Public Information Notice No. 05/154

Public Information Notice: IMF Executive Board Discusses Implications of the New Basel Capital Adequacy Framework for Banks ("Basel II")

November 7, 2005

On October 26, 2005, the Executive Board of the International Monetary Fund (IMF) discussed the implications for the Fund and the World Bank of the new capital framework for banks, issued by the Basel Committee on Banking Supervision in June 2004 ("International Convergence of Capital Measurement and Capital Standards-A Revised Framework").¹

Background

Basel II, the new capital standard for banks, was released by the Basel Committee in June 2004, for implementation starting in January 2007 in Group of10 countries. This new framework, which is far more complex than the 1988 Accord (Basel I), consists of three "pillars." Pillar 1 introduces a menu of options for assessing capital adequacy of banks, including technically advanced options, based on banks' internal risk management systems, but also comprising simpler approaches, basically representing a refinement of the Basel I system. Pillar 2 requires an upgrading of supervisory practices to review banks' internal capital adequacy assessments, and Pillar 3 requires public disclosure of more information on banks' risk profile and risk management systems, thus supporting the exercise of market discipline.

In the view of the Fund, the revised Capital Accord (Basel II) represents a significant improvement over the 1988 Capital Accord, and its implementation should lead to enhanced financial stability through better risk management systems in banks, better banking supervision in member countries, and improved market discipline. Basel I has been adopted by most jurisdictions around the world and more than 100 countries have announced intentions to implement Basel II over time.

However, given its complexities and substantial resource implications, Basel II may not be the first priority for many member countries with more resource constrained and less advanced regulatory and banking systems. As shown by the assessments of countries' compliance with the Basel Core Principles for Effective Banking Supervision, many countries still need to strengthen their basic supervisory systems. For instance, some countries have not fully implemented the 1988 Accord.

There may be short-term risks in the transition and implementation of the new standard. A supervisory focus on meeting the specific requirements of Basel II, with the associated reallocation of resources, may distract supervisors from more immediate concerns, such as building a strong system for day-to-day risk-based supervision. Even for countries that are in a position to migrate to Basel II, the speed of implementation of Basel II should not take precedence over quality.

In their assessments of a country's compliance with the Basel Core Principles, the Fund and the Bank will not assess compliance based on whether or not a country has implemented Basel II. Bank/Fund assessments of supervision will be against the capital standard (Basel I, Basel II, or other forms) chosen by the country in the context of the country's capacity and sound international practice. The choice of which capital standard to adopt must be made by national authorities. Neither the Fund nor the Bank intends to push countries toward implementation of Basel II, nor toward specific country options under the Basel II framework.

At the same time, Basel II has stimulated substantial interest on the part of member countries to upgrade banking supervision systems and banks' risk management. Thus, interest in Basel II implementation can provide leverage to stimulate diagnosis of, and improvements in, banking regulation and supervision. Basel II will also stimulate better cross-border cooperation and exchange of information between home and host supervisors, in particular, when foreign banks operate under different regulatory capital systems than domestic banks.

Basel II will impact the Fund's and the Bank's financial sector surveillance work. Countries that wish to strengthen their supervisory system may also require assistance in diagnosing the adequacy of their present systems, sequencing the further development of their supervisory systems, and building credit information and data pooling systems. The Fund and the Bank will work together in exploring technical assistance opportunities, and coordinate with other donors to help countries deal with these issues, including addressing deficiencies in the existing supervisory framework and the capital adequacy framework.

Fund staff has commented directly to the Basel Committee, and also participated in two rounds of public commentary on the Basel II proposals. The latter comments have been placed on the BIS website (www.bis.org). Staff participates in the work of the Basel Core Principles Liaison Group, the Working Group on Capital, and in the current revision of the Basel Core Principles. Staff has also discussed a number of the issues related to Basel II with members of the Executive Board at a briefing on February 24, 2004.

Executive Board Assessment

Executive Directors welcomed the opportunity to discuss the implications for the IMF of the new capital adequacy framework for banks, International Convergence of Capital Measurement and Capital Standards-A Revised Framework (Basel II), issued by the Basel Committee on Banking Supervision in June 2004. Directors considered the new framework to be an important step toward addressing weaknesses in the existing Basel I framework, especially in improving risk management in financial institutions. Successful implementation of Basel II will strengthen the financial system in individual countries and the international financial system, and help ensure global financial stability.

