Expert File

Can banks reconcile all Basle II, IAS 39, and other home-host regulatory issues?

Almost all large banks currently run large and expensive projects whose aim is to implement new so called “Basle II” new regulatory framework. The main goal of the regulation is to improve calculation of regulatory capital requirements related to credit risks and to motivate banks to manage their risks better and more efficiently. The regulation sets new standards on so called credit rating process, assessment of expected and realized credit losses, recognition of default, as well as on credit risk monitoring and back testing. The regulatory capital is on a receivable level mathematically calculated from own or regulatory estimations of so called probability of default, loss given default, and other parameters. The total regulatory capital then reflects potential credit losses in low probability pessimistic scenarios. The banks are required to hold sufficient (real) capital to cover such potential losses. The new regulation will become fully effective in 2007 and the banks will run a parallel process in 2006.

The banks also already had to implement new accounting standards set by another well known regulation called IAS 39 effective since the beginning of 2005. One of the important new requirements is to set provisions, i.e. amounts adjusting the book value of impaired banking receivables, based on discounted expected cash flows. Although all publicly quoted banks must already comply with the IAS 39 requirements a lot of fine tuning work needs to be done, in particular in relation to the new Basle II framework.

Different words, different meanings?

The two regulations use different words and definitions for related concepts which sometimes turn out to be difficult to reconcile. For example Basle II uses the concept of Expected Loss while IAS 39 systematically avoids (and essentially forbids) the notion using rather the words “Incurred Loss” computed on the basis of the discounted net value of expected future cash flows from impaired receivables. Impairment must be based according to IAS 39 on an objective evidence and the modeled future cash flows should reflect some expected problems, for example future bankruptcy proceedings. Basle II on the other hand uses a not exactly identical concept of default. While Basle II works with basic probability theory tools admitting existence of different scenarios, IAS 39 wants to base the incurred loss on only one fixed future scenario. The total IAS 39 provisions must be also compared with the total expected loss according to Basle II. If the latter exceeds the former, the difference will generate an additional capital requirement. However, these two aggregates, produced for different purposes and through different processes, might actually turn out to be quite different.

Local regulatory interpretation and home-host issues

The international regulation is in fact implemented through local regulations prepared by the Czech National Bank for Basle II and by Ministry of Finance regarding IAS 39. To make things even more complex the Czech banks belonging to international groups have to deal with different interpretations of the two regulations coming from the local regulator and from the mother company regulator as the financial group needs to deal with all the issues in a consistent manner.

The Czech National Bank for example continues to use the five grade classification scale introduced in the Nineties in order to force banks to monitor properly financial situation of their clients and to book sufficient provisions. According to Basle II the Banks must establish a rating scale (with at least 8 grades) which should be used not only for credit origination but also for an ongoing monitoring of client financial situation. The two scales seem sometimes duplicit and a simple relationship is not so easy to find. The classification scale is not moreover used in all European countries.

Provisioning has been traditionally tied to classification in the Czech banking environment. Currently the banks are expected to charge specific provisions against receivables classified as Watch, Substandard, Doubtful and Loss. The banks may create so called portfolio provisions for selected groups of Standard receivables. Specific provisioning however Basle II considers as a sign of default, hence category Watch clients should be already marked as defaulted ones. But this is not definitely the case according to the definition and usual interpretation of the category Watch. This shows only one of many contradictions found when all the regulations and requirements are put together.

Will the regulations positively change the banking sector?

The banks seeking advanced Basle II standards definitely need to reshape their credit process, quality of databases, monitoring and back testing analyses. At the same times the banks must face and solve a number of inconsistencies highlighted above. This will lead hopefully to an alignment between the different areas, between the accounting world and a more mathematical world of the risk management, and among different national regulatory environments. The key responsibility lies with the regulators to clean up many of the old and outdated regulations and to establish a new simple and efficient framework. The effort of the banks should then be spent more on real improvement of their processes rather than on puzzle solving of contradictions between different regulations. The new and consistent regulation implemented by the banks may then bring significant benefits to the financial community and to the whole economy.

Jiří Witzany holds a management position within the Credit Risk Arm of Komerční banka