Calming supervisory fears

Regulations

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Asked what gives them the most cause for concern when it comes to Basel II, the bulk of the 70 or so Asian banks that took part in a recent survey by consultants KPMG pointed not to the complexity of the new Accord, nor to the tight implementation schedule as their number one anxiety. The area that elicited most unease from Asian banks was actually Pillar II, the part of the Accord covering supervisory review.

In fact, 71% of the respondents in Asia identified this as the area of most concern. That compares with 56% of the US institutions questioned and 47% of those banks that took part in the survey in Europe. Why the disparity? Part of it is most likely to do with the number of discretion items open to national regulators, and a perception that, given a penchant by some of the region’s regulators to taking very much a ‘hands-on’ approach to banking supervision, this will potentially translate into more formal capital requirements and higher costs for Asian institutions.

Under Pillar II, supervisors have a remit to assess banks’ approaches to managing risk and validate the risk models of domestic institutions. While Pillar I sets minimum capital requirements for credit, market and operational risk, Pillar II covers a wider assortment of risks – including interest rate risk in the banking book, liquidity risk and concentration risk – and gives domestic regulators the flexibility to set their own formal capital requirements for these risks if necessary.

As well as the fear of higher capital charges, this flexibility granted to national regulators also raises the issue of complexity. Given the number of different supervisory jurisdictions across Asia, those banks with operations right across the region may be subject to slightly different risk management requirements in each country.

For Singapore, one of the region’s major financial hubs, the Monetary Authority of Singapore (MAS) is currently reviewing these various discretion items and formulating its own national guidelines. However, the regulator is well aware of the challenges banks will face if there are too many regulatory discrepancies across different jurisdictions; and it recognises the need to maintain, as much as possible, a consistent, global framework for Basel II.

“Where there is common ground, less national discretion will give greater comparability between jurisdictions,” says Low Kwok Mun, executive director in the prudential policy department at MAS in Singapore. “But where there is clearly no single right approach, you will probably need to allow regulators some leeway to make some adjustments based on the particular circumstances in their respective jurisdictions. It all depends on how regulators apply those national discretions. However, there may be concerns that some regulators may exercise their discretions to enhance the competitive position of their banks.”

Despite beginning its review, MAS has not arrived at any firm decision as to how it will approach the various items of national discretion. It is, though, looking closely at a number of items, with interest rate risk being one area that the regulator “perhaps needs to provide clearer direction on”. MAS is currently consulting with the city-state’s financial institutions, and national guidelines are likely to emerge in stages over the course of this year, says Low. “We have been talking to banks to get their feedback on a number of issues, and we will be consulting with them on the proposals and approaches that we intend to take,” he adds.

However, Low does not expect too many changes to the current supervisory and inspection regime, both for domestic banks and for the bevy of foreign financial institutions with offices in Singapore. MAS currently employs a risk-based supervisory review process, with the frequency of its on-site inspections dependent on the scale of the bank’s operations, the potential impact of any failure on Singapore’s financial system, and the types of risks it takes. “There will be no major changes,” says Low. “But we will want to know how the [foreign bank’s] head office is approaching the revised capital rules, because like any other regulator, we want to be satisfied that the Singapore branch belongs to a banking group that is well capitalised.”

The city-state’s three domestic banking groups – DBS Bank, UOB and OCBC – will have the flexibility to choose which of the approaches to managing credit and operational risk to adopt – although MAS is encouraging the banks to adopt elements of the most advanced approaches to conform with best practice risk management, even if they don’t implement the internal ratings-based (IRB) approaches throughout the whole organisation. “We have already told them we will not mandate any particular approach, so they will have to do their own assessments,” explains Low. “But at the same time, we have encouraged them to adopt the better risk management practices embodied in the advanced approaches. Ultimately, it is for the banks to make the decision on the choice of approach they should adopt.”

However, the main stumbling block is the cost-versus-reward considerations of implementing Basel II. Certainly, the cost of implementation is one of the main obstacles highlighted in the KPMG survey, with 71% of Asian respondents identifying this as the biggest hurdle for Basel II compliance. However, Singaporean banks are unlikely to achieve much of a reduction in regulatory capital, with capital ratios likely to remain more or less unchanged, according to the results of the third quantitative impact study conducted last year. “If [the banks] use the advanced approaches, there will probably be a little bit of capital saving, but nothing very major,” says Low. “It really depends on the banks’ risk profile.”

