Sunday, November 28, 2010

Challenges of Basel II implementation in Indonesia

After previous talks about the grand institutional and regulatory set up (re: discussion on OJK), lets step back for a minute and think about the challenges faced by the Indonesian regulator when Basel II is implemented (planned 2011 for Pillar 1). One way is to learn from experience in other countries having comparable conditions as Indonesia. The article describes the discussion before the Basel II era in India and several implementation challenges.

One of the pitfalls mentioned is related to the very limited rating penetration by external rating agencies. Moreover, ratings are often restricted to issues, not issuers.

Encouraging banks to adopt Internal Rating Based Approach is neither practical nor prudent, even for larger banks, which perhaps have staffs and infrastructure to carry out the program. If the banks are able, the question still is if the regulator has adequate capacity to supervise and validate rating models in the first place.

So, it will be sensible like in many other countries to require all banks to first adopt the standardized approach for credit risks and allow them to migrate to the IRB approach after several years.

This being perfectly understandable, implementation of Basel II will only be worth doing (in the Indonesian case after a delay of multiple years ...), if, among others, rating activities of external rating agencies are thriving and their quality of works is well overseen.

Today, Committee of European Banking Supervisors (CEBS) issues a guideline on the recognition of external credit assessment institutions. You know..., the track record and practices of ratings agencies have been heavily under attack. It is only proper that the supervisor starts to subject them to inspection mechanisms and better oversight.

While the need of more regulatory support for rating agencies sector is the main message of today's post, I find it equally important that Bank Indonesia has a framework to build national rating institutions according to good standards. Here is the mentioned CEBS publication.

Sunday, October 3, 2010

Applying for Basel III without Basel II experience?

The final Basel III proposal, pending ratification in G-20 meeting in Seoul next November 2010 is expected to pose no problem for the Indonesian banking sector.

How true is this claim?

Unlike Basel II, which is more a substitute for Basel I, Basel III refers to a combination of the (revised) Basel II capital framework and the new global capital standards . For instance, the Pillar 2 supervisory process and the banks' own assessment of capital adequacy (ICAAP) will remain key elements of the Basel III framework. As indicated in a summary below, increased capital requirements under Basel III are still expressed in term of the risk weighted assets (RWAs) calculated according to the (revised) Basel II parameters.

Implementation of Basel III is aimed to considerably increase the quality of banks' capital and level of their capital. It is also intended to reduce systemic risks. Another important aspect is the introduction of new global minimum liquidity standards that promote banks' short-term resilience to potential liquidity disruptions. It also provides incentives for banks to use stable sources to fund their activities and thus address funding mistmatches. New because no such international standards currently exist.

According to the IMF's Financial System Assessment (September 2010, see my previous post), a full implementation of Basel II in Indonesia is expected from January 2014 and Pillar I from 2011.

It seems obvious to me that a full adoption of Basel II should precede the claim of 'compliance' with Basel III!

Unfortunately thus, key regulatory initiatives (such as Basel II/III) are often communicated as a matter of application of formulae and compliance with, for example, a minimum capital adequacy ratio (CAR). However, high CAR would mean much less for financial soundness of banks without adequate risk management standards including sufficient loan provisionings, sound valuation and proper disclosures. All of these elements would normally be inherent parts of banks' implementation of Basel II's Pillar 2 and Pillar 3 requirements.

Stated differently, we cannot jump into the Basel 3 world without Basel 2 experience...