The November 2009 edition of the Basel ii
Compliance Professionals Association (BCPA) newsletter
October 2009 Survey:
We have a winnerAdeyanju
Alade
Dear members,
Do you remember our survey?
"Which
is the most important opportunity and the most
important challenge for risk and compliance management
professionals, working for the implementation of the
Basel ii framework, in 2010?"
Adeyanju Alade gave the best answer, and we will send
him the CBiiPro program for free.
His answer:
Most important challenge to professionals
Cross-Border Implementation of Basel II: The adoption
of differing approaches to Basel ii framework by
various countries will pose challenges for banking
organizations and their risk and compliance management
professionals during their operations in multiple
jurisdictions. The home-host issues against the
backdrop of the process of changing to new version of
Basel ii is bound to heighten concerns amongst risk
and compliance management professionals from one
country to the other. All Basel-member countries have
their own rollout timelines and their own ways of
addressing matters that are left to national
discretion under the Accord.
Adeyanju Alade, thank you. This is really a big
challenge.
Some of the most important challenges for risk and
compliance management professionals,
according to our members:
1. "The lack of support by senior management and
the board"
2. "To
select the best model"
3. "To
overcome the perception that risk models do provide
sufficient value to justify moving forward"
4. "To make people / users aware of the risk and
various controls, to make users comply to the
processes and policies"
October 2009 Survey
I am surprised, nobody can see any important
opportunities!
Where are the opportunities?
Basel ii is becoming much more important. Basel ii
experience is becoming a great advantage.
Why?
Because 20 leaders (G20) say so.
Which other framework is endorsed by 20 presidents and
leaders?
Which country, bank, financial organization can ignore
it?
It is good to read:
Breaking News
PROGRESS REPORT ON THE ECONOMIC
AND FINANCIAL ACTIONS OF THE LONDON, WASHINGTON AND
PITTSBURGH G20 SUMMITS PREPARED BY THE UK CHAIR OF THE
G20 ST ANDREWS, 7 NOVEMBER 2009
1. SUMMIT COMMITMENT
We ask regulators to make use of available flexibility
in capital requirements for trade finance.
PROGRESS AND NEXT STEPS
Eligible countries continue to consider flexibilities,
including through ongoing co-operation in the
Basel Committee on Banking
Supervision (BCBS) and Financial Stability Board (FSB).
The World Trade Organisation chaired Expert
Group on trade finance will also take stock on Basel
II and trade finance ahead of the Pittsburgh Summit.
2. SUMMIT COMMITMENT
Establishment of the remaining supervisory colleges
for significant cross-border firms by June 2009.
PROGRESS AND NEXT STEPS
Supervisory colleges have now been established for
more than thirty large complex financial institutions
identified by the FSF as needing college arrangements.
These colleges will continue to meet on an ongoing
basis.
Over the summer, the FSB, BCBS
and International Association of Insurance Supervisors
(IAIS) carried out a comprehensive stocktaking of
college arrangements and practices in the banking
sector and insurance sector.
The main findings of these surveys were reported to
the G20 at the Pittsburgh Summit. The BCBS is working
to develop a baseline set of principles along with
good practice guidelines to assist the efficient
operation of colleges and sharing of information.
The principles and guidelines
will be completed in the first quarter of 2010.
In October 2009, the IAIS adopted a supervisory
guidance on the use of supervisory colleges.
In June IOSCO launched a Supervisory Cooperation Task
Force, which will develop principles for cooperation
in the supervision and oversight of cross-border
securities market participants.
This Task Force will produce its final report for the
Technical Committee early in 2010.
The FSB will review whether there is any merit in
having a broad set of principles setting out good
practices in the operation of colleges and information
sharing that would apply on a cross-sector basis.
3. SUMMIT COMMITMENT
Prudential regulatory standards should be strengthened
once recovery is assured.