Directors considered, however, that for many countries the new framework-in particular, Pillar 1-may be too complex and resource intensive to become an immediate priority-while acknowledging that Basel II was designed to be applicable to a variety of country circumstances. They emphasized that premature adoption of Basel II in countries with limited capacity could inappropriately divert resources from more urgent priorities, ultimately weakening rather than strengthening supervision. In this regard, they noted the weak compliance across countries with many of the existing Basel Core Principles that are important to the effective implementation of Basel II.

Under these circumstances, Directors generally considered that many countries may benefit more in the short term from a strengthening of supervisory practices as set out under Pillar 2, and from an enhancement of banks' disclosure practices under Pillar 3 to facilitate the exercise of market discipline. They agreed that countries should give priority first to developing their financial sector infrastructure-through increased risk-based supervision, a stronger supervisory foundation, and improved disclosure requirements-so as to allow them to move over time toward Basel II implementation. Directors stressed that roadmaps for Basel II implementation should be comprehensive and realistic, and should give appropriate attention to necessary preconditions, such as adequate credit data systems. In countries where banks implement the advanced approaches under Basel II, financial sector surveillance should include an assessment of the adequacy of Basel II implementation by the supervisory authorities.

Against this background, Directors cautioned that Fund staff should avoid conveying the perception that countries will be criticized for not moving to adopt the Basel II framework. They urged staff to be completely candid when asked to assess countries' readiness to move to Basel II and to indicate clearly the risks of moving too quickly and too ambitiously.

Directors discussed a number of issues associated with Basel II. Concerns were voiced that increased risk sensitivity would result in higher capital requirements for loans to emerging market and developing countries as well as higher risk-related capital charges, resulting in reduced capital flows to these countries. Also, bank lending to these countries during an economic downturn would become more costly, resulting in reduced bank lending and increased procyclicality. On the other hand, it was noted that bank lending rates to emerging market and developing countries may already incorporate the risk premium, and that the greater risk sensitivity under Basel II could mitigate "herd behavior" by banks, which make it less likely that Basel II will have a significant effect on capital flows and procyclicality.

Directors stressed the importance of good cooperation, coordination, and exchange of information between home and host supervisory agencies, especially when foreign banks operate under a more advanced Basel II variant at home than in the host country. Directors underlined that, in the end, host supervisors are responsible for supervision over the institutions in their jurisdiction, even if foreign banks are also subject to parental control and home country consolidated supervision. Host country supervisory authorities, even if not implementing Basel II or one of its advanced methodologies, should, however, develop sufficient expertise to be able to communicate and cooperate effectively with home country supervisory agencies, in particular if foreign banks in their jurisdiction apply advanced capital approaches. Most Directors concurred that staff should take a neutral position with regard to the question of whether host supervisors should permit foreign banks in their countries to operate under Basel II, particularly the advanced approaches, if domestic banks are to remain under Basel I.

Many Directors considered it appropriate for Fund staff, together with other relevant institutions, to develop guidance materials to support assessments of countries choosing to adopt Basel II. They stressed that such assessments should take into account each country's specific circumstances. Several Directors emphasized the importance of staff closely coordinating with the Basel Committee on Banking Supervision in the preparation of guidance materials.

Directors underlined that staff needs to carefully manage expectations of member countries regarding technical assistance, given that the Fund currently is not in a position to help countries develop the more technical aspects of Basel II, such as building and detailed validation of risk models. They concurred that Fund and Bank technical assistance should focus on putting into place the prerequisites for countries seeking to adopt the Basel II framework, namely: strengthening financial sector infrastructure, core supervisory functions-including risk-based supervision-in line with the Basel Core Principles, and the conditions allowing for the exercise of market discipline. They emphasized that technical assistance should be closely coordinated with other providers, particularly with the members of the Basel Committee on Banking Supervision and other relevant standard setters. Directors also called for a clear division of labor between the Fund and the World Bank, with the Fund bearing primary responsibility for financial stability issues and the supervisory framework and practices, and the Bank primary responsibility for financial sector infrastructure and institutional development.

Directors agreed that, to be able to conduct financial sector surveillance effectively in the Basel II environment, the Fund will need to build its expertise on all aspects of Basel II, including the more advanced elements of Pillar 1. Although availability of resources in the area of Basel II will be scarce for the coming years, the Fund will need to position itself, within the existing resource envelope and using external funding where possible, to recruit outside short-term and long-term experts to assist in building its own expertise and to participate in surveillance and, to a more limited extent, technical assistance activities. A number of Directors stressed that the Fund's expertise-building should be aimed primarily at improving the Fund's regular surveillance instruments, such as Article IV consultations and FSAPs. A number of Directors requested a quantitative assessment of the cost to the Fund of building its expertise on aspects of Basel II as well as the cost of upgrading capacity of member countries.