Countdown to compliance

While the Basel II framework is widely regarded as a positive step in managing and mitigating risk in the financial services sector, many of Australia's ADIs – which are yet to see the final version of the new framework – are becoming increasingly frustrated in the run up to its January implementation.

The aim of Basel II is to create much-needed incentives for better risk measurement and management practices, including securitisation exposures and liquidity lines, among banks, building societies and credit unions.

Australia's ADIs have been introducing the new framework gradually over the last few years and already the changes are claimed to be actively encouraging lenders to improve their risk management practices, as well as boosting investor confidence in the RMBS markets.

But the adoption of Basel II has been a lengthy process in Australia – and the regulators have copped some flack as a result.

Weak at the needs?

Abacus' senior policy and public affairs advisor Mark Degotardi says he appreciates the benefits of Basel II in improving the financial sector's overall approach to risk management, but he says more could have been done to help ADIs prepare for the implementation deadline. He's also concerned that a final version of the framework has yet to be released.

"We're disappointed," Degotardi told Mortgage Business. "It's [the Basel II framework] been a long time coming. At this point we're concerned that with the final date rapidly approaching we still haven't seen a final copy of the standard."

There are concerns that any further changes ADIs would need to introduce to comply with the new framework – especially IT infrastructure that needs to be built or applied – could take months. In particular, any changes to reporting methods could create considerable work for organisations already under the pump.

Wayne Nagle, manager of finance and administration at Hume Building Society, says while the run up to implementation has been "time consuming", making the necessary changes to comply with the framework has not been too onerous a task.

Nagle says understanding the ins and outs of the framework and doing the preliminary work took time, but implementation has generally been a smooth process.

"For Hume Building Society, that specifically involved determining how much capital to allocate, but overall implementing the framework has been fairly straight forward."

Nagle says Basel II is essentially a different method of calculating capital allocations that will not impact greatly on Hume Building Society.

"All ADIs have been calculating for APRA for a very long time. This is just a different format," he says.

While the lending sector has always been subject to regulatory change, 2007 has been a particularly significant year. Many argue that new regulatory and compliance requirements have placed a significant strain on the resources of smaller ADIs in particular.

The CEO of Community First Credit Union John Tancevski agrees that the sector is facing compliance overload. "The sheer number and size of compliance burdens forced onto the financial services sector in the last few years has been expensive and time consuming," he says.

Abacus' Degotardi is concerned that some industry members may be suffering from "compliance fatigue" and may struggle to adjust their infrastructure if any changes are made to the final Basel II framework.

Degotardi says the burden of complying with any last minute changes may place significant pressure on the sector's smaller organisations.

"Introducing new infrastructure – whether it needs to be built or applied – costs money. Any changes that need to be made to reporting methods would create a lot of work for smaller institutions and would cause a significant amount of concern."

Implementing the IT infrastructure needed to support Basel II is rated amongst lenders as the most difficult and costly aspect of implementation.

Says Nagle: "The greatest job has been making sure our database is complete and accurate, ensuring all LVRs are correct."

According to Nagle, allocating resources to Basel II has been challenging when coupled with other current compliance challenges. Still, he says Hume Building Society is meeting the challenge of Basel II.

"We're confident that we'll have everything ready by the first reporting deadline of March 31. There's also 14 days leeway – so we have until mid-April if necessary," Nagle says.

Changes afoot

For smaller lenders like mutuals, the new regulations under Basel II are arguably less restrictive – reducing the percentage of capital required against loans from 50 per cent to 35 per cent: a bold move given the recent US sub-prime fall out.

According to Basel II program director Bernie Egan, the new capital requirements will be more "granular" in their assessment and therefore risk sensitive.

"APRA has developed a 20 'bucket' grid which will take into account LVRs, whether the loan is standard or non-standard [i.e. low doc] and whether or not the loan has mortgage insurance," Egan says.

But according to Tancevski, the lower risk costs aren't much of an incentive for mutuals when it comes to risk management.

"As a credit union using the standardised approach, the impact on our capital will be neutral. The banks, however, using the more complex models may get a small capital concession. The intent of Basel II was never to provide our competition with any 'free kicks'," says Tancevski.

The perceived advantage the bigger banks have is a sore point with other sectors of the lending industry, with claims it will impact significantly on competition.

The non-bank sector, for example, it's not directly affected by the framework, but it will still be competing against ADIs in the securitised market. Not all are happy about the situation.

Under the new framework's guidance, ADIs will be required to maintain less capital by retaining lower-risk assets such as standard prime loans – something that concerns RESIMAC's director of securitisation Mary Ploughman.

"With lower capital standard loans, the cost of originating these loans will be lower which may stimulate further competition in the mortgage market," says Ploughman.

With the transition deadline fast approaching, the absence of a final version of Basel II is the lending industry's main concern.

Degotardi says the prospect of changes being introduced retrospectively is a worry. For example, regulations that will apply to securitisation have yet to be released by APRA but a different capital treatment is expected to be applied retrospectively.

"It seems unfair to change the rules after the fact. Having the right framework in place is extremely important but smaller lenders simply do not have the money or time needed to apply changes to vehicles that have already been put in place," he says.

Tancevski is also concerned that APRA's powers to govern and 'tweak' the framework may make it harder for smaller operations in the lending industry to compete with the banks.

"APRA has the ability to change some of the framework to suit the Australian system. In principle that sounds acceptable so we would like them to consider the implications [for] the industry before they apply any discretion. Banks don't need any more advantages over the mutual sector."

Looking ahead

The deadline for comment on the final draft of Basel II has now passed, and APRA says it has heard and understands the lending industry's concerns.  But it's not making any guarantees.Says Egan in response to concerns around the lack of guidance on reporting methods: "APRA will carefully consider comments being made as part of the current round of consultation, including in respect of the draft prudential standard on Pillar 3, aspects of which are causing some angst within ADIs."

With time running out, Degotardi is hopeful there will be a chance to review the situation once the framework has been introduced.

Compliance issues aside, others such as Tancevski are questioning the overall value of the Basel II platform at a grassroots consumer level.

"Issues like FSR, Anti-Money Laundering and Counter Terrorism legislation and Basel II may improve the integrity of the financial services sector, but do they provide consumers with a better banking experience?" he asks.

While it's clear the big banks will be the winners from Basel II, it's too early to know by how much, particularly against the rest of the lending sector says RESIMAC's Ploughman.

Ploughman says it’s hard to predict the impact of the introduction of Basel II on mortgage and securitisation markets in the current credit environment, as the market is currently going through a period of re-pricing risk, she says.  "As originators of mortgages and securitisers of assets, RESIMAC and other non-bank lenders will undoubtedly be indirectly affected by Basel II as we compete against ADIs in the origination of mortgages and participate in the same securitisation market.''

ADIs will no longer receive significant capital relief when securitising standard loans which means they may choose to keep these assets on balance sheet. With lower capital for standard loans, the cost of originating these loans will be lower, which may stimulate further competition in the mortgage market.

“Whether the banks use securitisation as a diversification of funding play remains to be seen. The ADIs may choose not to compete in higher risk assets which demand greater capital.”

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The three pillars of Basel II

Pillar I: minimum capital requirements

ADIs must review all risks including credit, market and operational to assess their capital adequacy requirements

Pillar II: supervision requirements

APRA will assess the need for additional supervisory capital requirements of ADIs

Pillar III: market disclosure requirements

ADIs must make detailed disclosures of their risk management approaches and other data