Basel II: and Enterprise Content Management

Date: 7/02/2005 Contents Basel II: enterprise management systems and the future of international banking regulation .............................................................................................................. 1 Background: the Bank of International Settlements, the BCBS, and the Basel I accord.................................................................................................................... 1 The main provisions of Basel II ............................................................................. 2 Implementation of the Basel II Framework............................................................ 3 TRIM Context and Basel II.................................................................................... 4 Conclusion ............................................................................................................ 5

Basel II: enterprise management systems and the future of international banking regulation
In June 2004, the Basel Committee on Banking Supervision (BCBS), a committee of the Bank of International Settlements (BIS) finalized the terms of the new framework for international financial regulation commonly referred to as Basel II.1 These standards built upon the success of the 1988 Basel Accord,2 and aim to bring a greater degree of precision and flexibility to the capital standards established by the earlier agreement. In designing the agreement to achieve these objectives, the BCBS focused on three pillars for sound international finance: (1) minimum capital requirements; (2) the supervisory review process; and, (3) market discipline. For each of these pillars, the new opportunities and requirements presented by Basel II will require a substantial investment in information management technology. Most banks will, however, need to accept the short-term pain of implementation not only because of market and regulatory pressure, but also because the framework offers potentially substantial long-term benefits.

Background: the Bank of International Settlements, the BCBS, and the Basel I accord
The BIS was set up in 1930 to administer the payment of reparations by the defeated German state. Since the end of reparations, it has reinvented itself as inter alia a major forum for the discussion of international financial issues amongst central banks.3 The BCBS is a sub-committee of the BIS formed in 1974, comprised of representatives of the central banks of the G10 countries, and focused on systems of international financial regulation.4

The full title is International Convergence of Capital Measurement and Capital Standards: A Revised Framework (hereafter Basel II). 2 International Convergence of Capital Measurement and Capital Standards, Basel Committee on Banking Supervision (July 1988). 3 For a more detailed history, see Bank of International Settlements, BIS History, http://www.bis.org/about/history.htm, last accessed 7/2/05. 4 Countries sitting in the BCBS include: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. w w w . t o w e r s o f t . c o m

The most important document produced by the BCBS until 2004 was undoubtedly the Basel I Accord. Finalized in 1988, the agreement sought to stabilize international financial organizations by imposing a standard minimum capital:asset ratio of 8%, in order to prevent collapses of under-capitalized banks. The agreement has been an enormous success, and has been adopted by over 100 countries5 and the vast majority of large international banks. However, the experience of the adoption of the system, pressure from the larger international banks to allow the use of internal models of risk management, and recent financial scandals led the BCBS to produce a new, more sophisticated agreement: the Basel II framework. Basel II is an attempt to fine-tune the risk management provisions of Basel I, and introduces new corporate and supervisory governance provisions to help support these changes.

The main provisions of Basel II

Basel II focuses on three main areas for improvement of internal, supervisorial, and market control of the management of risk in international banks: minimum capital requirements, the supervisory review process, and market discipline. Firstly, and perhaps most importantly, the Basel II framework sets up a new and sophisticated system for the management of minimum capital requirements (Pillar I). Under Basel I, banks were required to adhere to a rigidly set table of risk weighting for particular classifications of loans. While this system will continue to operate under Basel II (as the Standardized Approach), a new and substantially more sophisticated system for risk management has been introduced the Internal Ratings Based (IRB) Approach. Under the IRB approach, banks which demonstrate their ability to adequately track information about their credit portfolio may be allowed by their countrys financial supervisor6 to use their own internal models to assess the credit risk attached to each particular debt.7 This will allow banks to significantly reduce the risk weighting attached to many debts,8 and hence allow them to reduce the amount of capital required to satisfy the 8% ratio. Moreover, the IRB approach is divided into foundation, and advanced methods. Under the foundation methods, banks can only use internal models of the probability of default (PD),9 whilst under the advanced approach, banks can use internal models for PD as well as Loss Given Default (LGD), Exposure at Default (EAD), and Effective Maturity (M), subject to minimum regulatory standards.10 In order to reap the benefit of more accurate (and thus less conservative) capital ratios under the advanced IRB, banks will be required to keep a complex and well-documented set of metadata on all their financial liabilities, including hierarchical divisions of exposures into broad taxonomies, and enough contextual metadata to allow reclassification of exposures.11 They must also develop, apply and justify sophisticated models and statistical processes for each category of exposure.12
5

