ISDA PRESS REPORT - DECEMBER 27, 2001

ISDA PRESS REPORT - DECEMBER 27, 2001

RISK MANAGEMENT
* A spanner in the works - Risk

TRADING PRACTICE
* ISDA and FpML.org to merge - Risk

A spanner in the works
Risk - December 2001

When the Basel Committee issued its second consultative document proposals
(CP2) for a new regulatory capital Accord in January, it prompted fierce
opposition from banks, academics and lobbying groups over its treatment of
loans to small- to medium-sized enterprises (SMEs). This sector is the
backbone and growth engine of many major economies. Now, nearly a year
later, the issue has come to a head. The US and Germany - which is fiercely
protective of its SME sector, the mittelstand - are engaged in brinkmanship
over the capital treatment of loans to SMEs that could cause the entire
Basel II capital Accord to unravel.

SME lenders' initial concerns included the steepness of Basel's credit risk
weighting curve for the internal ratings-based (IRB) approach, its
insistence that expected loss provisions should be made in addition to
typical unexpected loss provisions, confusion over which SME loans could be
included under the retail approach, and the extent to which physical
collateral could be used as a risk mitigant. The Committee has moved to
address many of these concerns, although some, like the risk weighting
curve, remain prickly. But a critical issue, the use of maturity adjustments
in the calculation of capital charges for corporate and SME lending, which
requires banks to put aside more capital for longer-dated loans, is far from
being settled.

The German banking industry in particular is worried that overly harsh SME
treatment would push up lending costs, thereby stifling capital to a vital
source of the country's economic growth. While German banks have several
concerns, the country's lack of flexibility on the maturity issue threatens
to derail the entire Basel II process, which in turn would throw the
European Directive based on Basel II into disarray.

While most Basel lobbying has been carried out via traditional banking
channels - with national banking associations petitioning their regulators
that sit on the Basel Committee and its working groups - the debate in
Germany, Europe's largest economy, involves the highest levels of
government. German chancellor Gerhard Schr?der and economics minister Werner
M?ller said in late October that German funding to the mittelstand must not
be impaired by Basel II. "Basel II is not acceptable to Germany in its
present form. Everyone must reckon with our opposition to a European Union
guideline based on Basel II," said Schr?der, referring specifically to
treatment of SMEs.

The Basel Committee has since issued a paper, 'Potential modifications to
the Committee's proposals', which outlines current thinking within the
Committee and indicates that it will make key concessions to SME lenders.

The most important aspect of the paper, released November 5, is the
Committee's move to lower and flatten the IRB risk weighting capital curve -
which is a function of a firm's probability of default. This significantly
lowers capital requirements for SME lending. The move is based on evidence
that small companies are less likely than large corporates to default during
economic downturns.

But the paper failed to touch on the maturity debate. "[It] says nothing
about maturity, just about the risk weights without any maturity
adjustments," says Tobias Winkler, head of international banking issues in
the department for banking supervision at the Bundesverband deutscher Banken
(Association of German Commercial Banks). "This a right step, but certain
additional things have to be done to take account of special circumstances
of SME lending [in Germany]," he adds. "The maturity adjustment has to be
abolished in the advanced approach," he argues.

The German side claims the terms of loans to the mittelstand are
significantly longer than those to their SME counterparts in the US or the
UK.

"We have got very long maturities, this would put German banks at an
enormous competitive disadvantage compared with other countries," says
Winkler.

Evidence to support this argument is hard to come by, especially since the
Basel Committee refuses to disclose cross-country comparisons for factors
like average loan maturities from its second quantitative impact study (QIS
2). But several officials with access to QIS 2 data say the average maturity
of loans made by domestic financial institutions to businesses in Germany is
4.28 years, a figure that falls to 2.95 years for Germany's internationally
active banks. Average maturities for business loans in other G-10 countries
were said to lie between two and 2.5 years.

