Basel II & Globalization

Luncheon remarks by Christopher Whalen, Managing Director, Institutional Risk Analytics

to the Global Interdependence Center & Philadelphia Council of Business Economists

October 5, 2005

The Federal Reserve Bank of Philadelphia

www.institutionalriskanalytics.com

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When David Kotok of Cumberland Advisers asked me to speak to you

today, I was a little bemused by the prospect of relating our work in the

world of financial analytics and risk management with the noble ambition of

global interdependence. Fortunately, my business partner Dennis Santiago,

who was born in the Philippines, has for months now been very vocal in

pointing out to us that the nations of Asia view the modernization of their

banking systems and their capital markets via Basel II as a crucial step in

their economic development. This reality is reflected in the usage patterns

on our web site. More than half of the traffic we receive on any given day –

and at any hour of the day or night -- originates in Asia.

Today I propose to discuss how the evolution of the common international

consensus behind maintaining the safety and soundness of the national

banking systems around the globe may, in fact, serve to also advance the

intertwined goals of free international trade and increased economic growth.

The mechanism for accomplishing this obvious good may not be

immediately apparent, but as in most of life, there are sometimes big

opportunities in secondary and tertiary effects of seemingly unrelated events.

In 1988, the bank supervisors from the major industrialized countries agreed

on a new set of capital guidelines for commercial banks that became known

generally as the Basel Accord, this after the Swiss city where the Bank for

International Settlements (“BIS”) is located. The central focus of this

relatively simple financial template was credit risk and, as a further aspect of

credit risk, country transfer risk—a legacy of the Latin American debt crisis.

The new bank capital rules were hailed as an important tool to avoid sudden

financial shocks and the ultimate bogey man, “systemic risk,” which has

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haunted the global financial markets since the collapse of Penn Square Bank

in July of 1982. Other similar financial shocks during the subsequent two

decades – particularly the market meltdown in October 1987 and the default

by Russia in October 1998 -- only served to validate the decision to

implement the original Basel Accord, which, it is generally agreed, increased

the stability of the international financial system by requiring banks to have

a minimum level of capital to serve as a buffer against losses.

By the end of the first transition period to Basel I in 1992, all banks in the

industrialized nations were expected to maintain a level of capital equal to 8

percent of total assets, of which core capital (Tier 1, equity and reserves)

was at least 4 percent. This simple standard not only served to give bank

managers a clear and easily understood hurdle for the minimum capital

levels they needed to maintain to conduct business, but also provided

regulators with a threshold for safety and soundness below which corrective

action needed to begin.

Since those early days of the first Basel Accord, the BIS has hosted a

consultative effort among the G-10 regulators to keep the capital standards

and bank management practices up-to-date with the evolving marketplace,

especially the growth in the use of derivatives and other forms of financial

“innovation,” what some would describe as financial alchemy. Events such

as Enron, Long Term Capital Management and Gibson Greetings, are

included on a growing list of unfortunate examples of the benefits of

financial innovation. And all share a common factor: derivatives.

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With the rise of derivatives trading and related risk management concepts

such as the Black-Scholes option pricing model, the financial markets have

grown more complex and, unfortunately, more opaque, limiting the ability of

the regulators to understand much less supervise the activities of the major

banks.1 The largest banks have also grown increasingly dependent upon

principal trading, especially trading in OTC derivatives contracts, for a large

portion of their profits. This highly-leveraged private market is

predominantly populated by hedge funds and is, not surprisingly, is a

significant and growing source of credit risk to the more than 700 US banks

that actively participate in derivatives today.

According to the International Swaps and Derivatives Association, Inc.

(ISDA) the notional amount for credit derivative swaps or CDS grew by

almost 48% in the first six months of 2005 to $12.43

trillion from $8.42 trillion at the end of 2004. This represents a year-on-year

growth rate of 128% from $5.44 trillion at mid-year 2004.

It is hard to think of another part of the US economy – or any economy for

that matter – which grows at such rates, a troubling thought since the

counterparties in the majority of the CDS transactions initiated by hedge

funds are commercial banks. When you think of the poor financial

performance of most hedge funds during the past year and the rising interest

rate environment orchestrated by the Federal Reserve Board, you may

understand why a hedge fund would be interested in generating short-term

premium income by selling credit default insurance to a US bank. A cynic

1 See “No Margin of Safety: New bank-capital requirements are based on ruinous risk models,” Barron’s, March 7, 2005.

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might even say that some hedge funds are window dressing their

performance with premium income from CDS sales to banks to prevent

investors from withdrawing their funds at the end of 2005. But I digress.

