Basel II: Reducing the Capital Charge in Banks with Insurance

257 Basel II: Reducing the Capital Charge in Banks with InsuranceNFT 3/2003 The 1988 Basel Capital Accord The current capital adequacy rules are based on the Basel Capital Accord finalized in 1988 (the 1988-Accord). In this agreement, look- ing to secure stability in the international financial system, the G-10 countries adopted a common regulation for setting up reserves in banks covering unexpected losses in the in- dustry. The current capital adequacy rules states that a bank should hold a capital of at least 8% of their total risk exposure to cover such unexpected losses. Changes in the financial markets, the devel- opment of new instruments, together with experiences from financial crises, came to increase the awareness of the need for a new and updated version of the capital adequacy regulations. In December 1998, 10 years after Basel II: Reducing the Capital Charge in Banks with Insurance Fredrik Engman fredrik.engman@ikano.lu Fredrik Engman, M.Sc, is Assistant Treasurer at IKANO Capital S.A. in Luxembourg. Basel II will in many ways change the way that capital allocation in credit institutions and investment firms is calculated. In the proposed regulatory framework, due to come into effect end 2006, fundamental changes have been made to how the capital charge for credit risk is decided. In addition, a new capital requirement to cover operational risk has been introduced. The term operational risk cover faults, mistakes, crime or accidents and include legal risk, basically insurable risks. Recent empirical evidence shows that the overall capital charge is adversely affected by this inclusion. The negative effect may however be significantly reduced by way of insurance. This paper reviews the changes in regulatory framework and give recommendations to how firms affected by Basel II should best prepare and manage these changes. the 1988-Accord, the Basel Committee com- menced their work to provide a new and improved regulatory framework1. The New Basel Capital Accord (Basel II) On 29 April 2003 the Basel Committee on Banking Supervision (the Basel Committee) issued its third and final consultative paper (CP3) for a New Basel Capital Accord (pop- ularly known as Basel II). Basel II is to be implemented by the end of 2006 for interna- tionally active Credit institutions and Invest- ment firms2. For the European Union this will mean that the framework need to be incorpo- by Fredrik Engman 258 Basel II: Reducing the Capital Charge in Banks with Insurance rated in European legislation first on a EU level and later on a national level. Overall, the new Basel II regulations differ from the 1988-Accord in a number of re- spects. Specifically, in the calculation of risk weights, two major changes can be found: 1) change in methodology to calculate the risk weight for credit risk, and 2) the addition of a specific capital requirement for operational risks. In what follows, the impact of the addition of the specific capital requirement for opera- tional risk shall be studied. It will be shown that existing and new insurance policies will reduce the overall requirement for capital allocation to cover operational risk. We shall for now not consider the changes to method- ology to calculate the risk weight for credit risk. How insurance techniques can be used to mitigate adverse changes to risk weights for credit risk will be covered in a later paper. Operational risks The Basel Committee defines operational risk as "the risk of direct of indirect loss resulting from inadequate or failed internal processes, people and systems or from external events, including legal risk"3. Operational risk would therefore, as defined, include risks from fault, mistake, crime or accidents where the bank is hit directly or indirectly, basically risks that can be insured. The reasoning behind the inclusion of a specific capital charge for operational risk is that it has been shown by empirical evidence that banks allocate capital to cover for opera- tional risk. The Basel Committee has judged it necessary to provide an explicit regulation that governs the level of capital covering such risks. Based on empirical evidence the Basel Committee has estimated that approximately 20% of the total capital requirement should be attributed to operational risks.4 In order to estimate the operational risk in a bank, the Basel Committee has provided three alternative methods; the Basic Indicator ap- proach; the Standardised approach; and the Internal Measurement approach. The first two are less complex standardised measures, whereas the third more advanced Internal Measurement approach will require compa- nies to comply with comprehensive demands from regulatory authorities e.g. show and explain the method leading up to the capital requirement. The Basic Indicator approach The Basic Indicator approach is as the term suggests a simple model where capital re- quirement is based on one single measure. The banks must hold a capital equal to 15% of average annual gross income from the imme- diately preceding three-year period5. The Standardised approach Under the Standardised approach to deciding capital allocation for operational risk, the bank is divided into eight operational areas. The bank must hold, depending on area, 12% to 18% of average annual gross income from the immediately preceding three-year period. The Internal Measurement approach The Internal Measurement approach is an advanced method, where the bank may use own systems to measure the existence of op- erational risk and to allocate capital accord- ingly. Operational risk and capital charge In a recently published 3rd Quantitative Impact Study (QIS 3), the Basel Committee presents a survey of 350 banks under regula- tion, estimating how the new regulations would affect the capital requirements in these com- panies. As can be seen in Table 1 the overall change in capital charge fundamentally de- pends on what approach for evaluating credit risk is used, with an adverse change for the Standardised approach and a neutral or posi- 259 Basel II: Reducing the Capital Charge in Banks with Insurance Table 1. Estimated change in capital requirements in the New Accord 7 Standardised