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Storm clouds ahead?

by: By Adrian Coles, director general of the Building Societies Association
  • 22/09/2003
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Basel II may eventually prove very favourable for residential lenders in the UK although many are still unaware of the full extent of its implications

Protection against unforeseen problems or fraud is an issue for everyone who works in financial services, and none more so than for mortgage lenders who provide the capital for borrowers. How they go about doing so in a standardised manner is a matter currently under consideration, but what will it mean for mortgage rates and who is likely to be affected?

Essentially, the question under discussion here is how much ‘rainy day’ money should financial institutions keep aside to cover losses on their portfolio of mortgages, or on developing country loans, or to cover a major fraud? In very simple terms, this is the basic question that is being asked by the world’s financial supervisors as they struggle to devise a comprehensive set of rules that will cover the risks faced by the very wide range of deposit taking institutions around the world – and ensure that they all compete on a reasonably level playing field.

The supervisors are working under the aegis of the Bank for International Settlements – the ‘central banks’ central bank’ – which has its headquarters in the Swiss city of Basel. The first set of rules, Basel I – although the numerical designation was not necessary until recently – was put together in 1988; and a revised set of rules, Basel II, designed to cover the much more complicated financial world in which we now live, has been under development since 1998, but is now almost ready.

In more formal terms, Basel II is a shorthand term representing the development of a revised international agreement designed to regulate the amount of capital that credit institutions should hold on their balance sheets to meet the various risks that they face in their business. There are the obvious risks that borrowers will not repay the loans they have borrowed. But some other risks are less obvious and require careful calculation; what would be the impact on an organisation, for example, of a 2% rise in interest rates, or a 10% re-alignment of the euro against sterling, or a 24 hour breakdown of an institution’s central computing system? Banks, and other deposit-taking institutions like building societies, cannot just help themselves to their depositors’ money. They must have funds of their own, typically provided by shareholders, or built up from their past profits.

Basel II is designed to apply to what are known as ‘internationally active’ banks. However, the authorities in America, India and China have given a very lukewarm reception to the ideas so far developed, and the rules will apply to only a very small minority of, if any, institutions in these countries. In contrast, a European Union Directive will apply the Basel principles to all credit institutions in Europe, and in the UK the Financial Services Authority (FSA) will be responsible for implementation.

Recent developments

The final version of the international agreement has not yet been determined but some developments are now clear.

Most importantly for building societies, the capital risk weighting for many residential mortgages will fall from 50% to 35%, under what has been termed as the standardised approach to credit risk. In very simple terms this means that in determining how much capital to hold to cover the risks of lending on residential mortgages – which is seen as a very safe form of lending – a bank or building society can assume that the loan is only 35% of its actual size, so that less capital needs to be held. For riskier loans no such assumption can be made, so the loan counts to its full extent (or at an even greater amount for particularly risky lending).

This will mean that, in general terms, the amount of capital required by the FSA to be held by building societies in respect of the credit risks – typically the risk of a loan not being repaid – inherent in their mortgage books will be reduced. However, Basel II includes a new capital charge for operational risk – typically, the risk of the computer system breaking down, or of a major fraud, which will partly counteract the impact of this reduction. It is, of course, up to building societies – and other institutions – to decide whether or not they wish to follow through any reduction in overall capital requirements by reducing the amount of capital they actually hold. Currently, most building societies (and banks) hold well above the regulatory minima required. They may well wish to remain in such a position. Few institutions in the UK would wish to run their capital down to close to the minimum.

Some large institutions are expected to move on to what Basel II calls the ‘internal ratings based’ (IRB) approach, which will enable them to determine their own rules for assessing their capital requirements for credit risk rather than sticking to a series of risk weights determined by regulators. These institutions will undertake a segmented analysis of the qualities of the assets which they hold, the probability of there being a default on these assets and the loss that might occur were default to take place. Some of the early calculations suggest that some institutions might have sharply reduced capital requirements, particularly for residential mortgages, as a result of going through this process. It is not clear if these institutions will, as a result, reduce the actual capital that they hold.

However, they will have a number of options that could affect the mortgage products available to brokers; they could decide to use the excess capital to move into new markets, or invest in the existing mortgage business and reduce the pricing of their products in order to gain market share, or to enhance returns to shareholders – or, in the case of mutual institutions, to members – to acquire other institutions or to repay alternative forms of capital. Of course, this is still dependent on external factors such as where we are in the economic cycle and how interest rates are standing.

Pillar talk

It is still too early to calculate how much spare capital institutions moving onto the IRB approach will have. The detailed calculations represent just the first ‘Pillar’ of the new Basel proposals. Pillar 2 requires firms to determine the additional capital needed to address business, systems and controls, and other risks not adequately captured in the minimum capital requirements in Pillar 1.

Pillar 2 also allows domestic regulators to increase capital requirements further for those areas that they feel have not been reflected in the institution’s calculations. Regulators will also be concerned to ensure that the models developed by large institutions are not pro-cyclical – that is that they encourage low amounts of capital to be held against rapidly expanding loan books during periods of boom leaving institutions under-prepared for a recession. The downturn might then be characterised by institutions attempting to build up capital and cutting back their lending in a way that might reinforce the cycle rather than ameliorate it.

The possibility of some large institutions having a potential advantage under the IRB approach has led a few commentators to conclude that smaller building societies could be disadvantaged under the new arrangements. It remains to be seen whether this will be the case. A number of building societies and professional services firms are examining whether a data-pooling exercise involving a number of smaller lenders might be possible, so as to create the very large amounts of data that are required to predict the circumstances in which losses might occur – a prerequisite for adopting the IRB approach. No announcements about collaboration have been made yet, but could come soon. Others argue that the advantages to be gained by adopting the IRB approach – a reduced amount of capital to be held – are not worth the very considerable costs of devising the new systems required.

It is important not to forget Pillar 3 of the new arrangements: a requirement on institutions to publish much more information on the risks that they face and the systems they have in place for managing and controlling those risks. The framers of the Basel II rules believe that one way of meeting the risks which institutions face is to hold the right amount of capital; they also believe that market discipline is important. If, on the basis of its disclosures, the market believes that a particular institution is risky, or does not manage its risks well, it will obtain less business, and will be less of a risk to the financial system as a whole.

At the time of writing, the Basel committee is examining the feedback on its third detailed consultation paper, to assess what changes, if any, are required to the proposed new rules. There is still a long way to go in relation to eventual UK implementation; one of the biggest problems that most institutions currently face is that they do not know the precise rules under which they will operate in the future to manage their risks.

key points

Under Basel II it is likely residential lenders will have to hold smaller capital reserves than at present.

Basel II will affect all European Union credit transactions but it is not being adopted worldwide.

Lenders will need to make provision for risks relating to the failure of IT systems in terms of both functionality and fraud.

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