Risk Management, PRMIA

The new proposal termed 'Basel II-Based Standardized Approach Capital Proposal' is a step forward to make the smaller US banks adopt the more simpler and easier elements of Basel II standardized approach.

This is consistent with some other large countries that opted to mandate Basel II standardized approach for Credit Risk and Basic Indicator approach for Op Risk as the first phase for its banks with an option to adopt Basel II Advanced as an optional Phase II. This also means that the often speculated upon Basel II IA or Basel I.5 option in US, whatever one may choose to call it is mostly off the table as an option.

FDIC expects this standardized approach capital framework to add greater risk sensitivity without creating excessive complexity and burden and thus, should minimize inequities between large and small banks. The key factor in favor of standardized approach is the fixed risk weights that provides supervisors with better control over fluctuations and unconstrained reductions in risk based capital. In my view this is a safe and pragmatic approach especially given the credit crisis in the US.

Some of the key aspects of this proposal are:
- adding more risk buckets to the existing rules
- expanding the use of external ratings to a broader range of exposures
- expanding the recognition of credit risk mitigants, such as collateral and guarantees
- establishing a more risk-sensitive approach for residential mortgages based largely on loan-to-value measures
- increasing the capital requirements on certain off-balance sheet exposures, including liquidity lines to asset-backed commercial paper exposures
- requiring a capital charge for operational risk using the Basic Indicator Approach under the Basel II capital framework

The Basel II standardized albeit being a lot simpler and easier to adopt, still would prove to be a challenging initiative for smaller institutions. Some banks did underestimate and underinvest in the Basel II standardized approach projects in other countries ahead in the Basel II journey. This was due to overconfidence in their readiness and the ability to implement Basel II. Due to which some did face issues with the Basel II supervisory validation process.I do hope this learning carries over to the US market.

This FDIC proposal is open for comments and feedback from the industry for 90 days. Perhaps some of the leading Basel II experts from PRMIA community could submit feedback on a collective basis. I am happy to facilitate such an effort if there is enough interest.

The burden of regulation has lately been a hot topic in the US, specially on the stock exchange listings requirements and also led to the review of some of the SOX requirements. But at same time pressure builds up for better regulation of markets after the credit crisis and bail out of Bear Sterns. There was also Deptt. of Treasury led initiative to rationalize the supervisory system in the US comprising OCC, Fed Reserve, SEC, FDIC etc. Combined with the IFRS ratification, its perhaps conveys the urgency in the way US regulators are looking to streamline its financial sector vis-à-vis other leading economies, walking the thin line between competitiveness, market friendly policies and effective oversight.

Source: www.fdic.gov