The Implementation Of Basel II Finance Essay

This chapter presents the methods used in the study which include the research philosophy, research design, research methods, the method of data collection, selection of sample, and the tests used for the analysis of data. All of which shall be discussed empirically. The main aim of this study is to determine the preparedness of the selected sample banks in adopting the Basel II.

Research Philosophy

This research will make use of the positivist research method as applied in a case study setting. The positivist theory was introduced in 1853 by the French philosopher Augusto Comte. According to him, "all good intellects have repeated, since Bacon's time, that there can be no real knowledge but that which is based on observed facts". Comte has gained attention with regards to many issues by this statement. The first issue is that reality is objective and external to some point, and this is what is called as ontological assumption. The second issue is that knowledge requires the observation of reality, thus, this makes knowledge important (cited in Easterby-Smith et al., 2006). The positive approach gained acceptance in the United Kingdom and United States since the assumptions of this theory are understandable (Delanty, 2003). The main assumptions of positivism are independence, value-freedom, causality, hypothesis and deduction, operationalization, reductionism, generalization, and cross sectional analysis.

The ontology of the positive theory is the world of objective. It is completely independent from human beings. The positive person assumes that the world is external and objective, and that people have no any influence on the social reality (Chua, 1986). Epistemology, it is considered that all the observations are separate from theories, in other words positive researcher tend to test hypotheses and after that he/she can deduce future events (ibid.). Positive researcher can be inductive or deductive. Induction is a process starting from observations in order to develop theories. In contrast, deduction is a process where you start from theory (hypotheses), so the researcher will make further observations to ensure that the theories meet the findings (Drever, 2007).

Essentially epistemology concerns itself with how knowledge is accepted, how we know what we know. It is about how we can establish which truths are both adequate and legitimate. Western epistemologists have often distinguished between two types of knowledge which is gained through reason alone and that which is gained through application and experience. The epistemology that will be adapted in this research is the knowledge gained in the area of commercial contract through application of law and the experience of legal practitioners.

The central element in any philosophy is its epistemology which refers to the theory of knowledge and the fundamental epistemological question of how we know what we know. In epistemology one strives to generate truthful and justified descriptions and explanations of the world. Associated with epistemology is the philosophical framework of ontology, which Johnston (1986) describes as the nature of being, existence and reality, or 'what can be known'. The manner in which we answer the question of 'what exists' determines what can be accepted as fact and thus is the basis of every investigation. The divergent epistemologies and ontology's together inform the methodologies for any piece of research, which, in turn, must be appropriate to the questions or problems that prompt the research enterprise.

Research Design

A research design can be stated as the major constituent who structures the entire research project. Also there are many research designs that one could follow such as action research, ethnography research and the case study approach. When focusing on the research design which will be discussed further in this chapter it could create a major impact on the desired sample size of the research as well.

This study will utilize the experimental design in determining the empirical preparedness of utilizing the BASEL II in the selected four Saudi Arabian banks.

Sample

The samples used for this study are chosen based on the accessibility of the researcher. The four Saudi Arabian banks that will be the sample are the Saudi British Bank, Saudi American Bank, Arab National Bank and the National Commercial Bank.

Data Collection

Data from the four banks were collected using a survey questionnaire. These questionnaires were sent to these said banks using courier and a letter of intent from the researcher.

The survey questionnaire has five parts. The firs part constitutes of the basic information about the banks (years in operation, major officers, etc.). The second part constitutes of the statement of the progress of risk management set up of the individual banks. The third part is the level of awareness of the top bank's top management and concerned officers regarding Basel II. The fourth potion is the statement of the minimum capital requirement for the implementation of Basel II. The last part is the development of standardized models and processes for such implementation such as IT projects, development of data bases and warehouses, preparedness of human resources and others

Analysis of Data

The data collected were measured through the use of measures of central tendency. The developed hypothesis is tested using a simple arithmetic mean. Cronbach's Alpha Reliability and Factor Analysis. Charts were used as well in order to illustrate the findings of the study.

