The Future of Banking Regulation 7-8 April 2005, LSE Oliver Page OBE Director Major Retail Groups Division

G10 – a key issue - cyclicality

Stress “In estimating necessary levels of risk capital, the primary concern should be to address those disturbances that occasionally do stress institutional insolvency - the negative tail of the loss distribution that is so central to modern risk management. As such the incorporation of stress scenarios into formal risk modelling would seem to be of first-order importance” Alan Greenspan

Pro-cyclicality Main risks for banks is still credit risk So main potential for Pro-cyclicality is capital requirements for credit risk Basel 2 makes clear that capital is for unexpected losses Clear that probability of defaults and the losses given default highly cyclical So is it a problem? Basel 2 tried to ensure not

Cyclicality in PDs Rules require long term view for PDs Plus P2 stress test Important that banks and supervisors deliver

Cyclicality in LGDs Rules require LGDs cannot be less than the long run default weighted average loss And if higher in downturns than average, then must use downturn values i.e. LGDs must reflect economic downturn conditions – “stressed” LGDs Similarly for EADs The problem – banks don’t have enough data to be able to do this

Why is this an issue

Mortgages

Summary Basel 2 is a contribution to financial stability But this requires that cyclicality is dealt with Banks and supervisors are not on different sides

Non-G10 Implementation of Basel 2 in the near future “may not be a first priority for all non-G10 supervisory authorities in terms of what is needed to strengthen their supervision” But Basel 2 has a lot to say to banks and supervisors on governance, risk management and controls – not new but rather a codification of what is already good practice in well managed banks

Non-G10 Pillar 1 Aim to adopt the standardised approaches as these are a material improvement, even if external ratings not widespread Don’t aim to implement the advanced approaches too soon nor push banks too early to adoption by them Press banks to adopt improved governance and controls as in Basel 2 Press banks to adopt advanced risk methods of Basel 2 for their own internal use Pillar 2 Apply this whatever approaches are adopted under P1 Press banks to develop capability to assess own risks and adequacy of capital As a supervisor adopt the supervisory review Pillar 3 In many markets less usable, but worth thinking through how market discipline can be made to work

Conclusions Basel 2 is what it set out to be: A framework that further strengthens the soundness and stability of the international banking system while maintaining a level playing field between internationally active banks Achievement of those objectives depends on effective implementation