Basel III Imposes Greater Capital Adequacy Requirements on Banks. What New Role Will this Mean for Risk Management and IT?
Questions
1. In light of the sobering experience of the crisis we are just emerging from, lessons for a new approach to effective bank supervision must be quickly drawn and implemented. What initiatives are being taken to accomplish that?
2. Can you describe new developments in bank supervision and market regulation for us?
3. How can banks respond to these changes?
4. In light of all this, what can banks do to deploy their capital to best possible advantage?
Answers
1. In light of the sobering experience of the crisis we are just emerging from, lessons for a new approach to effective bank supervision must be quickly drawn and implemented. What initiatives are being taken to accomplish that?
Dr. Buttler:
First, the MaRisk (the bulletin on Minimum Requirements for Risk Management by the German Federal Financial Supervisory Authority, BaFin) was revised. Important additions and modifications were made to ensure stable and solid risk management at banks.
Another step is enhancing the capital adequacy requirements to back risks that have been assumed. These new requirements have quickly become known as Basel III. One key element in all this is the increase in capital adequacy requirements, a future minimum core capital ratio of six percent (currently four percent), in conjunction with the introduction of another capital buffer and a more restrictive definition of capital under supervisory law. In the end, a minimum of seven percent of risk- weighted assets must be covered by Tier 1 capital.
2. Can you describe new developments in bank supervision and market regulation for us?
Dr. Buttler:
These regulatory initiatives are coupled with limitations on, and greater monitoring of, certain transactions that have the potential to threaten market stability. One in particular that merits mention here is unsecured short sales.
There has been a response to the financial crisis at the organizational level of bank supervision as well. For example, what has been the two-track structure of BaFin and the Bundesbank in Germany has been consolidated; in the future, the Bundesbank will be the sole bank supervisory authority. And at the European level, a new bank supervisory authority with the requisite powers and authority is being created. This new agency will be headquartered in London.
Other initiatives under consideration go as far as to include creation of a European rating agency in order to achieve a higher degree of objectivity and reliability in assessing creditworthiness.
But of course Basel III cannot be viewed as an initiative limited to Europe. Only when all significant financial markets are operating on the basis of the same regulations will we achieve lasting stabilization of financial systems and ensure growth. The new Basel III proposals have been met with relief and a great deal of optimism in Asia, while in the US, institutions tend to be much more skeptical about additional regulation. This was quite evident in the sluggish implementation of Basel II. Against the backdrop of the crisis we have experienced, however, political will is sufficiently strong to tackle this new program with resolve.
To quote Axel Weber, President of the Bundesbank, “What can’t be allowed to happen is that we implement Basel III and the US falls behind. It must be implemented on both sides of the Atlantic.”
3. How can banks respond to these changes?
Dr. Buttler:
At first glance these new regulations can seem very restrictive. Implementation is complex and will entail considerable expenditures. On the other hand, the measures that must be implemented are quite reasonable and natural, as part of solid risk management. Procedures related solely to the past will be supplemented by scenario analyses oriented toward the future as well as stress testing to assess risk capacity under crisis conditions. Reliable knowledge of possible concentrations of risk plays a key role since it is natural these risk concentrations will manifest themselves in crisis times. Ongoing risk monitoring with the aid of appropriate early warning systems enables the individual institution to take timely action when negative developments loom so as to put effective limits on the danger of losses.
This elevates the importance of risk management, giving it a place fitting as a strategic function within the financial institution. The challenge is to closely align risk management with market-related activities. Viewed from that perspective, these new measures make a real contribution to enhancing and elevating the business model.
4. In light of all this, what can banks do to deploy their capital to best possible advantage?
Dr. Buttler:
According to statements by Andreas Dombret, member of the Executive Board of the Bundesbank, in Manager Magazine, German banks will need 50 billion Euros in additional Tier 1 capital in the coming years, according to the Bundesbank’s calculations.
Using an internal rating approach (IRBA: Internal Ratings Based Approach), proprietary, internally estimated risk parameters such as PD, LGD and EAD can be used to determine capital adequacy under supervisory regulations. This empowers the individual bank to target its deployment of capital precisely where it is needed. Over time, it should be possible to achieve a reduction of capital adequacy requirements compared to simpler approaches. The results of the fifth quantitative impact study show that there is potential for a reduction of about five percent of capital requirements, compared to the standard approach. In the case of banks with very specialized business, even greater reductions can be observed. This stems from the fact that, for instance, asset-backed securities could be credited to reduce risk to a greater extent. So from a business management perspective, implementing an IRBA is reasonable, if not a necessity, in order to strengthen competitiveness.
5. How can an IT system support a financial institution in determining the best possible deployment of its resources?
Dr. Buttler:
In my opinion, a software solution can represent an economic advantage if it allows the business people to directly maintain and enhance the rating system. That also significantly reduces the major cost elements caused by consultation between the business people and IT, and by the subsequent implementation of changes. Comprehensive and consistent documentation should not be overlooked either since it can ensure the required auditability. This increases the speed of the financial institution in adapting to new market conditions and enhances its competitive position.
About Buttler Consulting
Buttler Consulting advises banks and insurance companies in the areas of risk management and supervisory law. Current issues include implementation of the new Basel Capital Adequacy Agreement (Basel II), implementation of Solvency II, and the development and implementation of customer-specific risk assessment and control procedures. Our years of experience consulting with financial services providers form a solid foundation for our services. Our philosophy entails a clear focus on the client, creation of custom-tailored solutions, and support through the entire process of implementation.