The CP2 proposals for Basel II contained two maturity approaches in IRB
treatment, one called the 'default model', ironically said to be a German
proposal, and the other a US 'mark-to-market' approach strongly backed by
the British. Under these two approaches, it is assumed that the risk of
default on a loan is higher if it is longer-dated, an assertion that has
been supported by several studies of historic data. The 'mark-to-market'
approach also takes into account the economic deterioration of the position
and not just final default. This Anglo model heavily penalises longer-term
loans. According to the Zentraler Kreditausschus (ZKA), a central banking
association which represents the interests of German commercial banks,
savings banks, regional state banks and co-operatives, long-term exposures
of seven years could require up to six times as much capital as one year
exposures - although one German banking official said a cap had now been
placed on maturities at five years, reducing this figure to 400%. "Capital
add-ons for long-term loans would therefore seriously affect the
international competitiveness of the German banking industry and result in
higher interest rates for borrowers that would not be justified by the risk
exposure," said the ZKA in a statement during the comment period.

But Germany stands virtually alone in its refusal to accept the US-led
maturity proposals. "The data analysed by the Committee clearly shows that
you have these upward-sloping curves for maturities. What kills a bank is
deterioration of value, and it has got to provide for a lot of things on the
books, so you can't wait for final default," said a Basel Committee member.
"But you can argue about the steepness, and that is a matter for debate."
The fact that Germany's other key allies in the wider SME debate - namely
Japan, Italy and Spain - are in favour of maturity adjustments, has prompted
a number of non-German regulators, albeit veiled behind the protection of
anonymity, to play down the importance of the maturity impasse to Basel II's
implementation. But such views fail to take into account the depth of
feeling that German banks, banking associations, the Bundesbank, parliament
and the general public have in protecting funding to the mittlestand. This
unusual level of pressure has left the German negotiators with very little
room for manoeuvre.

Gerhard Hofmann, director of banking supervision at the Deutsche Bundesbank,
was one of the few regulators prepared to speak publicly on the issue. He
said his hands were all but tied on the maturity debate, and confirmed that
the German side would be prepared to scupper Basel II's timetable should a
deal fail to be reached. "If this does not come to an end, then the European
effort will be postponed too. I have difficulties imagining that we would
introduce Basel II in Europe and not have a level playing field on a G-10
basis." While Hofmann said the matter was "very serious", he remained
confident that all sides could reach a solution.

Compromise
Risk was told by one European banking representative who claims to be
closely involved in the talks that a current compromise suggestion is to
halve the US mark-to-market maturity adjustments. This would mean the 600%
figure mentioned in the ZKA paper for a 'AAA'-rated, seven-year loan would
be reduced to 200%. But a US representative distanced himself from this
being a US proposal. "I would not describe the negotiating position that
way," he said. Asked if the US team would agree such a concession, he added,
"I couldn't say that we would, but it would depend on the whole package.
Fifty per cent on the mark-to-market adjustment seems an obvious point to
try and compromise on, but I'm not sure the US side would agree to that."

Hofmann was also cautious, saying "I would rather hesitate to comment on
that, but yes, it is a direction we are heading. This is a critical point
and I hesitate to comment in public because we are in the midst of this
rather difficult negotiating process and I really don't want to jeopardise
anything. It will be quite tough." While almost every country that supports
maturity adjustments believes a 50% mark-down would be an acceptable
compromise, Germany may still hold out. Another German bank executive says
it may find a 50% mark-down unsatisfactory.

Another area of potential compromise is to allow banks with loan maturities
of less than three years to gain a downward capital allocation adjustment,
while banks with loans of more than three years would be capped at the
three-year level - as factored into the current proposed standardised credit
approach.

But German bankers appear set to resist even this level of compromise,
claiming that German internationally active banks (with average maturities
of 2.95 years) would be on an unfair playing field with other
internationally active banks, which have average maturities closer to the
two years. But German banking officials could not come up with hard data to
support the claims.

