Friday, January 02, 2009

Kenyan Banks and BASEL II: Review

At its heart, the current credit crisis is about reckless risk management, failure of risk management regulation and credit ratings...
Basel2 is in my humble opinion one of most complete approaches to risk management designed for the banking industry or any other industry. So what is it and how would it affect Kenyan banks were they to adopt it?

The Basel (Basle) in Basel II is the name of a Swiss town where bank international settlements are done. Its the son of Basel I, which was created back in 1988 as a recognition by the G10 nations plus two other nations that banks required a common approach to risk (credit & market) management and capital set aside to mitigate that risk. Being an initial effort, it was very broad brush and BII was therefore designed to add detail in terms of credit and market risks; cover off other risks (specifically operational risk) and other issues such as disclosure and regulation.
All these facets are covered in 3 pillars. For each of the 3 key banking risks (credit, market and operational), BII recommends a menu of approaches that banks and their regulators can adopt, but importantly specifics for each sub-type of business.
Credit risk: Risk that borrower (counterparty in banking-speak) defaults.The trio of approaches are :

(i) standard: allocate capital based on credit rating of counterparty;
(ii) internal rating-based- where bank uses regulator-sanctioned internal ratings models. Can either be foundation IRB i.e. just use internal model to estimate probability of default
or Advanced IRB where bank is allowed to use its model to estimate PD as well as loss given default and exposure at default.
Market risk: Risk from changing market factors(interest /fx rates; share/commodity prices). VaR for value at risk is the preferred approach.
Operational: Risk arising from banks’ way of doing things. BII recommends either basic indicator approach i.e. capital set aside must be the average of last 3 yrs annual gross income OR standardised approach which divides banks business into 8 different lines, takes their gross income and multiplies with a beta factor OR advanced measurement approach where the bank can use its own model.
The other two pillars deal with how the regulatory approach and in particular ICAAP which is the internal capital adequacy assessment process covering the bank’s approach to pillar 1 risks and other risks and disclosure of the same.

In terms of impact of regulatory capital, the experience in G10 nations has been that capital required is either the same or lower because banks can leverage broad credit rating coverage or strong internal models. As you’d expect, there have been criticisms of Basel II, but most have actually focused on what went wrong to spark the current credit crunch namely very ropey credit ratings and regulators evaluation of internal models used by banks. So far, many countries have taken up Basel 2.

In Africa, South Africa is far ahead having started using B2 in Jan 2008. In most other countries, B2 is only mentioned in passing. However, as a general rule, those nations with presence of international subsidiaries stand a better chance of early adoption. As do those with banks interested in going abroad. To bridge the knowledge and resource gap, some like Egypt are sourcing help from EEC. Adaption is now seen as given banks a competitive advantage.
Turning to Kenya, CBK has handily released a survey of 31 of our banks showing their awareness, intent, understanding and preparedness towards adopting Basel2. The survey fitted neatly with a review I was doing of how the listed banks do risk management. BDA has focused on the so-called talent war but there is a lot of other issues.
Here are my salient points:

  • CBK wants to start adopting Basel II from 2010
  • Banks have not yet adopted Basel1 wholly e.g. none actually allocates capital against market risk
  • Awareness of BaselII is medium, less 5 than have done any assessment for B2 purposes
  • Only 5 banks have in place a Basel II steering process
  • The 7 subsidiaries of international banks were ready to adopt Basel II from 2008
  • Only 3 local banks had any budget for Basel II in 2008
  • CBK does not yet do risk-based supervision of the banks-uses Prudential rules
  • BII is not seen as a competitive tool-parochial view
  • Only 5 of the 31 deal in any non-plain vanilla financial instruments
  • In UK, most banks took 2 to 3 years to prepare
  • For credit and operational risk where there is a menu of approaches on offer, most prefer internal models
  • Majority of local banks have an IT and human resources constraints (hence the BDA headline)

From annual reports, KCB seems to be ahead of the game in terms of its coverage of Basel II ( it was the first to appoint a CRO, already calculates probability of default and Temenos, its new IT system will at least give it the centralised banking data view)

Next post will look at the implementation process for Kenyan banks...

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