QIS 4: what do the numbers really mean?

U.S. policymakers have recently voiced concern over the estimated impact of the Basel II Framework as captured in the Fourth Quantitative Impact Survey (QIS4). Minimum capital requirements were generally down from today's levels, and individual institutions' results varied considerably. As a result, the regulatory agencies postponed further work on implementation until they can better understand what the QIS4 numbers mean.

Some observers also claim that implementation of the Basel II Framework could cause considerable competitive disparity for non-Basel-II institutions. So, is there a problem with the Basel II process? And if so, can it be fixed?

When the reform process began more than six years ago, it was widely agreed that the old Capital Accord was not risk sensitive, since it assigned a flat 8% capital charge to all corporate exposures (4% for mortgages), regardless of their relative risk. Basel II was designed to align capital requirements with risk, ensuring that high-risk institutions were covered with adequate capital and, at the same time, enabling lenders to earn an appropriate return for low-risk borrowers, whose loans had often left their balance sheets under Basel I.

It is this very risk sensitivity that explains why the QIS4 numbers behaved as they did, with significantly diverse results across Basel II banks. Compared to Basel I, Basel II capital will be higher or lower depending on the level of risk. The primary reason the QIS4 results were lower than today's capital numbers is that they were derived from third-quarter-2004 data, a period of very low loss rates for the industry.

It is important to understand that the regulatory models embedded within Basel II generate capital for a particular point in time, so capital levels will vary over the economic cycle. No doubt, the Basel II models will generate substantially higher capital charges for credit risk during an economic downturn. Internal analysis undertaken by a number of institutions has shown that Basel II capital could swing upward by as much as 35% during a less benign point in the economic cycle.

Regarding the diverse results, different business mixes and portfolio compositions among the QIS participants largely explain the variation. Institutions with subprime or other higher-loss portfolios saw little decrease or even an increase in capital requirements, while investment-grade commercial and prime mortgage lenders saw requirements fall significantly. This is exactly the result one should expect from a risk-sensitive framework.

Basel II takes several important steps toward the economic capital procedures many banks use to monitor and manage their risks, and for this reason it is an improvement over Basel I. Basel I simply assigned lots of capital crudely to credit risk, with much of that capital covering many of the non-credit risks banks take. Basel II moves closer to the level of capital needed for credit risk and separately computes capital needed to cover operational and market risks.

A recent RMA survey of capital allocation practices at 14 global institutions showed that in addition to credit, operational, and market risk, banks also hold significant capital for other risks. The primary risk types for which these institutions assigned economic capital as a percentage of total capital are shown in Table 1.

So while Basel II has moved much closer to banks' own internal procedures for measuring risk, it is still not in total alignment. This could partially explain some of the confusion surrounding the QIS numbers.

The QIS results also create some anomalies since the risks not covered are not necessarily proportional to credit risk. For example, while mortgages generate very low credit risk capital charges because of their low loss rates, holding mortgages often entails interest rate and other risks that are larger--in proportion to credit risk--than for other loans. This primarily explains why capital for mortgages dropped in the QIS. Indeed, Standard & Poor's has stated publicly that it will downgrade any institution that allocates capital solely on the Basel II mortgage model because it does not capture capital for either interest rate risk or prepayment risk.

But it is also important to note that Basel II has sufficient mechanisms under Pillar 2 to ensure that institutions with significant risks in any of these other areas hold a level of capital to cover such risks. For most institutions, however, these risks will be covered by the calibration of the credit risk capital charge.

In the long run, the regulators should make use of the considerable modeling that banks do to measure these risks by permitting full use of rigorous internal capital models, as is done with market risk capital today. The Basel Committee has acknowledged that Basel II is a point on the continuum between purely regulatory measures of credit risk and an approach that builds more fully on internal credit risk models. Movement toward this objective, an evolution to Basel III, must continue at a deliberate pace.

The competitive advantages Basel-II-compliant banks could possibly enjoy under a more risk-sensitive capital regime have more to do with the superior risk measurement and management systems they will be forced to adopt and implement rather than with the possibility of capital relief. But these complex risk management systems do not come without a significant cost, a cost currently beyond the reach of all but the largest institutions. This is the competitive disparity implicit within Basel II.

The Basel II reform process was designed to bring about greater risk sensitivity to regulatory capital requirements, but it is really about enterprise risk management. Economic capital and the internal models used by the industry to allocate capital have become effective management tools because they provide a common vocabulary and set of metrics for measuring risk across the entire enterprise. While Basel II is an improvement over Basel I, it still falls short in this regard and no amount of tweaking can fix it. It might be best at this point to view the Basel II implementation process, currently set to begin in 2007, as an opportunity to validate banks' own internal models and move to Basel III in 2010 or shortly thereafter.

What, then, should we do about competitive issues that may arise for non-Basel-III banks? Promote improved enterprise risk management for institutions of all sizes. The major U.S. banks developed much of the science driving Basel reform, and it is likely that these advances will soon be more readily available to the industry at large.

This is why it is necessary to move to a full internal-models-based approach as soon as possible so that industry innovation can continue. Better risk measurement and management is tantamount to risk reduction. And lower risk means higher risk-adjusted profitability for all banks.

Contact Pamela Martin by e-mail at [email protected].

Pamela Martin is director of Regulatory Relations and Communications at RMA; she also serves as executive editor of The RMA Journal. The opinions expressed in this article are the author's and do not necessarily reflect those of RMA.

Table 1

Risk Category as a Percent of
Total Capital

Credit Risk          47%
Market Risk          16%
Operational Risk     13%
Equity Investments   12%
Business Risk         9%
Other                 3%

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