Critics fire conterblast at damaging op risk impact
WASHINGTON - In a counterblast to regulators who suggest that a capital charge for operational risk will have no competitive impact, Financial Guardian Group (FGG), a Washington-based advocacy firm, published in February a study arguing that the proposed charge will actually have serious, adverse implications.
Around two dozen banks in the US may be subject to an operational risk capital requirement when the new, risk-based Basel accord takes effect in 2008, under present proposals. Some nine of these banks will be obliged to apply the new accord - Basel II - while others are expected to voluntarily comply with it.
The FGG study* says the operational risk capital charge is potentially a $67 billion cost to US banks adopting Basel II - a capital requirement "that is all burden and no benefit." Indeed, argues the study, it creates a perverse incentive against effective disaster preparedness because essential resources will be diverted from critical infrastructure protection to capital compliance.
A capital charge for op risks such as fraud, systems failures, and payments foul ups, would not have helped to deal with the business impact of the attack on the New York twin towers in September 2001, say critics of the op risk charge.
Moreover, because the regulatory capital charge is sharply different from the amount of capital that the market thinks right to buttress operational risk, banks subject to it will also experience serious adverse consequences, says the study, written by FGG senior counsel Christopher Young. One consequence is that it could trigger bank mergers that would lead to undue concentration, "with negative systemic risk, and customer service impact."
The right solution, the study argues is for operational risk to be addressed under pillar 2 of the new Basel accord. While pillar 1 sets the minimum capital requirement, pillar 2 involves supervisory evaluation of a bank's risk controls and systems. This approach, the study says, would eliminate the proposed new regulatory capital charge unless, or until the charge is proved to be well aligned with a bank's allocation of economic capital - the actual capital regarded as necessary to support the business.
The banks that feel that they will be particularly hit are those that specialise in services such as securities custody, payment processing and asset management, but have relatively small loan books. Such banks include State Street, Northern Trust, Bank of New York, and Mellon Financial (which is believed to be a client of FGG). They say they will not be able to offset the op risk capital charge against possible reductions in credit risk capital under Basel II - unlike big lending banks. And, they will also be at a competitive disadvantage against non-banks engaged in the specialised areas, who will not face the op risk charge.
Hitting back at a recent Federal Reserve study that concluded the Basel II op risk capital charge would not have an impact on competition between financial institutions in the US (see previous story), the FGG study suggests that the inadequacy of the data does not permit such a conclusion. The Fed study's assessment that non-banks already hold enough economic capital to cover their op risks "is based on inference and does not reflect the major problems measuring risk, which has been separately acknowledged by the Federal Reserve," says the FGG.
The FGG's estimated $67 billion cost of the op risk capital charge is based on an assumption that the top 25 banks in the US will be obliged to comply with the Basel II requirements or will opt to comply. It also uses official estimates that the op risk charge will add 13% to regulatory capital. However, it does not allow for any offsetting reduction in capital held against credit risk, even though the likelihood of some big banks benefiting from such offsetting reductions is a crucial part of the FGG case that Basel II will have an unfair competitive impact.
*The Risk of Operational Risk-based Capital: Why Cost and Competitive Implications Make Basel II's Requirement Ill-Advised in the United States
