29 October 2008
The financial market turmoil is not an indicator of the failure of Basel II norms, Michael Zamorski, Managing Director, Supervision Department of the Dubai Financial Services Authority (DFSA), told Emirates Business in an exclusive interview.
"The success or failure of any institution largely rests with its management team," Zamorski added. "While liquidity and concentration risks are part of an institution's risk management and capital adequacy framework, Basel II was not specifically designed to address these risks," he explained.
"The Basel Committee has addressed these risk components in other publications," said Zamorski, who served as a member of the Basel Committee on Banking Supervision from 2000 to 2006. Zamorski maintains that although the implementation of the banking norms specified in the Basel II accord are supposed to make an institution more risk-sensitive, the accord in itself is not a substitute for risk-management.
"The fundamental objective of Basel II was to revise the 1988 Capital Accord, making it more risk sensitive. Therefore, it is important to remember that Basel II is not a substitute for sound risk management," he said.
Zamorski was responding to queries about the inadequacy of these norms to address some of the inherent, structural weaknesses in the banks' operations that have been partly responsible for the mess that the global financial system finds itself in.
The implementation of Basel II coincides with massive losses reported by some of the world's largest banks, requiring large-scale re-capitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Zamorski, however, disagrees that Basel II has added to boom-bust cycles (Promulgated by the Bank of International Settlements, Basel II is a set of guidelines on how much capital banks should hold to guard against current and future risks).
"Basel II contains three basic components, called 'Pillars.' The three Pillars are: minimum capital requirements; supervisory review and market discipline. While one can argue that Pillar 1 of Basel II - through its focus on historical data and credit ratings - might be pro-cyclical, Pillars 2 and 3 are specifically designed to add balance and judgment to Pillar 1 calculations for minimum capital," Zamorski explained.
Basel II has come under criticism of late, with some experts arguing that it creates perverse incentives to underestimate credit risk. Because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be over-optimistic about their risk exposure in order to minimise required regulatory capital and to maximise return on equity.
However, Zamrosky believes that the responsibility for capital adequacy rests with the institutions themselves rather than the regulators. "Prudence dictates that management of an institution should add a buffer level of capital, above the minimum, based on the size, complexity and unique risks of each individual institution," he said.
He also disagrees with critics of Basel II who believe that it is already outdated as some of the products now being traded were just a twinkle in the traders' eye when the norms were being developed.
"For regulatory standards to be effective, they need to be accompanied by an adequately staffed supervisory function that regularly conducts reasonable levels of transaction testing," he argued. "Any regulatory standard - including capital - should be under constant review for any potential inadequacies and inefficiencies. Regulators need to be vigilant towards new products and new risks in the financial system, and their ability to affect the system, as a whole. This vigilance comes from experience, training and considered analysis, not necessarily through continuous refinements to multi-lateral regulatory guidance."
The need of the hour is that Basel should evolve more organically and more fluidly in a fast moving world.
"In terms of capital adequacy standards, more emphasis should be placed on maintaining an appropriate buffer of capital based on each institution's level of risk, growth plans and strategic objectives," he said. "This is, in essence, the goal of Pillar 2 of Basel II. Pillar 3 should also receive added emphasis to ensure the market is able to digest the risk profile of each institution to make more informed decisions. Although not specifically related to Basel II, due to the global integration of the financial sector, regulators around the globe need to develop more effective methods of communicating with each other on emerging risks. Undoubtedly, the current market turmoil will offer many lessons learned for better firm-level risk management, industry-level analysis of risk and regulatory oversight."
What is Basel II accord?
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.
Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices.
Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.
The final version aims at:
Ensuring that capital allocation is more risk sensitive;
Separating operational risk from credit risk, and quantifying both;
Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects.
The Basel I definition, as modified up to the present, continue to remain in place.
Three pillars concept
The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk.
Other risks are not considered fully quantifiable at this stage.
The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardised approach, Foundation IRB and Advanced IRB. IRB stands for 'Internal Rating-Based Approach'.
For the operational risk, there are mainly three different approaches - the basic indicator approach (BIA), standardised approach (TSA) and the advanced measurement approach (AMA).
For market risk the preferred approach is VaR (value at risk).
