New Basel proposals may help reduce banks� instability � analyst

Isaac Pinielo | Friday April 15, 2016 12:33

Early last month, the Basel Committee on Banking Supervision proposed a plan to prohibit lenders from using internal models to calculate credit risk toward financial firms, equities and large corporations.  The plan calls for banks to adopt a standardised method of assessing risk, known as the Standardised Measurement Approach (SMA), which replaces the Advanced Measurement Approaches (AMA). According to Segonetso, risk management for capital optimisation has taken centre stage in the modern banking environment post the collapse of the asset-backed securities market and the “poisonous” collateralised debt obligations of the 2008/2009 credit crunch.

“Following these events, the Basel Committee on Banking Supervision has been constantly orchestrating rules to curb similar cases in the future. For instance, stricter rules on how banks calculate the amount of capital they need to cover risks from fines or other parts of their operations has been enhanced, and are likely to see some banks need to bolster their balance sheets,” he said. While this phenomenon is viewed in some quarters as the Basel Committee’s attempt to limit the ability of the big banks to use their own models to cut the amount of capital they need, Segonetso said the changes in the operational risk framework are part of the committee’s aim to improve the simplicity, comparability and risk sensitivity of the frameworks. He noted that after the 2008/2009 financial crises, regulators found huge disparities in capital holdings because big banks used different models to assess risk. “As a result, banks are now being told to be more consistent and often increase the risk weightings they apply to their assets,” he said. Basel II only came into effect in Botswana at the beginning of this year whereas banks elsewhere have been calculating operational risk capital requirements for over 10 years since its implementation in 2006.

Pursuant to the implementation of the rules in the past decade, Segonetso said it has since emerged that capital set aside proved inadequate to cover substantial losses arising from operational risk factors such as misconduct fines, controls failure or fraud.  He noted that Basel II framework introduced several methods for calculating operational risks to reflect particular risk profiles across banks, variations in operating environment and management practices.  Banks were given an option to use an internal model-based approach for measuring operational risk through the AMA.  However, this measurement approach of estimating operational risk capital has been removed from the operational risk framework as detailed in the consultative document recently released by Basel Committee to the market participants for comment.  Segonetso said the committee believes that the modelling of operational risk for regulatory capital purposes is unduly complex and that the AMA has resulted in excessive variability in risk-weighted assets and insufficient levels of capital for some banks.  He indicated that the AMA gave banks the greatest amount of freedom to set operational risk charges, hence flexibility on the modelling approach meant risk charges would differ even when applied to the same base data.  On the other hand, the new SMA, which borrows from the current advanced measurement approach by incorporating a requirement for banks to continue to collect operational risk loss data, will not use internal modelling to determine appropriate capital levels.

“Now under the proposed operational risk framework, lenders will use a ‘business indicator’ based on their financial statements, which would reflect the complexity and size of the balance sheets,” he said.

The analyst further explained that banks would then be allowed to have a “loss indicator” that reflected actual losses going back a decade, which would justify a lower capital figure than the one thrown up by the business indicator. However, he said, for banks that have had big fines or other costs, it could increase the estimated loss figure.  “In a nutshell, the revised methodology combines a financial statement-based measure of operational risk – the “Business Indicator” – with an individual firm’s past operational losses,” said Segonetso. He added that this is expected to produce a risk-sensitive framework, while also promoting consistency in the calculation of operational risk capital requirement across banks and jurisdictions.  He said given today’s operating environment in the banking sector, operational risk is anticipated to rise as banks increasingly rely on technology, heightening exposure to systems failure and cyber attacks.  He said banks also face growing compliance and regulatory risks, adding that the overhang of unresolved litigation is still a humongous challenge in some markets.  As usual, he pointed out, following changes in regulatory framework, Basel Committee on Banking Supervision plans to conduct a quantitative impact study (QIS) to help inform the final calibration of the proposed standard.

Notwithstanding this QIS exercise, Segonetso said the committee notes that for most banks, the above discussed proposals will have a relatively neutral impact on capital, but it is inevitable that minimum capital requirements will increase for some banks even though the objective of the proposals is not to significantly increase the overall capital requirements.