While maturity is the largest single SME-related issue for the Basel
Committee to resolve, there are a number of other matters that also need
clearing up, and, once again, the Germans are digging in their heels. For
example, the IRB credit risk-weighting curve proposed by the Committee on
November 5 fails to completely assuage concern about higher SME lending
charges. While Basel's current approach would mean that banks would have to
set aside significantly less capital against SMEs, which typically fall in
the 1% to 3% probability of default range, compared with CP2 proposals,
charges are still higher than under the present rules. For example, a bank
lending to an SME with a 2% probability of default would now have to set
aside 10.3% of the capital, compared with 15.4% under the January proposals.

Collateral mitigation could reduce this to 9.3%, and receivables mitigation
might further reduce the amount to 8.3%.

But Hofmann believes this risk-weighting curve does not go far enough. "When
you look at the curve, the typical probability of default range for an SME,
which is around 2%, still triggers a capital charge of above 10% - 2
percentage points above the current treatment," he says. This will translate
into the pricing of these loans. "How big will the interest rate effect be
on SMEs? According to our calculations it is still significant," Hofmann
says.

As a result, the Bank of Italy and the Deutsche Bundesbank drafted a
confidential joint paper, released October 19, which was submitted to the
Committee's working group on overall capital. The paper proposes that a
function based on the relationship between asset correlation and size should
be added to the IRB risk-weight curve methodology based on the relationship
between asset correlation and probability of default. The paper,
'Calibration of benchmark risk weights in the IRB approach to regulatory
capital requirements', contends that joint treatment of probability of
default and a firm-size effects on asset correlation could produce a risk
weighting function that addresses both procyclicality issues produced by the
new framework and concerns related to the treatment of lending to SMEs. The
Committee is now investigating the matter as part of an additional
quantitative impact study, QIS 2.5.

But many banks, including German financial institutions, are strongly
opposed to the introduction of additional parameters, such as number of
employees, assets and turnover functions into the risk-weighting curve. They
see a size function as an unnecessary complication. "Segmentation on the
grounds of turnover is unsatisfactory to us. Retail businesses and wholesale
businesses may have similar turnover, but the characteristics and the way
you would manage them in risk terms would be quite different," says Colin
Jennings, senior manager, non-retail related risk at Lloyds TSB, the UK's
third largest bank. "If that was imposed on us we would have to change our
systems considerably to do what we think would achieve no real benefit,"
adds Simon Baker, Lloyds TSB's head of risk policy, overseeing about ?6
billion in commercial portfolios (above ?2 million in turnover) and an equal
amount in small business portfolios, plus retail loans to its 16 million
retail customers base.

Further effects
Bankers are also opposed to another key aspect of Basel II that affects SME
lending. The Committee believes banks should put aside capital for expected
losses in addition to the current practice of making capital charges against
unexpected losses - credit risk. From a theoretical view of capital, such
requirements should be fulfilled by future margin income and not by
regulatory capital allocations. The Germans favour this 'pure' approach.

"Expected losses are covered by future margin income. We don't need any
double counting by using regulatory capital to cover expected losses," says
a German banker.

Although Basel has made some concessions in this area, saying it would scrap
expected loss provisions for retail loans - excluding mortgages - and allow
deductions from special and general loan loss reserves against expected
losses, the Committee's 'inelegant solution' has again run into German
opposition. "The German Ministry of Finance restricts the amount of
loan-loss reserves due to fears that banks would attempt to reduce their
income figures to avoid tax payments," says one German banker. "We fear that
this could lead to a severe international competitive disadvantage for
German banks because of tax regulations, so we are very much against
covering expected losses with regulatory capital."

A potential solution is to include expected losses under Pillar II of Basel
II, leaving it up to the discretion of national supervisors to ensure
expected losses are fully covered, while ensuring a level playing field
among nations. But some claim the Committee is unconvinced that expected
losses are fully accounted for by national regulators in specific product
areas or nations like Japan, and have pushed for specific Pillar I treatment
to alleviate their concerns. "The current envisioned compromise is that this
will not be done across the board. While it is not an elegant solution, it
addresses the most important substantive concerns the industry has raised
about the inclusion of expected loss," says a Basel Committee member.