Driven by the growing complexity of the financial markets, the transition to

the new “Basel II” capital proposal has as its central premise the idea that

banks should use their own internal risk models to assess the appropriate

level of capital required to support various types of business and risks. In

return for developing the internal capability to assess specific operational

and credit risks, qualifying banks get to lower their effective capital cost.

This set of requirements to allow the most sophisticated banks to model their

own risk-based capital needs is one of the key motives for the larger, global

banks to participate in Basel II and also one of the least understood aspects

of the new framework.

But lowering effective capital requirements for the largest banks is also the

reason why some of the smaller banks in the US have, a year before the

2006 mid-term election, used their considerable political clout to delay the

implementation of Basel II in this country until, at the earliest, a year from

now. Indeed, our meeting today is very timely for a number of reasons

related to both the difficulties involved in implementing Basel II and the

opportunities that will arise when the accord becomes, as I fully expect,

widely adopted around the world.

On Friday, several US bank regulators announced a one-year delay of the

adoption of Basel II, this following the hearing before the House Financial

Services Committee two days before. The regulators had attempted,

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unsuccessfully, to delay the HFSC hearing, but instead the meeting went

forward, populated almost exclusively by opponents of Basel II, who raised

the ugly specter of under-capitalized foreign banks coming into the US

market to acquire small community lenders, the sort of defensive,

protectionist yowling one used to hear in Washington several decades ago.

Last week marked a major rebuke to the proponents of Basel II in this

country and served as the catalyst for a full-scale retreat by the Federal

Reserve Board and the other US bank regulators. But around the world,

other nations, large and small, are moving ahead with a framework for the

prudent regulation of the business of banking that was originally conceived

by US regulators! This is quite a comment on the state of affairs in the US

political economy in 2005.

Consider the irony that as the US Congress, driven by various parochial

interests in America’s community banking lobby, delays adoption of Basel

II, the EU and much of the rest of the world is moving forward with the new

bank capital requirements. Last week, for example, the European Parliament

approved the Basel II accord for all 25 of the member states, clearing the

way for final go-ahead before the end of the year by the community's

finance ministers.

Countries throughout Asia and Latin America are following suit, again

illustrating the divergence between American perception, where Basel II is

viewed as an onerous burden, and the rest if the world, where it is often

viewed as an opportunity to improve the quality of bank management and

validate entire economies. Whereas the heads of governments in nations

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around the world know precisely what Basel II entails and how it will affect

their national markets, I think it is fair to speculate that our own President

and his Cabinet would be hard pressed to describe it in any detail, if at all.

For those of us who recognize the fact of the global marketplace, that US

banks of all sizes have lobbied for the prevention or delay of Basel II seemss

a pyrrhic victory. The opponents of Basel II have succeeded only in making

themselves more vulnerable to the very foreign-led competition and

consolidation they purport to fear.

The die is cast. A global tide of Basel II-enabled institutions which report

their financial results using uniform accounting standards and risk metrics,

and perform their own internal risk assessment of the probability of

customer and counterparty defaults, is awakening outside the US.

Meanwhile, we Americans temporize and fret about the regulatory burden of

Basel II, never taking time to consider that this latest evolution of risk

management principles may actually contain opportunities. And we have

only ourselves to blame.

While the very temporary setbacks of the type I have described this morning

regarding Basel II are disappointing, let me focus now on the positive and

even revolutionary aspects of the Basel II process and how the eventual

adoption of the accord will help expand the global economy in the years and

decades ahead. To do this, I shall focus on the core credit risk measures

which are, in my view, the most important part of the Basel II proposal,

including:

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Probability of Default or P(D) = the likelihood that a given subject will default on a loan or other obligation over a period of time. Loss Given Default or LGD = the percent loss after default per dollar of exposure, effectively the efficiency of an organization in recovering value after a default. Weighted Average Maturity or WAM = the maturity of loans or the aggregate loan portfolio, a familiar measure that will be known as “M” under Basel II. Exposure at Default or EAD = the amount an obligor could borrow immediately under existing lines prior to default expressed as % of existing credit exposure.

