Risk Partner – Fundamental terms
- What is Basel II?
The commercial law stipulates that newly created enterprises must provide sufficient capital resources. The
founders are personally liable if liquidity problems occur. The idea behind this is to avoid for example: A dealer
sells airplanes without having previously required an advance payment and has then not the necessary funds, in
order to cover the operational costs.
This principle exists also with banks, however it was not always kept in the past. The Crash of 1929 and the following recession have taught banks to always keep sufficient funds in order to cover a sudden important inquiry of liquidity.
Banking operations foresee that in order to give a yield to a deposit, the founds are reinvested in the financial market under the form of credit, investments or participations in other banks. Hence follows, that if a bank has a problem and it demands other credit institutes to suddenly redeem claims against them, a domino effect occurs that could, in certain circumstances, lead the whole banking system to collapse.
In order to avoid this, supervisory authorities have been created to control the credit institutes and to assure that the banking system remains stable. Thus developed the Basel Committee, which is supported by the 10 largest industrial nations, and by today it created a new framework to ensure that the banking system remains solid.
The risks of the banks is limited not only to the liquidity risk, but also to the credit risk, the market risk, the operational risk and the interest rate risk. Each risk results from a possible damage, which the bank has to bear with its own capital funds.
The credit risk is the risk that a debtor (private or corporate...) does not repay its debts as agreed. Thus a loss for the bank develops.
The market risk develops if a bank invests funds for example in a foreign currency or in shares. In the case of a drop in share prices, again a loss can result.
The operational risk is the risk that certain procedures within the bank do not exist or have not been considered, and so can result in a loss for the bank. For example, a cheque has been cashed without being previously checked by the bank.
If the bank invests in the market, and on the other hand guarantees its customers an interest rate, it can occur that due to the development of the interest, the interest-rate margin becomes negative, which is represented with the interest rate risk.
The new capital resources agreement Basel II intends for the credit institutes to have sufficient capital, in order to cover all these risks, so that if there should be problems, the bank system continues to function, and that savings account holders do not loose their assets.
The new accord intents for the banks to incorporate a sound risk management in order to supervise risks. If this is led well and the risks are normal, the bank can expect capital reduction.
To supervise risks means in case of credit risk, to supervise the customer credits in a systematic way and to control and evaluate it regularly.
To that extent Basel II concerns not only the banks but also their customers, which we will describe in a following article "Basel II – whom does it concern?".
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- Whom does it concern?
Basel II is a new capital regulation which stipulates a "Capital Adequacy" for credit institutions. Capital
adequacy means that the capital resources correspond to the bank's risk profile, as described in the article "
What is Basel II?".
To that extent, Basel II directly concerns the credit institutes, however, indirectly concerned are all
participants of the financial system, such as:
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The Investor (private or corporate)
The investor is informed by the bank, through the disclosure obligation, about the undergone risk. The investor is
been informed twice yearly, about the credit risk, the market risk (value and foreign exchange risk), the
operational risk and the interest rate risk. He will receive detailed information about these risks, how
effective the risk management is and whether the bank has sufficient capital to cover the risks.This information
is published like financial statements, and one can expect that specialized analysts and magazines will process
this information, in order to inform their customers. This might influence the investor's decision to select his
bank in the future not only because of the net yield but also because of the security measures the credit
institute has to offer.
One can also expect that banks with a higher risk profile, offer their customers a higher net yield, in order to
maintain them as customers.
- The debtor (private or corporate)
Since the credit institution must introduce a developed credit control, if it does not want to freeze too much of
its own capital resources, applicants for new and existing credits will have to supply the institution with more
and repeated information. The Basel II agreement regards a credit under two criteria the applicant for the
credit and the credit itself.
The applicant for the loan can sometimes become insolvent (corporate clients: bankruptcy, liquidity crises....
private individuals: income loss, insolvency....) and therefore, the bank will demand updated information
regularly, directly or indirectly (at least once a year). An indirect inquiry can be made for example in the
case of a corporate client with a rating institution. With the help of this information the bank will evaluate
the loan applicant regularly with regards to its insolvency. The bank must also supervise the credit itself and
the associated collateral. The respect of the payment schedule and the use of the credit line are part of the
credit control. The goal of monitoring the security measures is to protect the integrity of security. Therefore
banks will require an insurance for e.g. mortgage credits, which protects the real estate from
"accidents". The credit institution will also ensure, that the real estate is well maintained, so that
the value of the real estate does not decrease. For this reason the credit applicants will have to make more
information available to the credit institution.
- The credit institution
The credit institutions will have to introduce operational changes, however, they will also be classified
according to their risk profile by other credit institutes. That means that credit institutions with a higher risk
profile have to be aware, that financing themselves will be more expensive, and the capital market will be
narrower.
Basel II will lead to extensive changes, also in regard to the transparency of the participants. Participants
acting cautiously will benefit. Participants taking great risks and not having sufficient capital resources to
cover the risks, will loose. The latter endanger the assets of others, because in case of insolvency, the lender
will have to cover part of the losses. These latters endanger the assets of others, there in the case of an
insolvency, for whose credit givers a part of the losses must cover.
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The effects of Basel II on the banks
The new capital agreement also intends the credit risk to be better and more realistically evaluated as
in the past Basel I agreement. In the past agreement for example, all states were evaluated with a risk factor
of zero, which means that Argentina and Brazil are being regarded with a risk factor of zero, which does not
correspond anymore to the reality in the current situation, where Argentina is nearly insolvent. In order to avoid
this, the credit rating was introduced in the new agreement. All firms, banks, states and private individuals are
being rated.
That means that each credit applicant is being assessed for the probability of insolvency. The capital, which
is to cover the credit risk, is determined on the basis of these ratings.
The consequence of this new method of calculation it, that banks, which want optimum use of their capital must adapt
their credit policy to the new computations. If the bank mainly worked with credit applicants that have a bad credit
rating, the banks, upon introduction of the new agreement, will suddenly face new capital requirements.
These ratings could come from credit rating agencies (e.g. Standard & Poor’s and Moody’s) or the
banks themselves can establish them. In the last case, banks must show an appropriate organization. This
organization must be able to administer the credit risk well.
For example the bank must supervise the credit
payments and the credit taker regularly. The supervisory authorities check whether this is being done properly,
that the credit rating is appropriate and that sufficient capital is provided for, in order to cover the credit
risk.
The new agreement offers one new feature, which is, that banks are able to deduct collaterals from the credit
risk. A secured credit costs less than an unsecured credit. The supervisory authorities are only granting this
deduction if the bank itself has a good risk administration.
To that extent the banks stand today before a strategic challenge. They have to decide with which credit clientele
they want to do business, how much capital they want to provide for this purpose and if they could decrease their
capital resources with collaterals. This has to be considerate now, because certain forms of credit
organizations will only be recognized if they exist and function for more than three years. Since the agreement
is effective since beginning of 2007, and the organizational adjustments are very time consuming, there
is not much time to put these considerations into practice.
In Luxembourg, there are many subsidiaries of large international banks whose parent company decided to study and
process the Basel II requirements centrally. This leads to the fact that local subsidiary banks are not
sufficiently familiar with the topic and thus will be too late to tackle the strategic considerations and more of
their own capital funds will have to be used. This can lead to certain lines of business being shifted into other
countries, where the bank has Basel II conformal organizations and where fewer own capital funds is are being
used.
Basel II includes opportunities and risks, which must be tackled by the banks in the near future.
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