The Aberdeen executive white paper, “Analytics and Reporting: A Basel II Requirement” offers an executive overview of the Basel II initiative from a credit and operational risk perspective. It also offers observations on the Basel-mandated technologies particularly the role of scorecards, reporting, and a host of analytic applications to meet this regulatory challenge.
Although most bankers know that reducing risk can directly boost earnings, few banks other than the big money centers have developed and implemented comprehensive risk programs and platforms.
This disparity between the need for risk prudence and the apparent unwillingness among many financial institutions to pick up the pace has not gone unnoticed by the banking industry’s watchdog, the Basel Committee. This international rulemaking body for banking compliance has issued the 2001 Basel II Accord, demanding that banks either increase their capital reserves or demonstrate that they can systematically control both their credit and operational risk.
Under the accord, banks that exhibit the appropriate risk diligence get a big payoff. They can use a significant portion of the money formerly forced into reserve to fund other business. Although the accord officially begins in 2007, the Basel Committee expects banks to start proving that they already are getting a handle on risk compliance today. Failure to demonstrate an upward trend in compliance will force “risky” banks, starting in 2007, to reserve far more money than they have had to in previous years.
Proving and documenting risk acumen demand taking credit and operational risk analysis to the extreme. The risk manager’s technology arsenal data warehousing, multidimensional analysis, data mining, and reporting will be more necessary than ever before and will need to be applied in novel ways. Institutions will not only have to gather, organize, and analyze new types of data linked to the risk characteristics of financial instruments and transactions but also measure and document the effectiveness of their risk mitigation strategies. Risk officers and other senior management will need metrics that enable them to assess their risk positions and observe the continuing effects of actions on that position.
Although Basel II is often confusing, the accord could not be clearer on one point: banks must build “an appropriate systems infrastructure” to identify and gather data for an enterprise-level risk database. To meet these demands, banks will need robust, risk-related analytic technology and processes.
Aberdeen conservatively estimates that banks will spend $3.2 billion in the next four years preparing for Basel II. When compared with the $400 million that banks spent in 2002 on risk management technologies, however, the $3.2 billion reflects an annual compounded growth rate of 20 percent. The $3.2 billion signals the significance of Basel II; it is important because it determines the amount of a bank’s capital reserves, thus directly influencing a bank’s financial and operational performance. As a rule of thumb, the larger the reserve requirement, the less business a bank can transact. In essence, the Basel II initiative is a complex calculation, the capital ratio that is applied to a bank’s risk-related assets, including the bank’s trading portfolio, book of loans, and operational systems. This percentage is based on Basel dictates as well as on the bank’s own assessment of its performance. To derive its risk position and thereby calculate the amount of money it must place in reserve, the bank must tally the amount of risk associated with each asset.
Basel II must be examined relative to its predecessor. Much to the dissatisfaction of banks that already have the technological wherewithal to measure themselves, Basel I demanded (and still does) that banks reserve approximately 8 percent of each asset class. Thus, if a bank has about $1 billion in loans, it must reserve approximately $80 million, or 8 percent of this asset class. Basel II is much more liberal, but much more demanding. Basel II is a much more granular calculation than its predecessor, but the onus is on a bank to derive and prove its risk position.
As every banker knows, the actual amount of capital reserve pales in comparison with the detrimental, multiplier effect it has on the bank’s ability to invest and lend. In short, the capital reserve takes money out of the hands of bankers who want to do business with it. Here is why. Banks are built on a leveraged model. Basel II dictates that a bank must reserve between $0.37 and $42.00 for every $100.00 in business loans. Banks obviously want to keep to the low end of the spectrum.
Aggressive banks play with riskier activities, and the accord says that these banks have one of two options. The banks either must keep a larger capital reserve than their more conservative brethren or demonstrate a superior ability to monitor and control the elements of risk exposure.
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