The national implementation of higher level and better
quality capital requirements, counter-cyclical capital
buffers, higher capital requirements for risky
products and off balance sheet activities, as
elements of the Basel II capital
framework, together with strengthened liquidity
risk requirements and forward-looking provisioning,
will reduce incentives for banks to take excessive
risks and create a financial system better prepared to
withstand adverse shocks.
Leaders have committed to developing by end-2010
internationally agreed rules to improve both the
quantity and quality of bank capital and to discourage
excessive leverage.
These rules will be phased in as financial conditions
improve and economic recovery is assured, with the aim
of implementation by end-2012.
PROGRESS AND NEXT STEPS
In Pittsburgh Leaders welcomed the key measures agreed
on 7 September 2009 by the Group of Central Bank
Governors and Heads of Supervision, the oversight body
of the BCBS, to
strengthen the supervision and regulation of the
banking sector.
These include:
• Raise the quality, consistency and transparency of
the Tier 1 capital base.
• Introduce a leverage ratio as a supplementary
measure to the Basel II risk-based framework with a
view to migrating to a Pillar 1 treatment based on
appropriate review and calibration.
• Introduce a minimum global standard for funding
liquidity that includes a stressed liquidity coverage
ratio requirement, underpinned by a longer-term
structural liquidity ratio.
• Introduce a framework for countercyclical capital
buffers above the minimum requirement.
The Committee also agreed to assess the need for a
capital surcharge to mitigate the risk of systemic
banks.
The BCBS will issue concrete
proposals on these measures by the end of this year.
At its October meeting, the BCBS
agreed the framework and timeline for undertaking a
quantitative impact study and the calibration of the
overall capital level by end 2010.
The impact assessment will look at the cumulative
effect of all the reforms and how they interact.
Appropriate implementation standards will be developed
to ensure a phase-in of these new measures that does
not impede the recovery of the real economy.
Government injections will be grandfathered.
4. SUMMIT COMMITMENT
The FSB, BCBS and Committee on the Global Financial
System (CGFS), working with accounting standard
setters should take forward implementation of the
recommendations published to mitigate procyclicality,
by the end of 2009, including a requirement for banks
to build buffers of resources in good times that they
can draw down when conditions deteriorate.
PROGRESS AND NEXT STEPS
The Group of Central Bank Governors and Heads of
Supervision, the oversight body of the BCBS, reached
agreement on 7 September 2009 to introduce a framework
for countercyclical capital buffers above the minimum
requirement.
In October, the BCBS agreed to develop concrete
proposals to reduce the pro-cyclicality of Basel II
and introduce a counter-cyclical buffer mechanism.
There will be four elements to
this:
• dampening the cyclicality of the minimum capital
requirement;
• promoting more forward looking provisions;
• conserving capital to build capital buffers at
individual banks and the banking sector that can be
used in stress;
• achieving the broader macroprudential goal of
containing excess credit growth and protecting the
banking sector from system-wide risk.
Proposals for the first three elements will be
developed by the end of this year and on the fourth by
the middle of next year.
A comprehensive package to address procyclicality will
be finalised by the end of next year.
The BCBS is actively engaged with accounting standard
setters to promote more forward-looking provisions
based on expected losses.
5. SUMMIT COMMITMENT
Risk-based capital requirements should be supplemented
with a simple, transparent, non-risk based measure
which is internationally comparable, properly takes
into account off-balance sheet exposures, and can help
contain the build-up of leverage in the banking
system.
We support the introduction of a
leverage ratio as a supplementary measure to the Basel
II risk-based framework with a view to migrating to a
Pillar 1 treatment based on appropriate review and
calibration.
To ensure comparability, the details of the leverage
ratio will be harmonised internationally, fully
adjusting for differences in accounting.
PROGRESS AND NEXT STEPS
The Group of Central Bank Governors and Heads of
Supervision, the oversight body of the BCBS, reached
agreement in September to introduce a leverage ratio
as a supplementary measure to the Basel II risk-based
framework with a view to migrating to a Pillar 1
treatment based on appropriate review and calibration.
