banking control commission 1 lebanon’s preparations and related issues from basel ii assessing...

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Banking Control Commission

LEBANON’S PREPARATIONS LEBANON’S PREPARATIONS AND RELATED ISSUES FROM AND RELATED ISSUES FROM

BASEL IIBASEL II

Assessing Progress & RoadmapAssessing Progress & Roadmap

Dr Amine Awad, Board Member, Banking Control Commission Member of the Higher Banking Council

Washington D.C. May 17, 2004

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Before starting the draw up of Lebanon’s Before starting the draw up of Lebanon’s preparation to implement Basel II, it is useful to preparation to implement Basel II, it is useful to show the role of the various authorities involved in show the role of the various authorities involved in this subject.this subject.

Description of the Central Bank and Description of the Central Bank and The Regulatory BodyThe Regulatory Body

1.Banque du Liban (BDL) and the Banking1.Banque du Liban (BDL) and the Banking Control Commission(BCC) are the twoControl Commission(BCC) are the two independent authorities in Lebanon that workindependent authorities in Lebanon that work side-by-side and coordinate their actions together.side-by-side and coordinate their actions together.

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2.B.D.L, besides its role in the monetary policy, is 2.B.D.L, besides its role in the monetary policy, is the authority that decides on the different aspects the authority that decides on the different aspects of the development of the banking sector; it is of the development of the banking sector; it is responsible for licensing of Banks and Financial responsible for licensing of Banks and Financial Institutions; thus BDL issues circulars related to Institutions; thus BDL issues circulars related to banking policy.banking policy.

3.The BCC is the authority responsible for (a) 3.The BCC is the authority responsible for (a) following up the banks’ operations, (b) following up the banks’ operations, (b) controlling their development and performance, controlling their development and performance, (c) supervising their systems and management. (c) supervising their systems and management.

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Accordingly, it is the authority that issues Accordingly, it is the authority that issues application circulars and receives periodic application circulars and receives periodic reports in order to follow up the operations of reports in order to follow up the operations of banks, financial institutions and exchange banks, financial institutions and exchange houses.houses.

4.Whenever the BCC faces the case of a 4.Whenever the BCC faces the case of a "problematic" institution that it cannot remedy, it "problematic" institution that it cannot remedy, it refers the institution to the "Higher Banking refers the institution to the "Higher Banking Council" (H.B.CCouncil" (H.B.C):):

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BDL and the BCC are represented in the HBC, BDL and the BCC are represented in the HBC, in addition to other members who are a in addition to other members who are a seasoned judge with relevant experience in seasoned judge with relevant experience in financial matters, the Head of Deposit financial matters, the Head of Deposit Guarantee Institution and the Director of the Guarantee Institution and the Director of the Ministry of Finance. The H.B.C is aMinistry of Finance. The H.B.C is a judicial judicial authority that decides on the fate of the authority that decides on the fate of the institution being tried, its verdicts are not institution being tried, its verdicts are not subject to any type of appeal.subject to any type of appeal.

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Governor4th Vice Gov. 2nd Vice Gov.

1st Vice Gov.

3rd Vice Gov.

ChairmanBoard

MemberBoard

Member

Board Member

Board Member

Director, Ministry of Finance

One Board Member (as Member) (+) B.C.C (as prosecutor)

Governor (as Chairman of HBC) (+) one Vice Gov. (as Member)

One Judge H.B.C

Chairman of Deposit Guaranty Institution

B.D.L. Board B.C.C.

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What about Lebanon’s policy regarding What about Lebanon’s policy regarding

The application of Basle IIThe application of Basle II

1.Since the year 2002, Lebanon has been following 1.Since the year 2002, Lebanon has been following closely the research and publications related to closely the research and publications related to Basle II, basically:Basle II, basically:

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- First Consultative Paper – CP1, in June 1999First Consultative Paper – CP1, in June 1999- Second Consultative Paper – CP2, in January 2001Second Consultative Paper – CP2, in January 2001

- Several Working Papers, Press Releases and Impact - Several Working Papers, Press Releases and Impact Studies during 2001.Studies during 2001.

- Third Quantitative Impact Study QIS 3, carried out in Third Quantitative Impact Study QIS 3, carried out in Autumn 2002.Autumn 2002.

