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Basel II at the Crossroads
September 13, 2005

The fall of 2005 finds the United States in a quandary regarding bank supervision. Basel II seems to be degenerating into a tribal argument between factions representing large and small banks, and their supporting regulators and lobbies. The reason is clear: Basel II's template is at once rational and conflicted, thus many of the diverse participants in the US banking industry are reluctant about its adoption.

Like finches in the Galapagos, bank business models have evolved into separate species, each filling the niches of financial services in a given market. Evolution creates contorted operational profiles, like US mortgage lenders that rely overmuch on subsidized funding or back-office specialist banks with no credit risk but huge operational exposure. These peculiarities do not align well under a generalized risk testing construct like Basel II, especially when you throw a new and largely undefined factor into the mix in the shape of operational risk.

It is important to remember that Basel II, as proposed, is not supposed to be Sarbanes-Oxley, which assigns to managers and directors responsibility for ensuring the adequacy of internal controls to manage "business risk." SOX includes all of the operational risks associated with business model level risk taking over the full range of COSO risk appetites that public companies may choose to adopt.

Basel II, on the other hand, is about improving the transparency of credit risk practices at banks. Its chief benefit is enabling banks to do business across disparate banking regimes on a global scale. Unfortunately for US banks, efforts to eliminate opacity are not necessarily in the business interests of entities that have evolved to push the limits of free market competition.

We probably do not understand how to describe the operational risk SOX requires public directors to assess any better than we do op-risk in the context of managing banks. What should be simple measures of financial condition become muddied by statistics and options in regulatory equations that must accommodate a broad range of risky business strategies. In the United States, this is a topic still dealt with mostly in working papers as was documented recently in IRA's comment on "Safety and Soundness."

Regulators and banks do need to gather and study operational risk data, but since today no major US banks can convincingly defend a specific weighting for operational risk within Basel II, it may be time for global regulators to "clarify" Basel II by starting the research for Basel IIa.

Recall that the original Basel Accord limited itself to interest rate risk. In turn, Basel IIa should be a purely credit risk exercise and explicitly defer the "factor for operational risk" to a future enhancement. By focusing the time and resources of the global banking community on enhancing credit risk factors - risks which can be measured today -- the Basel Committee on Banking Supervision and its constituents in each participating country can actually move forward with the core recommendations of Basel II without any prejudice to future incorporation of operational risk factors.

Look at the damage done because of the uncertainty over the operational risk issue. We see increasingly irrational models for amending Basel II that are full of "special interest" accommodations pushing their way into otherwise straight forward calculations of Basel II's Pillar III reporting numbers. Is there another way to explain risk equations that start with a logic fork asking which of the Three Stooges you most closely resemble? (See our IRA comment, "Complexity is not Clarity," where we discuss why the simple, transparent approach to Basel II metrics may be the superior choice.)

The continued fratricide of domestic self-interest among the US banking industry regarding Basel II is not good for the US national interest. Other parts of the world are going full speed in their efforts to implement Basel II. We see offshore banks in Bahrain and Singapore taking the lead in pursuing credit risk measurement standards that enable counterparties to work more closely together. And these are places where, as in the US, vast differences in bank operations practices do exist.

Indeed, while banks in the US and Europe view Basel II as a chore, in Asia Basel II is seen as a vehicle to assist rather than impede the business communication, for example between Western and Islamic banking. The reasons for a common and usable credit risk information market are clear for those parts of the world preparing for the next 50 years, when oil flow and industrial expansion will shift from the maturing West to the developing East.

When we try to discuss the practical aspects of accommodating operational risk within Basel II, we are literally dealing with two worlds separated by stages of economic evolution. Instead of continuing this single track for all madness, the Basel Committee on Banking Supervision should focus on the simpler task of implementing enhanced credit risk measurement systems to improve counterparty transactions. This alone will improve the connectivity of the global economy and will be sufficient until these nations also become hyper-complex economies.

In the meantime, work should continue to quantify the future meaning of operational risks. The members of the Basel Committee and the leading international banks must ask (or repeat) some basic questions. Are operational risk factors understood sufficiently to be quantified and thus included as factors for Basel II regulatory capital calculations? Or are these issues, in reality, still so vague and theoretical that inclusion in the current Basel exercise only serves to interfere with the global credit ratings alignment agenda at this time?

Questions? Comments? [email protected]

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