Leading the Way is a column written by PricewaterhouseCoopers professional staff. It appears in the Business section of the Bangkok Post twice each month. The column provides specialised advice to corporate decision-makers in Thailand on global and local business trends.
This article appeared in the October 2, 2007 issue of the Bangkok Post.
By Cameron Evans
The recent credit squeeze in the United States is providing a timely reminder of unexpected financial risks that could hit the banking sector. This is particularly pertinent as the Bank of Thailand, and regulators around the world, prepare for the transition to Basel II, a set of upgraded capital adequacy standards for banks.
All stakeholders across the financial services industry are now getting ready for Basel II. Most areas of banking operations will need to deal with new rules for process and governance changes, information technology systems and data upgrades and strategy reviews. At the same time, new regulatory standards will be applied. The complexities of cross-border regulation will increase with differing interpretations and implementation timetables.
Despite the significant effort of all players, and even before the new framework comes into operation, the current credit pressures generate further concerns regarding the impact of risks on bank capital and how they should be regulated. The past decade has seen historically low default rates and generous provision of credit. This can be misleading in determining current and future capital requirements. Recent events may also lead to greater scrutiny of ratings agencies and the use of risk measures given the large effect they have in determining risk capital for credit risk.
While many banks have focused on the potential for holding lower levels of capital, based on their own modelling of risks, the key point of capital adequacy and risk management regulation is to establish a floor of stability to underpin the financial sector in times of stress. This will bring greater focus and attention from the items established in Pillar 2 that guide the Supervisory Review Process.
The requirements here extend well beyond the prescribed approaches for measuring capital under Pillar 1 for credit, market and operational risk. Banks will need to be able to demonstrate how they perform a comprehensive internal capital adequacy assessment process (ICAAP). This pays significantly more attention to the banks' understanding and management of the full risk spectrum of businesses and the markets to which they are exposed. Banks will need to show:
- How capital adequacy levels perform in ''stressed'' and forward-looking scenarios.
- How they cover other risks inherent in banking, particularly liquidity, concentration, securitisation and interest rate risk in the banking book.
- How the banks' boards and executives understand the risk appetite of a company.
- How well this risk appetite is translated into operational processes, procedures and limits.
- Who is responsible for identifying and managing crisis situations.
These issues are at the heart of Basel II and will be at the forefront of banking regulators' minds when implementing new standards and assessing the readiness of banks to comply with Basel II benchmarks.
Regulators in Europe have been leading the way on this front under the guidelines from the Committee of European Banking Supervisors (CEBS), which has been applied under the EU's Capital Requirements Directive (CRD). This will result in banks going through an assessment process that will take into consideration the broader application of measurements for ''other risks'', stress testing, risk governance, economic conditions, use of risk-management tools in regular operations and even the capabilities of peer banks.
It is only a matter of time before this becomes standard practice for regulators around the world. Even banks whose home regulators have not established upgraded assessment processes may be affected if a bank that is regulated in these jurisdictions is a major shareholder.
Many leading banks have invested in methods, processes and systems to better align their risk and finance management infrastructures to measure, manage and understand risk-adjusted performance and tolerance levels using economic capital frameworks.
This capability is viewed as more than a risk-management tool. It also provides a strategic competitive advantage. Practices and approaches vary, but are now recognised as a standard requirement in today's banking environment.
The upcoming implementation of Basel II will drive significant improvements in risk management practices across the banking industry. The degree of cultural, behavioural, systems and process change, plus the investment required, is not to be underestimated and will continue to evolve and, potentially, sow the seeds for Basel III. Recent events may have already done this.