- Third Consultative Paper – CP3, in April 2003 Third Consultative Paper – CP3, in April 2003 - "Draft Implementation of Basel II" document: "Draft Implementation of Basel II" document:

(Practical Considerations), issued in August 2003(Practical Considerations), issued in August 2003

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Through the continuous participation of Through the continuous participation of Members of the BCC in conferences, meetings Members of the BCC in conferences, meetings and seminars, especially in the F.S.I. in Basle and seminars, especially in the F.S.I. in Basle to accommodate the research about the subject to accommodate the research about the subject and to prepare for Lebanon’s banking sector in and to prepare for Lebanon’s banking sector in close coordination with the BDL Boardclose coordination with the BDL Board

2. Since the year 2002, Lebanon has been trying 2. Since the year 2002, Lebanon has been trying to play an active role in spreading the to play an active role in spreading the philosophy of Basle II and in the development philosophy of Basle II and in the development of related research in the Middle East region.of related research in the Middle East region.

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Lebanon hosted two regional conferences in Lebanon hosted two regional conferences in 2002 and 2003, to which 22 Arab and Middle 2002 and 2003, to which 22 Arab and Middle Eastern countries were invited to follow the work Eastern countries were invited to follow the work of the FSI for implementing Basel II; With major of the FSI for implementing Basel II; With major instructors from the FSI, IMF, World Bank, FSA instructors from the FSI, IMF, World Bank, FSA and the BCC.and the BCC.

3. Several big banks in Lebanon besides Lebanon’s 3. Several big banks in Lebanon besides Lebanon’s Bankers Association contributed to the Bankers Association contributed to the consultative Papers of the Basel Committee, thus consultative Papers of the Basel Committee, thus helping developing and enriching the research.helping developing and enriching the research.

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4. Lebanon was one of the few countries in the 4. Lebanon was one of the few countries in the world whose supervisory authority was world whose supervisory authority was underwent an initial IMF assessment in 1998, underwent an initial IMF assessment in 1998, then a follow up assessment in March 2001 then a follow up assessment in March 2001 which covered the progress Lebanon achieved which covered the progress Lebanon achieved with regards to the "Core Principles for with regards to the "Core Principles for Effective Banking Supervision". Effective Banking Supervision".

The result of the assessment of the supervisory The result of the assessment of the supervisory process in Lebanon was highly graded.process in Lebanon was highly graded.

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In addition, Lebanon was among the In addition, Lebanon was among the countries chosen by the FSI to contribute to countries chosen by the FSI to contribute to the amendment of The Core Principles for the amendment of The Core Principles for Effective Banking Supervision issued by the Effective Banking Supervision issued by the Basle Committee to accommodate the Basle Committee to accommodate the requirements of Basle II.requirements of Basle II.

5. After Lebanon was classified by the FATF 5. After Lebanon was classified by the FATF (GAFI) among the non-cooperating countries (GAFI) among the non-cooperating countries with regards to money laundering because of with regards to money laundering because of its Banking Secrecy Law,its Banking Secrecy Law,

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the Lebanese Government and Parliament the Lebanese Government and Parliament enacted Law 318 in April 2001 in order to put enacted Law 318 in April 2001 in order to put in place a global framework for combating in place a global framework for combating money laundering. Since then, BDL and the money laundering. Since then, BDL and the Special Investigation Commission (SIC) issued Special Investigation Commission (SIC) issued a number of circulars, the last of which was a number of circulars, the last of which was BDL Circular No. 35 dated September 17, BDL Circular No. 35 dated September 17, 2003, regarding the same issue; this led to the 2003, regarding the same issue; this led to the removal of Lebanon from the list of non-removal of Lebanon from the list of non-cooperating countries.cooperating countries.

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6. Finally, Lebanon participated in the Survey 6. Finally, Lebanon participated in the Survey which was prepared by the F.S.I. and the which was prepared by the F.S.I. and the Secretariat of the Basel Committee on Banking Secretariat of the Basel Committee on Banking supervision and which was designed to supervision and which was designed to identify the international current plans identify the international current plans regarding implementing Basel II and regarding implementing Basel II and corresponding capacity building needs.corresponding capacity building needs.

