practical implications of regulatory convergence – lessons from basel ii mary frances monroe...
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Practical Implications of Regulatory Convergence – Lessons from Basel II
Mary Frances MonroeDivision of Banking Supervision and RegulationBoard of Governors of the Federal Reserve System
Presentation to CPCU Society SymposiumBoston, MassachusettsJune 11, 2005
Practical Implications of Regulatory Convergence –Goals of Basel II
Goals of Basel II:
Greater risk sensitivity – reliance on a bank’s internal assessments of capital adequacy
Suitability – reflect and support sound credit risk management practices
Incentive Compatibility – improve internal risk management practices and adapt to evolving markets and products
Competitive Equity – promote and enhance a level playing field across international boundaries
Practical Implications of Regulatory Convergence –Goals of Basel II
Goals of Basel II (continued):
Safety and Soundness – ensure consistency with fundamental banking principles
Balance – attempts a reasonable trade-off between enhanced risk sensitivity and implementation burden
Non-cyclicality – capital charges should be relatively stable over the economic cycle
Aggregate capital level – roughly maintain the current amount of capital in the banking system
Practical Implications of Regulatory Convergence –Overview of Basel II
Structure of Basel II:
Pillar I Minimum Capital Requirements
Credit Risk, Operational Risk, and Trading Book components
Importance of Qualifying Criteria for Advanced Approaches Importance of Corporate Governance Structure Importance of Validation
Practical Implications of Regulatory Convergence –Overview of Basel II (continued)
Structure of Basel II:
Pillar II Supervisory Review:
Focus on risks not fully captured in Pillar 1, factors not taken into account under Pillar 1, and external factors
Four key principles
Pillar III Market Discipline/Disclosure:
Materiality
Frequency
Practical Implications of Regulatory Convergence – Lessons from Basel II
Need to balance convergence with flexibility
Basel II goal of convergence of regulatory capital standards and measurement Reality is different national markets Necessitates degree of national discretion in implementation
Accord Implementation Group established to promote consistency in application of Basel II, especially where national discretion exists Address cross-border home-host issues Case studies have been conducted
Practical Implications of Regulatory Convergence – Lessons from Basel II
Importance of Stress Testing and Scenario Analysis
Regulatory minimums are only a starting point
Models are imperfect Models may not capture all material risks Model assumptions/parameters may understate degree of risk Models may be based on backward-looking data
Taking stress conditions and scenarios into account involves both quantitative analysis and qualitative judgment with an enterprise-wide view
Practical Implications of Regulatory Convergence – Lessons from Basel II
Need to supplement risk-based capital standards with other supervisory tools
Importance of leverage ratio
Need for mechanism for early intervention For U.S. banks, this is accomplished through prompt corrective
action Ability of bank to engage in certain activities or expand operations is
constrained if cushion above minimum capital standards is not maintained or bank is deemed to have engaged in unsafe and unsound practices
Practical Implications of Regulatory Convergence – Lessons from Basel II
Importance of Enterprise-wide Risk Management
Risks transcend legal entity/line of business/functional boundaries
Need to consider impact of business line activities and risk-taking decisions on other parts of the organization
Consolidated supervisor must assess impact of different prudential supervision frameworks
Federal Reserve supervision has moved from historical analysis on legal entity basis to more forward-looking assessments of risk management and financial condition of consolidated organization
Practical Implications of Regulatory Convergence – Lessons from Basel II
Importance of quantitative impact studies
QIS 4: U.S. regulators are faced with lower than expected capital levels and broad divergence across firms
Data limitations give rise to need to balance quantitative and qualitative approaches and rely more on the latter in the short term
Loss data collection exercise for operational risk indicates more robust operational risk data collection and increasingly sophisticated approaches to measuring risk
Practical Implications of Regulatory Convergence –Beyond Basel II
Joint Basel/IOSCO Working Group on Trading Activities and Double Default
New option for treatment of counterparty credit risk
Limited recognition of double default
Improvements to the trading book capital regime Boundary between firms’ banking and trading books Prudent valuation guidance Capturing full range of risks of traded positions
Consistent approach to unsettled and failed trades
Practical Implications of Regulatory Convergence –Beyond Basel II
Joint Forum Working Group on Liquidity Risk
Involves banking, securities, and insurance sectors
Focus: promotion of financial stability
Developing paper for publication later this year along three workstreams: Trends in liquidity risk management and supervision Stress testing and contingency funding plans Sources of liquidity risk (especially in stress environments)