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Country Case Studies: Addressing Country Case Studies: Addressing the Challenges of Basel IIthe Challenges of Basel II

Mohd Razif Abdul Kadir Mohd Razif Abdul Kadir Assistant GovernorAssistant GovernorBank Negara MalaysiaBank Negara Malaysia

17 May 200417 May 2004  

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AGENDAAGENDA

• Basel II in the context of Emerging Basel II in the context of Emerging Economies Economies

• Implementation Challenges and Impact Implementation Challenges and Impact

• Implementation Approach & Road MapImplementation Approach & Road Map

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Most Emerging Economies Aspire to be Most Emerging Economies Aspire to be Basel II CompliantBasel II Compliant

• Potential benefits in terms of capital savingsPotential benefits in terms of capital savings

• More efficient capital allocationMore efficient capital allocation

• Better risk management capability Better risk management capability

• Enhance competitiveness of banking institutionsEnhance competitiveness of banking institutions

• Minimise regulatory arbitrage opportunitiesMinimise regulatory arbitrage opportunities

• Market expectationsMarket expectations

Strengthened Strengthened Banking Sector Banking Sector

and Greater and Greater Financial Financial StabilityStability

BUT, priorities may be on other supervisory initiatives…BUT, priorities may be on other supervisory initiatives…

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Basel II Implementation to be Balanced Basel II Implementation to be Balanced with Other Supervisory Prioritieswith Other Supervisory Priorities

• Capacity Building of Capacity Building of Domestic BanksDomestic Banks

• Legal Infrastructure and Legal Infrastructure and Regulatory FrameworkRegulatory Framework

• Robust Risk Robust Risk Management and Management and Sound Corporate Sound Corporate GovernanceGovernance

• Market Discipline Market Discipline - Accounting standards- Accounting standards

- Institutional transparency- Institutional transparency - Market education- Market education

Basel II must fit into the overall Basel II must fit into the overall

supervisory agendasupervisory agenda

Banking sector plays key

intermediation role in most

emerging economies

• Deepening Domestic Deepening Domestic Capital MarketCapital Market • Consumer Protection Consumer Protection

FrameworkFramework

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• How could emerging markets benefit from How could emerging markets benefit from Basel II?Basel II?

• Customise Basel II design with local conditions Customise Basel II design with local conditions (e.g. in determining most appropriate options, (e.g. in determining most appropriate options, appropriate size threshold for SME retail appropriate size threshold for SME retail definition)definition)

• Impact assessment require calibrations to be Impact assessment require calibrations to be conducted based on local dataconducted based on local data

Basel II – Calibrated based on G-10 Basel II – Calibrated based on G-10 Countries’ Standards Countries’ Standards

Comprehensive impact analysis and implementation Comprehensive impact analysis and implementation sequencing is criticalsequencing is critical

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• Understanding the procyclicality impact Understanding the procyclicality impact

• Ensuring competitive equality and economic impactEnsuring competitive equality and economic impact

• Managing resource constraints Managing resource constraints

• Managing market pressures for early adoption of Basel II Managing market pressures for early adoption of Basel II

• Addressing data constraints Addressing data constraints

Challenges in Implementing Basel II must Challenges in Implementing Basel II must be fully Appreciatedbe fully Appreciated

Emerging economies should not rush to adopt Basel II without Emerging economies should not rush to adopt Basel II without understanding its challenges and potential impactunderstanding its challenges and potential impact

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• Understanding the procyclicality and economic impactUnderstanding the procyclicality and economic impact

• Emerging economies are more fragile, having greater dependence Emerging economies are more fragile, having greater dependence on banking system as provider of funds – economic sectors are on banking system as provider of funds – economic sectors are more correlated and sensitive to effects of economic cycle more correlated and sensitive to effects of economic cycle

• Calibration of IRB (based on G-10 environment) results in Calibration of IRB (based on G-10 environment) results in significant acceleration in capital charge as ratings (PDs) significant acceleration in capital charge as ratings (PDs) deteriorate deteriorate

greater likelihood of credit crunch for emerging economies during greater likelihood of credit crunch for emerging economies during recessionary periodsrecessionary periods

Concerted use of IRB approach may affect lending behavior and Concerted use of IRB approach may affect lending behavior and starve financing to certain critical sectors of the market e.g. SMEsstarve financing to certain critical sectors of the market e.g. SMEs

• Emerging economies are generally more volatile fuelled by Emerging economies are generally more volatile fuelled by imperfect markets (see chart) ………… hence greater need to imperfect markets (see chart) ………… hence greater need to conduct thorough analysis to expect the unexpected.conduct thorough analysis to expect the unexpected.