Daniel E. Ho, Compliance and International Soft Law : Why do Countries Implement the Basel Accord?, Journal of International Economic Law (2002) v.5(3), p. 647, at p. 649. 6 i.e., organizations such as the SEC in the US, and APRA in Australia. 7 Basel II, para 211. 8 Of course, it is not necessarily the case that all risk weighting will decrease; indeed, some banks may find that their capital requirements may actually rise under the IRB approach. 9 Basel II, para 245. 10 Basel II, para 245. 11 Basel II, para 218. 12 See, for example, Basel II, para 394ff. w w w . t o w e r s o f t . c o m 2

Secondly, the Basel II framework mandates a system of supervisorial review. These Pillar II requirements are aimed at ensuring that internal process and controls within banks are implemented adequately, and are founded on recognition that capital should not be regarded as a substitute for addressing fundamentally inadequate control or risk management processes.13 Of the principles established by the framework in this area, the most important for the field of management information systems are Principle 1 that banks should have a process for assessing and maintaining their overall capital adequacy, including board oversight, sound capital assessments, a comprehensive assessment of risks, systems for internal monitoring and reporting, and internal control review, and Principle 2 that supervisors should monitors banks compliance with Principle 1, and their ability to monitor and ensure their compliance. This supervisory framework puts a substantial burden on banks management information systems to ensure that the data in the system can be subjected to ready analysis and summarization, and that it provides rich metadata on creation and modification to allow adequate internal review. Finally, the Basel II framework imposes obligations on banks to provide information to the general public on their implementation of the requirements of the framework (Pillar III). These requirements are intended to encourage full compliance with the Framework through the normal processes of market discipline; generally, it seems clear that a fully Basel II compliant bank should be both a safer investment, and provide competitive market performance through its ability to operate with lower capital reserves. In order to provide the requisite information for the markets to come to accurate conclusions, reporting requirements include information on corporate structure, capital structure, capital adequacy, and risk exposure and assessment.

Implementation of the Basel II Framework

As a recommendation of the BCBS, the Basel II framework is not a binding instrument in either international or domestic law.14 Basel II is simply issued as a set of norms to inform the development of a consistent international system of banking regulation. Therefore, in order for the framework to have any binding force, it must be explicitly implemented in the domestic legal frameworks of countries in which it will apply. Already, APRA,15 the Australian financial services industry regulator, has announced that it will be implementing the framework from the first quarter of 2008,16 the US SEC17 has announced that they will be imposing the Basel II requirements on the Big 10 international banks from 2007/8,18 and the British FSA has stated that
13 14

Basel II, para 723. Felsenfeld and Bilali, The role of the Bank for International Settlements in Shaping the World Financial System, 25 U. Pa. J. Intl Econ. Law 945 at 991; see also Basel Committee on Banking Supervision, The Basel Committee on Banking Supervision, http://www.bis.org/bcbs/aboutbcbs.htm, last accessed 7/2/05. 15 The Australian Prudential Regulation Authority. 16 See Bernie Egan, APRA Update: Basel II Implementation in Australia, The Australian Financial Reviews 5th Annual Banktech Conference,14 September 2004, http://www.apra.gov.au/Speeches/04_15.cfm, last accessed 31/1/05, p. 2. 17 The Securities and Exchange Commission. 18 See Federal Deposit Insurance Corporation, Interagency statement U.S. Implementation of the Basel II Framework Qualification Process IRB and AMA, http://www.fdic.gov/news/news/press/2005/pr0305a.html, last accessed 7/2/05. w w w . t o w e r s o f t . c o m 3

they will implementing the accord.19 The European Central Bank, while it has not made a formal announcement yet, was deeply involved in the drafting process, and has expressed its positive opinion of the framework.20 Implementation in the other G10 and European countries is likely to follow at the same pace,21 given the involvement of these countries central banks in the development process for the agreement. Moreover, there are a number of reasons to think that major international banks will have to adopt the principles enshrined in the agreement, and should prepare to do so. Firstly, the experience of adoption of the first Basel agreement has been very positive. The principles it established have been implemented in over 100 countries despite its non-binding status. Moreover, the reputational nature of the international economic system has meant that most major banks have felt that it was necessary to implement its principles regardless of legislative enforcement (indeed, many conservative banks over-comply with its principles, and the Pillar III requirements of the Basel II framework are directed towards ensuring just this form of pressure to implement.) Secondly, and extraneous to the Basel II framework, many developed countries have already begun to seriously examine the issue of corporate governance in large companies, including financial corporations. Disasters such as the collapse of Enron have led to legislation imposing new and stricter standards of accounting discipline, such as the Sarbanes-Oxley Act in the United States. Continuing legislation in this area means that the interests of international financial regulators and domestic corporate legislators are rapidly converging.

