Pillar 2 of the Regulatory Capital Framework SAARCFINANCE

Pillar 2 of the Regulatory Capital Framework SAARCFINANCE Regional Seminar on Basel II Enhancements and Policy Responses Islamabad, Pakistan 11 April 2011 Jason George Financial Stability Institute / Bank for International Settlements Hong Kong SAR 1

Agenda l Why does Pillar 2 exist? l Key principles of Pillar 2 l Specific aspects of Pillar 2 l Cross-border communication and cooperation in Pillar 2 l Pillar 2 challenges

What is Pillar 2? l An overall assessment of risk that includes – Quantitative and qualitative factors l An assessment of capital management and planning l Pillar 2 should cover all parts of the financial group l Pillar 2 is a strategic assessment of an institution l Pillar 2 is flexible and proportional to the risks faced by an institution

Rationale for Pillar 2 l Encourage banks to utilise better risk management techniques l Ensure banks have adequate capital to support all risks (but some risks may be managed outside of the capital framework) l Focus on internal, not regulatory, capital l Accommodate differences between banks

Agenda l Why does Pillar 2 exist? l Key principles of Pillar 2 l Specific aspects of Pillar 2 l Cross-border communication and cooperation in Pillar 2 l Pillar 2 challenges

Supervisory Review of Capital Adequacy Pillar 2 is based on four key principles: 1. Banks' Own Assessment of Capital Adequacy 2. Supervisory Review Process 3. Capital Above Regulatory Minimums 4. Supervisory Intervention Foundation = existing supervisory guidance, especially Core Principles for Effective Banking Supervision

Banks’ Own Assessment of Risk and Capital Adequacy Principle 1 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.

Banks’ Own Assessment of Risk and Capital Adequacy l The level and sophistication of the capital adequacy assessment process should be tailored to the bank’s activities and the risks involved in these activities l There is no “best practice” with regard to the design and implementation of such a process (no “one size fits all”) l However, there are some key features that should be included in every bank’s process

Banks’ Own Assessment of Risk and Capital Adequacy l Board and senior management oversight l Policies and procedures designed to ensure that the bank identifies, measures, monitors and controls all material risks l A systematic, disciplined process: – that relates capital to the level of risk – that states capital adequacy goals vis-à-vis risk, considering the bank’s strategic focus and business plan – of internal controls, reviews, and audit to ensure the integrity of the overall management process

Banks’ Own Assessment of Risk and Capital Adequacy l Have an assessment process l Which is the firm’s responsibility l Proportionate l Formal, documented and management’s responsibility l Integrated into the management process and decision-making l l l culture Reviewed regularly Risk based Comprehensive Forward-looking Fit for purpose Produce a reasonable outcome

Banks’ Own Assessment of Risk and Capital Adequacy What factors should management consider? l Regulatory ratios and requirements l Peer comparisons l Expectations of counterparties and rating agencies l Business cycle effects l Forward-looking stress tests l Concentrations of credit and other risks l Other qualitative and subjective factors l Formal modelling and risk analysis l Building value for shareholders

Supervisory Review Process Principle 2 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.

Supervisory Review Process Traditional methods for monitoring compliance with minimum regulatory capital ratios: l On-site examinations l Off-site surveillance l Meetings with bank management l Periodic reporting l Review of work of internal and external auditors

Supervisory Review Process Renewed focus on supervisors’ evaluation of process to determine: – that target levels of capital chosen are comprehensive and relevant to the current operating environment; – that these levels are properly monitored and reviewed by senior management; and – that the composition of capital is appropriate for the nature and scale of the bank’s business.

Capital Above Regulatory Minimum Ratios Principle 3 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.

Capital Above Regulatory Minimum Ratios l Pillar 1 requirements include a buffer for uncertainties that affect the banking population as a whole l All banks are expected to operate ABOVE the minimum requirement (i. e. not just at 8%!) l Supervisors will need to consider whether the particular features of their banks/markets are adequately covered

Capital Above Regulatory Minimum Ratios Means to ensure banks are operating with adequate capital levels: l Reliance on a bank’s internal capital assessment l Establishment of “trigger” and “target” ratios l Establishment of defined capital categories above minimum ratios (e. g. “Prompt Corrective Action”) l Higher requirements for outliers

Supervisory Intervention Principle 4 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.

