The Calculus of Basel II

When math teachers demonstrate how to estimate the area under a curve, they divide the enclosed space into rectangles and then add the areas of those rectangles. Under the rules of the Basel II capital accord, banks will be able to employ a similar approach to determine the amount of capital they must hold as a reserve against risky loans.

Basel offers three approaches for determining capital reserves. The simplest is the Basic Indicator approach, which is calculated based on an established percentage of a bank's gross income. Then, there's the Standardized approach, by which a bank divides its operations into eight segments, for each of which a fixed percentage is taken based on the inherent risk of the segment.

Finally, banks can assess risks on an extremely granular scale. The Advanced Measurement approach allows banks to use internal measurements, models and scorecards to set capital requirements to the extent that a bank can prove that its risks have been adequately assessed. While this offers the best chance at reducing capital requirements for most financial institutions, it also requires the most data and computational power - hence, the greatest initial investment.

Despite the cost and effort involved, the granular approach to risk does not guarantee a smaller capital allocation. In fact, the envisioned savings have been elusive. "Very few banks believe that there will be savings in terms of regulatory capital," says Pierre Pourquery, global head of risk management and Basel II, financial services sector, IBM UK (London).

To the contrary, some banks that scour their entire portfolios may find that they contain more risk than they did under the old system. "This is what's happening in Germany," Pourquery notes. "They still have [corporate] portfolios that are not extremely healthy."

Nevertheless, there's little choice for a big bank but to adopt the Advanced Measurement approach. "If you're a large bank [taking] the standard approach, then you may be seen by your competitors or clients that you're not as sophisticated as you should be in terms of risk management," Pourquery explains. "For that reason, most banks will go for the advanced approach."

All Is Not Lost

Fortunately, there are other tangible benefits to implementing advanced risk management techniques. "Basel II provides a framework to look at your operations and make sure that you have the proper controls in place so that you can reduce and mitigate risk," says Lester Owens, the New York-based managing director and global head of high-value payments operations, Deutsche Bank (Frankfurt; $1.01 trillion in assets). "From that standpoint, there's a benefit."

Owens is responsible for operations of the bank's global clearing business, messaging and customer investigations within high-value payments. As such, he's been involved with implementing operational risk controls required under the Basel II capital accord throughout the bank's global clearing business, working closely with the risk management group.

To support the operational risk effort, Deutsche Bank has developed three levels of Key Risk Indicators, or KRIs, according to Owens:

1. Core KRIs - These include business continuity planning, application security and data center redundancy, which are baseline requirements across the entire firm.

2. Business-specific KRIs - These are mission-critical items that may have different implementations across business units within the firm, including transaction processing, regulatory risks, technology risks and financial reporting.

3. Discretionary business-specific KRIs - Monthly quality review by staff, relating to maintaining the ability to process on a timely and accurate basis.

For the most part, these KRIs had existed prior to the Basel II effort. "We had a lot of the key indicators already in place because that is the way that we manage our operation," Owens says. "We had to be able to take the information and put it into a reporting format that would be consistent with what the bank's risk management group required."