Elimination of Bias, Ethical Consideration and Issues

The results were based mainly on the output of the tests conducted. The researcher will not make his own assessment and voice out his own opinions, but would merely state the obvious and accurate representations of the observation. All observation would be objective, and would not be subjective and biased in any way.

There would be no discrimination in this paper. The researcher would allow all kinds of persons to partake of the study, whether they are of any color, race, gender, age, religion, or any other background or distinguishing factor. The questions will not be derogatory in any way. They will be free of malice and intrigue with only the intention of disclosing information about the study. There would be no personal questions which could compromise the respondents' answers.

There is no ethical issues involved with the performance of this study and therefore, the researcher does not need to seek any ethical clearance from external body.

Results, Analysis and Discussion

From the literature we found that the implementation of Basel II in various banks is a very challenging task for banks because risk management is at its initial stages. Therefore, the researcher conducted a survey that is based upon the examination of the risk management capabilities prior to the adoption of Basel II Accord in various banks in Saudi Arabia. This is a questionnaire-based survey from the concerned bank officials. The main findings are mentioned below based on the questions:

Risk Management Set Up

It is recommended that risk management set up should be there at each of the banks so that these banks can effectively manage the risks that they are exposed to. The information obtained from the four sample banks are summarized in Table 1 below:

Minimum Capital Requirement

The result taken out from the questionnaire clearly shows that all the four banks (sample size) are meeting the existing minimum paid-up capital requirement that is required to be maintained by each bank. But the requirement of paid-up capital of riyal six billion by 2009 is a question mark? Because there are small domestic banks operating in the country, who might not meet that much amount of capital, that might lead to them to merge with any big banks or takeover by some foreign bank. This strategy of Central Bank of Saudi Arabia leads to the foreignization of the entire banking sector in Saudi Arabia.

Independent Risk Management Division

The answer obtained from the questionnaire revealed that out of four banks (sample size), three banks have independent risk management division. This shows a positive sign for development in risk management and then transition towards implementation of Basel II in Saudi Arabia. Personnel have been there in every bank for the managing of various risks inherent in the business of banking and the demand of the concerned officials / staff has been growing due to major development in risk management i.e. implementation of Basel II in Saudi Arabia.

The results from the questionnaire regarding the progress for developing standardized models / processes for the measurement and mitigation of risks are explained with the help of Figure 2:

From the above figure, it can be seen that the progress has been made for developing various standardized models and processes for risk identification, measurement and mitigation. 64% of the banks claimed that the progress to be medium, in 27% banks, progress has been low and 9% of the banks have not taken any action.

Adherence to Central Bank of Saudi Arabia's Risk Management Guidelines & Review of Risk Management Processes

The computed mean for the above frequency distribution table is 1. This means that the level of adherence is medium which shows that progress has been made however, it is not that significant.

Central Bank of Saudi Arabia has also emphasized upon review of risk management function and processes. Central bank of Saudi Arabia is of the view that risk review function should be independent of those who approve and take risk. In this regard, the response of the survey is explained with the help of Table 5:

From the sample survey, the researcher found out that 50% of the sample banks do yearly assessment of the risk management functions and processes, while 25% of the banks do it semi-annually while the other 25% do it monthly. The banks Internal Control Department do this review.

Operational Risk Management

It is of everyone's knowledge that operational risk is the risk due to inadequate internal processes and control systems and external events like tsunami.

It is the responsibility of bank that it should put in place an adequate system for all area of bank operations. A capital charge has been included in new Basel II Accord for the first time. A charge for operational risk is to be included in calculation of minimum capital requirement by 2009 as per the roadmap issued by Central bank of Australia. The outcome regarding the awareness with operational risk management is very low. Out of the four banks (sample size), three banks have low level of awareness with operational risk management, and one bank has low level of awareness. The mean of -0.09 shows that the level of awareness is low. The deadline for capital allocation for operational risk is 2009, which is the main reason of this low response.

Development of the Bank's IT Infrastructure

There researcher has reviewed various literature and after doing such, it was found out that the development of the banks IT infrastructure is of vital importance. Due to the expansion in banks business, there is need to measure various risks, which require complex calculations so there is need to strengthen the IT infrastructure of each bank. The banks responses are summarized on Table 6 below:

The mean calculated to be 1, shows that the preparedness of banks is above low level. From interview with bankers, the researcher came to know that banks have been investing a lot amount of funds in various IT projects; especially the progress of foreign banks operating in the country is quite remarkable. Foreign expertise could be hired for launching IT project in Saudi Arabia.

