Complex questions

The world of banking regulation is set to change post-Basel II. Jonathan Walsh asks: do the new rules work or are they just too complicated?


Unless the widespread criticism of the proposals has a significant effect, the Basel Committee on Banking Supervision at the Bank of International Settlements will finalise the complex rules comprising the proposed new capital accord by the end of this year. The new capital accord, or ‘Basel II’, as it has become known, is intended to apply to most financial institutions operating any sort of financial business within the EU. It will supersede the existing capital accord, first implemented in 1988. If the timetable is followed, Basel II will come into force in 2007. In the same way that the 1988 accord was itself a revolution as far as the capital management of banks and other financial institutions was concerned, Basel II also represents a sea change in the thinking and approach of the regulators to the monitoring and regulation of banks.

Although it is fair to say that the existing Basel accord was not initially greeted with a great deal of enthusiasm, reactions to the Basel II proposals have suggested that there may be something very seriously wrong with the current set of proposed rules. Put simply, they are too complicated, too onerous and too costly to implement. There is no doubt that the task facing the committee was an enormous one, but faced with a horse to design, it appears to have produced a rather lame camel. The Basel II proposals introduce a number of key principles that are new to the regulatory sector, and as a consequence, the resulting draft rules – now extending to more than 200 pages of text and formulae – are unwieldy and overly complex.

There are a few specific areas of concern to bankers and lawyers alike. The new proposals set out a regime for applying a capital charge to ‘operational risk’; they allow banks to differentiate their capital treatment for particular assets, depending on the ability of each bank to report specific information; they introduce credit assessments based upon external rating factors by ‘piggy-backing’ off external rating agencies; they give for very detailed and specific rules in relation to securitisation and synthetic securitisations including derivatives – so-called “credit risk mitigants”; they introduce wide-ranging and administratively onerous disclosure obligations; and they attempt to give the capital standard real teeth by giving significant powers of sanction to home regulators.

Operational risk

The problem with attempting to assess operational risk – the risk of direct or indirect loss resulting from inadequate or failing internal processes – is that it is almost impossible to measure in any acceptable way. Very sensibly, the existing accord makes no attempt to attach a value to operational risk or the capital that should be allocated against that risk. It simply sets the level of capital high enough so as to include an element of operational risk. The ability of banks to predict with any certainty when the next fraud or failing system is likely to occur is probably significantly less likely than the average punter predicting the next Cheltenham Gold Cup winner. The British Bankers’ Association has made a number of detailed points about the way in which operational risk is proposed to be treated, but thus far to no avail.

No level playing field

The Basel II approach of treating different sizes of bank differently, so that larger banks with a greater spread of business than niche players are more likely to be able to take advantage of the ‘internal ratings-based’ approach to measuring risk, as opposed to the ‘standardised approach’, fails to take a number of key factors into account. The whole essence of the approach is also likely to impact adversely on small and medium-sized (SME) lending, as SMEs are singled out as particularly ‘risky’ investments on an item-by-item assessment and therefore attract a potentially high capital charge.

Rating agencies as gamekeepers

The whole system of rating-based assessments forming the basis of Basel II is itself an extremely difficult one to justify. It is thought that the rating agencies are not particularly happy to serve as independent third-party arbiters of capital standards. An interesting question is whether this somehow draws them into potential liability to depositors should they have got the rating analysis incorrect, as their analysis will have formed the basis for the capital charge.

Securitisation

The securitisation market has been particularly vocal in its criticism of Basel II. The application of the various formulae produces anomalous results in relation to securitisation tranches. The risk weighting of liquidity facilities has provoked significant response and the new rules are generally thought to be overly complicated. There is also concern over the supervisory sanctions and disclosure issues generally.

Indecent disclosure

Basel II sets out a requirement for banks to adopt a formal disclosure policy on both a qualitative and quantitative basis. Vast quantities of information will have to be compiled and distributed to market participants. Even if one ignores the additional work that will be required to produce this information in the format required, it is not clear how this additional obligation will sit with existing obligations, such as the Financial Services and Markets Act and the Listing Rules, among others.

Crime and punishment

While general market discipline in the financial sector is clearly important and regulators must have the ability to enforce the rules, there is no level playing field. Many financial institutions feel that there is likely to be a disadvantageous difference between the treatment accorded to US institutions under the application of their ‘home rules’, as opposed to that required for institutions bound by Basel II. Furthermore, there is still an enormous amount of work to be done in ensuring a consistency of approach even within Europe. While the existing accord represented a step change on previous systems, its rules remain sufficiently clear and simple so that regulators in different home jurisdictions cannot make widely different interpretations of them. Anyone doubting that there will be wide differences between the interpretations of Basel II proposals need only look at the current Financial Services Authority’s (FSA) consultation paper on the outstanding questions that need to be addressed, debated and settled by the FSA with reporting banks. There have already been calls for the implementation of Basel II to be delayed. The British Bankers’ Association has taken this one step further and suggested that the existing accord should continue to apply in parallel with Basel II as a transitional measure for the next 10 years, simply to give institutions and regulators time to become accustomed to the new regime.

Complexity makes for bad regulation. There is immense scope within Basel II for misinterpretation, and the criticism that the application of some of the proposed formulae leads to disproportionate capital charges for less risky business has some merit. If adopted on the date set for its implementation, Basel II will be difficult to comply with, almost impossible to police consistently and result in a divisive approach among institutions. Legal opinions covering the compliance by banks with the new rules are likely to become more heavily qualified and significantly less certain. While compliance personnel are already putting systems in place at prohibitive expense, business divisions of banks and the lawyers who advise them will have their work cut out for the foreseeable future.

Jonathan Walsh is head of Norton Rose‘s financial institutions group