Basel II makes for much-needed Boogieman

Basel II regulations are officially in force as of January this year and the central bank has scheduled the first reporting on their implementation for April. Still, in September 2007, only half of the local banks had in place the requested risk-mitigation policies, IT systems and data recovery plans, according to statements from the central bank prime deputy-governor Florin Georgescu in December last year. Furthermore, only a quarter of the local credit institutions had tested their IT applications and assessed the results of the tests, said Georgescu.

Most of the Basel II foot-draggers are the smaller banks in the system which feared the effects of the implementation on their profit charts. “The majority of these banks have tried to postpone the implementation for as long as possible. The reasons behind this decision were: firstly, not enough internal resources to be allocated to the Basel II Program in addition to their day-to-day responsibilities; secondly, a limited Basel II knowledge inside the bank and thirdly, the significant work to be carried out in different areas (such as Data and Systems, Governance and Procedures),” said Andrew McCartney, partner with Ernst & Young. He added to the abovementioned reasons the high external costs of acquiring Basel II engines or implementation advice that would eventually impact their profits. “Paying for calculations engines has been a major issue with boards of directors often unwilling to make the appropriate investment in this which they deem ‘non-core',” said McCartney.

His general comment was that local banks' main focus has been upon satisfying minimum regulatory compliance and particularly data and regulatory reporting. Small banks' fears that they might go bankrupt or even extinct for Basel II reasons alone are unjustified, said bankers. But will the high cost of implementation speed up the consolidation process in the local banking system or the extinction of some small banks in the system? “I don't think that it will be a decisive factor for either one or the other hypothesis,” said Steven van Groningen, head of Raiffeisen Bank. “The implementation cost may be difficult to cover by a small bank but not impossible,” said Jose Toscano, general manager of Millennium Bank. He added: “Unlike international banks, small banks will not have capital flexibility. Ongoing administrative costs may be high, which will erode margins: e.g. mandatory periodic valuation of collateral.” “The costs of applying Basel II regulations were high, but the group implementation meant we had an economy of scale and thus less costs. Still, the price of switching to Basel II can have a significant impact on small banks which do not benefit from the support of strong banking groups,” said Lusiana Pavel, Organization Manager of Volksbank, a lender which completed the implementation in November last year.

All in all, there are several good sides to being a small-sized lender forced to comply with new rules. One of them is rather general and lies in the fact that the system should theoretically grow healthier and healthier once the rules are fully instated. Another one is the small costs attached to the switch to the new regulating system. “Smaller banks are advantaged on the IT side with generally a single system to enhance. Also, these banks have been far slower to address some of the fundamental risk governance principles in Basel II principally because their organization is too small to warrant dedicated resources for independent units and oversight,” said McCartney. Nevertheless, although word of future Basel II requirements has been floating in the air since 2006, all banks have only given it the necessary thought and effort in the last part of 2007 and beginning of 2008, said the E&Y partner. Most were prompted by the central bank's decision to start reviewing the status of implementation and launch the capital adequacy calculations and reporting simulation exercise.

Since a true motivation to actually abide by the new rules might be lacking in some cases, analysts fear that some of the efforts put into the implementation might go to waste. “After the completion of the Basel II design work, the big challenge facing the banks may be the actual implementation in the day to day activities and across the bank. There is a risk that all the work will be completed only for regulatory purposes and the banks will not reap the business and risk management benefits,” said McCartney. Banks in Romania have been employing aggressive targets and business strategies to increase the number of clients, portfolio size and market share, he said. “To achieve their goals, the financial institutions may stray from ‘cherry picking' in the market and accept clients with a questionable creditworthiness.” said McCartney. The E&Y analyst continued: “In order to reach their business goals, banks may use subjective approaches when calculating the credit price from one client to another. Most of pricing today is not risk based and it is market led with the emphasis upon volumes and market share. This may create the foundation of a non-uniform analysis at clients and portfolio level.”

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“Models to assess creditworthiness are often not statistically robust and only at the end of the next recession will we really see the winners and losers in the Basel II game,” said McCartney. He divided local banks into three categories depending on their efforts to comply with the new norms. The first category included lenders who performed a Basel II diagnostic early in 2006 to see exactly where they were with the requirements of the three pillars and what they would have to do. They started to implement the requirements step by step but not in an organized manner, said McCartney. The second category includes banks that carried out the diagnostic in early 2007, after NBR had issued the new capital adequacy regulatory package. After the diagnostic finished, the program implementation stopped, but started aggressively in the last quarter of 2007, the E&Y partner said.

Finally, the third kind of banks are those that have relied to some extent on the parent bank's Basel II efforts either by using entirely the capabilities of the parent bank or by adjusting themselves the tools as per their needs, said McCartney. This last category includes both big banks like BRD-SocGen and Raiffeisen Bank, who made use of the expertise available from abroad, and smaller lenders like Bank of Cyprus and Millennium Bank. “We have completed the calculation of capital requirements based on the Standardized Method for all three Risk Management Divisions and the foundations for the implementation of the IRB approach have been laid. Since the end of 2006, this was done on a Group basis covering all subsidiaries (Romania and Russia as from 2007) and returns are being submitted to the Central Bank semi-annually,” said George Christoforou, general manager of Bank of Cyprus Romania. The reliance on group experience is one of the ways in which local banks can cut down on most of the costs incurred by the crossing over to the new set of rules. “The implementation cost was limited to the internal human and technical resources utilized, as the capital calculation engine was developed in-house with no use of external consultants and no purchase of software packages. The effect of the implementation cost on the profits for 2006 and 2007 as well as the effect on the profits of 2008 is, thus, limited to the extent of the cost of the internal resources utilized by the Group,” said Andreas Artemiou, internal auditor at the Bank of Cyprus.

Costs have not been an issue for ProCredit Bank either. “By the end of February, we will complete the adaptation of IT systems, including the testing part and the sign off option for users. Cost-wise, the Basel II implementation process was done in-house, with our own resources,” said Marius Sindile, head of the risk department within ProCredit Bank. Millennium Bank (BM) chose to take part in local Basel II studies shortly after it entered the market, even though that made them irrelevant. “We participated in the quantitative impact study which was carried out in Romania based on financial statements as of the third quarter of 2007. It proved to be a good exercise to compute capital adequacy although the results were not relevant given the fact that the official opening of BM was on October 11, 2007. Still, we produced financial statements up until September 30 last year, and thought this was a good opportunity to test our people and systems,” said Toscano. BM used more advanced approaches for market risk and operational risk, which was possible by leveraging the group's prior experience. The bank is prepared to compute capital adequacy at the end of March this year.

Toscano said there were several benefits in the new norms for small banks. “They can redefine their strategies and become more specialized in their area of expertise, focus on transactional banking rather than lending and differentiate through the quality of service,” said the GM. All in all, the pros attached to the Basel II set of norms are not as scarce as some banks' reluctance to adopt the new regulations might lead one to believe. At the end of the day, they will actually serve as an eye-opener for banks on the local market. “In essence, Basel II regulations will force the banks to develop a better understanding of the real costs of their credit activity. For the customers, it might be an advantage for the higher rated ones and a disadvantage for clients with a higher risk profile,” said van Groningen.

By Ana-Maria David