Eurochambres’ XI Congress - Rome, 9-10 October 2003
Workshop Session 1
“Entrepreneurship and Access to Finance”
The Basel II we need
(Head of Risk Management Dept.)
1 – The principles.
During the last few years, the debate on the virtues of a free market economy has been frequently blurred by problems created by the improper working of the “invisible hand” of the market in a deregulated context.
Savers’ anxieties, investors’ uncertainties, market instability, bankruptcies and losses of wealth, are some of the consequences that common wisdom traces back to the diffused opacity that, among other things, has impeded a clear understanding of the risks and a coherent reading of the connected rewards.
If we go through the New Basel Accord (N.A.)., it is clear that the Regulators’ efforts are addressed to facing the same issues stated above, enforcing the stability of financial and monetary markets by fostering the effectiveness of the banking industry in measuring, managing and communicating the risks involved in their activities and by establishing clear links between them on one hand and the capital to be kept as a cushion on the other.
From the principles perspective we can conclude that the business community couldn’t agree more on the need of having the New Accord implemented. Unfortunately, when we try to translate it into practice, these certainties are overcome by even stronger (and sometimes irrational) fears, mainly connected with the possible negative impacts on lending to small companies.
2 - The worries.
To detect where the worries stem from, I think we need to bear in mind that the complexity we are facing is twofold:
(a) on one hand some methodological issues are still open and, consequently, some of the suggested solutions might not be so convincing. As a reminder I would like to mention the discussions on the necessity to distinguish between expected and unexpected losses, on the most appropriate measure of the diversification effect that reduces the risk within small enterprise portfolios characterized by a high granularity, on the need to allow banks a more ample possibility of diversification among different activities and, finally, on the tricky question of procyclicality;
(b) on the other hand the task is not so easy because we are trying to set up and apply the same rules to countries characterized by different economic structures and business practices (e.g. default definition and pass-due management).
With cultural disalignments still in place and with a playing fields still unlevelled, any attempt, even if successful, to find a solution that fits them all, ends up necessarily in a greater complexity that is in itself worrisome.
The results of the 3rd impact study are telling in this respect.
The difficulty in interpreting (and applying) the complexity of the new rules, the effect of the compromises on the models chosen, as well as the differences in business practices, probably explain the uneven evidence of the study when referring to different countries and different banks. Moreover, in some cases the most rigorous approach turns out to be penalizing for capital requirements, and this contradicts the aim of creating incentives for a more accurate measure of risk profiles.
3 - The narrow path to be singled out
In front of these complexities we must resist two opposite temptations:
(a) to take a step back, renouncing the application of the new rules to smaller companies and banks (that in any case will be allowed to use a simplified approach);
(b) to go ahead in any event, ignoring the pitfalls and potential distortions connected with a rigid implementation of the New Accord.
I see no point in adding comment on the latter as the current debate is already overstating it.
On the contrary, I think that there is not sufficient focus on the fact that the former could weaken the setting up of the common market we Europeans are working towards.
This is because:
(a) an effectively levelled playing field cannot be conceived without rules applicable to all players on the market stage.
Among these rules, those related to a transparent measurement of the riskiness of a given activity are pivotal in allowing an efficient allocation of resources (mainly savings) in a sound market economy;
(b) permitting some opacity could be particularly detrimental for small companies, that must be helped to face the “chilly winds” of the competition and not protected from them artificially.
The sharing of transparent rules on the risk side, as Basel II implies, increases the degrees of freedom for small companies, not only by significantly reducing subjectivity and opacity in their banking relationships, but also because it represents the prerequisite (necessary condition) for opening up their access to financial markets that are wider then the banking ones.
So, also in this respect, our conclusion can be nothing less than favourable to the implementation of the N.A., even if we probably need to abandon a too rigid approach.
4 - Some suggestions
Now, the question to be answered is: what can be done to transform worries into opportunities and set up a meaningful risk-sensitive framework we need?
Probably in this respect some changes could still be carried out in some areas. For instance:
(a) to reduce the impact of the economic cycle on capital requirements, the possibility of quantifying the benefits of running diversified business activities could be considered (i.e. considering the risk within banking operations as a whole);
(b) to answer the worries of small companies, also the diversification effect within small business portfolios could be further revised, moreover reducing their capital requirements, even if a lot has already been done in this direction during the fatiguing revision process that ended up in text now under discussion.
The evidence that can be drown from a recent simulation carried out by Prometeia on a sample of 75,000 small and medium-sized Italian companies is telling in this respect. There are two aspects that I would like to underline:
(c) if we take the sample as a whole, applying IRBA the capital ratio is close to 7.5% and thus lower than the 8% in place. The saving is even greater for the small companies (with reported sales < 5 mln. €, and banking exposure < 1 mln. €), in which case we would have 4.8%;
(d) if we go through the figures from a different perspective, we find that we have an advantage for 76% of the companies included in the sample. This percentage increases up to 94% for the smaller ones.
These figures speak for themselves and fuel the suspicion that, at least in our country, worries stem much more from business attitudes and culture, than from technical drawbaks.
Some incentives could also be conceived for small companies in connection with their disclosure (transparency) towards the market. At the some time, probably, small companies should be helped to face the adjustments needed in a broader competitive arena, by appropriate economic policies;
(e) a reduction in capital requirements could also come from higher incentives for banks to move to the use of advanced measurement methods, i.e. those based on data supplied by the banks rather than on regulatory assumptions.
All this is particularly relevant if we consider the differences in the business practices prevailing in different countries;
(f) given so many country-specific business practices, it could be wise to simplify (at least at the beginning) the framework to allow a smooth convergence towards commonly shared rules. The required flexibility and strictness could, for a while, be assured by giving greater autonomy to the Supervisory Authorities of each country in interpreting and implementing the N.A. principles.
Now, with the New Accord within reach and with a debate that is involving not only bankers and regulators but the business community as a whole (at last I would say after 15 years of indifference), it would be a pity not to have a little more time to remove the most evident inconsistencies and to answer the remaining open questions.
I think that a good compromise between principles and practices can be found by working on the implementation steps.
Some more time, some more flexibility, some slight simplification and more autonomy delegated to the local Supervisory Authorities during the transition period, could help in a smooth approach toward the levelled playing field we need for the European market.
Some final words on the looming question regarding the negative impact of the N.A. on the availability of the financial resources that small companies should invest in innovation, both to upgrade their scale of production in an enlarging market and to face an ever more severe competition from outside Europe.
This issue is so relevant that it cannot be solved around the tables where only bankers and entrepreneurs meet. We do also need some specific economic policy that could help the market to face, and properly handle, the higher risks inevitably connected with small business’ operations, during cyclical discontinuity phases like the present one.