To ensure comparability, the details of the leverage
ratio will be harmonised internationally, fully
adjusting for differences in accounting.
A key issue will be the appropriate level and how it
interacts with the risk based ratio.
6.
SUMMIT COMMITMENT
All major G-20 financial centres commit to have
adopted the Basel II capital framework by 2011.
PROGRESS AND NEXT STEPS
G20 countries have either implemented or are taking
steps to implement Basel II into national regulatory
frameworks.
7. SUMMIT COMMITMENT
BCBS to review guidelines for processes for
measurement of risk concentrations in 2009 to ensure
they are timely and comprehensive.
PROGRESS AND NEXT STEPS
The BCBS has strengthened guidance for use in the
Pillar 2 supervisory review process of the Basel II
framework to address key lessons of the crisis,
covering governance, the management of risk
concentrations, stress testing, valuation practices
and exposures to off-balance sheet activities.
8. SUMMIT COMMITMENT
Regulators should develop enhanced guidance to
strengthen banks’ risk management practices, in line
with international best practices, and should
encourage financial firms to re-examine their internal
controls and implement strengthened policies for sound
risk management.
PROGRESS AND NEXT STEPS
The BCBS has strengthened guidance for use in the
Pillar 2 supervisory review process of the Basel II
framework to address key lessons of the crisis,
covering governance, the management of risk
concentrations, stress testing, valuation practices
and exposures to off-balance sheet activities.
National authorities have also
strengthened their guidelines for risk management
practices following the shift to Basel II.
The Senior Supervisors Group (SSG) issued in October
2009 a report setting out the results of a self
assessment exercise by twenty large financial
institutions to benchmark their own risk management
practices against official and industry
recommendations issued since the outbreak of the
crisis.
The report also reviewed in-depth the funding and
liquidity issues central to the recent crisis and the
areas of risk management practices warranting
improvement across the financial services industry.
9. SUMMIT COMMITMENT
The Basel Committee should study the need for and help
develop firms’ stress testing models, as
appropriate.
PROGRESS AND NEXT STEPS
The BCBS has strengthened guidance for use in the
Pillar 2 supervisory review process of the Basel II
framework to address key lessons of the crisis,
covering governance, the management of risk
concentrations, stress testing, valuation practices
and exposures to off-balance sheet activities.
The BCBS issued in May 2009 Principles for Sound
Stress Testing Practices and Supervision.
10. SUMMIT COMMITMENT
Supervisors should require that institutions which
have hedge funds as their counterparties have
effective risk management, including mechanisms to
monitor the funds’ leverage and set limits for single
counterparty exposures.
PROGRESS AND NEXT STEPS
The BCBS is reviewing the treatment of counterparty
credit risk under all three pillars of Basel II.
Concrete proposals will be presented at the December
2009 BCBS meeting.
11. SUMMIT COMMITMENT
BCBS should integrate FSB principles on pay and
compensation into their risk management guidance by
autumn 2009.
PROGRESS AND NEXT STEPS
The BCBS incorporated the Principles in Pillar 2 of
Basel II in July 2009, with an expectation that banks
and supervisors begin implementing the new Pillar 2
guidance immediately.
The Group of Central Bank Governors and Heads of
Supervision, the oversight body of the BCBS, endorsed
in September 2009 the following principle to guide
supervisors: compensation should be aligned with
prudent risk taking and long-term, sustainable
performance, building on the FSB sound compensation
principles.
