Financial & Private Sector Development

Supervisory Review Process

DAMODARAN KRISHNAMURTI OCTOBER 23, 2013

How to implement in LICs & MICs

Presentation Structure

• Context

• Objective

• ICAAP Review

• Capital determination

• Capital requirement

• Supervisory response

What is the context for supervisory review process?

• Basel II – Pillar 2 refers to Supervisory Review Process (SRP)

• Focus has been on Pillar 1 and to some extent Pillar 3 of Basel II

• Focus on Pillar 2 (P2) was limited • A few questions to get us rolling ….

– Is it because these are banks’ responsibilities? – Is it because P2 is optional? – When is SRP relevant?

Basel I Basel II Basel III

Here? Here? Here? Here?

What is the objective of SRP?

• To ensure banks have adequate capital for all risks – Bank managements hold primary

responsibility – Holding higher capital is not a substitute for

improved risk management processes

• To encourage banks to develop and use better risk management techniques

• To foster an active dialogue between banks and supervisors; to promote prompt and decisive action when required

Principles 1 and 2

• Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels – (referred to as ICAAP)

• Supervisors should review and evaluate banks’ internal

capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process

Principles 3 and 4

• Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

• Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Prevailing environment in Imaginaria

• Banks implement standardised approaches for CR and MR, and BIA for OR

• Availability of data not assured – History – Consistency – Granularity

• Very few banks use models for risk management • Banks not engaged in innovative or exotic transactions • All banks required to maintain minimum 8 percent CAR

How do we implement?

• Require banks to comply – Guidance to banks – Supervisory expectations

• Assess adequacy of banks’ internal capital adequacy assessment processes (ICAAP), and capital strategy;

• Evaluate all inherent material risks and adequacy of capital held by banks;

• Establish bank-specific comprehensive capital adequacy ratios based on a bank’s risk profile and risk management capacity

• Respond in time when a bank is likely to breach the established ratios

ICAAP Review

Capital determination

Capital requirement

Supervisory response

ICAAP Review • Coverage of all material risks

– Pillar 1 risks – Elements of Pillar 1 risks not adequately

captured in Pillar 1 – Pillar 2 risks – Risks external to the bank

• Coverage of relevant risk drivers, positions or exposures for each risk

• Treatment of risks that are difficult to quantify in terms of capital

• Which risks would we expect an Imaginarian bank to cover?

• Credit concentration • Residual risk in CRM • Residual operational

risk

• IRRBB • Liquidity • Reputation • Strategic

ICAAP Review (2)

• Whether internal capital estimate adopts a forward looking approach?

• Assumptions underlying estimation • Review how banks plan and maintain estimated capital

– Whether capital planning is robust? – Whether bank is complying with plan?

• Review Pillar 1 compliance

• Are we missing something?

ICAAP Review (3)

• Senior management buy-in • Adequacy of resources committed to ICAAP • Transparent documentation of ICAAP (including model)

and sharing of results • Understanding of limitations of economic capital

measures • Use while making business & risk management decisions

and capital planning

Supervisory approaches to capital

• Pillar 1 “Plus” approach – Pillar 1 risks – Pillar 2 risks – Basel III capital : buffers & ‘systemic’ capital charge

• Holistic approach

– Determine overall capital required for each bank wrt its risk profile

– Compare with capital maintained by the bank – Compare with Pillar 1 capital requirement

• Which one should we adopt for Imaginaria?

Supervisory assessment

• Decide on the approach

• Assess bank’s risk profile

– Can rely on existing bank rating systems to

• assess Pillar 1 risks;

• determine risk profile;

– Assess Pillar 2 risks – if not already covered;

• review bank’s risk profile

– Assess Pillar 3 compliance

Supervisory assessment (2)

• Determine level and direction of material risks – Credit risk – Operational risk – Market risk – IRRBB – Credit concentration risk – Residual risk in CRM – Liquidity risk – Reputation risk – Strategic risk

Supervisory assessment (3)

• How to estimate capital requirement for …? – Credit risk – Operational risk – Market risk – IRRBB – Credit concentration risk – Residual risk in CRM – Liquidity risk – Reputation risk – Strategic risk

• Is there a role for stress test? which risks? • Business prospects

How much capital?

