Turning Basel II Compliance into a Competitive Edge

Firms that take a strategic look across the enterprise and adopt a forward-looking perspective can cost-effectively build a powerful competitive advantage for today and tomorrow. How are you shaping your infrastructure to support the greater demands of data capture, data mining and risk management? Which models and information sources are you using to validate and enrich your own credit risk analysis? How will you demonstrate a robust risk management culture, from the boardroom to the back office?

Challenges

In the new Basel II world order, financial institutions will need to:

• Establish a robust infrastructure – strengthen systems and processes and establish strong information controls. Demonstrate the ability to systematically track operational losses and risks by business line and support the greater data demands.
• Establish a strong risk culture across the organization – adopt practices and processes that support risk awareness and management.
• Accurately aggregate exposures across the enterprise portfolio – demonstrate the ability to reliably measure and mitigate risks across asset classes, and ensure diversification and reduce conflicts of interest by identifying relationships across the global portfolio.
• Reliably assess credit and operating risks – the first tenet of Basel II mandates that firms, with a strong international presence, adopt a methodology for computing capital reserve requirements that accurately reflects the firm’s risks. Depending upon size and structure, a firm may rely on the assessments of a credible third party or build and externally validate an internal ratings model. The advanced methodologies rely on ready stores of detailed credit risk information, such as probability of default and loss given default data. The quality and availability of the underlying data is paramount.

Solutions

Establish an Infrastructure that Supports Compliance

Basel II and other new regulations pose new challenges to banks. Amid the cries for greater disclosure and transparency, there are new accounting wrinkles and more complex algorithms for assessing the risk on different types of transactions and counterparties. All of these present technological challenges in implementation and compliance.

More than ever, there is a strategic need to master the data that’s collected across the organization and to be able to analyze and serve it up in meaningful ways and in real-time. Central to these increased demands is a robust infrastructure and data that can be shared and mined across applications and systems.

In a time of information overload, it is not the amount of information that’s in question but whether it’s the right information and in a format that can be readily analyzed. For cost reasons, many organizations have taken a piecemeal approach to upgrading systems and automating key processes. M&A activity often exacerbates the issue, culminating in a sub-optimal mix of old, new and hybrid systems and processes. Critical data may be housed in different systems and categorized in non-compatible lexicons. In order to comply with the demands of Basel II, banks will need to make the time/money investment to develop systems and processes that enable them to efficiently collect, store and draw on the data.

By using Basel II and other mandates as the catalyst for an enterprise-wide examination and refinement of its infrastructure and processes, a firm can achieve significant operational efficiencies and improvements. An effective action plan would include: eliminating redundancies in applications, standardizing processes, establishing a system of information protection controls, and adopting best practices that decrease the overall operational risk of the organization.

Forge a Risk Culture that Reduces Operational Risks

How is a risk-savvy culture created? Desired risk management practices must be supported at every level of the organization. Central to that is a process for ensuring compliance with a documented set of internal policies, controls and procedures. These policies must reflect not just the prevailing wisdom of the regulatory watchdogs, but also the longer-term business objectives of the organization.

Corporate governance and internal controls are essential; at the highest levels, there needs to be assurance that there are appropriate controls for the inputs, sound processes for obtaining capital estimates and ratings, and that these all support the larger risk strategy.

Aggregate Risks Across the Portfolio

Although Basel II may not be in full force until 2007, the time to act is now. Financial institutions whose national regulators endorse the code (all the EU, the G-10 and most other developed economies) must take steps now that will ensure compliance.

How does an institution continually present an accurate picture of its own aggregated and counterparty risk across all the disciplines of investment, loans, trading books, derivatives and other exposures? A lending institution needs a complete profile of each counterparty in order to properly weight different credit default scenarios. Firms need access to detailed knowledge of all the other indebtedness within those borrower and counterparty organizations to accurately show potential losses. This means compliance and risk management teams need to consolidate as much information as possible to be able to produce a true credit risk picture across the spectrum of the bank’s activities. They need to fully comprehend their data needs and adopt methods that will enable them to accurately measure loss based on the data.

In addition, one requirement is a database of all operational losses and exposures in the preceding three years. The priority on delivering this in an auditable and robust fashion will demand extensive and sophisticated data collection and consolidation. Internal data must be easily accessed and analyzed alongside reliable third party credit research and data. Banks must make decisions today that will ensure not just their ability to comply with regulations, but their ability to compete, long-term.

Reliably Assess Risk and Capital Requirements

The less capital that needs to be set aside for unexpected losses, the more that’s available for investment and growth. By demonstrating that capital reserve calculations are in line with risks, firms may be able to free up more of their working capital, or return capital to shareholders. To do this, a firm needs to:

• Develop a framework for measuring, monitoring and mitigating risks.
• Adopt an approved methodology for computing capital reserve requirements. Firms must demonstrate that they can measure credit risk reliably, either by accepting the ratings of a third party, such as Standard & Poor’s, or by building an internal ratings model that is validated with credible third party data. Banks that employ internal ratings systems must clearly and objectively define ratings categories and criteria and apply them in a consistent manner.

By adopting an effective internal rating system, a firm can demonstrate that it understands the credit quality of individual assets as well as the overall portfolio. The payoff is a potential reduction in lower capital requirements, but even more importantly, stronger decision making capabilities. Greater insights lead to better decisions about each risk driver, and ultimately stronger risk management.

• Track all of the elements that comprise expected credit loss, such as probability of default, loss given default, and exposure at default.
• Methodically measure and monitor operational risk events.

Financial institutions need to define the data requirements, the mechanisms to collect, analyse and report the data, and a methodology for cost-effectively implementing the system and process enhancements to make it happen. It will also mean that in order to have confidence in the end results, financial institutions will need to rely heavily on the credibility of information suppliers, their data consistency and the application of dependable tools.