Breaking News: Important Changes in the Basel ii
framework in the European Union
The amendment of the Capital Requirements Directive
Accompanying document to the
Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT
AND OF THE COUNCIL
amending Capital Requirements Directive on trading
book, securitization issues and remuneration policies
IMPACT ASSESSMENT
Summary of problems and objectives
A. Capital Requirements for
Trading Book
- Not all material credit risks in
trading books are
appropriately reflected in current capital
requirements
- Capital requirements of institutions as determined
by using VAR models are
not robust enough to
absorb potential trading book losses
- Swings in capital position, linked to trading losses
and volatility of capital requirements for trading
activities, risk exacerbating pro-cyclicality of bank
lending and investment with possible negative
implications for the real economy
- Regulatory arbitrage
possibilities possibly lead to undercapitalization
B. Capital Requirements for
Re-securitizations
- Capital required for re-securitizations does
not adequately reflect their
higher risk compared to "normal"
securitisations
- Swing in capital position, driven by losses from
resecuritizations, exacerbated pro-cyclicality of bank
lending with possible negative implications for the
real economy
C. Disclosure of
Securitization Risks
-Lack of transparency of banks' exposure to
securitizations contributed to the loss of market
confidence, which had a negative impact on the
liquidity of inter-bank markets, particularly
affecting banks who relied on wholesale funding
D. Remuneration Schemes
-Excessive short-term risk
taking impaired soundness of institutions,
disrupted financial stability and exacerbated
procyclicality in the financial system
Capital requirements rules stipulate the minimum
amounts of own financial resources that banks must
have in order to cover the risks to which they are
exposed.
The aim is to ensure the financial soundness of these
institutions and, in particular, to ensure that they
can weather difficult periods and that their
depositors are protected.
This is aimed at ensuring financial stability and
maintaining confidence in financial institutions.
In the EU, the current bank
capital framework is represented by the Capital
Requirements Directive (CRD) comprising Directives
2006/48/EC and 2006/49/EC and reflecting the
proposals of the Basel Committee for the Basel II
Framework (Basel II) and Trading Book Review.
It covers both credit
institutions and investment firms.
With the adoption of the CRD, capital requirements
became more comprehensive.
In particular, they were expanded to cover
'operational' risk (e.g. the risk of systems breaking
down).
Also, the rules were made more
risk-sensitive, with a possibility for
institutions to adopt approaches to determining
regulatory capital that are appropriate to their
situation and to the sophistication of their risk
management.
For instance, the Internal Ratings Based (IRB)
approach enabled institutions to determine capital
requirements for credit risk of their corporate
portfolios, by using their own ‘risk inputs’ such as
probability of default and loss given default.
The calculation of these risk inputs was made subject
to a strict set of operational requirements to ensure
that they are robust and reliable.
The CRD also enhanced the role
of the ‘consolidating supervisor’ by assigning
it responsibilities and powers in coordinating the
supervision of cross-border groups and laid out a
three-pillar structure representing additional marked
differences from a predecessor legislation.
Shortcomings of VAR Models
Drivers:
VAR models based on short periods of historical data
which may not capture relevant market stress episodes
VAR models' assumption of independent returns does not
hold at times of market stress when correlations
between risk factors increase
Problems:
Capital requirements as determined by using VAR models
are not robust enough to absorb potential trading book
losses and contribute to sub-optimal level of risk
management.
Swings in capital position, linked to trading losses
and volatility of capital requirements for the trading
book, risk exacerbating procyclicality of bank lending
and investment with negative implications for the real
economy.
Starting with the second half of 2007, several banks
reported trading losses many times exceeding their VAR
estimates.
While the VAR estimates had soared due to historically
high volatility, they still grossly underestimated
market risks.
As a result, banks experienced a large number of 'backtesting
exceptions', i.e., instances when the actual loss
exceeded estimated VAR for a given day. Statistically,
this number should not be higher
than three per year for VAR calculated assuming
a 99% confidence level.
An analysis by Standard and Poor's, however, shows
that a number of backtesting exceptions recorded by
several large
European and US banks in 2007 reached
multiples of this number.
The large number of VAR exceptions casts doubt on the
robustness of VAR models in stress conditions.
To recall, banks may calculate capital requirements on
the basis of these VAR models. Even though capital
requirements, when derived this way, also incorporate
a safety margin, backtesting exceptions constitute
events when actual losses in the trading book may have
exceeded the actual capital required for the trading
book.