Basel II has Greater Far Reaching Impact Basel II has Greater Far Reaching Impact on Emerging Economieson Emerging Economies

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Market volatility of Developed and Market volatility of Developed and Emerging EconomiesEmerging Economies

Emerging Economies - Maximum 10 day yield changes

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

5 yr MYR Gov-Bonds

5 yr Thai Gov-Bonds

5 yr PHP Gov-Bonds

Percentage Points

Developed Economies - Maximum 10 day yield changes

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

5 yr US Gov-Index

5 yr UK Gov-Index

5 yr AUD Gov-Index

Percen

tag

e P

oin

ts

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• Industry structure must be considered in the implementation plan Industry structure must be considered in the implementation plan

Internationally active banks enjoy benefits of diversification and hence greater Internationally active banks enjoy benefits of diversification and hence greater capital relief from advanced approaches capital relief from advanced approaches

pressure on local supervisors to accept advanced approachespressure on local supervisors to accept advanced approaches

greater competitive advantage over domestic institutions greater competitive advantage over domestic institutions

• Implementation of Basel II should not be merely a regulatory exerciseImplementation of Basel II should not be merely a regulatory exercise

Emphasise on Cost and benefit analysisEmphasise on Cost and benefit analysis

Understand impact of banks’ roll-out plans/changes in lending behaviour on Understand impact of banks’ roll-out plans/changes in lending behaviour on availability of credit to all consumer segments (e.g. SME)availability of credit to all consumer segments (e.g. SME)

• All banks should be subject to similar minimum requirements (such as on All banks should be subject to similar minimum requirements (such as on data specifications) – foreign banks may have the tools for Basel II, but data specifications) – foreign banks may have the tools for Basel II, but they still lack local data to meet requirements like most domestic banks they still lack local data to meet requirements like most domestic banks

• Regardless of timing for Basel II, Regardless of timing for Basel II, primary focusprimary focus should be on enhancing should be on enhancing ability of ability of all banksall banks to better price risks (e.g. banks to have robust internal to better price risks (e.g. banks to have robust internal rating system)rating system)

Basel II and Competitive Equality Basel II and Competitive Equality

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• Managing resource constraintsManaging resource constraints

• Flexible timeline required to justify large investment Flexible timeline required to justify large investment

• Greater demand for specialised skills by banks and Greater demand for specialised skills by banks and supervisors – longer time to trainsupervisors – longer time to train

• Managing market pressures for early adoption of Basel IIManaging market pressures for early adoption of Basel II

• Effective communication and clear road map of Effective communication and clear road map of implementation to minimise potential adverse market implementation to minimise potential adverse market reaction reaction

• Addressing data constraintsAddressing data constraints

• Should never be overlooked (garbage in, garbage out)Should never be overlooked (garbage in, garbage out)

Complexity of Basel II Implementation Complexity of Basel II Implementation Creates Challenges in itselfCreates Challenges in itself

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Basel II in Malaysia – Further Enhancement Basel II in Malaysia – Further Enhancement to Market Structuresto Market Structures

• Various measures were taken to strengthen the banking Various measures were taken to strengthen the banking sector and financial sector infrastructuresector and financial sector infrastructure

Industry consolidation Industry consolidation

Number of domestic banking institutions dropped from Number of domestic banking institutions dropped from 89 to 30 banking institutions (10 domestic banking 89 to 30 banking institutions (10 domestic banking groups)groups)