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives bank a power to review their risk management system.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
The financial market turmoil is not an indicator of the failure of Basel II norms, Michael Zamorski, Managing Director, Supervision Department of the Dubai Financial Services Authority (DFSA), told Emirates Business in an exclusive interview.
"The success or failure of any institution largely rests with its management team," Zamorski added. "While liquidity and concentration risks are part of an institution's risk management and capital adequacy framework, Basel II was not specifically designed to address these risks," he explained.
"The Basel Committee has addressed these risk components in other publications," said Zamorski, who served as a member of the Basel Committee on Banking Supervision from 2000 to 2006. Zamorski maintains that although the implementation of the banking norms specified in the Basel II accord are supposed to make an institution more risk-sensitive, the accord in itself is not a substitute for risk-management.
"The fundamental objective of Basel II was to revise the 1988 Capital Accord, making it more risk sensitive. Therefore, it is important to remember that Basel II is not a substitute for sound risk management," he said.
Zamorski was responding to queries about the inadequacy of these norms to address some of the inherent, structural weaknesses in the banks' operations that have been partly responsible for the mess that the global financial system finds itself in.
The implementation of Basel II coincides with massive losses reported by some of the world's largest banks, requiring large-scale re-capitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Zamorski, however, disagrees that Basel II has added to boom-bust cycles (Promulgated by the Bank of International Settlements, Basel II is a set of guidelines on how much capital banks should hold to guard against current and future risks).
"Basel II contains three basic components, called 'Pillars.' The three Pillars are: minimum capital requirements; supervisory review and market discipline. While one can argue that Pillar 1 of Basel II - through its focus on historical data and credit ratings - might be pro-cyclical, Pillars 2 and 3 are specifically designed to add balance and judgment to Pillar 1 calculations for minimum capital," Zamorski explained.
Basel II has come under criticism of late, with some experts arguing that it creates perverse incentives to underestimate credit risk. Because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be over-optimistic about their risk exposure in order to minimise required regulatory capital and to maximise return on equity.
However, Zamrosky believes that the responsibility for capital adequacy rests with the institutions themselves rather than the regulators. "Prudence dictates that management of an institution should add a buffer level of capital, above the minimum, based on the size, complexity and unique risks of each individual institution," he said.
He also disagrees with critics of Basel II who believe that it is already outdated as some of the products now being traded were just a twinkle in the traders' eye when the norms were being developed.
"For regulatory standards to be effective, they need to be accompanied by an adequately staffed supervisory function that regularly conducts reasonable levels of transaction testing," he argued. "Any regulatory standard - including capital - should be under constant review for any potential inadequacies and inefficiencies. Regulators need to be vigilant towards new products and new risks in the financial system, and their ability to affect the system, as a whole. This vigilance comes from experience, training and considered analysis, not necessarily through continuous refinements to multi-lateral regulatory guidance."
The need of the hour is that Basel should evolve more organically and more fluidly in a fast moving world.
"In terms of capital adequacy standards, more emphasis should be placed on maintaining an appropriate buffer of capital based on each institution's level of risk, growth plans and strategic objectives," he said. "This is, in essence, the goal of Pillar 2 of Basel II. Pillar 3 should also receive added emphasis to ensure the market is able to digest the risk profile of each institution to make more informed decisions. Although not specifically related to Basel II, due to the global integration of the financial sector, regulators around the globe need to develop more effective methods of communicating with each other on emerging risks. Undoubtedly, the current market turmoil will offer many lessons learned for better firm-level risk management, industry-level analysis of risk and regulatory oversight."
What is Basel II accord?
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.
Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices.
Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.
The final version aims at:
Ensuring that capital allocation is more risk sensitive;
Separating operational risk from credit risk, and quantifying both;
Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects.
The Basel I definition, as modified up to the present, continue to remain in place.
Three pillars concept
The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk.
Other risks are not considered fully quantifiable at this stage.
The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardised approach, Foundation IRB and Advanced IRB. IRB stands for 'Internal Rating-Based Approach'.
For the operational risk, there are mainly three different approaches - the basic indicator approach (BIA), standardised approach (TSA) and the advanced measurement approach (AMA).
For market risk the preferred approach is VaR (value at risk).
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives bank a power to review their risk management system.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
By Shuchita Kapur
© Emirates Business 24/7 2008