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Even if the official position of Lebanon Even if the official position of Lebanon concerning the potential scope of implementation concerning the potential scope of implementation of Basel II New Capital Accord is "of Basel II New Capital Accord is "undecidedundecided" yet, " yet, however the answer of the Lebanese monetary and however the answer of the Lebanese monetary and supervisory authorities on the question if “our supervisory authorities on the question if “our jurisdiction intend to adopt Basel II” was jurisdiction intend to adopt Basel II” was YES.YES.

The major topics on which the regulatory The major topics on which the regulatory authority in Lebanon is now working on, are as authority in Lebanon is now working on, are as follows:follows:

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Pillar 1: Capital Requirements

Mechanics of IRB approach

Validation of internal estimates

Supervisory and own – estimated haircuts

Standardized Approach(Incl.Simplified

Standardized Approach)

IRB Approach

Credit risk mitigation techniquesTreatment of securitization exposures

Cre

dit R

isk

Basic Indicator or(Alternative) Standardized

Approaches

AMAsOpe

ratio

nal

Ris

k

_

Calculation of capital requirements using internal assessment techniques

Pillar 2: Supervisory Review Determining bank’s internal assessment process Assessment of incremental capital requirement

Pillar 3: Market Discipline

Disclosure methodologies. Verification of achievement of disclosure requirementsIdentification of the changes in reporting & information systems to produce the required disclosures.

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Steps Taken in preparation for Steps Taken in preparation for

The Application of Basle IIThe Application of Basle II

The monetary and supervisory authorities in The monetary and supervisory authorities in Lebanon have been continuously and actively Lebanon have been continuously and actively working since two years on the preparation of the working since two years on the preparation of the financial sector readiness for the progressive financial sector readiness for the progressive application of Basle II. Thisapplication of Basle II. This is being done in two is being done in two parallel directions as follows:parallel directions as follows:

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1. Preparing empirical studies and field surveys 1. Preparing empirical studies and field surveys on the banking and financial sector in Lebanon on the banking and financial sector in Lebanon to determine what has to be amended to determine what has to be amended regarding capitalization, placement policies regarding capitalization, placement policies and other issues.and other issues.

2. Spreading progressively, the culture of Basle 2. Spreading progressively, the culture of Basle II inside the banking sector when it comes to II inside the banking sector when it comes to ““Internal AuditInternal Audit”, “”, “Corporate GovernanceCorporate Governance”, ”, ““Risk ManagementRisk Management” and other areas.” and other areas.

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1.1. With regards to the statistical surveys With regards to the statistical surveys::

These are being prepared by the BCC and These are being prepared by the BCC and discussed with a joint Committee, appointed by the discussed with a joint Committee, appointed by the Governor of BDL since March 26, 2003, whose Governor of BDL since March 26, 2003, whose role is to prepare for the application of Basel II. role is to prepare for the application of Basel II. This Committee is composed of the This Committee is composed of the First Vice-Governor, two Board Members of the First Vice-Governor, two Board Members of the BCC and two representatives of the Lebanon’s BCC and two representatives of the Lebanon’s Bankers’ Association. It may have recourse to Bankers’ Association. It may have recourse to experts on the subject when deemed necessary.experts on the subject when deemed necessary.

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The joint committee has conducted various The joint committee has conducted various simulations assessing the impact of the application simulations assessing the impact of the application of Basel II on the capital adequacy ratios of banks of Basel II on the capital adequacy ratios of banks operating in Lebanon. The scenarios were based operating in Lebanon. The scenarios were based on the current banks’ financial statements adopting on the current banks’ financial statements adopting the following approaches:the following approaches:Standardized approach with respect to Credit Standardized approach with respect to Credit and Market Risksand Market RisksBasic Indicator Approach with respect to theBasic Indicator Approach with respect to the Operational RiskOperational Risk

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Then, the committee identified the banks Then, the committee identified the banks whose capital adequacy ratios will fall below whose capital adequacy ratios will fall below the minimum capital requirements and it is the minimum capital requirements and it is currently developing an action plan to deal currently developing an action plan to deal with these banks on a case by case basis.with these banks on a case by case basis.

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In the draft document called:" Implementation of In the draft document called:" Implementation of Basel II: Practical Considerations", issued in Basel II: Practical Considerations", issued in August 2003, The Basel Committee said:August 2003, The Basel Committee said:

A key objective of Basel II is to encourage A key objective of Basel II is to encourage improved risk management through the use of improved risk management through the use of three mutually reinforcing Pillars. three mutually reinforcing Pillars.

