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REGULATORY RISK - critically review the International and UK regulatory…
REGULATORY RISK - critically review the International and UK regulatory risk environment. - BASEL
Risk-based capital - Risk-based capital as a concept is the blending of the assessment of the amount of risk faced by an organisation against the level of capital to be held to provide resistance to that risk.
Benefits
align risk appetite with capital allocation and communicate the tangible strengths and
potential of the business to analysts, investors and rating agencies.
help organisations to spot threats and weaknesses, to identify opportunities that may be missed by competitors and to target investment where it can earn its best return.
Weaknesses
It's only as good as the reliability of the data, validity of the
assumptions and quality of the application that underpin it.
UK Reg
FSA - required additional capital
charges to compensate for several recognised shortfalls - Namely, lack of consideration of key risks, including interest rate, legal, reputational and operational risks,
that had the potential to produce losses and lead to bank failure.
PRA - One of the key directions of this is to focus on the
capital strength of the firms it supervises.
FSA found that banks raised capital in favorable economic conditions & there was a negative relationship between capital & GDP growth.
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Basel II
was the second of the Basel Accords
which are recommendations on banking laws and regulations issued by the BCBS. - 2004 published
four main components to the framework:
It is more sensitive to the risks that firms face: the framework includes an explicit measure for operational risk and includes more risk-sensitive risk weightings against credit risk.
It reflects improvements in firms' risk management practices; for example, the internal ratingsbased approach (IRB) allows firms to rely to a certain extent on their own estimates of credit risk.
It provides incentives for firms to improve their risk management practices, with more risksensitive risk weightings as firms adopt more sophisticated approaches to risk management.
The new framework aimed to leave the overall level of capital held by banks collectively broadly
unchanged.
The Basel Accord was implemented in the European Union via the Capital Requirements Directive (CRD),
which was designed to ensure the financial soundness of credit institutions. The new
framework consists of three Pillars.
Pillar 2 refers to the supervisory review process. Under Pillar 2, firms and supervisors have to take a view on whether a firm should hold additional capital against risks not covered in Pillar 1 and must take action accordingly.
Supervisors (meaning regulators) will evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions.
Supervisory Review Process of Pillar 2 has two key elements:
Firms should have a process for ensuring that they hold capital consistent with their risk profile and strategy – the name for this is the Internal Capital Adequacy Assessment Process or, in short form, ICAAP.
Supervisors should review that process and strategy and if they identify weaknesses or deficiencies should take appropriate prudential measures, including the setting of a higher capital requirement – this was called the Supervisory Review and Evaluation Process or the SREP.
ICAAP is a requirement where the financial institution needs to:
(1) Assess the adequacy of Pillar 1 minimum capital requirements
(2) Assess how much total shareholders’ funds are required in order to meet the firm’s strategy and ensure that the minimum capital requirements are not breached
(3) Ensure that all the material risks of the group are understood by the board and there is appropriate and proportional risk management action being taken
The aim of Pillar 3 is to improve market discipline by requiring firms to publish certain details of their
risks, capital and risk management.
Pillar 1 of the new standards sets out the minimum capital requirements firms will be required to meet
for credit, market and operational risk. - Requires firms to hold more capital as per customer riskiness & operational risk
The Basel II framework describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities were working to implement through domestic rule-making and adoption procedures. It sought to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Basel II framework intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, at the present moment and in the future, and to develop or improve their ability to manage those risks.
Basel III - Basel III is the third iteration of the stages of development of banking standards and sound practices * 2015
Effective as of 2019, lenders will also need to add a conservation buffer of 2.5%, meaning banks must
hold a total core capital equal to 7% of their RWA.
As part of the Basel III rules, the minimum requirement for banks’ Tier 1 capital ratio (ratio of equity
capital to risk-weighted assets (RWA)) has been raised from 2% to 4.5%.
Key Basel III improvements:
Enhancing the quality and quantity of capital
Strengthening capital requirements for counterparty credit risk (and in CRD III for market risk) resulting in higher Pillar I requirements for both
Introducing a leverage ratio as a backstop to risk-based capital
Introducing two new capital buffers: one on capital conservation and one as a countercyclical capital buffer
Implementing an enhanced liquidity regime through the net stable funding ratio and liquidity coverage ratio
The crisis in financial markets over 2008 and 2009 prompted a strengthening of the Basel rules to
address the deficiencies exposed in the previous set of rules.
Some argue that regulation was too strict others too lenient. Regulation is said to have had a detrimental effect on the returns private investors are receiving given they need to hold more capital and can't lend as much as they would typically do.
Oddly enough, the area of operational risk is possibly the least affected area of Basel III, which remains
very much unchanged from the Basel II requirements.
One measure that Basel III introduces is a limit on dividend payouts and staff compensation for banks that are experiencing difficulties. It is a basic requirement under Basel III that the regulators are seeking to increase the loss absorbability of capital.
Much of its new requirements address the management of liquidity risk. This is to be achieved by the introduction of a leverage ratio together with short- and medium-term quantitative liquidity ratios. Another measure that Basel III introduces in order to set aside reserves for future downturns is what they call a counter-cyclical capital buffer.
Countercyclical capital buffer requirement requires banks to add capital at times when credit is growing rapidly so that the buffer can be reduced when the financial cycle turns.
So the following ratios will be introduced:
Leverage ratio
– to counter the build-up of an excessive on- and off-sheet leverage. The ratio is intended to constrain leverage in the banking sector and introduce a financial safeguard against model risk and measurement error.
The capital conservation buffer
– restrictions will be imposed when capital levels fall within the conservation range and therefore distribution of capital via dividends, share buy-backs and discretionary bonus payments will be restricted once the trigger level is reached. The minimum capital conservation ratios will be applied expressed as a percentage of earnings.
The counter-cyclical buffer
– here the proposal is for a countercyclical buffer to act in addition to the capital conservation buffer with an aim of providing a defence against the build-up of system-wide risks associated with excess aggregate credit growth. This measure will be deployed by national regulators and such deployment is expected to be infrequent. The buffer can vary between zero and 2.5% of RWA as decided by the local supervisory body.
NSFR
– the purpose of this measure is to ensure stable funding on an ongoing, viable entity basis over one year in an extended firm-specific stress scenario where a bank encounters and customers become aware of decline in profitability, downgrade events or any material event that calls into question the reputation or credit quality of the institution.
The Required Stable Funding
– a set of supervisory assumptions relative to the liquidity risk profile of a bank’s asset and off balance sheet exposures. It represents what supervisors believe should be supported with stable funding (i.e. assets that are more liquid and more readily available to act as a source of liquidity in stressed market conditions).
Incremental Risk Capital Charge
, which is calculated based on a risk measure that includes default risk as well as migration risk (Going from one state of risk to another - detrimental) for unsecuritised credit products held in the trading book at a 99.9% confidence level under a 1-year capital horizon and a minimum liquidity horizon of 3 months.
Comprehensive Risk Capital Charge
, which is calculated based on a risk measure that can be applied to banks’ so-called correlation trading portfolios and captures not only incremental default and migration risks but also all price risks at a 99.9% confidence level and a 1-year capital horizon.
Wrong Way Risk -it arises when default risk and credit exposure increase together.
Basel III addresses this phenomenon and requires that banks should identify exposures which generate wrong way risk. This can be done by stress testing and scenarios in order to identify any possibility of severe shocks.
nder Basel III banks must have a comprehensive stress testing programme for counterparty risk
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