The Future of Banking Regulation 7-8 April 2005, LSE

1. The Future of Banking Regulation7-8 April 2005, LSE Oliver Page OBEDirector Major Retail Groups Division

2. G10 – a key issue - cyclicality

3. Stress “In estimating necessary levels of risk capital, the primary concern should be to address those disturbances that occasionally do stress institutional insolvency - the negative tail of the loss distribution that is so central to modern risk management. As such the incorporation of stress scenarios into formal risk modelling would seem to be of first-order importance” Alan Greenspan

4. Pro-cyclicality • Main risks for banks is still credit risk • So main potential for Pro-cyclicality is capital requirements for credit risk • Basel 2 makes clear that capital is for unexpected losses • Clear that probability of defaults and the losses given default highly cyclical So is it a problem? Basel 2 tried to ensure not

5. Cyclicality in PDs • Rules require long term view for PDs • Plus P2 stress test • Important that banks and supervisors deliver

6. Cyclicality in LGDs • Rules require LGDs cannot be less than the long run default weighted average loss • And if higher in downturns than average, then must use downturn values • i.e. LGDs must reflect economic downturn conditions – “stressed” LGDs • Similarly for EADs The problem – banks don’t have enough data to be able to do this

7. Why is this an issue

8. Mortgages Why is this an issue

9. Summary • Basel 2 is a contribution to financial stability • But this requires that cyclicality is dealt with • Banks and supervisors are not on different sides

10. Non-G10 • Implementation of Basel 2 in the near future “may not be a first priority for all non-G10 supervisory authorities in terms of what is needed to strengthen their supervision” But • Basel 2 has a lot to say to banks and supervisors on governance, risk management and controls – not new but rather a codification of what is already good practice in well managed banks

11. Non-G10 Pillar 1 • Aim to adopt the standardised approaches as these are a material improvement, even if external ratings not widespread • Don’t aim to implement the advanced approaches too soon nor push banks too early to adoption by them • Press banks to adopt improved governance and controls as in Basel 2 • Press banks to adopt advanced risk methods of Basel 2 for their own internal use Pillar 2 • Apply this whatever approaches are adopted under P1 • Press banks to develop capability to assess own risks and adequacy of capital • As a supervisor adopt the supervisory review Pillar 3 • In many markets less usable, but worth thinking through how market discipline can be made to work

12. Conclusions Basel 2 is what it set out to be: A framework that further strengthens the soundness and stability of the international banking system while maintaining a level playing field between internationally active banks Achievement of those objectives depends on effective implementation