While banks have primary responsibility for While banks have primary responsibility for appropriately measuring material risks and appropriately measuring material risks and maintaining adequate capitalization,maintaining adequate capitalization,

(cont.)(cont.)

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(cont.)(cont.)

the Basel II proposals recognize that Pillar 1 the Basel II proposals recognize that Pillar 1 minimum capital requirements cannot be the sole minimum capital requirements cannot be the sole answer to adequate capitalization and risk answer to adequate capitalization and risk management in banks or safety and soundness in a management in banks or safety and soundness in a banking system. Strong risk – based supervisory banking system. Strong risk – based supervisory review with early intervention and market review with early intervention and market discipline under Pillars 2 and 3, respectively, discipline under Pillars 2 and 3, respectively, complement minimum capital requirements.complement minimum capital requirements.

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BASEL IIBASEL IIFinal Implementation date Dec.31st 2006Final Implementation date Dec.31st 2006

MinimumMinimum

CapitalCapital

RequirementsRequirements

We will summarize each pillar as follows:

SupervisorySupervisory

ReviewReview

ProcessProcess

MarketMarket

DisciplineDiscipline

RequirementsRequirements

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I- I- First PillarFirst Pillar

Banks should maintain sufficientBanks should maintain sufficient

capital funds to cover:capital funds to cover:

A. Credit RiskA. Credit Risk::

Minimum capital requirements are basedMinimum capital requirements are based

on one of the following approaches:on one of the following approaches: * Standardized approach

* Internal ratings-based approach

* Credit Risk modeling

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B) Operational Risk

To develop a capital charge that covers the risk of deficiencies in information systems or internal controls of which will result unexpected losses ;This is based on one of the following approaches:

* Basic Indicator

* Standardized Method

* Advanced Method (AMA)

C) Market Risk

To develop a capital charge that covers interest rate and exchange rate risks in banks’ books.

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II- Second PillarIs intended to achieve a level of capital commensurate with a bank’s overall risk profile and to encourage banks to develop better risk management techniques in monitoring and managing their risks.

Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene where appropriate.

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III- Third PillarBanks have to strengthen the transparency with their stakeholders ( i.e. customers, employees, shareholders, supervisors and public authorities), by:

* Adopting full disclosure through reliable and timely accounts.

* Adopting policies that control all types of risk.

* Avoiding lack of confidence.

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Supervisors – including those who choose to retain Supervisors – including those who choose to retain the current Accord - are encouraged to move the current Accord - are encouraged to move towards a system of risk – based supervision. towards a system of risk – based supervision. Specifically, supervisors, to the extent possible, Specifically, supervisors, to the extent possible, should shift their emphasis towards the quality of a should shift their emphasis towards the quality of a bank’s risk management process and ability to bank’s risk management process and ability to assess risk exposures properly.assess risk exposures properly.

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What B.D.L and B.C.C. do to cope What B.D.L and B.C.C. do to cope with Basel II implementationwith Basel II implementation

1.1. During August 2000, the B.C.C. issued its During August 2000, the B.C.C. issued its circular No. 222, which was implemented in circular No. 222, which was implemented in three phases, ending in March 31, 2002. three phases, ending in March 31, 2002.

This circular sets an action plan This circular sets an action plan for banks to for banks to improve their IT security.improve their IT security.

This circular was the first action taken by the This circular was the first action taken by the B.C.C. and aiming at reducing one of the most B.C.C. and aiming at reducing one of the most important operational risk in banks important operational risk in banks ((Pillar IPillar I).).

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22. The BDL issued the circular No. 77(dated . The BDL issued the circular No. 77(dated 15/12/2000),on Internal Control in Banks and 15/12/2000),on Internal Control in Banks and Financial Institutions.Financial Institutions.

Banks and F.I. should establish internal systems to measure, monitor and control their risks.

(Pillars I & II)

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3. 3. The BDL issued the circular No. 81 (dated The BDL issued the circular No. 81 (dated 21/02/2001).21/02/2001).

This circular concerns Corporate Governance in This circular concerns Corporate Governance in Banks.Banks.

