Basel II May Impact Securities Biz More Than Expected

By Maria Trombly | Securities Industry News | May 5, 2003

The Basel II accord-which would require that financial services firms set aside capital reserves to ensure against credit and operational risk-is likely to extend to securities firms as well as to banks, TowerGroup analysts said last week. The third draft of the Basel II accord was released on Tuesday by the Bank for International Settlements in Basel, Switzerland. There will be a comment period through July 31, and the final accord is due to be completed by the fourth quarter. The recommendations are slated to go into effect at the end of 2006.

"It became clear that Basel II would apply not only to banks but also for investment companies," said TowerGroup analyst Ole Skjodstrup. Previously, he said, there was a possibility that the accord would not extend to the financial services industry.

According to Angela Knight, chief executive of the London-based Association of Private Client Investment Managers and Stockbrokers, the draft Basel II proposal only talks specifically about banks. The problem, she said, is that the European Union is likely to interpret it as applying to all financial institutions, including brokerages and insurance companies.

"That will result in very big increases in capital that they have to hold," she said. "If the brokerage house is actually in the United States and has no branches in Europe, there's no effect. But if a brokerage house has a branch in the EU, then it will be affected by the EU capital requirements."

Basel II doesn't have any actual enforcement powers. It will be up to local regulators, such as the SEC in the United States, to enforce its provisions, she added. In Europe, that means member countries will need to pass new legislation.

"What organizations like mine are arguing for is differing types of calculations to be done for brokerage houses and investment management houses," she said. "We're arguing for the same calculations in the future as we have currently."

Under the accord's recommendations, financial institutions will need to set aside 8 percent of assets under management to ensure against credit risk. They may also have to set aside an additional amount to ensure against operational risk. According to TowerGroup analyst Lee Kidder, operational risk includes such events as system breakdowns, transactional errors, internal control deficiencies and fraud.

Financial institutions will need at least two years of data about their ops risks, added Skjodstrup. That means that they need to start preparing their assessment methodologies if they want to reduce those capital reserve requirements. In addition, the top 10 largest U.S. banks will also be required to assess their ops risks by regulators. "If you're from a bank, then chances are you are spending too little time, effort and money on preparing for Basel II and the clock is ticking," he said.

"It's a hard case to make to ask for money for something that will yield a benefit only in 2006," added Kidder. But he added that reducing operational risk is a worthwhile goal in and of itself as it improves ops efficiency, reduces losses, and adds to the bottom line. According to TowerGroup estimates, the financial industry as a whole loses $50 billion a year in diverse ops losses.

Although it wasn't spelled out until Tuesday, it was always the intent of regulators to include all financial services institutions in the accord, said TowerGroup analyst Guillermo Kopp. "I don't think it was a last-minute inclusion," he said. "The intention was for all financial services to get added because there is so much diversification in the industry."

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