A Surplus of Capital (At Least of Capital Measures)

While the effective date of the implementation of the Basel II Capital Accord in the U.S. has been delayed (see Federal Reserve Board Joint Press Release "Banking Agencies Announce Revised Plan for Implementation of Basel II Framework", 9/30/2005), Basel II is nonetheless having an impact on banks'

finance, risk and profitability reporting systems. Clearly, the Basel II mandatory and opt-in banks have needed to make changes to comply with the Accord's requirements. However, other banks are upgrading or enhancing their reporting systems as well, either because of regulatory pressures or the perceived need to do so in order to remain competitive.

This article is not intended to be another description of the Basel II Accord and the many challenges that banks face in meeting its demands. Instead, it focuses on the impact that Basel II is having in the area of capital-based profitability measurement and reporting. In particular, it describes some of the issues that bank finance, treasury, and risk departments need to address with respect to the many types of capital that are being calculated and reported (e.g., regulatory minimum required capital, economic capital, and GAAP capital).

While it would be natural to expect that Basel II would align capital measures by allowing banks to use some of their own risk management data and models, this is not necessarily the case. Seeing that internal and external users of the information understand the similarities and differences among the capital measures is important. Just as important is seeing that the measures are used appropriately.

A BRIEF OVERVIEW OFTHE PILLARS OF BASEL

An overview of the Accord's three pillars can help shed light on the potential complications that Basel II can cause in reporting on capital measures. The summaries below will not capture all of the elements of each pillar, but will consider the important parts that affect capital measurement.

Pillar 1: Minimum Capital Requirements

Most U.S. banks have concentrated on developing infrastructures that satisfy the Basel II Accord's approach to calculating Pillar 1 minimum regulatory capital requirements. The previous Basel I Accord used an unsophisticated approach to determining minimum capital requirements, based on the perceived riskiness of broad asset and loan categories and making no provision for operational risk. Basel II uses more refined asset categories and explicitly recognizes the need to hold capital against operational risk.

Under the so-called "advanced" approaches to determining minimum capital requirements, banks can use their own data and models - up to a point. To oversimplify, banks that use the "Advanced Internal Ratings Based" approach for credit risk can use their own values for Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity (M) for each of the Basel II defined portfolio types. PD, LGD, EAD and M are all inputs into risk-weighted asset (RWA) formulae for each portfolio type, against which a minimum of 8% capital must be held. Similarly, the "Advanced Measurement Approaches" to the operational risk minimum required capital calculation allow banks to use their own internal models if certain criteria are met.

Pillar 2: Supervisory Review Process

The Basel II Accord's second Pillar describes the way regulators will oversee banks' risk management processes and practices. In part, this involves the manner in which bank management measures various types of risk and holds prudent amounts of capital against those risks. Supervisory Letter SR 99-18 ("Assessing Capital Adequacy in Relation to Risk at Large Banking Organizations and Others with Complex Risk Profiles", 7/1/99) represents how U.S. regulators will implement Pillar 2.

Most large U.S. banks currently use economic capital as a measure of risk. That is, they model the amount of capital that needs to be notionally held to protect against unexpected loss for a specified confidence interval (such as 99.97% of possible outcomes) for a defined implied debt rating (usually "AA"). They generate economic capital estimates for credit, market/interest rate, operational and business risks, on aggregated (e.g., bankwide) and disaggregated (e.g., by line of business or product) levels. Measuring economic capital required helps banks understand and manage the risk profile of their activities on a consistent basis using a common language and "yardstick".

Further, most large U.S. banks also use economic capital allocation as part of their profitability measurement systems. They produce risk-adjusted performance measures (RAPM) such as Return on Equity (ROE), Return on Risk-Adjusted Capital (RAROC), Economic Profit (EP), and Economic Value Added (EVA), generally along line of business or segment bases. The Annual Reports and 10-K filings of Citigroup, JPMorgan Chase, Bank of America, and Wachovia provide excellent examples of RAPM in practice as they describe business segment performance.

Pillar 3: Market Discipline

The third Basel II Pillar is market discipline, essentially achieved through disclosure. Among other things, it requires qualitative and quantitative disclosures of capital adequacy, broken out by risk type (i.e., credit, equity exposures, market, and operational risk) and in some cases by portfolio type. Pillar 3 also requires disclosure of Tier 1 capital by amount and type (e.g., paid-up share capital/common stock, reserves, minority interests in the equity of subsidiaries, and other capital instruments) as well as Tier 2 and Tier 3 capital. Because U.S. regulators have not issued guidance, Pillar 3 has not received much attention as of yet, with many banks believing that it will not require significant disclosure beyond what is currently required. However, accurately presenting all of the information required under Pillar 3 is likely to require more effort than is commonly understood, especially when combined with SEC supervision regarding disclosure.

WHAT CAPITAL REPORTING CHALLENGES EXIST?