The strong German opposition to so many SME-related treatments will make a
speedy resolution difficult, with much said to be hinging on sideline
discussions between the German and American contingents ahead of the Capital
Task Force and Basel Committee meetings, scheduled for December 6 and 7 in
New York, and the December 12 and 13 in Basel, respectively. With the timing
tight in terms of enshrining a European Directive in European Union and
European national legislation, the industry needs a major breakthrough based
on sound banking supervision practices, rather than an appeasement in
response to political sabre-rattling, which risks weighing down the entire
Basel II process.

ISDA and FpML.org to merge
Risk - December 2001
By Rob Dwyer

The International Swaps and Derivatives Association plans to integrate
FpML.org the not-for-profit company set up to develop Financial products
Markup Language (FpML) - into its organisational structure by the end of the
year. The merger of the two organisations is aimed at facilitating the
development of FpML by allowing FpML.orgs members to concentrate on
technical issues.

Mart Meinel, co-chair of FpML's standards committee and head of fixed-income
IT at UBS Warburg, says becoming part of ISDA will remove the burden of
administration from the technical team. We will be able to use ISDA
resources which will speed up the implementation of version 2.0 and the
development of version 3.0,' he says. 'The standards committee ended up
doing a lot of the administration work to run the FpML symposiums, and we
hope to leverage off ISDA conferences (for future symposiums)."

FpML based on the flexible extensible markup language' (XML), is designed to
create an industry standard for electronic trading. FpML 1.0, launched in
July 2000, covers interest rate swaps and forward rate agreements. FpML is
presently working on version 2.0, which will include swaptions, caps,
floors, collars and straddles, as well as several other instruments, as well
as those covered in 1.0. Implementation is slated for the end of December.
The committee is also planning to publish a draft of 3.0, which will extend
FpML coverage to foreign exchange and equity derivatives, by the end of this
year.

Meinel says FpML's integration with ISDA was part of the standards
committee's strategy from the organisation's inception. 'Since we have been
working on ISDA documentation then converting that into XML, our work has a
natural fit with ISDA," says Meinel, Operating from inside ISDA will help
the development of FpML be better aligned with the documentation of new
products as it comes along."

Strain
Robert Pickel, ISDA's chief executive officer, says the merger will allow
members of FpML to focus on technical development. But will it prove a
strain on often-stretched ISDA resources? We envision adding some extra
staff, and we project that we will be able to find the extra funding needed
through due-based revenues' says Pickel. "As a volunteer organization, it
was an issue for FpML members to find time aside from their day jobs. And
yet they have still managed to establish FpML as a brand that is the basis
for OTC derivatives transactions in the future," he adds.

FpML users welcomed the announcement. Mark Brickell, chief executive
officer of online swaps trading platform Blackbird, and chairman of lSDA
between 1988 and 1992, says: "We actively encouraged ISDA to take on this
project. Creating FpML is as important as the ISDA Master Swap Agreement,
because it will strengthen the framework for the swap negotiation."
Brickell says Blackbird was the first company to offer FpML confirmations to
its customers, and he believes ISDA will accelerate the adoption of 2.0 and
expand FpML further to cover more kinds of transactions more quickly.

Observers say the success of the project depends on recruiting. An official
at an FpML-affiliated company says: "ISDA hasn't had this level of
technology project before, so the key will he whether it hires someone with
the requisite level of technological expertise." ISDA officials say details
about FpML recruitment have yet to be finalised.

**End of ISDA Press Report for December 27, 2001**

THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S
BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS
REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION),
AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.

Scott Marra
Administrator for Policy and Media Relations
International Swaps and Derivatives Association
600 Fifth Avenue
Rockefeller Center - 27th floor
New York, NY 10020
Phone: (212) 332-2578
Fax: (212) 332-1212
Email: smarra@isda.org