TRIM Context and Basel II

Compliance with Basel IIs stringent requirements with respect to process and data management, economic modeling, and disclosure requirements necessitate a sophisticated information technology framework. Systems which hope to provide a full solution to the information management challenge posed by the Basel II framework must meet a number of basic requirements. At the most practical level, Basel II systems must be highly scalable to cope with the heavy loads generated by day-to-day banking business and data analysis. In terms of implementing the present requirements of the framework, Basel II systems must be capable of organizing rich metadata, presenting both a contextual and hierarchical approach to the data. In order to comply with the internal process auditing requirements they must have solid abilities to verify the authenticity of records, and enforce the adequate and accurate entry of metadata at creation. They must also be capable of aggregating financial data,
19

Hector Sants, Basel 2 Implementation, Speech to the FSA Annual Public Meeting 15/7/04, http://www.fsa.gov.uk/pubs/speeches/sp190.html, last accessed 31/1/05, Para 915. 20 Jean-Claude Trichet, The International Financial Architecture Where do we stand?, http://www.ecb.int/press/key/date/2004/html/sp040614.en.html, last accessed 31/1/05. 21 Other countries planning implementation include Canada: Office of the Superintendent of Financial Institutions Canada, Consultative Paper on the new Basel II Framework, August 13 2004, p. 9, http://www.osfi-bsif.gc.ca/eng/documents/guidance/docs/Basel_II_Aug2004_e.pdf, last accessed 31/1/05; Korea: Choi Kyong-ae, Korea to Introduce Basel II by 2007, The Korea Times, 21/12/04, http://times.hankooki.com/lpage/200412/kt2004122116311410230.htm, last accessed 31/1/05; and the UAE: Ibrahim Taha, UAE banks to adopt Basel II by 2006-end, Khaleej Times, 3/1/05, http://www.khaleejtimes.com/DisplayArticle.asp?xfile=/data/business/2005/January/business_January3 2.xml&section=business, last accessed 31/1/05. The EU will be issuing a Capital Requirements Directive instructing EU national governments to implement the framework in their domestic laws: Financial Services Authority, Basel 2/Capital Requirements Directive, http://www.fsa.gov.uk/international/1_caf.html, last accessed 31/1/05. w w w . t o w e r s o f t . c o m 4

applying complex models to them, and providing statistical data by which to judge and improve the efficiency of the internal data models employed by the bank. Ideally, they should also be capable of taking some of the pain out of the stringent reporting requirements by automating the document production process. Finally, Basel II systems must be capable of future extensibility and flexibility, given the continuing evolution of international banking standards which is likely to occur, and the allowance in the Framework for the evolution of internal models. TRIM Context can provide solutions to these requirements through its core functionality and through the rich SDK it makes available to developers. Much of the required functionality with respect to data authenticity (authoring and change tracking), metadata, structure, and scalability is already in place in the basic package. Using the SDK to extend the functionality of Context can allow banks both to comply with the current requirements of Basel II and their domestic supervisors, as well as providing the functionality required for them to maintain control of the extensibility of their product into the future. Thus Context can provide a forward-looking solution to the current challenges posed by the new framework.

Conclusion
The complex and onerous internal review obligations set out in Basel II present some profound challenges to international banking corporations. Implementation of adequate enterprise management systems will require a substantial investment in planning, integration, and training. These difficulties, however, are more than offset by the potential advantages in efficiency, accuracy of risk assessment, and accountability which properly organized enterprise management systems will provide to institutions implementing the Basel recommendations. The transition period is likely to be painful, but ultimately the world financial system should be the better for it.

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About TOWER Software TOWER Software delivers Electronic Document and Records Management (EDRM) Solutions, empowering organizations to take control of their corporate information assets. TOWER Software's award-winning TRIM Context solution is a single, integrated platform that manages business information throughout its complete lifecycle. By relying on its proven domain expertise, strong strategic partnerships, and powerful solutions, TOWER Software enables organizations to maintain accuracy, maximize efficiency, and achieve and maintain standards compliance across industries, resulting in sustained competitive advantage. TOWER Software is a privately held company with operations in North America, Europe and AsiaPacific. For more information, visit www.towersoft.com.

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