Importantly, institutions' own estimates of economic
capital for market risk indicate that current
regulatory capital requirements for market risk are
insufficient. For example, Deutsche Bank in its annual
report estimated economic capital required for its
traded market risk at €5.5 billion at the end of 2008.
Meanwhile, its regulatory market risk charge was
around €1.9 billion, i.e., 65%
less than bank's own economic capital estimate.
VAR models are based on historical data on risk
factors, regulatory requirements setting a look-back
period of one year.
They therefore provide limited insight into risks that
do not show within the model's 'time window'. In
particular, if the time window does not encompass
periods of illiquidity that leads to increases in
asset price volatility, VAR will fail to produce a
relevant measure of risk on some positions.
Not only will the short look-back period render the
VAR based regulatory capital less sound in the sense
that actual losses may exceed the regulatory capital
requirement. An additional problem caused by the
short look-back period is
that capital requirements become volatile.
For instance,
VAR
measure of Deutsche Bank increased from €76.9 million
at the end of 2006 to €131.4 million at the end of
2008,
i.e., by more than 70% - an increase that is still
likely to understate the actual volatility of the VAR
measure assuming a constant portfolio composition, as
one can safely assume that the bank have tried to
reduce its exposures over the stressed period in
question.
This volatility of capital requirements implies that
banks can take a lot of risk during good times but are
curtailed in their risk taking ability during more
difficult times, as regulatory capital requirements
rise at the time when the level of available capital
is eaten up by losses from operations yet raising
additional capital in the markets becomes more
expensive, if not impossible.
While such risk reassessment can be viewed as rational
from the individual firms perspective, it considerably
reduces liquidity in already stressed capital markets
and in a wider sense also introduces volatility into
banks' ability and willingness to lend to the real
economy thus exacerbating the underlying cyclical
trends.
Most VAR models use correlations among risk factors
that are not stressed.
Under stress conditions like the ones experienced
during the 2007-2008 episode, however, correlations
change and the benefits of risk diversification as
assessed by VAR in the preceding more benign
environment turn out to have been overestimated.
To illustrate, a bank trading in both equity and bond
risks will in good times benefit from risk
diversification as shares and bonds
will often not experience losses at the same time.
When market conditions deteriorate, extreme movements
can however occur in all risk categories
simultaneously.
Moreover, in times of stress,
bad days tend to cluster.
Proposed amendments to the Capital Requirements
Directives
The purpose of the Capital Requirements Directives
(2006/48/EC and 2006/49/EC) is to ensure the financial
soundness of banks and investment firms. Together they
stipulate how much of their own financial resources
banks and investment firms must have in order to cover
their risks and protect their depositors. This legal
framework needs to be regularly updated and refined to
respond to the needs of the financial system as a
whole.
The main
changes proposed are as follows:
Capital requirements for re-securitisations
Re-securitisations are complex financial products that
have played a role in the development of the financial
crisis. In certain circumstances,
banks that hold them can be
exposed to considerable losses. The proposal
will impose higher capital requirements for re-securitisations,
to make sure that banks take proper account of the
risks of investing in such complex financial products.
Disclosure of securitisation exposures
Proper disclosure of the level of risks to which banks
are exposed is necessary for market confidence. The
new rules will tighten up disclosure requirements to
increase the market confidence that is necessary to
encourage banks to start lending to each other again.
Capital requirements for the trading book
The trading book consists of all the financial
instruments that a bank holds with the intention of
re-selling them in the short term, or in order to
hedge other instruments in the trading book. The
proposal will change the way that banks assess the
risks connected with their trading books to ensure
that they fully reflect the potential losses from
adverse market movements in the kind of stressed
conditions that have been experienced recently.
Remuneration policies and practices within banks
The proposal will tackle perverse pay incentives by
requiring banks and investment firms to have sound
remuneration policies that do not encourage or reward
excessive risk-taking. Banking supervisors will be
given the power to sanction banks with remuneration
policies that do not comply with the new requirements.
