News Release
The Basel Accord: Systemic Issues
02 December 1999
Speech by David Clementi, Deputy Governor of the Bank of England, at an FSA Conference in London
TThe Bank of England strongly supports a move towards making banks' supervisory capital charges more sensitive to the risks in their loan portfolios, says David Clementi, Deputy Governor. In a speech today at a conference sponsored by the FSA on the Basel Committee's proposals for updating the 1988 accord on bank capital, he says the disadvantages of making capital charges more sensitive to risk are more than offset by the advantages.
Mr Clementi adds: "We fully support the Basel Committee's objective of updating the 1988 Accord to make it more comprehensive and risk sensitive. And as a member of the Basel Committee, the Bank is working alongside the FSA to ensure that these objectives are delivered." The FSA, as regulator, is seeking views from the banking industry on the Basel proposals. The Bank of England, which is a member of the Basel Committee, is for its part holding regular meetings with the main trade bodies, in its capacity as the body responsible for the stability of the financial system as a whole.
More Risk Sensitive Capital Requirements
Mr Clementi acknowledges the possibility that making capital charges more sensitive to risk might amplify economic downturns and upturns. If a bank's loans deteriorate, the impact might be reinforced by demands for higher amounts of regulatory capital to be set aside. He adds: "There is a concern that the consequences could be particularly severe in the case of lending to emerging markets, where rating changes have sometimes lagged the onset of crises. This is certainly a risk, and one which we have to take seriously."
However, Mr Clementi comes down firmly in favour of greater sensitivity to risk in capital charges. He says: "Capital charges which are not related to risk do not provide the right incentives to ensure that borrowers are charged an appropriate price for their debt - the best way of limiting the build up of unsustainable volumes of debt."
Internal Risk Models Preferred To External Rating Agencies
Mr Clementi also supports the availability of the option of using banks' internal risk ratings as a tool for setting regulatory capital, as an essential alternative to the other option of using external credit rating agencies: the internal route anyway offers a number of clear advantages. Mr Clementi says:
"The Bank has, as some of you may know, been devoting considerable thought to development of the internal ratings based approach to setting capital for credit risk. The availability of this approach is a very important safety valve for the market pressures and distortions that could otherwise arise from the use of external ratings. We have no wish to see the supervisory net extended, by way of quasi-regulation, to rating agencies; nor do we wish to substitute regulatory judgements for the very satisfactory investor discipline that currently operates in the ratings arena."
There is a debate over whether the use of internal ratings should be reserved only for sophisticated banks.
Mr Clementi says:
"If banks do not have a reasonably robust systematic approach for assessing and pricing borrower risk, they should question the value they are adding to the credit intermediation process."
Mr Clementi says the capital framework - and, equally important, bank provisioning policies - need to be as forward looking and dynamic as possible so that lending terms adjust gradually. "Since ratings - whether external or internal - are influential in provisioning and will in the future be influential in capital, they in turn have to be more forward looking."
Turning to operational risk, Mr Clementi admits that this is very difficult territory. "The term operational risk covers a wide range of types and sources of risk, and banks' data bases of loss are generally patchy. There are numerous questions not only about the appropriate design of the charge, but also about the appropriate level. It is clear that some types of operational risk, such as fraud, can result in huge spikes of loss, ….. I am optimistic that, over time, operational risk will become more measurable and that, as was the case for market risk models, a consensus on methods of quantifying it will emerge."
Mr Clementi highlights some challenges for the future as well. "The use of internal ratings will arm supervisors with more information about expected losses, and could turn international attention to the harmonisation of provisioning policies, which would be on forward looking basis. Internal ratings are also first step on road to full credit risk modelling - eventually this may mean we have to explicitly address issue of how much capital we really want in systemic banks."