As banks implement Basel II, they are encountering some challenges with respect to capital reporting. Some key ones are:

1. Regulatory minimum capital amounts differ from economic capital.

2. Capital calculated from financial systems data differs from capital coming from risk systems data.

3. Multiple capital measures make planning and management more complex.

Regulatory minimum capital amounts differ from economic capital

Bank finance, treasury, and risk professionals will need to communicate to management that differences will exist and why they exist. Bank managers may have been expecting that Basel II would finally make the two measures converge. Many reasons for the differences can be present.

Among them:

* Regulatory capital excludes any intra-risk and inter-risk correlations

* Regulatory capital is based on through-the-cycle PD's while economic capital may be based on point in time PD's

* LGD's for regulatory capital purposes are "stress" LGD's, while internal economic capital models can use other LGD values

* Regulatory capital calculations use a fixed confidence interval (CI) of 99.9%, while economic capital calculations may use other CI's

* Economic capital used for RAPM purposes can include accounting concepts such as goodwill

At some organizational level, a reconciliation and comparison of regulatory minimum capital to economic capital will be required (Pillar 3 may implicitly require this as well). However, regulatory capital is calculated for legal-entity reporting, while economic capital is usually calculated and attributed along a management/line of business hierarchy. This will complicate reconciliation and explanation of differences at anything other than corporate levels.

Also, the new Basel II regulatory minimum capital requirements may reopen old debates about the proper capital measure to use for RAPM purposes: "true" economic capital, regulatory minimum capital required for the business, or the actual GAAP tier-one capital a bank carries on its books to maintain a desired credit rating and or to be regarded as "well capitalized" versus minimum regulatory capital requirements.

Capital calculated from financial systems data differs from capital calculated from risk systems data

Regulatory minimum capital measures produced by banks' financial systems differ from those produced by banks' risk systems. Traditionally (e.g., for Basel I), banks' financial systems produced regulatory reports, including regulatory capital reports. In large part, that was because the balances used for regulatory reporting matched general ledger (G/L) account categories, and the methods for calculating required capital were unsophisticated. However, under Basel II, banks' credit, market, and operational risk management and measurement systems all have a much bigger role to play in the calculation of regulatory capital. In fact, risk systems, rather than financial systems, may feed the Basel II risk-weighted asset (RWA) calculator systems now being selected and implemented. Applying the same set of rules to financial data versus risk data can provide different results.

Similarly, economic capital measures may differ, whether coming from financial or risk systems. Reasons for the differences include type of balance used (e.g, average daily balance or month-end), differences in portfolio definitions and reporting hierarchies, inclusion of accounting concepts (such as goodwill) and presence or absence of portfolio diversification effects. Clearly identifying how the information flows will work and which measures will be used for specific purposes will be vitally important.

Multiple capital measures make planning and management more complex

Capital planning and management has never been easy. Determining the capital implications of organic growth, portfolio acquisition/divestiture, and other M&A activities at legal entity (regulatory capital constraints) and line of business (economic capital impact) bases is made more complicated by the introduction of the Basel II regime. The regulatory capital impacts need to be assessed at a more granular level of portfolio definition, and need to take into account operational risk components that previously did not matter.

Further complicating the issue of capital planning are the multiple regulatory capital measures that currently exist, and the transitional arrangements that will be put in place as banks move to a complete Basel II environment. Currently, affected U.S. banks need to comply with Basel I and the minimum leverage ratio for regulatory capital purposes.

While these will remain in place, U.S. regulators expect that Basel II banks will run the Basel II RWA calculations in parallel in 2008. From 2009 to 2011, the U.S. regulators will allow banks to use the Basel II Pillar 1 capital calculations (or the more nebulous Basel IA*) subject to "floors". That is, risk-based capital could not decline by more than 5% in 2009. Including all the applicable regulatory capital requirements that will exist during the next few years will challenge planning and analysis groups.

CONCLUSION

The impacts of Basel II are rippling through the U.S. banking system. Among the impacts are greater attention to capital by regulators and use of capital measures to measure and manage risk and performance. While economic capital concepts underpin the Basel II regime, they are not perfectly aligned with the capital measures that banks use internally. Bank management accounting and reporting units will need to understand the differences in the capital measures and educate management about which measures are appropriate for which uses. They will also be asked to help reconcile and explain the differences between the measures. This will require attention to defining and documenting data sources, definitions, models, and hierarchies that exist in financial applications and risk applications.

FOOTNOTE

* Basel IA was included in the September 30 Joint Statement. It proposes changes in the U.S. risk-based capital framework that currently exists, and that would apply in the future to non-Basel II banks. Many changes are not specifically defined, but presumably will be once comments are received (due January 18, 2006).

AUTHOR_AFFILIATION

by John Karr

Partner- Financial Services Advisory Practice

Ernst & Young

John.Karr@ey.com