The McDonough ratio and Basle II rules for banks

From an English name…

Banks are companies regulated by public authorities that want to prevent weakness in the credit system. In most European countries, banking rules are based on the 1988 Basle agreement, particularly on the international ratio of solvency, the so-called Cooke ratio, which sets the minimum capital that banks must set aside to mitigate risks on their various assets.
Current requirement is a minimum 8% solvency ratio. For the ratio's denominator, regulators use coefficients to weight banks' assets and off-balance sheet items. The 1988 rules are based on one-size-fits-all weightings for certain classes of borrowers and certain types of loans.
In the late 1990s, this approach began looking outdated, as it did not reflect either new financial instruments or the nature of the various types of risk carried by banks. In particular, it did not at all reflect loan guarantees, it put all borrowers on the same plane, and it gave too favourable treatment to government borrowings. Moreover, major international banks have improved their risk management, gradually developing tools and sophisticated models for measuring their true risk and calculating "operating capital" (as opposed to regulatory capital) for internal allocations of equity among their different divisions and business lines.

… to an American one

The Basle committee is headed up by William McDonough (1), includes banking inspectors from the main countries and meets at the Bank for International Settlements in Basle, Switzerland. The committee reviewed this issue and in June 1999 produced an initial consultative document. Since then, several consultative documents have been drafted, and the banks and national associations affected have been referred to numerous times.
Central banks of signatory countries will be responsible for implementing the agreement in their own countries, and a European directive will impose the new regulations on financial establishments in the European Union.
The agreement will become effective on 1 January 2006. During that year, the Cooke ratio will still be used, but on 31 December 2006 the McDonough ratio will become the sole standard.

An edifice built on several pillars

The Basle Committee sought a new standard for calculating capital requirements, based on banks' existing best practices. This is the first pillar of the reform. The committee added two other pillars, which will constitute a novelty in regulations: Pillar 2, which consists of a more elaborate monitoring procedures, with internal control rules and external audits; and Pillar 3, which consists of increased market discipline, including financial communication obligations for each bank.
The reform will have a major impact on IT systems for monitoring and calculating exposure, and in audits and internal control procedures. While major international banks have long been preparing for this change, which was enacted in part at their request, smaller banks and banks that are more oriented to the French market still have their work cut out for them in the next three years.
Pillar 1 will institute minimum capital not just for credit risk (losses due to borrower default) but also for operating risks (losses caused by breakdowns in the bank's internal procedures) and market risk (losses caused by erroneous or insufficient hedging on the fixed-income, currency or capital markets). 85% of a bank's capital will be assigned to hedging credit risks, 10% for operating risks and 5% for market risks.
There will be no change from the current 8% minimum requirement.

The denominator will be calculated differently

While the numerator will still be calculated on the same basis, under Basle II the denominator will change considerably from the Cooke ratio's one-size-fits-all asset weightings. Banks will have a choice of several approaches, depending on how their decision-making and risk management procedures are set up:

• The standard approach which is based on weightings set by regulators, which, in turn, reflect agency ratings;
• two approaches based on banks' internal ratings systems:
  - under the "foundation" approach the bank uses its own calculations for estimating the probability of borrower default;
  - under the "advanced" approach, the bank uses, in addition to its own calculations of loss given default, its exposure at default and the maturity of the asset.

These two latter approaches are based on models developed by US banks and, since the mid-1990s, by major European banks, to determine operating equity. Each borrower is assigned a probability of default on a scale with several rungs, and each loan is assigned a the residual loss after the guarantees and collateral kick in. The weighting used to calculate the denominator of the McDonough ratio will thus be a function of this default probability and of this loss in the event of default. Of course, the weighting will be calculated using a formula that reflects the probabilities defined by the bank, as well as the regulatory coefficient.

A difference in weighting

Under Cooke, a loan is 100% weighted, regardless of the credit-worthiness of the corporate or individual borrower and regardless of the loan's collateral. The only loans weighted less than 100% are to: 1) central government administrations or the public sector entities of OECD countries (0%); 2) advances to OECD banks (20%); or 3) involve off-balance sheet transactions, letters of credit (20% in the case of goods, 50% in all other cases) and bank-issued guarantees (50% for market guarantees 100% for financial guarantees). Real-estate lease financing is also weighted at 50%.
Under Basle II, the weighting will be based on a finer assessment of risks and, for the banks that choose this option, it will be based on the approaches already used in their in-house procedures. As a result, the same loan to two different borrowers will not require the same capital allocation; loans to borrowers with the same rating, but without the same financial structure or who have not offered the same collateral, will not consumer the same amount of capital.
In retail banking (loans to individuals and professionals and certain SMEs) the standard approach is mandatory. The rules are a little less strict than under the current system, in particular for real-estate mortgages (weighted at 35%) and loans of less than €1m to small companies (weighted at 75%).

For specialised and structured financing, some banks managed to win their argument on covenants, collateral and guarantees. Letters of credit and market guarantees outside the bank's home country which are backed by an asset or by a financial performance should have a lower weighting (20%) than is currently the case (50%).
Loans to SMEs will be weighted by 10 to 20% less, as they constitute a more diversified risk for the bank (thanks to the portfolio effect) and SMEs are less vulnerable than major companies to systemic risk, such as a sector crisis or a national event.

A reform fraught with consequences

As McDonough said, a change in the quality of borrower should be directly reflected in the bank's capital requirement. To minimise their equity needs, banks will try to lessen losses in the event of default by taking more collateral and guarantees from lower-rated borrowers.
Banks' lending decisions are likely to become more streamlined. In particular, banks will no longer be able to ignore the cost of risk in setting their remuneration.
To avoid an increase in interest rate, low-rated companies will probably have to accept greater restrictions in their loans or offer more collateral. This is how banks will maintain their PD-LGD (probability of default-loss given default) levels. This already seems to be happening, in fact.

Jean-Louis Cayrol, June 2003

(1) W. McDonough is also a vice-president of the Federal Reserve Bank of New York.