For Immediate Release Wednesday,
April 4, 2001
For More Information, Please Contact:
Ruth Ainslie, ISDA New York, (212) 332-1200; Fax (212) 332-1212; rainslie@isda.org
According
to the Association, the new Consultation Paper, which was released for comment
in January, meets essential objectives of regulation in defining an approach to
setting banks' capital requirements that is risk sensitive, granular and
flexible. The Consultation Paper also, however, raises a number of issues of
concern relating to the introduction of capital floors, the imposition of new
capital charges (including the W factor pertaining to credit risk mitigation
tools), and the complexity of disclosure and other requirements.
Risk Sensitivity: As stressed in ISDA's response to the first Basel Committee's Consultation
Document, the principal failing of the 1988 Capital Accord was its lack of
sensitivity to the main risk drivers recognized by banks, particularly in the
area of credit risk measurement. ISDA considers that the Basel Committee, by
relying on banks' internal ratings and by disentangling the impact of the many
individual risk drivers (probability of default, loss given default, exposure
at default, maturity) on banks' capital, has designed a truly risk sensitive
capital framework. Importantly, this framework is transparent, as regulators
disclose the key parameters of the calculation, including the target loss
percentile and average asset return correlation assumption retained. Risk sensitivity
is also found in the eligibility of a broader variety of collateral types,
itself reflective of greater regulatory reliance on banks' risk management.
ISDA welcomes in particular the recognition of banks' own collateral haircut
estimates.
Granularity: ISDA emphasized the need
for the Basel Committee to retain a sufficient number of probability buckets in
its approach to credit risk, so as to ensure that capital charges effectively
reflect the true underlying credit risk. The Committee has exceeded ISDA's suggestion, by determining banks' credit risk
capital as a continuous function of the risk drivers.
Flexibility: Finally, it was essential
that the new Accord reflect the varying degree of precision observed in banks'
risk management systems. ISDA was therefore pleased with the Committee's
proposals in this area; Pillar 1 capital is effectively defined through stages
from the less sophisticated to the most sophisticated institutions, leaving
banks' increasing freedom to use their own risk estimates, for both credit and
operational risk. Furthermore, it is possible for banks not yet fully qualified
for entry into the foundation internal ratings based (IRB) approach to avail
themselves of this approach from 2004 onwards, should they commit to meeting the
full requirements within an appropriately defined time frame.
ISDA,
however, also perceives a number of deficiencies in the current proposals,
which it hopes can be corrected during and, if necessary, after the
consultation period. These fall into three main categories:
Rigidity: One substantial flaw in the
proposals lies in the introduction of capital floors. These are mentioned in
relation to the main risk types (operational and credit) and in neither case,
are suitably justified. Specifying a floor hampers flexibility, by adding
significant costs onto firms, which might be sufficient to discourage evolution
from one step in the regulatory spectrum to the next. ISDA maintains that the
need for a floor to be applied should be subject to strict cost- benefit
analysis, which does not seem to have been performed by the Committee.
Arbitrariness: The new proposals contain a
number of examples of charges, or approaches, that are
not satisfactorily substantiated.
One
major example is the size of the operational risk charge, arbitrarily set at 20
percent of global banks' regulatory capital. The percentage retained might, as
implied in the Consultation Paper, reflect the pro-rata of banks' economic
capital set aside against operational risk. However, ISDA would point out that
(i) only a few institutions perform these
calculations; (ii) there is substantial variability around the average; and
(iii) loss data available at present is insufficient to derive a meaningful
industry-wide figure.
Another
area of concern for ISDA is the introduction of a legal charge for credit risk
mitigation instruments, in utter contradiction with the efforts made by a
number of industry bodies, including ISDA itself, to ensure that collateral and
credit derivatives documentation is enforceable and effective. ISDA is likewise
concerned about the inequality of treatment between credit default swaps (15% W
charge) and bank guarantees (exempt). It is highly unusual for the Basel
Committee to lend a premium to the less standardized/less liquid side of a
market, such as the market for unfunded credit risk protection, and it is
difficult for ISDA to conceive of how such a decision might be justified.
Finally,
the Association questions the calibration of the Internal Ratings Based
function, which currently reflects adjustments assuming a systematic 50 percent
under-estimation of probabilities of default, as well as lack of Tier 1
capital. ISDA would argue that such adjustments are unnecessary, as they do not
reflect typical practice at well-managed institutions, and should therefore be
treated under Pillar 2 of the new
Complexity: Finally, parts of the Basel
Committee's proposals are overly complex, notably the disclosure requirements
listed under Pillar 3. ISDA would recommend that cost-benefit analysis be
performed in order to assess the need for firms to carry out the required tasks
in a manner as detailed as that prescribed in the proposals.
ISDA
has identified a number of areas requiring further work in the proposals and
focuses on the following in its response: Conceptual Framework, Internal
Ratings, Credit Risk Mitigation, Operational Risk and Market Discipline. The
full response is expected to be completed and provided to the Basel Committee
on 31 May 2001.