Data Warehouses/Databases Maintenance

Another requirement is the availability of data warehouses and databases for the last three to five years data. Each bank requires this for every single customer and single facility for the calculation of capital charge under internal rating based approach. This is also one of most important issue for banks. The result of the questionnaire survey is explained with the help of Figure 3:

It is clearly see from the above graph that 75% of the banks have partial data available and 25% claimed to have complete data availability.

Development of Human Resources

Human resource development may be the most important requirement for the implementation of Basel II in Saudi Arabia, both for the Central Bank as well as the commercial banks. The result of the survey questionnaire is as presented on Table 7 below:

The mean from the above table is computed to be 1, that's shows the level of preparedness in term of human resource development is at very low level. From the interview with bank officials, the researcher came to identify that banks have taken the expertise of chartered accountant firms, who have been planning to hire foreign consultants for fulfilling the training needs of personnel.

Central Bank of Saudi Arabia has also the responsibility to prepare itself in terms of training and IT development because it is the one who is to monitor all the commercial banks. Most of the banks as per the sample agree expected to adopt Basel II by 2009, as per the roadmap issued by the Central Bank of Saudi Arabia.

Results of Cronbach's Alpha

Normally, the Cronbach's Alpha reliability coefficient ranges between 0-1. However, there is no actual limit for the coefficient. The closer Cronbach's alpha coefficient is to 1.0 the greater the internal consistency of the items in the scale. Based upon the formula _ = rk / [1 + (k -1)r] where k is the number of items considered and r is the mean of the inter-item correlations the size of alpha is determined by both the number of items in the scale and the mean inter-item correlations. George and Mallery (2003) provide the following rules of thumb: "_ > .9 - Excellent, _ > .8 - Good, _ > .7 - Acceptable, _ > .6 - Questionable, _ > .5 - Poor, and_ < .5 - Unacceptable".

In the case of the obtained data, the reliability coefficient is .887 which indicates good reliability coefficient. While increasing the value of alpha is partially dependent upon the number of items in the scale, it should be noted that this has diminishing returns. It should also be noted that an alpha of .8 is probably a reasonable goal. It should also be noted that while a high value for Cronbach's alpha indicates good internal consistency of the items in the scale, it does not mean that the scale is one-dimensional. The dimensionality of the scale can be computed using the factor analysis which will be discussed in the next section.

Results of Factor Analysis

The method followed here was to first examine the initial responses of the participants with a view to selecting a subset of characteristics that might influence further responses. Then, survey responses were analysed at the item level, using figures, tables, or text alone, to provide a first impression.

These item level responses were scrutinized for underlying patterns via factor analytic procedures (Note that all procedures reported here utilize SPSS). A prerequisite for including an item was that responses were not too badly skewed (i.e., 90% or more of responses clustered in single cell) and that more generally, the level of response to that item was not insufficient (<15-20%) to destabilize analysis. The factors identified in this fashion correspond to the primary topics or latent variables to which correspondents seem to be responding in terms of various related items.

The protocol adopted here for factor analysis was to use default settings initially (Principal Axis Factor - PAF) and to rotate the matrix of loadings to obtain orthogonal (independent) factors (Varimax rotation). The prime goal of factor analysis is to identity simple (items loadings >0.30 on only one factor) that are interpretable, assuming that items are factorable (The Kaiser-Meyer-Olkin measure of sampling adequacy tests whether the partial correlations among variables are small. Bartlett's test of sphericity tests whether the correlation matrix is an identity matrix, indicating that the factor model is inappropriate).

Once clearly defined and interpretable factors had been identified (Factor loadings =>.10 were illustrated via an included table even though only item loadings >0.30 were considered relevant to factor loadings), and responses related to these factors were saved in the form of factor scores. These Bartlett factor scores are equivalent to sub-scale or scale scores with means of zero and standard deviations of one (z-scores), and with participants credited with separate scores in relation to each identified factor.