Comprehensive restructuring initiatives involving: Comprehensive restructuring initiatives involving: (i) resolution of non-performing loans; (i) resolution of non-performing loans; (ii) recapitalisation of weak banking institutions; and (ii) recapitalisation of weak banking institutions; and (iii) restructuring of large corporate debts(iii) restructuring of large corporate debts

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Basel II in Malaysia – Further Enhancement Basel II in Malaysia – Further Enhancement to Risk Management Standardsto Risk Management Standards

• Market Infrastructure and Regulatory/supervisory Market Infrastructure and Regulatory/supervisory framework are being continuously enhanced…framework are being continuously enhanced…

Minimum standards on credit risk managementMinimum standards on credit risk management

Prudential standards on asset backed securitisation Prudential standards on asset backed securitisation

Strengthening the corporate governance frameworkStrengthening the corporate governance framework

Deepening of domestic capital marketDeepening of domestic capital market

Outstanding private debt securities increased by Outstanding private debt securities increased by threefold from 1996 to 2003 – now accounting for 35% threefold from 1996 to 2003 – now accounting for 35% of GDPof GDP

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Basel II would be a Natural Progression and Basel II would be a Natural Progression and Consistent with Malaysia’s Regulatory Consistent with Malaysia’s Regulatory PhilosophyPhilosophy

Comprehensive Financial Sector

Master Plan (FSMP) was

issued in 2001

The The objectiveobjective is to develop a more efficient, effective and resilient banking is to develop a more efficient, effective and resilient banking sector that will support the economic transformation and growth sector that will support the economic transformation and growth

Gradual liberalisation Gradual liberalisation processprocess

Increasingly Increasingly Diversified Financial Diversified Financial

SectorSector

Three phase approachThree phase approach capacity building capacity building

increasing competition in the increasing competition in the domestic marketdomestic market

greater integration with greater integration with international marketinternational market

Supervised Market ApproachSupervised Market Approach Emphasise on robust risk management Emphasise on robust risk management

Increase role of market discipline through Increase role of market discipline through enhanced transparencyenhanced transparency

Moving towards ‘what is not prohibited is Moving towards ‘what is not prohibited is allowed’ conceptallowed’ concept

Comprehensive customer Comprehensive customer protection frameworkprotection framework Consumer education program Consumer education program

Banking intermediation bureauBanking intermediation bureau

Deposit insurance fundDeposit insurance fund

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Key principles adopted:Key principles adopted:

1.1. Accommodation of capacity building efforts and Accommodation of capacity building efforts and gradual risk management enhancement for all banksgradual risk management enhancement for all banks

2.2. Flexible timeframe to facilitate capacity buildingFlexible timeframe to facilitate capacity building

3.3. Emphasis on strong business justification to adopt Emphasis on strong business justification to adopt IRB approachesIRB approaches

4.4. Enhance supervisory methodology to assess internal Enhance supervisory methodology to assess internal models and advance risk management systems models and advance risk management systems

Malaysia will Adopt Basel IIMalaysia will Adopt Basel II

Basel II, a flexible risk management capacity Basel II, a flexible risk management capacity building strategy to enhance financial stabilitybuilding strategy to enhance financial stability

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Malaysia’s Road Map to Basel Malaysia’s Road Map to Basel IIII

Phase 1 (January 2008)Phase 1 (January 2008)

• As a minimum, all banks adopt standardised approach for credit As a minimum, all banks adopt standardised approach for credit risk and basic indicator approach for operational risk.risk and basic indicator approach for operational risk.

However, banks intending to leapfrog towards the Foundation IRB However, banks intending to leapfrog towards the Foundation IRB (FIRB) may continue to remain on the current accord and submit (FIRB) may continue to remain on the current accord and submit approved business justification & implementation blueprintapproved business justification & implementation blueprint

Phase 2 (January 2010)Phase 2 (January 2010)

• Banks adopting the FIRB approach are expected to complyBanks adopting the FIRB approach are expected to comply

2 phase approach2 phase approach

Key Consideration: (i) cost of compliance, and (ii) readiness of Key Consideration: (i) cost of compliance, and (ii) readiness of banking institutionsbanking institutions

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Thank youThank you