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21 may 2003

Solvency ratios : final stage towards Basel II

The Basel Committee is due to publish its recommendations in November 2003, while the "Mc Donough" ratio is set to replace the "Cooke" ratio at the end of 2006. Introduced over ten years ago, this ratio is no longer appropriate given the increasing sophistication of banking activities and the progress made in methods developed by banks to assess risk.


The new recommendations should, for the most part,be covered by a European directive applicable to all credit institutions in Europe as of 2006. The aim is to define a regulatory framework common to all banks, enabling a more finely tuned management of risk and greater control.

Still room for improvement

The demands of French banks relate mainly to the system's balance and its implementation at a European level.

In order to improve the balance, it is necessary to:

  • clearly define concepts, such as equity capital and provisioning rules;
  • reduce certain weightings used in the evaluation of credit risk as regards both the corporate finance port-folio (specialised financing) and the retail portfolio;
  • improve the use of risk reduction techniques: securitisations backed by financial guarantees, broader recognition of credit derivatives;
  • facilitate the changeover to the more advanced methods recommended by the Basel Committee, notably by basing models on shorter statistical data sets.

At a European level, a directive (CAD III - Capital Adequacy Directive) has been in preparation since the end of 2002. It is very important, for reasons of coherence and fair competition, that this directive transposes the Basel recommendations, not only in terms of content but also timeframe and method of application.

Mobilised banking teams

The Basel Committee is aware of the significant resources required to implement this directive and has set up a working group with this in mind. Close co-ordination between the various regulators will be necessary right up until the practical application stage so as to avoid any distortion of competition.

Moreover, the application of the new solvency ratio has been made more complicated by the simultaneous adoption of new accounting standards, which could affect the (sought-after) stability of bank's equity capital. It is therefore vital to closely co-ordinate the IAS standards and the Basel Committee provisions so that both are underpinned by the same approach to banking activities and their specific characteristics.

French banks have made significant efforts over the past two years to keep to the timetable for implementation: a number of teams have been working on this vast project, which involves the time-consuming formatting of statistical data sets for banks that opt for the internal calculation method. For this reason, banks would like to have a certain degree of flexibility in interpreting the acceptance criteria when adopting advanced methods, particularly when it comes to the length

of the statistical sets, notably by taking into account the quality of monitoring procedures, which can be verified by the banking authorities.

Lastly, they would like to see current prudential standards stabilised until 2006.

Calculating credit risk

The Basel Committee sets out three methods for calculating capital adequacy requirements in relation to credit risk:

  • standard method: the rules are decided by the regulator and draw on external ratings;
  • basic internal rating: the default rate is calculated using data collected by the financial institution;
  • advanced rating: all calculations are made using the financial institution's statistical sets

Studies are underway to explore the possibility of allowing banks the option of combining different methods according to their portfolios or geographical location.

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