Impact of Basel II on Banks and Corporate Customers

By Donald H. MacKenzie

Senior Executive Vice President of Kookmin Bank

In July 1988, the International Convergence of Capital Measurement and Capital Standards, now referred to as the 1988 Accord or Basel I, was introduced. At the time this represented a significant advance that led to banks improving their capital adequacy relative to the credit risks inherent in their portfolios.

A key aspect of the 1988 Accord is the requirement for banks to hold capital equal to at least 8 percent of their risk weighted assets. The stability of individual banks around the world improved and, perhaps more importantly, the overall international financial system was strengthened.

The 1988 Accord was later enhanced through the 1996 Market Risk Amendment which from that time on required banks to hold additional capital in respect of their market risk exposure.

Over time, as banks expanded internationally and became more sophisticated in their risk management practices, there was a growing recognition that the 1988 Accord was deficient in a number of ways.

The Basel Committee on Banking Supervision then began the development of revised supervisory regulations governing the capital adequacy of internationally active banks.

Their efforts led to the introduction of a revised Framework which is now generally known as Basel II. In the introduction of the Basel II document, the committee makes a number of important statements, two of which I would like to quote here: ``The fundamental objective of the committee's work to revise the 1988 Accord has been to develop a framework that would further strengthen the soundness and stability of the international banking system. The committee believes that the revised Framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits.''

``In developing the revised Framework, the committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries.''

In Korea, Basel II comes into effect from January 2008, with banks applying either the Standard Approach or, for those that qualify, the Foundation Internal Ratings Based approach. The Advanced Internal Ratings Based approach will be available in 2009 for banks that meet the requirements of the FSS.

The nationwide banks in Korea have all been making considerable efforts in their preparation for Basel II.

In the case of Kookmin Bank, starting from 2003 we have been preparing for the implementation of Basel II through various projects including the development of credit rating/scoring models for our credit portfolios and the estimation of risk components based upon empirical data.

Also, in late 2005 Kookmin Bank completed the development of systems that calculate its risk weighted assets and BIS ratio under Basel II, and since then has been conducting a parallel run by comparing these numbers with those computed under Basel I.

Management of Risk

Kookmin Bank has also carried out a reorganization to ensure the independence of risk management, and has established an independent model validation team. In addition to the upgrade of credit risk management, Kookmin Bank has established a robust risk management framework for operational risk and is taking other risk types (interest rate, liquidity, strategic, reputation, and concentration risk) into full consideration as well.

Banks in a number of European countries switched over to the Basel II framework at the end of 2006, and several of these obtained approval for the Foundation Internal Ratings Based approach. Certain Japanese banks have also done the same this year.

With regard to credit risk, there are several components that drive the calculation of risk weighted assets. These are: 1) the Probability of Default, 2) Exposure at Default, 3) the Loss Given Default, and 4) Maturity, for corporate exposures.

If one or more of these components increases, the risk measurement for an individual credit facility increases, along with that for the credit portfolio as a whole.

In turn, a bank's risk weighted assets also go up, leading to a decline in a bank's capital adequacy which is measured in the form of the BIS ratio. This can have a number of serious, unwanted, implications for banks. In this competitive landscape it is essential for every bank to maintain an appropriate BIS ratio, and under the new Basel II regime they will need to make every effort to manage their credit risk more effectively, with even greater attention being given to the risk components mentioned above.

Some examples of how this all may impact banking practice vis-a-vis corporate customers around the world are as follows: 1) there may be a tendency of banks to focus their attention on higher rated companies, to include larger risk premiums in the build up of their loan pricing for lower rated companies, and to manage the cutoff between loans accepted and those rejected more tightly, 2) banks will give more attention to the types of credit facilities extended, the likelihood of them being fully drawn down, and the need to charge fees for unutilized limits, 3) the size and nature of any security received will be more closely scrutinized, and 4) there will be a more direct relationship between pricing and maturity.

These practices are likely to be applied by banks around the world in a more uniform way than is presently the case, with a growing degree of convergence taking place within the first one or two years following the implementation of Basel II.

It will therefore become increasingly important for corporations to work with their bankers in gaining an understanding of the financial and non-financial variables that influence their ratings, and of the measures that can be taken to improve these.

Corporations will also benefit from being more judicious in their requests for credit facilities which they do not expect to utilize fully. In cases where security is to be provided, it will be helpful for both corporations and their bankers to reconsider the optimum mix of guarantees and different forms of collateral that may be available.

Finally, corporations may wish to review and refine their long term funding and capital requirements, and better align these with the maturities of their various banking facilities.

None of this is new, but it does warrant a thorough review by every company to ensure that it is maximizing the balance between its funding needs and costs, and thereby improving its own competitive position.