When the Basel Committee on Bank Supervision started down the road

toward Basel II a decade ago, the goal was to develop a new methodology

for determining the adequacy of capital in the largest international banks.

The updated rule is designed to rely more on banks' internal risk models to

determine how much capital they must hold against credit risk as well as

operational risk factors. Specifically, Basel II will require that the most

advanced Basel II banks which qualify for the advanced Internal Ratings

Based (“IRB”) approach to prepare and maintain their own estimates for

how likely a given client is to default on a loan or other obligation.

Basel II Capital Matrix

Revised Standardized Approach (Basel I)

Foundation IRB Advanced IRB

Probability of Default (PD)

Relies on external ratings Internal Bank Estimate

Internal Bank Estimate

Loss Given Default (LGD)

Relies on external ratings Supervised Factor Internal Bank Estimate

Maturity (M) Attribute of Debt Attribute of Debt Attribute of Debt

Exposure at Default (EAD)

Supervised Factor Supervised Factor Internal Bank Estimate

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Consider for a moment what this means. Banks around the world which

participate in Basel II must, in many cases, develop new internal systems for

scoring the credit worthiness of their customers, both individuals and

institutions, since they may no longer rely exclusively on third-party ratings

to assess default risk. Remember, the benefit of lower capital requirements

of Basel II come only come to institutions qualifying for Advanced IRB

approaches starting in 2007.

This new, internal ratings process by banks around the world means, in turn,

that nations such as India, China, Brazil, Malaysia, Mexico and Singapore –

not to mention most of the 25 EU nations – will be compelled to develop

new sources of accurate data about companies and consumers, systems

which, in many cases, do not currently exist. Banks in many countries will

need to create methods to understand and monitor the credit behavior of

their customers, much as the credit reporting agencies in the US function

today, and to provide this information to banks and other financial

intermediaries in an electronic, machine readable format.

Similar systems for gathering financial data about companies must also be

established in many markets, including aggregating financial information for

publicly traded companies and agencies to provide credit default ratings for

public and private entities. In many of the most important emerging

industrial nations, there is little or no information available regarding public

or private companies, but the informational requirements of Basel II will

make access to such information mandatory, either through public disclosure

or privileged communications.

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And in many of these nations, building the informational infrastructure

necessary for adoption of Basel II is seen not as a worry, but as a part of the

larger process of nation building, that is, an opportunity to make money for

individuals and companies, and to increase national prosperity.

In India, for example, both that nation’s financial sector and the related

portions of the IT industry are intensely focused on Basel II. All banks large

and small in that nation of more than a billion souls are anxious to be a part

of the Basel II process, even if they will never fully implement the accord’s

most complex and onerous provisions.

Simply achieving compliance with Basel II’s most simple credit risk

measurements requirements, known as the Foundation level, is seen as a

major goal for financial institutions in India, a nation where 60% of the

population still do not have direct access to banks. Indeed, the Financial

Express reported yesterday that “The Reserve Bank of India (RBI) intends to

take a stringent view of banks that fail to comply with the Basel-II norms by

April 1, 2006.” For those of you unfamiliar with the lexicon of Indian

bureaucrats, being subject to a “stringent view” is most undesirable.

In the EU as well, banks in the former Soviet republics as well as institutions

in the NATO member countries are gearing up for Basel II adoption. In

most cases, these banks will only ever seek to achieve the Foundation layer

of Basel II, but adoption is still a priority. Contrary to the cries of woe heard

in Washington last week from the community bankers, EU banks which

don’t qualify for Advanced IRB status will not have a sudden advantage in

terms of minimum capital levels. In fact, nothing will change.

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As with much of the rest of the world, many EU countries must construct

green field systems for gathering consumer and company credit information,

a process that will be laborious and costly, but which will greatly improve

the ability of banks to manage their credit risks in these markets.

The impact of having both bank regulators and their political authorities in

the various participating nations demanding improved financial data from all

types of individuals and enterprises should not be underestimated. While

much of the press coverage of the Basel II process has been focused on the

technical and largely US-centric view of the Basel II process, in the EU, for

example, the federation’s infant bank regulatory agency has embraced

eXtensible Business Reporting Language or “XBRL” as the means to define

and transport data to be used in regulatory reporting by EU banks.

