Recent Market Turmoil and the Basel Committee's New Guidelines
The recent turmoil in the financial sector has emphasised the need for robust risk management practices. The centre of the whole turmoil lies in the market-based credit intermediation process. Failure to adopt sound underwriting standards, define prudent firm-wide risk limits for credit risk transfer instruments, not keeping in pace with rapid financial innovation, prudent regulatory supervision and disclosures, are the primary reasons that contributed to this.
Against this backdrop the Basel Committee on Banking Supervision (BCBS) has recently announced certain steps to strengthen the resilience of the banking system. The proposed guidelines from the BCBS will push banks to strengthen risk protocols and improve procedures for valuing and disclosing assets.
The BCBS will issue new guidance to enhance certain aspects of the Basel II Framework, including the capital treatment of complex structured credit products, event risk charge, liquidity risk management, valuation processes and strengthening Pillar 2 and 3 requirements. The new steps BCBS intends to take are:
The BCBS intends to introduce the above measures in a manner that promotes long-term bank resiliency and strong supervision. The actions of the BCBS are also in support of the Financial Stability Forum’s Working Group on Market and Institutional Resilience. The chairman of the BCBS has mentioned four key building blocks to core bank resiliency as strong capital cushions, robust liquidity buffers, strong risk management and supervision, and better market discipline through transparency.
The BCBS reiterated the importance of implementing the Basel II Framework as it better reflects the types of risks banks face in an increasingly market-based credit intermediation process. The Committee has learned its lessons from recent market turmoil and intended to further strengthen certain aspects of the Framework. The Committee has introduced a number of measures to help ensure sufficient capital, to capture off-balance sheet exposures more effectively and to improve regulatory capital incentives.
The most important measure in this direction is to revise the Framework to establish higher capital requirements for certain complex structured credit products, such as so-called ‘resecuritisations’ or CDOs of ABS, which have produced the majority of losses during the recent market turbulence. It will strengthen the capital treatment of liquidity facilities extended to support off-balance sheet vehicles such as ABCP conduits. The Committee intends to publish more detailed proposals later this year.
Another equally important measure is to strengthen the capital requirements in the trading book. Global banks’ trading assets have grown at double digit rates in recent years, and in some cases represent the majority of a bank’s assets. The proportion of complex, less liquid credit products held in the trading book has likewise increased rapidly. The Committee is in the opinion that the current value-at-risk based treatment for assessing of capital for trading book risk did not capture extraordinary events that can affect many such exposures. The Committee proposes to extend the scope of its existing guidelines for ‘incremental default risk’ to include other potential event risks in the trading book. As this event risk charge is not in place as of now, an interim treatment will be applied for complex securitisations held in the trading book. However, the BCBS is planning to bring this event risk charge in place by 2010. The Committee will issue its event risk proposal for public consultation later this year, which will have a quantitative impact assessment also.
Apart from the above two additional measures for capital charge, the Committee intends to monitor Basel II minimum requirements and capital buffers over the credit cycle. To the extent that this analysis reveals any shortcomings in capital cushions, the Committee will take appropriate measures to help ensure Basel II provides a sound capital framework for addressing banks’ evolving and complex risk profiles.
The recent market turmoil has revealed significant risk management weaknesses at banking institutions. The supervisory review process of Pillar 2 is an important element in the capital computation process and provides supervisors with additional tools to assess banks’ risk management and internal capital management processes. The Committee intends to issue Pillar 2 guidance in a number of areas to help strengthen risk management and supervisory practices. These areas where Pillar 2 guidance will be issued include:
Banks need to have strong liquidity cushions to weather prolonged periods of financial market stress and illiquidity. The Committee intends to publish for consultation global sound practice standards for the management and supervision of liquidity risks in July this year. These will address many of the shortcomings witnessed recently by the banks. Among other weaknesses, these relate to stress testing practices, contingency funding plans, and management of on- and off-balance sheet activity as well as contingent commitments.
Weaknesses in bank transparency and valuation practices for complex products have contributed to the build-up of concentrations in illiquid structured credit products (credit risk transfer products) that undermined the confidence in the banking sector. The Committee intends to take concrete action to promote stronger industry practices in this area.
The Committee will promote enhanced disclosures relating to complex securitisation exposures, ABCP conduits and the sponsorship of off-balance sheet vehicles. Disclosure is a critical element of the Basel II Framework and Pillar 3 (market discipline) provides the Committee with the necessary leverage to achieve these enhancements, as such disclosures are one of the prerequisite for banks’ being able to implement advanced approaches under Basel II. The Committee intends to issue further guidance in this area by 2009.
Weaknesses in banks’ valuation practices and related disclosures contributed to amplifying the market dislocation in the recent turmoil. The Committee will develop guidance that supervisors can use to assess the rigor of banks’ valuation processes and thereby promote improvements in risk management in this area.
From the above discussion, it is clear that the committee intends to issue new guidance on the following areas:
Recent market turmoil has awakened the banks across the world. Banks are now realising the importance of Basel II implementation in particular and robust risk management practices in general. The latest guidelines issued by the BCBS are important measures for the banks in implementing robust risk management practices.