Basel II's Pillar II and the GCC Banks
In the financial services sector, the innovation and evolution in risk management practices occur continually on an incremental basis. Updates to regulations, on the other hand, happen with a lag and therefore typically occur in large jumps. The updated Basel II Accord is a quantum jump when compared with the first Accord originally proposed in the late 1980s. The regulatory response has been mixed across jurisdictions with regulators in the US looking at in between options to suit local requirements. In the Gulf Cooperative Countries (GCC) region, Kuwait was the first to implement the Accord. Others have followed, with Bahrain implementing the regulations as of the beginning of this year.
The Basel II regulations, grouped under three broad headings (Pillars) seek to bring structural changes not just in risk regulations, but also in the capital assessment process for banks. An important innovation in the Basel II framework is the system of self-assessment coupled with external counterchecks grouped under Pillar II and III respectively.
In contrast, the Basel I approach is straightforward and rules-based. In addition, most regulators – at least in emerging markets – prescribed higher levels of capital than the Basel norm of 8% to provide a cushion against unexpected losses. High capital levels were desirable in banks in commodity-based economies as the banking system was likely to experience volatility in earnings. This, perhaps, explains why the GCC banking regulators set minimum capital levels between 10%-12% under the Basel I regime.
The rule-based approach continues in Pillar I that prescribes minimum capital requirements for specific risks. The approach is non-judgmental and applies uniformly to all banks. The coverage of risks has been widened and the menu of choices to quantify risks has been considerably strengthened. However, capital to be allocated under Pillar II is institution specific and is based on the judgment of the supervisor. Thus, under Basel II, the focus of capital adequacy determination has shifted from a rule-based process to one that is a combination of rules and judgment emanating from a supervisory review of the bank’s capital assessment process.
Unfortunately, much of the debate of Basel II up to now has centred on the rules based approach of Pillar 1. As a result, many banks have failed to recognise the underlying importance of the capital adequacy assessment process as well as the supervisory review processes under Pillar II. The purpose of this article is to provide some insights on the Pillar II processes and its implications for banks.
Over the past two decades, the Basel approach of setting regulatory capital focused on major risks in the banking system – credit, market and now operational risk. These are comprehensively addressed under Pillar 1. While these represent the major risks that most banks face, there could be situations where other lurking risks could impact banks in systemic ways. For example, the crisis in the savings and loans industry in the US in the 1980s was due to the fact that most banks disregarded interest rate risk, a major risk in the banking book. The Basel II Accord clearly recognises that “interest rate risk in the banking book is a potentially significant risk which merits support from capital,” however, it has chosen a Pillar II approach to determine regulatory capital charges rather than prescribing rules. The Committee felt that this approach was appropriate as there was “considerable heterogeneity across internationally active banks in terms of the nature of the interest rate risk and the processes for monitoring and managing it.”
Consider a more recent example of sub-prime lending in the US. It was assumed that securitisation could help transfer risks from the originating bank. On the contrary, these exotic instruments have come home to roost as banks had to fold back these structures into their balance sheets. For large global banks engaged in the “originate and distribute” business, reputational risks have assumed significant proportions. However, the operational risk definition proposed under the second Accord ignores reputational risks for some reason. Nevertheless, this is a significant risk for the above stated banks.
These two examples demonstrate that all material risks in a bank need to be assessed comprehensively. This assessment needs to be done for each bank as some of the risks may be unique. Capital levels in the bank should be calibrated accordingly. The Basel Committee has sought to achieve this by bringing in a self-assessment process in banks for evaluating all material risks. The underlying aim of Pillar II processes is to enhance the link between a financial institution’s risk profile, risk management and risk mitigation systems and its capital.
The internal capital adequacy assessment process (ICAAP) in banks needs to be dynamic and forward looking. Banks are expected to have to identify and assess risks as well as plan for capital to meet the scale and the diversity of risks.
The output of the ICAAP process is an input for the supervisory review process (SREP). Regulators are expected to review the bank’s risk assessment independently and evaluate capital levels against the background of internal controls as well as risk governance mechanisms in the bank. The final capital guidance is thus a function of the judgment of the supervisor and it is safe to assume that banks are likely to actively challenge and debate the capital guidance.
It is expected that the intensity and depth of the debate would be proportional to the nature, scale, complexity and systemic importance of the institution in question. For example, a small non-complex financial institution would not be expected to have a sophisticated ICAAP, and its supervisor should not necessarily subject it to an intense and comprehensive dialogue.
So how should banks interpret Pillar II? This would depend on the interpretation of the local regulator and banks need to clearly understand the Pillar II regulatory framework as applicable to their system. However, there is a tendency to view a Basel II implementation project as a ‘gap’ plugging exercise, thereby missing the spirit behind these regulations.
As brought out in the above analysis, Pillar II processes will have a major bearing on the bank’s capital adequacy levels as the supervisor will determine capital guidance on a comprehensive basis by assessing the adequacy of bank’s capital assessment processes, material risks, as well as control and risk governance mechanisms. It is in the interest of the bank to put in place a sound ICAAP which ultimately will help not just in meeting Pillar II regulatory requirements but also help the bank in linking capital levels to embedded risks on a forward looking basis. In general, a bank’s ICAAP should reflect an appropriate level of conservatism to account for uncertainty in risk identification, risk mitigation or control, quantitative processes, and any use of modelling. In most cases, this conservatism will result in levels of capital or capital ratios above minimum regulatory requirements to be regarded as adequate.
Will the resultant capital guidance on banks create additional burden on banks? In this regard, GCC banks are favourably placed with many banks operating well above the minimum capital requirements of their jurisdictions. The imposition of additional capital charges is not likely to translate into capital raising requirements as banks already have sufficient capital in place. However, 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.
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 III requirements.
From a regulatory perspective, Pillar II entails considerable amount of work in the initial stages. Regulators will need to conduct comprehensive assessments for each bank licensee. In some countries, this is likely to be a daunting task, given the number of locally incorporated banks. In these jurisdictions, supervisors are also likely to make use the concept of proportionality embedded in the underlying principles of Pillar II: for example supervisors would subject complex and risky banks to a more intensive full scale review, while relatively less risky and simpler banks could be subject to a straightforward questionnaire based review.
It needs to be kept in mind that the Pillar II assessment will not undermine the risk assessment under Pillar I. More conceptually, mechanical formulas may play a role in regulation, but may be incapable of providing a solution to the question of how much capital a bank should have. An internal self-assessment process for risk linked capital supplemented by regulatory counterchecks can provide a better answer to the above question. For this reason, Pillar II can be viewed as the main load bearing column of the Basel II framework, as it would allow regulators to reap the benefit of informed supervision.