IRB Foundation IRB Advanced Entity Average Max Min Average Max Min Average Max Min G10 Group 18 11% 84% -15% 3% 55% -32% -2% 46% -36% G10 Group 29 3% 81% -23% -19% 41% -58% Source: Quantitative Impact Study – Overview of Global Results Table 2. G10 countries – Main contributors to change, without insurance Standardised Foundation IRB Advanced IRB Change Group 1 Group 2 Group 1 Group 2 Group 1 Group 2 Overall credit risk 0 -11% -7% -27% -13% n/a Operational risk 10% 15% 10% 7% 11% n/a Overall charge 11% 3% 3% -19% -2% n/a Source: Quantitative Impact Study – Overview of Global Results Table 3. G10 countries – Main contributors to change, with insurance Standardised Foundation IRB Advanced IRB Change Group 1 Group 2 Group 1 Group 2 Group 1 Group 2 Overall credit risk 0 -11% -7% -27% -13% n/a Operational risk 8% 12% 8% 6% 9% n/a Overall charge 8% 1% 1% -21% -4% n/a Reduction with insurance -27% -67% -67% -10% -50% n/a tive change under the two IRB approaches6. This is on the aggregated level, where the separate changes to risk weight for credit risk and operational risk has not been shown. We are here especially interested in learning how the introduction of a specific requirement for capital allocation to cover operational risk affects the overall change to risk weights. Table 2 takes the average changes from Table 1, and split them per main contributors to change. We clearly see that the overall capital charge is very much dependent upon the operational risk element, that increases the overall charge for all groups, under all ap- proaches. Reducing capital charge by way of insurance In Basel II there is however a possibility to reduce the capital charge to operational risk by way of Insurance. In CP3 the maximum allowed amount of insurance is suggested to be 20% and where the insurance protection is required to come from a third party insurer (thus reducing the possibility to include cap- tive insurance companies as direct insurers). In a joint letter dated 31 July 2003 to the Basel Committee, strong criticism to both the 20% cap of insurance and the requirement of third party insurers has been voiced by two leading international branch organisations10. They argue that a cap reduces the incentives to insure against operational risks, and note that it may in fact give banks incentives to self- insure certain specific operational risks, where by treating the risk as an expected loss (which may in principal be excluded from the capital requirement). However, even with a maximum amount allowed amount of 20% insurance shows to provide a good mitigation effect against an increase in capital charge due from operation- al risk. Table 3 illustrates how the change in capital charge due from operational risk is affected by introducing the maximum allowed amount of insurance (20%). As can be seen in the above, the overall capital charge in Basel II will change from the 260 Basel II: Reducing the Capital Charge in Banks with Insurance 1988-Accord, a change ranging from an 11% increase to a 21% decrease. With insurance these changes will reduce significantly, at its best a 67% reduction to the change in capital charge (going from 3% to 1%). Conclusion Remember the definition of operational risk set out by the Basel Committee that would include risks from fault, mistake, crime or accidents where the bank is hit directly or indirectly. These risks would under normal situations already be addressed in insurance programmes in a bank or other regulated company. For companies where insurance exist, a review of insurance programmes in the light of Basel II should be launched. The question of self-insurance (and excluding certain risk from the capital requirement by expected loss treatment) should be considered. Also, the insurance policies in captive insurance com- panies must be reviewed. If the Basel Com- mittee does not change the third party insurer requirement, insurances of operational risk written by direct insurance captives, would not be allowed as a risk-mitigating factor. Furthermore, a cost benefit study should be considered where it is possible to adjust pro- grammes in order to maximise the use of insurance to reduce the capital charge for operational risk. Any regulated companies currently unin- sured for risks mentioned above, should look at insuring these risks to take advantage of the mitigating effects of insurance. Following from what is stated above, it must be considered important to review insur- ance policies and programs. Using insurance, banks will be able to optimize their overall capital charge. This will be a paramount ele- ment in upholding a banks competitiveness and international success. Notes 1 The Basel Committee for Banking Supervision includes: Belgium, France, Italy, Japan, Cana- da, Luxembourg, the Netherlands, Switzerland, Sweden, Great Britain, Germany and the United States. 2 The meaning of ‘Credit institutions’ is defined in Article 1(5) of Directive 2000/12/EC, and the meaning of ‘Investment firms’ is defined in Article 1(2) of Directive 92/22/EEC – with some specific exclusions. 3 Overview of the New Basel Capital Accord, §607, page 120. 4 Critics to the inclusion of operational risk argue that this risk is idiosyncratic in nature, and could as such never pose a systematic threat to the system. They say that these risks are issues of management and that eventual bad management should be eliminated from the systems by other means, e.g. bankruptcy or take-overs. 5 The New Basel Capital Accord, Appendix IV, page 216. 6 The difference between Group 1 and Group 2 is mainly contributable to a larger proportion of retail exposure in the smaller Group 2 banks that, under Basel II, work favorably to reduce the capital requirement. 7 It should be noted that the data in QIS 3 show rather large standard deviation. The impact from the new regulation vary a lot from bank to bank as can be seen in the big gap between the mini- mums and maximums. 8 Generally large, diversified and internationally active banks with capital in excess of EUR 3 billion. 9 Generally smaller in size and activity than Group 1 banks. In many cases more specialized. 10 International Swaps and Derivatives Associa- tion (ISDA) and The Bond Market Association (TBMA).