Big Banks Face Costly Preparation For Risk-Management System

Major banks have a costly road ahead in meeting a risk-management system approved last week by the Bank for International Settlements, the governing body of worldwide bank regulators.

The system, known as Basel II, provides incentives for banks to use advanced statistical models for predicting the risk that a loan will default. Banks that use the models can reduce the amount of capital they're required to hold in reserve, freeing it up for more-productive uses. Basel II also requires banks to assess operational risk--the risk of computer glitches, reputation damage caused by rogue employees, and other hard-to-predict events.

The Federal Reserve has decreed that only large, money-center banks--perhaps 10 or 12 in all--will be required to adopt Basel II. Over the next year, it will undertake a study of Basel II's impact and intends to publish guidance for banks to use for conforming with Basel II. In the meantime, it's encouraging banks to begin planning implementation efforts.

Banks will phase in their Basel II systems during a one-year period beginning in January 2007, during which the systems will run in parallel with existing systems. They'll officially be required to switch to Basel II in January 2008. According to a global survey by Accenture, Mercer Oliver Wyman, and SAP, about three-quarters of European banks have performed strategic assessments and undertaken early-stage systems development work related to Basel II, versus just 12% of U.S. banks. This disparity can be partially accounted for by the small number of U.S. banks that will be implementing Basel II.