AGENDA

1. Country Case Studies: Addressing the Challenges of Basel IIMohd Razif Abdul Kadir Assistant GovernorBank Negara Malaysia17 May 2004

2. AGENDA • Basel II in the context of Emerging Economies • Implementation Challenges and Impact • Implementation Approach & Road Map

3. Most Emerging Economies Aspire to be Basel II Compliant • Potential benefits in terms of capital savings • More efficient capital allocation • Better risk management capability • Enhance competitiveness of banking institutions • Minimise regulatory arbitrage opportunities • Market expectations Strengthened Banking Sector and Greater Financial Stability BUT, priorities may be on other supervisory initiatives…

4. Basel II Implementation to be Balanced with Other Supervisory Priorities • Capacity Building of Domestic Banks • Legal Infrastructure and Regulatory Framework Banking sector plays key intermediation role in most emerging economies • Robust Risk Management and Sound Corporate Governance • Market Discipline - Accounting standards - Institutional transparency - Market education • Deepening Domestic Capital Market • Consumer Protection Framework Basel II must fit into the overall supervisory agenda

5. Basel II – Calibrated based on G-10 Countries’ Standards • How could emerging markets benefit from Basel II? • Customise Basel II design with local conditions (e.g. in determining most appropriate options, appropriate size threshold for SME retail definition) • Impact assessment require calibrations to be conducted based on local data Comprehensive impact analysis and implementation sequencing is critical

6. Challenges in Implementing Basel II must be fully Appreciated • Understanding the procyclicality impact • Ensuring competitive equality and economic impact • Managing resource constraints • Managing market pressures for early adoption of Basel II • Addressing data constraints Emerging economies should not rush to adopt Basel II without understanding its challenges and potential impact

7. Basel II has Greater Far Reaching Impact on Emerging Economies • Understanding the procyclicality and economic impact • Emerging economies are more fragile, having greater dependence on banking system as provider of funds – economic sectors are more correlated and sensitive to effects of economic cycle • Calibration of IRB (based on G-10 environment) results in significant acceleration in capital charge as ratings (PDs) deteriorate • greater likelihood of credit crunch for emerging economies during recessionary periods • Concerted use of IRB approach may affect lending behavior and starve financing to certain critical sectors of the market e.g. SMEs • Emerging economies are generally more volatile fuelled by imperfect markets (see chart) ………… hence greater need to conduct thorough analysis to expect the unexpected.

8. Market volatility of Developed and Emerging Economies Percentage Points

9. Basel II and Competitive Equality • Industry structure must be considered in the implementation plan • Internationally active banks enjoy benefits of diversification and hence greater capital relief from advanced approaches • pressure on local supervisors to accept advanced approaches • greater competitive advantage over domestic institutions • Implementation of Basel II should not be merely a regulatory exercise • Emphasise on Cost and benefit analysis • Understand impact of banks’ roll-out plans/changes in lending behaviour on availability of credit to all consumer segments (e.g. SME) • All banks should be subject to similar minimum requirements (such as on data specifications) – foreign banks may have the tools for Basel II, but they still lack local data to meet requirements like most domestic banks • Regardless of timing for Basel II, primary focus should be on enhancing ability of all banks to better price risks (e.g. banks to have robust internal rating system)

10. Complexity of Basel II Implementation Creates Challenges in itself • Managing resource constraints • Flexible timeline required to justify large investment • Greater demand for specialised skills by banks and supervisors – longer time to train • Managing market pressures for early adoption of Basel II • Effective communication and clear road map of implementation to minimise potential adverse market reaction • Addressing data constraints • Should never be overlooked (garbage in, garbage out)

11. Basel II in Malaysia – Further Enhancement to Market Structures • Various measures were taken to strengthen the banking sector and financial sector infrastructure • Industry consolidation • Number of domestic banking institutions dropped from 89 to 30 banking institutions (10 domestic banking groups) • Comprehensive restructuring initiatives involving: (i) resolution of non-performing loans; (ii) recapitalisation of weak banking institutions; and (iii) restructuring of large corporate debts

12. Basel II in Malaysia – Further Enhancement to Risk Management Standards • Market Infrastructure and Regulatory/supervisory framework are being continuously enhanced… • Minimum standards on credit risk management • Prudential standards on asset backed securitisation • Strengthening the corporate governance framework • Deepening of domestic capital market • Outstanding private debt securities increased by threefold from 1996 to 2003 – now accounting for 35% of GDP

13. Three phase approach Comprehensive customer protection framework • capacity building • increasing competition in the domestic market • greater integration with international market • Consumer education program • Banking intermediation bureau • Deposit insurance fund Supervised Market Approach • Emphasise on robust risk management • Increase role of market discipline through enhanced transparency • Moving towards ‘what is not prohibited is allowed’ concept Basel II would be a Natural Progression and Consistent with Malaysia’s Regulatory Philosophy The objective is to develop a more efficient, effective and resilient banking sector that will support the economic transformation and growth Comprehensive Financial Sector Master Plan (FSMP) was issued in 2001 Increasingly Diversified Financial Sector Gradual liberalisation process

14. Malaysia will Adopt Basel II Key principles adopted: • Accommodation of capacity building efforts and gradual risk management enhancement for all banks • Flexible timeframe to facilitate capacity building • Emphasis on strong business justification to adopt IRB approaches • Enhance supervisory methodology to assess internal models and advance risk management systems Basel II, a flexible risk management capacity building strategy to enhance financial stability

15. 2 phase approach Key Consideration: (i) cost of compliance, and (ii) readiness of banking institutions Phase 1 (January 2008) • As a minimum, all banks adopt standardised approach for credit risk and basic indicator approach for operational risk. However, banks intending to leapfrog towards the Foundation IRB (FIRB) may continue to remain on the current accord and submit approved business justification & implementation blueprint Phase 2 (January 2010) • Banks adopting the FIRB approach are expected to comply Malaysia’s Road Map to Basel II

16. Thank you