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European Banks Face Dual-Deadline Challenge

European banks face the prospect of meeting higher standards for risk management, while at the same time having to revamp their record-keeping and reporting practices in accordance with IAS.

With the new Basel II accord, European banks are faced with the prospect of meeting higher standards for risk management, while at the same time having to revamp their record-keeping and reporting practices in accordance with International Accounting Standards (IAS).

In 2005, publicly-listed companies in the European Union are slated to adopt IAS in parallel with the generally accepted accounting principles (GAAP) of their home countries. But since companies would also have to provide 2004 results under IAS treatments to go along with 2005 results, many are trying to get the appropriate systems in place well in advance.

To prepare for Basel II and IAS, five major German banks-DZ Bank, Hamburgische Landesbank, Landesbank Rheinland-Pfalz, Landesbank Schleswig-Holstein, and Westdeutsche Immobilienbank-have turned to the mySAP Banking solution from Germany-based SAP.

The transition will be easier for some countries than for others, said Jens-Peter Jensen, director of business development for financial services at SAP. "We see quite a gap between GAAP in France and the International Accounting Standard. Whereas you go to Switzerland, they're already fairly close to the IAS requirements with the current local GAAP."

The switch brings with it some major systems challenges. Although companies won't be required to publish transaction logs for investors, they will be required to maintain auditable records. "The banks now have to have information available on a single transaction level for accounting purposes," said Jensen.

Also, banks will have to adopt new valuation methods, including the fair value calculation for balance sheet assets. "The granularity of information required for this kind of valuation really means a change in the current infrastructure and interfaces in place," said Jensen.

Furthermore, IAS standards will apply to the group level for the presentation of consolidated results. "The problem's not so much the methodology, which is quite consistent with what's already required with regard to local GAAP," said Jensen. "However, lots of banks have in-house developed solutions-they have difficulties in extending the functionality."

Meanwhile, banks are grappling with new risk management requirements under the Basel II accord. Basel II provides a carrot as well as a stick: by adopting Basel II risk management practices, banks can reduce their capital reserves against loan losses.

Basel II introduces the measurement of operational risk based on data gathered about known losses, risk indicators, and self-assessments. But for many banks, operational risk management is very much a work in process. "A model framework has to be installed for interpreting all of these figures," said Jensen. "This is something that is in development within the banks."

Credit risk also gains new prominence under Basel II. "Banks have to ensure that, for every single transaction, that they have a rating available, either internal or external," said Jensen. Alternatively, banks would have to post additional capital reserves against loan losses for such transactions.

Banks can also reduce loan reserves though the use of robust collateral management systems. "Collateral risk-mitigating factors can be taken into account, for the first time, very explicitly," said Jensen.

For banks, Basel II presents organizational challenges as well as technical. Traditionally, the regulatory reporting function was distinct from risk management. "You had a risk department which solely focuses on internal risk management, and did not take care of external reports to the supervisors," said Jensen. "This results in separate solutions."

Under Basel II, banks will have to employ a single risk management methodology. "Basel motivates the banks to come up with one version of the truth," said Jensen.

mySAP, he noted, will allow internal processes, such as global limit management, to make calculations using the same risk exposures fed into the external capital measurement process.

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