Supervisory Intervention Objective Identify as early as possible the potential for serious erosion of the bank’s capital position in order to limit risk to depositors and financial system

Supervisory Intervention Intervening Actions l Determined by law, national policies, case-by-case analysis l Moral suasion to encourage banks to improve their capital positions l Capital ratios may represent triggers for supervisory action, up to and including the closure of the bank

Supervisory Intervention Potential Supervisory Actions l Increased monitoring of the bank l Requiring the bank to improve its internal capital assessment programme l Requiring the bank to submit a capital restoration plan l Placing restrictions on bank activities, acquisitions, investments, etc. l Restricting the payment of dividends l Requiring replacement of senior management and/or the board

Agenda l Why does Pillar 2 exist? l Key principles of Pillar 2 l Specific aspects of Pillar 2 l Cross-border communication and cooperation in Pillar 2 l Pillar 2 challenges

Specific Aspects of Pillar 2 Interest rate risk in the banking book l Significant risk that should be supported by capital l Use of bank internal systems – economic value relative to capital l Apply standardised interest rate shock l Banks with significant interest rate risk (“outliers”) should reduce risk, increase capital, or both Operational risk l Is Pillar 1 requirement under Basic Indicator or Standardised Approach sufficient (e. g. , for banks with low profitability)?

Specific Aspects of Pillar 2 Credit concentration risk l Single exposure or group of exposures that have potential to produce losses large enough to threaten bank solvency l Banks should have internal systems/policies & controls to identify/measure/monitor/control concentrations. l Bank should include concentrations, including periodic stress tests, in its internal capital adequacy assessment Other risks l IRB stress tests, definition of default, residual risk, securitisation

Specific Aspects of Pillar 2 Supervisory transparency and accountability l Criteria used in Pillar 2 assessments should be made publicly available l Factors to be considered in setting target or trigger ratios above the regulatory minimum should be publicly available l If capital requirements are set above minimum for an individual bank, supervisors should explain to the bank: – The risk characteristics specific to the bank – Any remedial action necessary

Specific Aspects of Pillar 2 Risk capital framework: Citigroup example l Pillar 1 risks are captured in the risk capital methodology l Additional risk formally managed in the risk capital methodology – Interest rate risk in the banking book – Concentration risk – Insurance risk (from insurance subsidiaries) – Business risk – Pension risk l Risks managed outside of the risk capital framework – Liquidity risk – Reputation risk – Strategic risk – Economic risks (covered through stress testing)

Agenda l Why does Pillar 2 exist? l Key principles of Pillar 2 l Specific aspects of Pillar 2 l Cross-border communication and cooperation in Pillar 2 l Pillar 2 challenges

Cross-Border Communication and Cooperation l Basel II will require enhanced, practical cooperation among supervisors of internationally active banks. l Legal responsibilities do not change under Basel II! l Hopefully, methods and approval processes at the group level can be accepted by host supervisors. l Supervisors should avoid performing redundant and uncoordinated approval and validation work—burdensome for banks and supervisors. l Roles of home and host supervisors should be communicated to banks operating in multiple jurisdictions. l Pragmatic approach of mutual recognition is desirable

Agenda l Why does Pillar 2 exist? l Key principles of Pillar 2 l Specific aspects of Pillar 2 l Cross-border communication and cooperation in Pillar 2 l Pillar 2 challenges

Pillar 2 Challenges Potentially Significant Obstacles l Legal and regulatory impediments l Resources (personnel, training, etc) necessary for effective supervisory review l Level playing field l Transparency l Ability to exercise supervisory judgment

Conclusions

Conclusions l The three pillars together are intended to achieve a level of capital commensurate with a bank’s overall risk profile l Starting point and emphasis is bank’s assessment l Sophistication of capital assessment should depend on size, complexity, and risk profile of the bank l Pillar 2 does not require specific, formal, across-the-board capital add-on requirements l Intention is to drive better bank risk management and more risk- focused supervision

Pillar 2 of the Regulatory Capital Framework SAARCFINANCE Regional Seminar on Basel II Enhancements and Policy Responses Islamabad, Pakistan 11 April 2011 Jason George Financial Stability Institute / Bank for International Settlements Hong Kong SAR 33