As the Banks in emerging markets have, to a reasonable extent, come to terms with the complexities of risk weights, external ratings and credit mitigants. Now the spotlight shifts to interest rate risk in the banking book, liquidity risk , stress testing and other risks. All of these risks have to be factored in Bank's overall capital assessment and management. The supervisor has the final say on the Bank's capital management process and can ask for corrective action or more capital.
What are the key takeaways from this exercise?
1. The signal from the regulator has put the Banks in an active mode in countries that have come out with guidelines in Pillar 2. That is an important gain in itself, as it propels the banks towards improved and holistic risk management and measurement framework.
2. This is good for the supervisors as they grapple to ensure financial stability in the midst of global financial turmoil.
the submission of ICAAP reports by the banks to the supervisors will give them a huge pool of knowledge on risk management systems and practices of the financial institutions adopting Pillar 2.
3.By forcing Banks to take a closer look at all material risks that they are exposed to, the bank's capital management policy will now be better aligned to its economic capital.
4. The ICAAP will be forward looking, as they will contain several stress tests on bank's financials and capital ratios.
5. Risk appetite will be closely monitored with a prompt corrective action strategy under ICAAP.
And the challanges....
While the process, as we can see, have significant direct and indirect benefits to banks, The transition to pillar 2 will bring its fair share of challanges. It will be an adventure into the road less travelled, and supervisors and market players have to surmount serious challanges.
It will be a journey into an unknown territory as methods for quantifying risks under pillar 2 are less well defined, though not less important. For instance, relating liquidity risks to an economic capital number will be difficult, given its known friendship with market and credit risk.
Risk aggregation will bring issues of diversification benefits and quantifying such risk aggregation benefits to capital strategy may be difficult.
The phase of negotiation with the supervisor will bring challanges of its own. Supervisory perception of banks have to find some common platform for all banks. Transparent supervisory guidance will be critical, so that banks are convinced that they have a fair and level playing field.
Supervisors will find difficulty in comparing various qualitative and quantitative information flowing from the banks and in ensuring consistency in their approaches.
Deciding on a minimum capital number for banks or slotting them in various CAR bands will be a challange that will force supervisors to have sleepless nights.
And finally, once the minimum ratios prescribed by the regulator will become public, the bank's business will be impacted by this small but power-packed additional piece of information.
With all these and more, the Pillar 2 promises to be full of action, drama, joys and tears - with all the essential ingradients of a great story!
