The credit crunch has increased the spotlight on risk and compliance issues. The role of Basel II is examined in this report by NS Venkatesh
In the financial services sector, the innovation and evolution in risk management practices occur continually, on an incremental basis. Updates to regulations, on the other hand, happens with a lag and therefore typically occur in large jumps. The updated Basel II accord is a quantum leap when compared with the first accord originally proposed in the late 1980s. The regulatory response has been mixed across jurisdictions with regulators in the US looking at options to suit local requirements. In the GCC region, Kuwait was the first to implement the accord. Others have followed, with Bahrain implementing the regulations at the beginning of this year.
Basel II seeks to bring structural changes not just in risk regulations, but also in the capital assessment process for banks. An important innovation in the Basel II framework is the system of self assessment coupled with external counterchecks grouped under Pillar II and III respectively.
In contrast, the Basel I approach is straightforward and rules-based. In addition, most regulators, at least in emerging markets, prescribed higher levels of capital than the Basel norm of 8 per cent to provide a cushion against unexpected losses. High capital levels were desirable in banks in commodity based economies as the banking system was likely to experience volatility in earnings. This, perhaps, explains why the GCC banking regulators set minimum capital levels of between 10 to 12 per cent under the Basel I regime.
The rule-based approach continues in Pillar I which prescribes minimum capital requirements for specific risks. The approach is non-judgmental and applies uniformly to all banks. Under Basel II, the focus of capital adequacy determination has shifted from a rule based process to one which is a combination of rules and judgment emanating from a supervisory review of the bank's capital assessment process.
Unfortunately, much of the debate of Basel II to date has centred on the rules-based approach of Pillar I. As a result, many banks have failed to recognise the underlying importance of the capital adequacy assessment process as well as the supervisory review processes under Pillar II.
Over the past two decades, the Basel approach of setting regulatory capital focused on major risks in the banking system, such as credit, market and now operational risk. While these represent the major risks that most banks face, there could be situations where other lurking risks could impact banks in systemic ways. For example, the crisis in the savings and loans industry in the US in the 1980s was due to the fact that most banks disregarded interest rate risk. The Basel II accord clearly recognises that 'interest rate risk in the banking book is a potentially significant risk which merits support from capital', however it has chosen a Pillar II approach to determine regulatory capital charges rather than prescribing rules. The committee felt that this approach was appropriate as there was 'considerable heterogeneity across internationally active banks in terms of the nature of the interest rate risk and the processes for monitoring and managing it.'
Consider a more recent example of subprime lending in the US. It was assumed that securitisation could help transfer risks from the originating bank. On the contrary, these exotic instruments have come home to roost as banks had to fold back these structures into their balance sheets. For large global banks engaged in the 'originate and distribute' business, reputational risks have assumed significant proportions. However, the operational risk definition proposed under the second accord ignores reputational risks for some reason. Nevertheless, this is a significant risk for the above stated banks.
These two examples demonstrate that all material risks in a bank need to be assessed comprehensively. This assessment needs to be done for each bank as some of the risks may be unique. The underlying aim of Pillar II processes is to enhance the link between a financial institution's risk profile, risk management and risk mitigation systems and its capital.
The internal capital adequacy assessment process (ICAAP) in banks needs to be dynamic and forward looking. Banks are expected to have to identify and assess risks as well as plan for capital to meet the scale and the diversity of risks.
Regulators are expected to review the bank's risk assessment independently and evaluate capital levels against the background of internal controls as well as risk governance mechanisms in the bank. The final capital guidance is thus a function of the judgment of the supervisor and it is safe to assume that banks are likely to actively challenge and debate the capital guidance.
So how should banks interpret Pillar II? This would depend on the interpretation of the local regulator and banks need to clearly understand the Pillar II regulatory framework as applicable to their system. However, there is a tendency to view a Basel II implementation project as a gap-plugging exercise, thereby missing the spirit behind the regulations.
As brought out in the above analysis, Pillar II processes will have a major bearing on the bank's capital adequacy levels as the supervisor will determine capital guidance on a comprehensive basis by assessing the adequacy of bank's capital assessment processes, material risks, as well as control and risk governance mechanisms.
It is in the interest of the bank to put in place a sound ICAAP which will ultimately help not just in meeting Pillar II regulatory requirements but also help the bank in linking capital levels to embedded risks on a forward looking basis. In general, a bank's ICAAP should reflect an appropriate level of conservatism to account for uncertainty in risk identification, risk mitigation or control, quantitative processes, and any use of modelling. In most cases, this conservatism will result in levels of capital or capital ratios above minimum regulatory requirements to be regarded as adequate.
Will the resultant capital guidance on banks create additional burden on banks? In this regard, GCC banks are favourably placed with many banks operating well above the minimum capital requirements of their jurisdictions. The imposition of additional capital charges is not likely to translate into capital raising requirements as banks already have sufficient capital in place. However, the target and trigger ratios for a bank will be determined individually and could be set at high levels if the outcome of the supervisory review process is unfavourable or the likelihood of a 'supervisory risk event' is high.
A high capital guidance ratio for a bank in relation to its peers could mean that the bank has a high level of risks or has poor internal controls or poor risk governance mechanisms or some combination of all three factors. In turn, this could invite supervisory intervention, or business restrictions. Further, it could send negative signals to stakeholders and could be viewed unfavourably by market participants, especially when disclosed under the Pillar III requirements.
From a regulatory perspective, Pillar II entails considerable amount of work in the initial stages. Regulators will need to conduct comprehensive assessments for each bank licensee. In some countries, this is likely to be a daunting task, given the number of locally incorporated banks. In these jurisdictions, supervisors are also likely to make use the concept of proportionality embedded in the underlying principles of Pillar II: for example supervisors would subject complex and risky banks to a more intensive full scale review, while relatively less risky and simpler banks could be subject to a straightforward questionnaire based review.
It needs to be kept in mind that the Pillar II assessment will not undermine the risk assessment under Pillar I. An internal self-assessment process for risk-linked capital supplemented by regulatory counterchecks can provide a better answer to the above question. For this reason, Pillar II can be viewed as the main load bearing column of the Basel II framework, as it would allow regulators to reap the benefit of informed supervision.
The Pillar II mechanism of Basel II regulatory capital framework establishes a more coherent relationship between regulatory measures of capital adequacy and the day-to-day risk management conducted by banks. An ICAAP driven bank is expected to make use of risk-management tools, such as credit-risk rating systems, value at risk measurement in market risk and economic capital measurement. As a result, it is hoped that Basel II will be better able than the earlier accord to adapt over time to innovations in banking and financial markets and will reduce incentives for arbitrage that arise from the gap between what the regulators require and what sound economic risk management requires.
NS Venkatesh is senior manager in the financial risk management and regulatory practice of KPMG in Bahrain.
© Banker Middle East 2008