B.O.D. should participate actively in designing the strategy of the bank and is fully responsible of the results. (Pillar II)

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44. . The B.C.C. mandated the application of the The B.C.C. mandated the application of the International Accounting Standards (I.A.S.), through International Accounting Standards (I.A.S.), through the issuance of several circulars the issuance of several circulars aiming at aiming at implementing market discipline in the banking implementing market discipline in the banking industry, by asking for timely and more transparent industry, by asking for timely and more transparent banks’ accountsbanks’ accounts (Namely Circular No. 227, dated (Namely Circular No. 227, dated February 2001) February 2001) ((Pillar IIIPillar III))

55. . The B.C.C. issued a comprehensive circular No. 238, The B.C.C. issued a comprehensive circular No. 238, dated 23/10/2002, on “ Analyzing, managing, and dated 23/10/2002, on “ Analyzing, managing, and processing processing Credit RiskCredit Risk in banks and financial in banks and financial institutions institutions ((Pillar IPillar I))

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6. The BDL issued the circular No. 41 ( dated 6. The BDL issued the circular No. 41 ( dated 17/11/2003), aiming at 17/11/2003), aiming at designing a general designing a general framework to solve N.P.L. in banksframework to solve N.P.L. in banks; this circular ; this circular was designed in preparation of implementing was designed in preparation of implementing Basel II requirements, by reducing N.P.L. and Basel II requirements, by reducing N.P.L. and consequently improving Credit Risk in banks consequently improving Credit Risk in banks ((Pillar IPillar I) )

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7. The B.C.C. issued the Memo No. 1/2004 in 7. The B.C.C. issued the Memo No. 1/2004 in January 26, 2004, asking Banks and F.I.’s to January 26, 2004, asking Banks and F.I.’s to communicate to the B.C.C the list of their communicate to the B.C.C the list of their "Specialists in Risk Management"."Specialists in Risk Management".

This memo has the following objectives:This memo has the following objectives:1)1) To draw the attention of Banks and F.I.’s on the importance of To draw the attention of Banks and F.I.’s on the importance of

the Risk Management Function in their organization.the Risk Management Function in their organization.2)2) To determine the lack of specialized persons in Risk To determine the lack of specialized persons in Risk

Management in the financial sector.Management in the financial sector.3)3) To determine the necessary trainings.To determine the necessary trainings.4)4) To know the qualified persons to deal with the B.C.C. and with To know the qualified persons to deal with the B.C.C. and with

the specialists in Lebanon and abroad.the specialists in Lebanon and abroad.

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8. The B.D.L. issued its circular No 49 dated April 8. The B.D.L. issued its circular No 49 dated April 3, 2004 on definition of TIER I & TIER II capital, 3, 2004 on definition of TIER I & TIER II capital, in accordance with the press release issued by the in accordance with the press release issued by the Basel Committee on October 27, 1998.Basel Committee on October 27, 1998.

An amendment to this circular is due to be issued An amendment to this circular is due to be issued by next week, putting limits on Preferred Shares by next week, putting limits on Preferred Shares and other Financial Instruments eligible for and other Financial Instruments eligible for inclusion in Tier I Capital.inclusion in Tier I Capital.

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9. In addition to the above, the B.C.C. is in the 9. In addition to the above, the B.C.C. is in the process of issuing a serie of very important process of issuing a serie of very important circulars, to help the lebanese banking and circulars, to help the lebanese banking and financial sector implementing the New Capital financial sector implementing the New Capital Accord:Accord:

9.1.Circular on 9.1.Circular on Risk ManagementRisk Management (end of May 2004) (end of May 2004) (Pillar I).(Pillar I).9.2.Circular on how to monitor 9.2.Circular on how to monitor Market RiskMarket Risk (June 2004) (June 2004)

(Pillar I).(Pillar I).9.3.Circular on how to define and measure 9.3.Circular on how to define and measure Operational RiskOperational Risk

(November 2004) (November 2004) (Pillar I)(Pillar I)..

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10. Finally the B.D.L. will issue during the 10. Finally the B.D.L. will issue during the current month (May, 2004) a new circular current month (May, 2004) a new circular fixing limits for « Overdrafts » and fixing limits for « Overdrafts » and encouraging banks to grant « encouraging banks to grant « Term Term LoansLoans » »

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