Steady as she goes on the good ship Basel II

Many of us are not entirely sure how it should be pronounced. Like snarl, bagel or frazzle?

That's not the only thing obscure about it. Or the only point of disagreement. Its importance, however, is not to be underestimated.

Like climate change protocols, the US doesn't appear to be particularly in favour of it, for reasons of competitiveness. But Basel II is on, or at least somewhere in, every banker's mind, in this region and worldwide.

To the non-specialist, the reams of flowcharts, acronyms and diagrammatic circuitry associated with its interpretation certainly make it appear the preserve of consultants thriving on jargon and complexity, whether duly or not. Thus, conveying even merely its essence in general terms is no mean task.

Basel II has been around for a while, and is more a general, rolling programme for implementation rather than specific event.

Essentially, it is a set of standards on bank safety in terms of capital adequacy relative to loan exposure, and how that is attained.

Though not policed by a governing authority, it will be legally enforceable in the EU, and other regulators will enforce rules with regard to its template.

Not too thrilling in itself, but in principle a worthwhile underpinning of a world financial system whose penchant for risk has had many commentators expressing concern.

Since the 1990s, it has been subject to much debate and prevarication, a prolonged state colourfully described by Suresh Kumar, CEO of Emirates Financial Services in Dubai as "animated suspension".

Eighteen years on from the original Basel I, the Basel II Accord was eventually signed in mid-2006.

On the global scene, the US authorities, having applied stricter controls on their own institutions following disasters in the savings and loans industry, seem to be going their own way in implementing it. For the rest of the world, this European-originated project remains a totem of aspiration.

Progress

So how is Basel II progressing in the region?

In the Middle East the majority of banking assets is expected to be covered by Basel II regulations during 2007-09. Generally speaking, capital ratios are fairly strong in the GCC, though they have fallen as banks have expanded.

Still, "Gulf banks have to get themselves up to speed" in terms of risk management, says Philip Smith, senior director, financial institutions, Fitch Ratings, though "I get the impression that the UAE is well advanced". Basel II has been "extremely useful" in forcing this process, "even if in some respects it is actually too elaborate".

Kuwait actually led the way in adopting Basel II in December 2005 and Qatar in January 2006, in that sense ahead of the game in its generalised adoption in 2008. Regulators in the region have wanted to see how the guidelines have been enacted elsewhere.

In some cases, they have not wanted to concede certain prudential issues which have been in place for many years, Smith explains, and will in any case apply their own modifications. Consequently, "it will be a patchwork or hybrid system". It is said too that some banks in the region are ahead of the regulator and are even being held back.

Naveed Seddiqi, coordinator for Basel II at the UAE Central Bank, confirms it is on track for a year-end 2007 target on the standardised basis. He is "positive about how it is proceeding", with all banks making the deadline, and "great progress" from some of the smaller banks. He confirms that "the 10 per cent capital ratio has always been there", but the way of getting there will change.

Regimes

So how does having different regimes around the world make sense, with countries having their own laws and regulations?

Seddiqi sees it as a collaborative venture. "All are working to a common goal. No-one wants to see issues arising in any jurisdiction," he says. For example, the UK's Financial Services Authority (FSA) invites regulators from around the world for "active dialogue" in London.

And what about banks operating cross-border? In this case, the local central bank will normally support the home regulator's requirements, without compromising its own standards. Thus, despite variations and overlaps, "practically speaking, there are no problems that cannot be overcome," he says.

Within the GCC, there have been negotiations for common application of rules, though with differing timeframes. The UAE is more diverse than Saudi Arabia, for instance, in terms of the presence of foreign banks. Extra time is therefore being taken, till 2011, to move to the IRB basis.

While progress is being made in a worthy cause, there have been criticisms of Basel II. One of the main drawbacks is that bigger banks and wealthier countries can obtain further advantage by earlier application of sophisticated systems. Another is that the business cycle might be exaggerated because of underlying credit models whose time horizon is short.

Some industry voices, while not denying the need for a systematised approach to banking risk, have inspected the meth-odologies and found them "needlessly complex and expensive", according to Suresh Kumar of EFS. He has called for other means of achieving the same end, such as a mandatory risk audit to accompany the yearly financial audit.

It suggests that there may still be work to be done to thrash out the issues. Basel III apparently is in the works. "It is important that [the] professional entities get together and adequately network for a holistic view on the financial health of a bank," Kumar says.

After all, in respect of risk, it is that practicality and reasoning - rather than ticking a regulatory box - that is the bottom line.

About as much as you need to know

Basel II's overall goal is to promote adequate capitalisation of banks, and encourage improvements in risk management, thereby strengthening stability in the financial system.

It does so by three complementary 'pillars': one concerning capital adequacy methodology and calculation, another on supervisory review, and a third setting disclosure terms to enable market discipline.

Basel I specified a capital ratio of eight per cent (for internationally active banks) for the level of core capital relative to an assets measure adjusted for risks. In the Gulf region, regulators typically require 10 to 12 per cent.

Two types of approach are offered for gauging a bank's risk profile, with guidelines for credit risk, market risk and operational risk.

The 'standardised' approach extends existing norms, making use of independent, external ratings from rating agencies.

Under the internal ratings-based (IRB) approach, with 'foundation' and 'advanced' variants, banks develop their own systems to estimate portfolio risks.

By IRB a bank's clients are assigned ratings equating to probabilities of default on the basis of actual experience.

Whereas the lever to tighter pricing of transactions would promote a tendency towards IRB systems, most of the region's banks are expected to stay with the less-demanding standardised approach to begin with. Banks will have effectively to qualify for the advanced method by means of systems capability.

The challenge they face is to build the necessary models without an adequate historical record of defaults, and they may need to pool data with each other to compensate for this relative deficiency.

- Andrew Shouler, Financial Editor