February 08, 2008
Brave New World of Pillar 2
It is entirely appropriate that I write about Basel II in my first post, given that financial institutions and regulators in many countries have taken a big leap into the brave new world of Basel II.
An important innovation in Pillar 2 is the system of self assessment (much like the quality self checks under the CMM or the ISO assessment process) that banks are required to undertake with regard to capital levels. Identifying material risks, and holding enough capital (even in unexpected downturns) is the essence of the internal capital assessment process (ICAAP) in banks. Of course, the regulator is just not going to accept what the banks propose in their ICAAP outputs; these will be subjected to a review process to finally determine the capital guidance This brings me to the question that is worrying many banks (and probably a few regulators): how will capital levels be decided for each bank? What are the implications?
In the good old days of Basel I, capital adequacy rules were uniform, non discretionary and non judgmental. In the brave new world of Basel 2, 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.
The imposition of additional capital charges under Pillar 2 may translate into capital raising requirements. The target and trigger ratios for a bank will be determined individually and could be set at high levels if outcome of the supervisory review process is unfavourable or the likelihood of a “supervisory risk event” is high. The depth and rigor of the ICAAP is crucial - this means that banks have to take this process very seriously – material risks need to be identified, methods of testing capital levels against downturns need to be implemented; policies and procedures need to be streamlined and most importantly, internal control mechanisms need to be strengthened. All this sounds like spring cleaning - hopefully, banks will put their best foot forward when being assessed under Pillar 2.
On the regulatory side, this means a lot of work. The ICAAP has to be reviewed and additional capital levels need to be arrived at for each bank. This process raises doubts among banks. How will regulators quantify risks like reputational risk, strategic risk and concentration risk to name a few? Some of these risks may be common across particular licensees – will the regulator apply the same yardstick or will use a different interpretation for each bank? Is the process open to appeal? (credit rating agencies have an appeal process in which issuers can provide additional information if they are not satisfied with the assigned ratings).
A high capital guidance ratio for a bank in relation to its peers could mean that the bank has 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 3 requirements.
The supervisory review process is also likely to place a lot of demand on the regulators in terms of time and expertise. Regulators will have to beef up their understanding of banking risks, quantification methods and also have an in-depth understanding of each bank to argue with smart and sophisticated licensees. How will regulators bring in their micro prudential regulatory framework into the supervisory review process? Sounds like quite a bit of work?
To put in other way, Pillar 2 represents an opportunity to banks to align risk management practices with the regulatory capital levels. This was one the basic flaws under the earlier system which is sought to be corrected. On the regulatory side, Pillar 2 represents an opportunity for regulators to strengthen the supervisory framework and customize responses for each bank depending upon its risk, governance and controls.
However this means a lot of work on both sides of the table and will not necessarily be smooth. Capital guidance is likely be debated and challenged by banks and regulators will have to find ways of dealing with the smart and sophisticated licensees. Sounds exciting indeed!
Posted by aaaaaaa at 09:38 AM
| Comments (0)
