided by the FT Research Centre. This sample was stratified according to region (Western Europe, Asia Pacific, North America), and banks were approached until a representative quota from each region was obtained. The banks were further categorised by size (large/medium) to ensure that the responses were representative of the population being studied. The fieldwork for this survey took place between April 1 and May 13, 2004. The quantitative survey was conducted by telephone with the executive responsible for Basel II implementation in each bank.

Source: SAP AG