• As appropriate for the bank’s

– risk profile (risks assumed)

– systemic importance (risks posed to the system)

– context of the markets and macroeconomic conditions in which

they operate (macro perspective)

• Should constrain the build-up of leverage in banks and

the banking sector

How much capital? (2)

• Will be determined by – business plan and risk appetite – potential loss absorbency of the instruments included in the

bank’s capital base – appropriateness of risk weights as a proxy for the risk profile of

its exposures – adequacy of provisions and reserves to cover loss expected on its

exposures and – quality of risk management and controls

• Establish bank-specific CAR based on a bank’s risk profile and risk management capacity

What supervisors can do • Convey supervisory expectations on capital level • Require bank to hold a buffer above minimum (Target)

– Fluctuations in CAR due to normal business activities – Costly to raise capital at short notice – Costly to breach minimum CAR – Other risks to banks or to economy at large – To secure better external rating;

• Establish triggers above minimum CAR for supervisory response and at minimum CAR for supervisory intervention

• Trigger response or intervention when thresholds are breached

• Escalate level of supervisory response when banks do not bridge the shortfall

Can all supervisors do

these?

WB Pillar 2 Toolkit

• Guidance for supervisors to assess banks’ internal capital

adequacy assessment processes and their risk profiles;

• Guidance for assessing some Pillar 2 risks

– Interest rate risk in the banking book;

– Credit concentration risk

– Residual risk in credit risk mitigation

– Liquidity risk

– Residual Operational risk

WB Pillar 2 Toolkit (2)

• Includes a quantitative tool designed for jurisdictions to

quantify the risks to which banks are exposed and

corresponding capital requirement for;

– Pillar 1 risks

– Pillar 2 risks

• Includes stress tests

• Adopts a forward looking approach

• Customisation, hand holding and capacity building for

supervisors

WB Pillar 2 Toolkit (3)

• Flexible in application:

– Can be used with minimal and high level data also

– Allows adjustments to yield curve shifts, size of shock, confidence intervals,

– Allows derivation of inputs from system level data, or bank level data or

more granular portfolio level data as available

• Adopts a conservative approach to risk and capital estimation

• Next steps :

– field tests, calibration and validation;

– Roll out in interested jurisdictions

Capital estimation - An example

Post Pillar 2 CAR 30.26% Total assets 6212 Total OBS items 1314 Leverage ratio 16.2

30-Jun-13 Risks Capital (Amount) Pillar I Total Capital Held 973 24.14%

Credit risk 823 Market risk 35

Operational risk 115 Minimum Regulatory Requirement 322.4 8.00%

Pillar II IRRBB 115.12 Credit concentration risk 129.84 Residual Operational Risk 166.46 Business growth 64.48 Stress testing 239.76 Systemic charge 80.6 Macro conditions 100.75 Assessed Pillar II capital 897.01 Additional Capital Required 246.41 Total Capital Required (Pillar I + Pillar II) 1219.41

SELECT ISSUES

• How to aggregate capital for various risks?

• How to estimate correlation and concentration?

• How to determine diversification benefits?

• How robust the supervisory model can be, given the prevailing

conditions in Imaginaria?

• Whether the supervisory model can be different for different

banks?

• Whether it is necessary to have a supervisory model?

Supervisory approach to Pillar 2 capital estimation

• Encourage supervisors to make a judgment on the overall capital that banks may need to support their risk profile

• Use the quantitative output as an indicative capital requirement

• Avoid overlaps or conflicts with Basel III • Pursue dialogue with bank management, using the

supervisory assessment as the basis • NOTE: Additional capital is not the first or the only

option

Supervisory response • Conduct ICAAP Review; Assess bank’s own target (which

should be above the pillar one minimum) • Undertake supervisory estimation of capital requirement • Determine where the bank is falling short

– Risk management – Capital estimation – Capital strategy – Capital management

• Require a bank to – strengthen risk management or apply internal limits – improve internal controls – strengthen reserves and provisioning – restrict its activities or dividend payments – hold higher capital

When is SRP relevant?

Basel I Basel II Basel III

Here? Here? Here? Here?

Questions ?

Thank You kdamodaran1@worldbank.org