Remarks by Jammaz Al-Suhaimi, 

Deputy Governor of the Saudi Arabian Monetary Agency At the IMF-WB Program of Seminars for the Session on New Basel Accord

�Adopting a Global Standard? Developing Countries and the New Basel Accord�

 

It is a pleasure to be here today and share with you my views on the proposed new Basel Capital Accord from the perspective of an emerging market supervisor.  I am delighted to share this podium with so many renowned experts, which should make this a lively session.  Basle 2 is an extremely important international supervisory initiative, with far-reaching implications for the stability of banking systems worldwide and for international capital flows.   

The New Capital Accord aims to modernize the risk-based Capital Adequacy Framework, first introduced in 1988 under Basel 1.  It is worth noting that while Basel 1 was primarily an agreement between the G-10 countries, it was endorsed and voluntarily adopted by most countries around the globe.  In due course, it has become the most important global yardstick for measuring and comparing capital adequacy for banks and banking systems.  In my view, the major reasons for this voluntary worldwide acceptance were the following:

• The sound logic on which it was based; that some assets are riskier than others, and therefore require a higher capital buffer;
  
• The simplicity and therefore the ease of implementation of the methodology;
  
• It had no major impact on supervisory resources and required no additional expertise or skills; and
  
• It was strongly supported by international entities such as the IMF, the WB, the rating agencies and financial analysts.

Notwithstanding its global success, for major international banks managing diverse risks and large portfolios, Basel 1 was already outdated by the mid-90�s.    These banks were developing and marketing innovative products and managing risks on a real time basis.  For them, the 1988 Capital Accord was a crude regulatory imposition not suited to meet their real needs, which could only be met by more sophisticated risk management techniques.  Consequently, International banks faced a growing misalignment of their regulatory and economic capital, which encouraged capital arbitrage.  Soon, it was evident that a new Capital Accord for these major internationally active banks was needed.

Many emerging market supervisors also confronted these same realities as major international banks were also present in their markets.  Also, their own significant banks embarked on sophisticated practices for competitive reasons.  However, for the most part, a majority of domestic banks in all markets were content with Basel 1.  It is worth noting that by year 2000, some developing countries had just barely succeeded in implementing Basel 1 in their banking systems.

This brings me to the central technical issues posed by Basel 2 for many emerging market countries.  These arise from the proposed introduction of a �Standardized Approach� to replace the credit risk part of the 1988 Accord.  While the Basel Committee has presented this as adding more risk differentiation, perhaps it was driven by a desire to make Basel 2 relevant to �most banks in most countries�, as was the case with Basel 1.

The �Standardized Approach� has drawn many comments during the consultative process from developing country banks and supervisors.  We have also raised some issues that we believe are shared by other supervisors.  These are as follows:

• The proposed use of External Rating Agencies to classify sovereign, bank and corporate risk is still a point of concern.  The lack of a rating culture, absence of domestic rating agencies and non-penetration of international ratings, in many emerging markets including my own, means that the main objective of the Capital Accord for greater risk differentiation, cannot be achieved.  It is also evident that this situation is unlikely to change in the short or even medium term.
  
• Similarly, the proposed use of Export Credit Agencies that use the OECD Methodology is problematic.  Very few non-G10 countries have ECAs, and they would be reluctant to use ECAs from other countries that lack transparency of ratings and methodology.  Moreover, ECAs are normally instruments of foreign governments whose objectivity cannot be assured.
  
• Based on external ratings, many emerging market supervisors will be requiring domestic banks to assign a higher risk weight to their own sovereigns for its foreign currency borrowings in comparison with other sovereigns, foreign banks and foreign corporations.  Not only will this prove to be politically difficult, it will provide a perverse incentive for domestic banks to favor foreign counterparties over domestic borrowers.  This has potential for a negative impact on capital flows to some emerging markets.
  
• Some new proposals such as the 75% risk bracket for retail customers and 35% bracket for residential mortgages are based on data from the G-10 countries and are not relevant to many emerging markets where conditions and environments are very different.