The Bank of Spain is currently leading an ambitious effort to create an

entirely new reporting schema for banks in the EU based upon XBRL. One

of a family of "XML" languages which is becoming a standard means of

communicating information between businesses and on the Internet, XBRL

combines the transport properties of the XML language with an accounting

taxonomy, a powerful pairing that will not only be used to define what data

will be reported by European banks, but how that data will be gathered,

delivered and even analyzed by investors and regulators.

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This same XBRL template is likely to eventually be applied to all company

reporting in the EU, again a major step forward for all consumers of

financial data and another of the positive side effects of the Basel II process.

The US is also studying the adoption of an XML-based filing format for

reporting by public companies and mutual funds. 2 This month, the Federal

Deposit Insurance Corporation begins accepting bank call reports in XBRL,

a development driven in part by Basel II. It should be a matter of

considerable pride to Americans that the electronic database of bank call

reports created by the FDIC over 20 years ago is the leading model for all of

the bank regulatory agencies around the world striving to meet the data and

analytical challenges of Basel II.

While the US currently enjoys the best bank regulatory system in the world,

Basel II will force all participating regulators and governments to focus

increased effort on issues such as transparency and the quality of financial

disclosure. But the considerable infrastructure-building effort necessary for

implementing Basel II will also provide companies and consumers with new

means of accessing the global economy in ways that could not heretofore be

imagined.

Let me give you a hypothetical example. It is 2014. You own a company in

Asia that wishes to begin exporting its products to the US and EU. You

approach your country’s largest bank for trade financing and related

services. The local banker, in turn, introduces you to their export services

2 IRA is a member of the US jurisdiction of the XBRL International consortium. As has been reported in the business press, in September 2005 SEC Chairman Christopher Cox approached the XBRL consortium with an invitation to provide comments on the state of XBRL, the SEC's XBRL voluntary filing program, and the measures necessary for the success of both. www.xbrl.org

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department representatives in New York and London via teleconference.

Both the local bank’s office and the credit officer in the bank’s HQ ask for

your company’s financial statement information – balance sheet, income

statements and cash flows for the past two years -- and request monthly

general ledger data and customer receivables aging each month as part of the

credit approval and credit maintenance regime.

Because your local bank is working toward full Basel II Advanced IRB

compliance, they request that your company’s monthly G/L data be provided

in electronic form by your auditor, using an XBRL-based schema that runs

off of your spreadsheet software, complies with international GAAP, and, by

no coincidence, is already imbedded in your corporate accounting software.

You gladly comply, realizing that by establishing this set of credit and

informational relationships, your company now has gained sufficient

recognition to operate outside of your home market.

Inside the local bank, credit limits are established for your company and a

probability of default or “P(D)” is set at “CCC” or 2,800 basis points (28%)

of default risk. This rating is assigned because of the size of your company,

the variability of cash flows and other factors. Because the bank badly

wants to retain your business, they make a number of concessions in terms

of the pricing of certain services, but they also make clear that the internal

default rating assigned to your company governs the overall pricing of your

line of credit.

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Debt Rating/Probability of Default

Rating Basis Points AAA 1 AA 4 A 12

BBB 50 BB 300 B 1,100

CCC 2,800 D 5,000

Default 10,000

Your bank also informs you that your internal risk rating for Basel II will be

shared with regulators and, if you so request, other lenders, again providing

your small, privately-owned company with access to credit and other

services from a myriad of other financial services providers. The mere fact

that your company has established a credit relationship with a bank which is

part of the Basel II Advanced IRB framework opens doors to you that might

otherwise have remained closed were you dealing with a non-Basel

institution.

Many people reading or hearing about the Basel II proposal focus overmuch

on the requirements for the participating institutions, particularly estimating

what is known as “operational risk” – another way of describing the

insurance industry -- and far too little time pondering the enormous

implications of wide adoption of the Advanced IRB approach to creating and

maintaining internal credit default ratings.

