Kevin Davis Commonwealth Bank Group Chair of Finance Risk Management, Pricing and Capital Provisioning under the New Basel Accord Kevin Davis Commonwealth Bank Group Chair of Finance Department of Finance The University of Melbourne Asian Bankers Association 19 th General Meeting Seoul 2-4 September 2002

Kevin Davis Commonwealth Bank Group Chair of Finance The Three Pillars Minimum (Risk Based) Capital Requirements Effective Supervisory Process Market Discipline

Kevin Davis Commonwealth Bank Group Chair of Finance Basel 2: The Implicit Assumptions Capital is more costly, at the margin, than deposits for financing bank activities Unregulated banks will choose capital and activity risk profile which has socially unacceptable risk of failure –Risk related regulated minimum capital is necessary –Lower capital requirements for “advanced” risk management provide incentives to adopt those techniques

Kevin Davis Commonwealth Bank Group Chair of Finance Basel 2: The Implicit Assumptions Capital requirements mean that shareholders bear risk, but –Management determine risk position –Shareholder control of management may be limited Hence –Effective supervisory processes as support –Market discipline needs to be encouraged These are, to some degree, substitutes.

Kevin Davis Commonwealth Bank Group Chair of Finance Questions –As a complementary /alternative approach, can distortions that make capital more costly be reduced? Is the relative cost disadvantage of capital (and thus the burden of capital requirements) constant across countries? –Tax systems, structure of deposit insurance premiums, disclosure / transparency and depositor awareness of risk are relevant considerations

Kevin Davis Commonwealth Bank Group Chair of Finance Questions If “advanced” techniques are beneficial, why won’t they be adopted anyway – why is a distorting, potentially inequitable, “tax/subsidy” solution required? –Should the capital incentives reflect international differences in the benefits of advanced techniques and in the cost of implementing them? –What can be done to reduce impediments (transition costs) for banks to adopt advanced techniques? Impediments may include management resistant to change!

Kevin Davis Commonwealth Bank Group Chair of Finance Questions How does the adverse effect on risk to depositors/ insurance fund/ taxpayers of a lower capital requirement compare to the beneficial effect of “advanced” techniques on such risk? –What should be the size of the capital incentive?

Kevin Davis Commonwealth Bank Group Chair of Finance Basel 2: The Challenges Understanding and Applying Modern Risk Management Techniques –“rocket science” v “basic principles” –Nobel prize winner explanations of their contributions to economics and finance include Demonstrating the merits of “not putting all your eggs in one basket” Demonstrating that “a pizza sliced into eight pieces doesn’t give more pizza than one sliced into quarters”

Kevin Davis Commonwealth Bank Group Chair of Finance Basle 2: The Challenges Coping with Diversity –Of country characteristics Legal and institutional structures differ –Governance and market discipline implications Economic structure and business structures differ –Risk weights have implications for pricing and flows of funds to different types of firms and activities

Kevin Davis Commonwealth Bank Group Chair of Finance Basle 2: The Challenges Coping with Diversity –Of bank types Multinational v small regional –Will multinational banks be able to leverage off favourable capital positions to make strategic loss leading incursions into regional markets?

Kevin Davis Commonwealth Bank Group Chair of Finance Pillar 1 Issues: Credit Risk Measurement and Management Banks in regional economies face challenges in moving to “Advanced Status” Internal Models –Require extensive data for calibration and testing Capital Markets –Availability of “Market based” information on corporate credit status differs substantially across markets Credit Risk Mitigation Techniques –Markets for credit risk transfer (derivatives, securitisation) are in varying stages of development

Kevin Davis Commonwealth Bank Group Chair of Finance Pillar 2 Issues: Supervisory Processes Regulator Education and Training Cross Border Cooperation Regulatory Structure –Specialist v Integrated Regulator Funding –Taxpayer/Budget, Industry, Seigniorage

Kevin Davis Commonwealth Bank Group Chair of Finance Pillar 3 Issues: Market Discipline Regional Economies have differences regarding –Governance Structures and the legal basis for stakeholder protection –Disclosure Requirements –Capital Market discipline

Kevin Davis Commonwealth Bank Group Chair of Finance Conclusion Three Pillars – the Principle Three Pillars – the Practice ? –One size does not fit all –Incentives and competitive neutrality in banking –Risk weights and economic effects

Kevin Davis Commonwealth Bank Group Chair of Finance Thank You