In our view, and one that is shared by many emerging market supervisors, the Standardized Approach would not materially impact credit risk differentiation in their banks nor have a major impact on their capital adequacy.  As a result, they may consider following the lead of those G-10 countries that argue that the cost of moving a majority of their banks from the 1988 Capital Accord to the Standardized Approach under Basel 2 is not justified in terms of benefits.  Consequently, they may decide that the efforts and funds required for this transition are better invested in the implementation of Pillars 2 and 3.

It is noteworthy that many emerging markets are likely to encourage their significant banks to adopt the IRB approaches under Basel 2 as early as possible.  This would be cost effective and also help the real objective of the Capital Accord by promoting greater sophistication in risk management.  However, there are some limitations and constraints in moving quickly to an IRB Approach.  For example, given the smaller size and scale of their operations, it could be a challenge for emerging market banks to gather sufficient statistical data for their asset portfolios required under an IRB approach.  Supervisors would have to guide banks to develop ways to pool and share data amongst themselves for implementing IRB models.

There is a broad consensus among the emerging market supervisors that Pillar 2 the �Supervisory Review Process� for capital adequacy should be strengthened.   Nevertheless, they also recognize that the lack of adequate financial and human resources at their disposal may hinder full implementation of Pillar 2.  Emerging market supervisors would need to lean heavily on their own governments as well as on supranational institutions, to enable them to acquire, train and develop the required human resources. 

Emerging markets also support the idea of enhanced transparency and disclosure under Pillar 3.  However, there are some concerns that given the highly technical nature of the disclosure requirements, it may require great efforts on the part of small and medium banks to comply.  Therefore, a thorough cost-benefit analysis would be needed before a supervisor enforces full implementation.

As a result of these concerns, some emerging market countries have suggested that the 1988 Accord with some modifications along with Pillars 2 and 3 and with an add-on for operational risk could be an acceptable option under the New Accord. 

In addition to these technical concerns, I wish to raise some important matters which, in my view, require further analysis and debate.

• First and foremost, the Basel Committee should define the terms �internationally active� and �significant� bank.  There is a risk that the absence of a clear definition or some criteria to guide supervisors could lead to inconsistent interpretation and application of the New Capital Accord.
  
• Second is the issue of procyclicality.  We note that many supervisors are concerned that Basel 2 has the potential to accelerate procyclicality with consequences for financial stability in their markets.  We believe that further empirical work needs to be conducted on this subject.
  
• Another common concern is the need for urgent progress in developing an international consensus on loan provisioning.  Differences in provisioning methods make it difficult to compare either the quality of assets or levels of capital in different countries as provisioning methodologies have a direct impact on these numbers.  These differences are further accentuated by some countries following the International Accounting Standards, while others follow their national standards.

Before I conclude, I would like to give you a brief overview of capital adequacy in Saudi Arabia.  We were among the first group of non-G10 countries to implement the 1988 Accord.  Saudi Banks have maintained high levels of capital adequacy of around 20% during the past decade and most of it is Tier-1 capital.  Given that we only have 11 banks of which 5 are associates of major international banks, we believe that the best course is to encourage our banks to make a transition from the 1988 Accord to a Foundation or even an Advanced IRB approach.  We are certain that this can be achieved within a reasonable timeframe.

In conclusion, I would like to commend the Basel Committee and particularly its ex-Chairman, Mr. Bill McDonough, and its Secretary-General, Daniele Nouy, for their personal efforts to strengthen the discussion and dialogue between the Basel Committee and the non-G10 countries.  As a member of the Basel Core Principles Liaison Group, we in SAMA found that this consultation process was comprehensive and effective throughout the evolution of the New Capital Accord.  This was a remarkable change from the 1988 Accord, when there was very little consultation outside the Basel Committee.  I am sure that these efforts would go a long way in garnering support of emerging market countries for this major global initiative. 

       I thank you for your attention!