With regulatory capital savings likely to be small, do Singaporean banks actually have the incentive to fork out for the systems, databases and personnel required for the advanced approaches? Low hopes so.

“The banks have to look ahead, particularly if they want to increase their level of sophistication. It is in the banks’ interest to expand and take on a little bit more risk than they are doing now. There could be some longer-term benefits. But in doing so, we would want them to improve their risk management practices, not just to benefit from some capital savings, but to adopt best practices for managing risks such as credit risk, market risk and the like.”

Given the scale of Basel II, Low recommends that the banks should prioritise by looking at the most important areas of the new Accord first; in particular, credit risk. “We cannot expect the banks to be looking at every single aspect all at once because the resource requirements are tremendous,” says Low. “So they should perhaps focus on the more significant areas and those that have greater impact on the banks first. You have to prioritise, you cannot be looking at all the areas at the same time.”

Operational risk doesn’t appear to be among these immediate priorities. MAS has not yet decided how it will approach the thorny issue of op risk management, and may take its lead from how other supervisors deal with it. “Presently, operational risk is an issue many regulators are grappling with,” says Low. “We can’t really say whether we are comfortable with the current approaches or not. We are studying this issue carefully. We haven’t reached any decisions on how we are going to approach that yet, but it is not such a straightforward measure. We may learn from other supervisors on how they approach operational risk.”

Despite these outstanding issues – and despite the fact that a comprehensive set of national guidelines are not expected to emerge before the end of the year – MAS intends to switch to the new Accord on the date recommended by the Switzerland-based Basel Committee on Banking Supervision. “We will implement Basel II in line with when the G10 and the other international regulators adopt Basel II. But it is left to the Singapore banks as to whether they use the standardised, foundation or advanced IRB approaches then.”

Basel Committee delays rollout of advanced IRB

The Basel Committee on Banking Supervision has delayed the implementation of the most advanced approaches to credit and operational risk within Basel II until the end of 2007. Rollout of the standardised and foundation approaches, however, will go ahead as planned at the end of 2006.

The delay gives those banks aiming for the advanced internal ratings-based (IRB) approach to credit risk and the advanced measurement approach (AMA) to operational risk an extra year to run systems in parallel and conduct impact analysis. The one-year postponement is also aimed at giving banks and supervisors more time to develop a consistent approach to implementing the advanced approaches.

Under the new schedule, banks planning to move directly to the advanced IRB approach will run parallel systems during 2006 and 2007. Parallel running for banks adopting the foundation IRB approach, however, will apply for one year throughout 2006. The floors on both foundation and advanced approaches will be set at 90% and 80% for 2008 and 2009, while the floor for the foundation approach in 2007 will be 95%.

The Basel Committee has also announced that it had reached agreement on the outstanding issues that had prevented the earlier publication of the new Accord. These include specifying a treatment for revolving retail exposures and resolving the measurements for loss-given default parameters in the IRB approaches. Now that consensus on the technical issues has been reached, the final version of the Accord will be published at the end of June.

The committee has also made further progress on the home/host issue, confirming that the home regulator will play the leading role in the approval and validation of models for the advanced approaches. This is aimed at avoiding duplication among supervisors and reducing the implementation burden on banks active across a number of jurisdictions. Supervisors that want information on Basel II implementation from foreign branches operating in their territory should ask the bank’s home supervisor first, the committee said.

One area still open to debate, however, is the allocation of operational risk capital across different jurisdictions by banks using the AMA approach. In January, the Basel Committee announced that internationally active banks using the AMA approach will be able to adopt a ‘hybrid approach’, using a combination of standalone AMA calculations for ‘significantly active banking subsidiaries’ and an allocated portion of the group-wide capital requirement for its other subsidiaries.

Despite strong calls for clarification, the committee declined to define ‘significantly active’ and therefore shed light on which subsidiaries will be required to calculate AMA capital on a stand-alone basis, simply pointing out that it is not its intent that a large number of banking subsidiaries should be required to adopt standalone AMA calculations. “The committee expects that home and host supervisors will work together in implementing the new Accord to determine which internationally active subsidiaries can reasonably be deemed to be significant,” it said.

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