The new banking capital adequacy accord has brought new uncertainties for political risk and credit insurers, says Maria Kielmas

It has been 17 years in the making and represents a fundamental change in banking regulation. It is all about understanding, mitigating and controlling risk, and it is forcing banks to demonstrate just how far insurance addresses risk reduction. It has also become a headache for political risk insurers who fear it may reduce capital flows to emerging markets and short-term trade credit.

The International Convergence of Capital Measurement and Capital Standards: A Revised Framework - commonly known as Basel II (see box 1) - is due to be implemented at the end of 2006. The basic idea behind this framework is that banks should make provisions against losses and that pricing should reflect risk. Drafted by the Basel II Committee, which does not have the power to make it law, implementation of the accord is at the discretion of national governments.

But while governments worldwide have made positive comments about the new accord's ability to improve banking regulation, their willingness to bring the rules into force has been varied. Basel II will become obligatory in the European Union member states through the Capital Adequacy Directive.

But in early May four US banking agencies - The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision - said they would take more time to assess the impact of Basel II on the US banking industry overall.

Guarantees

Basel II has become a heightened issue for insurers too as 2006 approaches.

"It's become a behemoth," says Daniel Riordan, executive vice president and managing director of Zurich Emerging Markets Solutions. "This is about a bank's ability to recognise political risk insurance and credit insurance." This is not a concern about buying political risk and credit insurance but how much internal credit such cover provides in the bank's risk calculations.

This in turn depends on the definition of "guarantee", notes Nicholas Robson, a partner at JLT Risk Solutions.

The Basel II framework stipulates: "There should be no clause in the protection contract outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payments due". It states that a guarantee should be direct, explicit, irrevocable and unconditional. But political risk insurance is neither unconditional nor irrevocable and policies carry a long exclusion list - typically, wars between the five great powers, the insured's failure to comply with the laws of the host country, criminal activity, nuclear/biochemical events etc.

Further complicating this issue has been internationally-operating banks' tendency since the mid to late 1990s of buying political risk insurance against the non-honouring of state guarantees and of arbitration award default. Such cover came about as a result of emerging market financial crises in the 1990s when standard expropriation cover was viewed by some insureds as too difficult to prove in projects where their investment vehicle had important contracts with host state entities, and the host state acted in a manner to frustrate the performance of these contracts.

If such insurance cannot mitigate risks adequately under the Basel II rules, then banks may opt to curtail their funding of such projects in emerging markets

"The concern is that we are creating a regulatory environment which distorts the price benefit of political risk insurance," says Michael Lempres, vice president of insurance at Overseas Private Investment Corporation (OPIC). "Whilst OPIC can provide financial guarantees under certain circumstances, there is a limit to how many such guarantees the agency can issue."

Multilateral solutions

However, policies from certain multilateral development banks (MDBs) can meet the new Basel II criteria under a footnote in the framework document (footnote 20) that was negotiated by them at the Basel Committee deliberations.

Such MDBs must have: very high quality issuer ratings; a strong shareholder structure comprised of a significant proportion of sovereigns with long-term issuer credit assessments of AA- or better; strict statutory lending requirements and conservative financial policies; an adequate level of capital and liquidity; and strong shareholder support. MDBs currently eligible for such a 0% risk weight are those of the World Bank Group comprising of the International Bank for Reconstruction and Development and the International Finance Corporation, the Asian Development Bank, the African Development Bank, the European Bank for Reconstruction and Development, the Inter-American Development Bank, the European Investment Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean Development Bank, the Islamic Development Bank and the Council of Europe Development Bank.

According to Peter Jones, head of reinsurance and operations support at the Multilateral Investment Guarantee Agency, the political risk insurance arm of the World Bank Group, such an MDB guarantee for a loan to a developing country financial institution may raise that institution's internal credit rating from say, BB+ to A, and result in a significantly lower cost for borrowing. A report by the United Nations Conference on Trade and Development (UNCTAD) noted that developing countries are handicapped as advanced banks apply a 1.1% charge for lending to a single-A borrower but 23.3% to a single-B-minus borrower.

Innovation

In the absence of such guarantees, sophisticated international banks will become more selective in their lending to riskier economies and projects.

Peter Jones thinks that this could force smaller banks into such higher risk business. In addition, there will be less capital applied to short-term trade credit, making that also more expensive and curtailing the ability of a developing country to trade properly. OPIC's Michael Lempres believes that financial flows into project finance in emerging markets will also be restricted and become more expensive.

But product innovation is moving apace. Alistair Mole, a member of the political risk insurance team at the Benfield Group says Benfield can arrange guarantees for clients rather than political risk insurance. This works as an alternative to the bank syndication market. Such products are developed in consultation with banks' credit committees as well as the state agencies. Nevertheless a lot of banks will still have to develop a stronger understanding of capital adequacy and risk rating. "There is a lot of difference between what banks are looking for, what (their) credit committees want, and what the market is offering," Mole observes.

