July 5, 2005
The final legal decision to implement Basel II in the US is in a temporary holding pattern, in part due to objections in Europe, but this quarter US bank regulators are moving forward with a series of important changes to the system for quarterly bank call reports that are a crucial component of making Basel II a practical reality. The changes improve what is already the world's most accurate structured financial database, a quality made possible by the system's wonderfully arbitrary rules.
Last week, the Federal Financial Institutions Examination Council (FFIEC) Call Report agencies - the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System (FRB) and the Office of the Comptroller of the Currency (OCC) - announced the schedule for financial institutions to enroll in the Central Data Repository (CDR). The CDR is a new Internet-based system created to modernize and streamline how the agencies collect, validate, manage and distribute financial data submitted by banks in quarterly "Call Reports."
The updated system is scheduled for implementation for the third quarter 2005 Call Report and will be the only method available for banks to submit their Call Reports. The data will be formatted in eXtensible Business Reporting Language or "XBRL" for those of you lucky enough to miss this new acronym until now. Think of XBRL as standard XML joined with a highly detailed accounting taxonomy, live update capabilities and endless hype. Like the 20-year old bank reporting template in use by the FDIC, XBRL imposes rules as to how a bank or company reports its financial results and uses a modern machine-readable format to speed data validation and processing for analytical purposes.
Whereas the SEC allows public company data in the US to be turned into "chopped salad" by embracing a user-defined reporting schema, federal bank regulators, led by the FDIC, have for two decades used an arbitrary reporting regime to create a rich public source of bank performance data which is both consistent and largely error free. Under Basel II's Advanced Internal Ratings-Based Approach, banks may be allowed to model their own economic capital -- if and only if they successfully "mark to actual" their internal projections for aggregate and specific probability of default or P(D) and other credit metrics. Having a reliable source of "as filed" historical data in machine readable form for use in benchmarking a bank and its peers is crucially important to this process.
The existing FDIC template for gathering bank data allows American bank regulators to immediately benchmark US institutions for Basel II compliance. Yet the 25 EU countries still do not yet gather consistent data in any form regarding the condition and operations of their commercial banks, let alone make available to the public data on commercial companies. In the societies of Europe there is no equivalent to the SEC's EDGAR portal or the FDIC's web site, where individuals and professionals alike can access current financial information on listed companies and federally insured banks, respectively.
No surprise then that the EU seems to be dragging its collective feet on Basel II, only partly because the political chaos inside the federation has so far delayed a unified approach to financial regulation or even accounting standards. The bigger issue is that most banks in Europe could never meet US standards for credit reporting. Popular capitalism is still not accepted in the EU, just as the notion of a credit "default" still has not attained in Europe (or much of Asia, for that matter) the level of finality required by law for US banks.
For example, we hear that in presentations by Unicredit last week seeking financial support for its acquisition of Munich-based HVB Group, the management of the Italian bank hardly mentioned the abysmal default experience of the target. "HVB, which grew out of the 1998 merger of Hypo-Bank and Bayerische Vereinsbank, has 24 billion euros of nonperforming loans. They are mostly inherited from Hypo-Bank's real-estate lending in eastern Germany," according to Bloomberg News, which adds that HVB lost $7 billion over the past three years.
During a conference sponsored by the XBRL consortium earlier this year, a representative from the Bank of Spain told The IRA that the EU did not have any plans for aggregating financial data for EU banks as part of the European effort to move toward compliance with Basel II because "we do not yet have a business case for gathering historical information." Reading between the lines, the message was clear: We got bigger problems to deal with.
The same Bank of Spain official had just finished a presentation on his institution's leadership of an effort to design a bank reporting template using XBRL for the 25 EU states - each of which will have final, unilateral control over the data collected from the banks in each jurisdiction. It was clear from his comments to the XBRL symposium that it may be years before the EU has in place a mandatory reporting system for all banks - if it happens at all.
Our response to the Bank of Spain official was polite, but our observation is this: if the Europeans have not yet realized that Basel II is a modeling exercise that requires historical data for analytical purposes, then how can Brussels possibly hope to ever comply and thus compete with the biggest US and Asian banks? Like many US economists and regulators, EU regulators seem entranced by the theoretical concept of calculating economic capital. They miss the practical point, though, namely that preparing projected internal default ratings and benchmarking same against actual experience is what makes the exercise worth the trouble in the first place.
In our view, if the EU does not quickly develop a template for gathering and aggregating data for EU banks, then there will be no consistent, publicly verifiable way of verifying the Basel II compliance of European institutions. Indeed, the EU already seems to be bailing out of the hardest part of Basel II, namely having banks prepare and maintain their own internal ratings for probability of default for all obligors.
News reports indicate that many EU banks will continue to rely upon the judgments of credit rating agencies, known conveniently as "External Credit Assessment Institutions." Global Risk Regulator reports that "banks using more sophisticated methods of measuring their credit risk will use their own internal assessments of creditworthiness." Given the small number of relatively large banks in the EU, this message suggests that most EU banks will effectively opt-out of Basel II's most important component, namely Advanced IRB.
The glaring deficiency with respect to bank performance data in Europe, and a similar lacking in much of Asia, creates a very substantial obstacle to either region achieving compliance with Basel II's most advanced levels. While some of the states in Asia might be forgiven for not having a fully developed bank data reporting system in place, the situation is Europe is a travesty which requires the urgent attention of EU regulators and political leaders. Indeed, our bet is that Asia as a whole, ranging from India to Japan, will be in compliance with Basel II Advanced IRB methods long before Old Man Europe ambles across the finish line -- if ever.
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