There's still plenty of debate among banking industry professionals regarding the latest draft of the Basle Accord, the international bank capital adequacy guidelines that have been in development for several years.

One of the latest voices of opposition comes from Standard & Poor's, who last week held a conference expressing its concerns with certain aspects of the capital accord.

Basle II will be implemented, at earliest, toward the end of 2006. Conference speakers noted, however, that there is increasing pressure to push that date back. As it stands the new accord is considered by comparison a "superior" framework that better reflects the changes in the banking industry.

"We are broadly looking favorably at the direction that Basle II and the [internal ratings-based] approach, but we can't ignore the critical comments, and our view of capital may be a little different than the way some participants are approaching this," said one S&P panelist. "We look at fine calculations of capital as a useful tool but it's not the be-all and end-all of capital - we look at it as a necessity for banks on a going concern basis and not as static pools of assets."

Capital holding requirements

In other words, S&P expects capital holdings not only to cover a worst-case loss scenario but also to sufficiently keep the bank in business. Under Pillar I of the Accord, the minimal capital requirement will be calculated by assigning a risk weight to the assets held by the bank, so that the bank's capital is in line with its credit risk profile.

As previously reported, banks can choose from three methods to calculate capital holding requirements (see ASR 5/26). Under the standardized approach, risk weightings are calculated from credit ratings of borrowers. The internal ratings-based approach (IRB) requires capital to be held according to the probability of default, while the advanced IRB approach allows banks to plug several factors into the formula to derive proper weightings.

"The problem we have is that there are certain categories of risk where we think there may be a tendency to underestimate the amount of risk in loan portfolios," said one speaker at the S&P panel. Analysts are particularly concerned with the commercial and retail sectors where the capital requirement approach under Basle II failed to consider and incorporate the cyclical nature of these markets.

A bank may underweight its risk in a sector that has not experienced a significant downturn for sometime. Further, banks in different countries or regions may be at different points in their cycles, which could lead some banks to base their capital requirements on the up cycle without fully considering potential downturns.

"Credit card and other unsecured consumer lending is a high-risk activity, for which banks earn high returns to compensate the risks," said S&P. "Allowances for high or excess margin in capital calculations will make capital more cyclical and require a commensurate supervisory and analytical focus on earnings."

S&P goes as far as to warn banks that compliance with Basle could result in a rating activity. S&P added, however, that there is no immediate "hit list."

"Our methodology will evolve as the banking practices do," said one conference speaker. "It will change and is changing but, at present... if an institution substantially reduces its capital while all else stays equal then it can potentially have a negative impact on ratings."

Securitization targeted

And while the accord intends to remain neutral on the subject of securitization, S&P analysts noted there are a number of disincentives to securitization, versus other sectors outlined under the accord.

In current form, Basle would require more severe capital requirements for securitized debt, which might discourage the evolution of the market internationally. "We believe the unduly harsh treatment of certain aspects of securitization provides clear disincentives to using securitization and goes against the original stated intention of the accord," said analysts. "The credibility and the acceptability of the accord depends heavily on equal treatment of equal risk."

Basle has already pushed the date back one year and, according to industry sources, until the kinks under the current draft proposal are adequately sorted out, it's likely that the implementation date will be pushed back for yet another year, said one market source.

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