Websites:

www.bis.org
www.unctad.org
www.isda.org

- Maria Kielmas is a freelance journalist and consultant.

Regulation Box 1 - Basel II and the three pillars

Central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries* (the Basel Committee on Banking Supervision) endorsed the publication of the "International convergence of capital measurement and capital standards: a revised framework" - the Basel II Framework - in June 2004. This sets out the details for adopting more risk-sensitive minimum capital requirements for banking organisations.

It lays out principles for banks to assess the adequacy of their capital and for supervisors to review such assessments to ensure that banks have adequate capital to support their risks. It also seeks to strengthen market discipline by enhancing transparency in banks' financial reporting.

This framework builds on the 1988 Basel I Accord that offered a set of standards for establishing minimum capital requirements for banking organisations and stipulated an 8% ratio of capital to risk-weighted assets. The Basel Committee intends for the new framework to be available for implementation in member jurisdictions as of year-end 2006. The most advanced approaches to risk measurement will be available for implementation as of year-end 2007.

The goal of Basel II is to promote adequate capitalisation of banks and to encourage improvements in risk management. This will be accomplished through the introduction of "three pillars" that reinforce each other and that create incentives for banks to enhance the quality of their control processes.

1. "Pillar 1" - Minimum capital requirements

Basel II improves the capital framework's sensitivity to the risk of credit losses generally by requiring higher levels of capital for those borrowers thought to present higher levels of credit risk, and vice versa.

Three options are available to allow banks and supervisors to choose an approach that seems most appropriate for the sophistications of a bank's activities and controls. Under the "standardised approach" to credit risk, banks that engage in less complex forms of lending and credit underwriting and that have similar control structures may use external measures of credit risk. Banks that engage in more sophisticated risk-taking and that have developed advanced risk management systems may, with the approval of their supervisors, select from one of two "internal ratings-based" approaches to credit risk.

The framework establishes an explicit capital charge for a bank's exposure to the risk of losses caused by failures in systems, processes, or staff or those caused by external events, such as natural disasters. As in their management of credit risk the banks may choose one of three approaches to measuring their exposures to operational risks that they and the supervisors agree reflects the sophistication of their internal controls over this particular risk area.

The framework provides explicit incentives in the form of lower capital requirements for banks to adopt more comprehensive and accurate measures of risk as well as more effective processes for controlling their exposures to risk.

2. "Pillar 2" - Supervisory review

Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial action.

The dialogue between supervisors and banks about their internal processes for measuring and managing risks should help to create implicit incentives to develop sound control structures and to improve those processes.

3. "Pillar 3" - Market discipline

This sets out the public disclosures that banks must make and that lend a greater insight into the adequacy of their capitalisation. The Basel Committee believes that when marketplace participates have a sufficient understanding of a bank's activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations.

* The G10 countries are Switzerland, US, UK, Japan, France, Germany, Sweden, Belgium, Canada, Spain, Luxembourg and the Netherlands.

Regulation Box 2 - Does insurance qualify for regulatory capital relief?

"There is no doubt that regulators have been disappointed by recent insurance failures and are nervous about accepting insurance in place of regulatory capital," said Richard Green, Marsh UK's practice leader for operational risk at a conference in March. The Basel Committee has highlighted the following issues that need to be taken into consideration when analysing the effectiveness of risk transfer under an insurance contract.

Counterparty credit risk

Insurance is unfunded in the sense that it is a promise to pay later.

Under such circumstances the protection buyer is always exposed to the financial collapse of the protection seller.

Liquidity risk

The time that elapses between a claim being submitted and a claim being paid can be considerable. In this way an insurance policy may be considered a relatively illiquid instrument.

Legal risk

Where the contractual terms of coverage are unclear, or where the protection buyer and protection seller have different views on the extent of coverage, there is a greater likelihood that payment will either be denied or litigated.

Duration of coverage

As the remaining term of a policy diminishes there is a greater uncertainty regarding the insured's ability to obtain similar coverage on expiry.

Cancellation provisions

Coverages that permit the insurer to cancel cover prior to the expiry of the policy term may be of limited value in a regulatory environment.

Given these concerns, the Basel Committee has chosen to limit the potential credit available for insurance obtained to mitigate operational risk exposures to a maximum of 20% of the operational risk regulatory capital requirement.

Richard Green adds that many financial instruments avoid these issues altogether and are therefore looked upon more favourably by regulators.

A securitisation is funded in the sense that the investors have to buy the notes up front and hence the "sum insured" is collected in advance.

This serves to reduce counterparty credit risk and liquidity risk. Credit default swaps are most commonly transacted on the International Swaps and Derivatives Association documents that are standardised, and hence the scope for legal risk is greatly reduced. In addition, financial instruments are often non-cancellable and multi-year in duration.