Unleashing Asia’s demons

Asia’s banks are only now slowly emerging from the economic crisis that ravaged the region between 1997–98. Many smaller institutions, still weighed down by crippling debt levels and high funding costs, are struggling to implement vast restructuring programmes. But the publication of the Committee’s latest consultative paper on capital adequacy could stretch many of Asia’s banks even further. While the new Accord pledges to create a level playing field across the world’s banking systems, some of Asia’s troubled institutions face tough times ahead, with soaring funding costs and heavy investments in risk management systems. Indeed, some bankers in the region even question its relevance to Asia’s banking systems.

One prominent Singapore-based banker, who requested anonymity, says he feels that the Accord may be too much of a leap for many of Asia’s banks. He says: “Not many Asian banks – I think one in Singapore, and maybe two or three in Hong Kong – are aggressively addressing capital adequacy, capital structure and balance sheets. Most of the banks, to put it very bluntly, are so far behind the curve, I’m not sure this Accord really means a lot.”

The Asian Crisis clearly demonstrated that the 1988 Accord was in dire need of a comprehensive overhaul. While the vast majority of the region’s financial institutions claimed to have implemented the proposals, in many cases they were paying mere lip service to the recommended 8% capital adequacy ratio. In reality, a large number of banks were crippled by ballooning non-performing loans (NPLs) and had dwindling capital reserves to deal with the problem, transforming what could have been at best a currency misalignment to an out-and-out economic crisis.

The result, a new consultative proposal on the Basel Accord, was presented on January 16. It attempts to address some of the shortcomings of the original agreement. The primary objective, says William McDonough, president of the Federal Bank of New York and chairman of the Basel Committee, is to make the new Accord more “risk-sensitive” and to strengthen banking systems hardest hit by the crisis by revamping the methodology for calculating capital levels.

Consequently, the new proposal ditches the one-size-fits-all approach and adopts a methodology for gauging capital adequacy ratios based on credit risk, while also incorporating charges for operational risk. Also included are proposals for a stringent supervisory review process and recommendations for increased levels of market discipline. The new document extends many of the characteristics of the first consultative paper published in June 1999, but leaves a consultation period of only four-and-a-half months, with a planned implementation in January 2004.

Central to the new framework is the idea that sophisticated international banks meeting stringent regulatory standards can internally assess the risk levels of their portfolios, effectively allowing the larger banks to calculate their own capital charges. The Committee estimates that high investment grade banks using this model, called the Internal Ratings-Based (IRB) approach, could reduce risk capital levels by around 2–3%, effectively acting as an incentive for investment in risk 
management systems.

This IRB approach is divided into two components. The first is a foundation approach, which allows banks to estimate the probability of default for each borrower, with other risk factors supplied by the regulator. The second, the advanced approach, enables banks meeting tough regulatory criteria to utilise their credit risk models to calculate additional risk factors.