Since the global credit rating agencies generally only go as far as 2,000 basis

points of default risk on the companies which they rate, and then only for

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publicly rated obligors, roughly a “B” in terms of the ratings break points

used by the major credit rating agencies, Basel II offers a vast opportunity

for commercial banks.

Not only can they lower their required capital levels compared with current

law and regulation, but all banks which embrace the discipline of internal

ratings could one day begin to aggregate these ratings on a global scale,

employing the same methodology used by FirstCall to gather and report

earnings estimates. Basel II banks could eventually replace the quasi-

monopoly of the third-party rating agencies with a global, anonymous, and

entirely public rating system for all companies, public and private, in all of

the global markets which adopt Basel II.

Indeed, one might foresee a time when the notion of a third-party rating

agency compensated by the company being rated, as is the case currently in

the US and EU, might be dispensed with entirely in favor of a blind

aggregation of Basel II credit default ratings, which would ultimately be

financed by the banks, vendors and investors.

Such a global system for assessing and disclosing the credit standing of a

given company would not only be transparent, but would give all of the

parties concerned an interest in making sure that the ratings process was

accurate and impartial – again, unlike the situation that currently prevails in

the global financial markets.

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Just as a fixed IP address is the prerequisite to commercial operation on the

Internet, in the years ahead, global business may look upon the internal

default ratings generated by financial institutions for Basel II purposes as

their passport to the global economy.

When you observe, as I noted earlier, that the market in CDS is the fastest

growing part of the US financial markets and that policy makers and

investors alike are already using CDS spreads as an indicator of short-term

microeconomic trends, is it so outlandish to suggest that the obligors

themselves may one day become the primary owners of their own default

ratings and manage them as companies look at research analyst ratings

today? Indeed, the CDS market, if it still exists a decade from now, is likely

to lead the call for public aggregation of Basel II default ratings.

If you think that such a suggestion is fanciful, let me remind you that a large

global financial services provider called General Electric is in the process of

building a consumer banking business outside the US. GE’s explicit target

for the P(D) of their average customer is a “D” rating, a company or

individual with some 5,000 basis points of default risk or a fifty-fifty chance

of failure. The folks at GE have chosen this target not because it is a more

profitable market niche than simply lending money to more affluent

consumers in the US – it is – but because the average retail customer or

company in markets like Poland, Malaysia or China is distressed under

generally accepted standards for measuring credit risk.

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It is tempting to think that the US is and will always be a superior market in

terms of the credit default profiles of businesses and individuals, but that

would be a false assumption in a global economy. As the US economy

adapts to the realities of competition in the international marketplace and a

government in Washington that does not know how to govern public

spending, the average P(D) rating for American companies and business is

slowly falling, even though current loan default rates at US banks are at

historic lows. I also would hold up for your consideration the explosive

growth in sub-prime lending and related “hybrid” mortgage products as

evidence of the gradual downward trend in the aggregate credit quality of

the US economy.

It seems fair to predict that as the US economy progresses through 2006 and

2007, and the Federal Reserve Board in Washington continues to raise

interest rates to maintain the appearance of low inflation, default rates at US

banks for obligations such as home mortgages and commercial loans will

very probably revert to the mean and then some, hopefully without too much

damage to the economy or the banking system.

We can thank the Basel framework and the Basel Committee on Bank

Supervision for giving us commercial banks and other types of lenders

which have the capital buffers and risk procedures necessary to adapt to such

a changing economic environment, but we should scold our spendthrift

government in Washington for making our economic cycles every more

volatile due to the massive overhang of public debt and related monetary

expansion.

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Washington’s inability to reign-in public spending has forced a compliant

Fed under Chairman Alan Greenspan to print a growing mountain of fiat

paper dollars which have little value save as a means of exchange. Looking

at the behavior of the real estate market over the past several years or the

fact that the derivatives market is expanding at a double digit rate, or the

New Economy bubble in US equities before that, it is difficult to reach any

conclusion but that the official inflation rate in the US significantly

understates the real erosion in the value of the dollar.

In coming weeks and months, as we observe how the US banking industry

manages the slow-motion collapse of the latest financial bubble in real

estate, including both housing prices and the stocks of the banks that have

financed it, we can take some comfort in the fact that when measured against

metrics such as P(D), with each passing day we are becoming more and

more like our brothers and sisters around the world. Thank you for your

attention.

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