A Principal Axis Factor (PAF) with a Varimax (orthogonal) rotation of 22 of the 24 Likert scale questions from this survey questionnaire was conducted on data gathered from 119participants. An examination of the Kaiser-Meyer Olkin measure of sampling adequacy suggested that the sample was factorable (KMO=.698).

Characteristics of the Implementation of Basel II

After the researcher has reviewed various literatures and assessing the results obtained through the survey questionnaire, he has come out of common points for banks before implementing Basel II for the Saudi Arabia. The following capabilities and characteristics should be present before the implementation of such:

1. Banks are required to raise their minimum capital requirements vide BSD Circular No. 5 of 2005. The Central Bank of Saudi Arabia should raise the minimum paid up capital by the end of 2010.

2. The required minimum CAR, on consolidated as well as on stand-alone basis, would continue to be 8 percent plus a variable percentage based on the risk assessment of each bank by Central Bank of Saudi Arabia, to be maintained by each bank.

3. Data warehouses and databases to be maintained for five years, banks need enough historical information that is needed for calculation of capital charge.

4. Banks need to have strong IT infrastructure that is required to handle large amount of data and to do statistic cal analysis under IRB approaches for the calculation of capital charge.

5. Designing an internal rating system that conforms to all the requirements is in itself a compelling task; assigning ratings to each exposure would mean that banks would essentially be doing the job of a full-fledged rating agency.

6. Establishing a full-fledged risk management division and risk management committee at the Board of Director's level for better risk identification, management and mitigation.

7. Human resource development in the field of risk management like hiring of risk analyst who are masters in mathematics, statistics, etc. and providing necessary training and skills.

8. Periodic review of risk management processes and validation of controls by the bank's internal audit and compliance department.

9. Develop and standardize new and improved risk models.

10. Operational Risk Management System - embedding risk processes within day-to-day operations.

Conclusion and Recommendation

This chapter shall summarize all findings in this study. Conclusions are formulated based on the main objective of this study which is to determine the preparedness of the selected sample banks in adopting the Basel II. Recommendations are also made based on the findings.

This study was conducted in order to determine the preparedness of selected sample banks in Saudi Arabia regarding the implementation of Basel II. Quantitative analyses were done to get the empirical results based on the data obtained from the survey questionnaire. The sample banks were Saudi British Bank, Saudi American Bank, Arab National Bank and the National Commercial Bank.

Based on the findings and results of various statistical analyses, the following conclusions ad recommendations were drawn by the researchers:

Conclusions

To say that Saudi Arabia is unable to implement Basel II is not correct. It is true that the risk management is at its infancy stage. However, the sample banks from Saudi Arabia have been making progress that are considerable as per the directions of the Central Bank of Saudi Arabia from time to time and making improvements in risk management framework in order to easily move towards the implementation of Basel II.

Basel is actually a name of performing the various calculations on the bank's current and past data. Whatever answer that one will get after the calculations will show the bank and the whole market on how much risk that the balance sheet is running.

Banks that have long term plan for business growth in the future would be capable in implementing Basel II. This is as per the roadmap of Basel II because these banks are willing to spend huge amount of the banks' capital allocated for projects that are IT related and development of human resources.

It is noted that the implementation of Basel II is easy for foreign banks since it has already been adopted in foreign countries. Over all, banks that are able to meet the characteristics mentioned in the previous chapter would be able to implement Basel II. Whereas, it would be very difficult for smaller banks to spend huge amount of money in IT projects as well as due diligence. This is the reason why smaller banks are very reluctant in adopting such. These are the banks that are not able to meet these requirements. Unfortunately, these banks that will fail to do so would end up with a cancelled license as govern by the rules of the Central Bank of Saudi Arabia. Another option is that these banks will be acquired by a larger foreign bank as a result of merging.

Finally, the hypothesis that banks is Saudi Arabia are not capable in adopting Basel II because risk management is at its infancy is rejected.

Recommendations

As mentioned in the previous chapter the following guidelines should be followed by banks in order to implement Basel II effectively: