Thursday, August 02, 2007

The Pillars of Basel II and the Banks Amendment Bill, 2007
By Garikai Matarirano

The Banks Amendment Bill, 2007 (‘the Bill") has been introduced to provide statutory force to the international strategic drive to further strengthen the credibility and stability of the international banking system. The amendments to the Banks Act, 1990 (‘the Act") have been necessitated by important revisions to the Framework on International Convergence of Capital Measurement and Capital Standards ("Basel II") or ("the revised Framework") published by the Basel Committee on Banking Supervision (BCBS) on 26 June 2004. Only the proposed amendments to the Bill as they relate to the implementation of Basel II will be considered and other technical changes necessitated by developments in the banking industry or to clarify certain provisions in the Act fall outside the scope of this discussion.
The Basel Committee asserts that, "an improved capital adequacy framework is intended to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities." Basel II represents a shift from the 1988 Capital Accord’s "one-size-fits-all" method of calculating minimum regulatory capital requirements with limited risk sensitivity and introduces a three-pillar concept that seeks to align regulatory requirements with economic principles of risk management.
Moreover, Basel I was restricted to measures of market risk and basic measures for credit risk. Basel II introduces an array of sophisticated credit risk approaches and a new focus on operational risk. The Basel II framework is based on a three-pillar structure consisting of minimum capital requirements ("Pillar 1"), the supervisory review process ("Pillar 2") and market discipline ("Pillar 3").
Pillar 1 deals with maintenance of regulatory capital calculated for three major components that a bank faces namely credit risk, operational risk and market risk. Basel II provides banks with three approaches for the calculation of the minimum capital requirements necessary to cover the credit risk component. These include a Standardised Approach based on external ratings, the Internal Ratings Based (IRB) Foundation Approach based on bank’s own estimates and the Internal Ratings Based (IRB) Advanced Approach to be used by more sophisticated banks.
The calculation of the operational risk component is determined in three different ways; the Basic Indicator Approach, the Standardised Approach and the Advanced Measurement Approach.
Pillar 2 deals with the key principles of supervisory review, risk management guidance and supervisory transparency and accountability with respect to banking risks, including guidance relating to, inter alia, the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk and credit concentration risk), operational risk, cross-border communication, and securitisation. The supervisory review process is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.
The first principle requires banks to put in place a rigorous process for assessing overall capital adequacy the main features of which are board and senior management oversight, sound capital assessment, comprehensive management of risks, monitoring and reporting and internal control review.
Secondly, 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.
Thirdly, 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.
Fourthly, supervisors are also required 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 such as intensified monitoring, restrictions in payment of dividends, the preparation of satisfactory capital restoration plan and / or raise additional capital immediately.
Pillar 3’s focus on market discipline is designed to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). This mechanism seeks to enable market participants to assess key information about a bank’s risk profile and level of capitalisation, thereby encouraging market discipline through increased disclosure. Enhanced disclosure is intended to improve the transparency of banks’ business and risk structures. It is also intended to provide banks with incentives to strengthen risk management and internal controls. More importantly, investors, armed with information, will be able to distinguish between well managed and poorly managed banks and to use this knowledge in determining a portfolio strategy and an appropriate risk premium.
The Memorandum on the objects of the Bill states that it is prudent to implement Basel II in its entirety and to amend the legal framework to facilitate its implementation. In this regard, the Bill introduces a host of new concepts in the definitions section of the Banks Act to facilitate the incorporation of the recommendations made by the Basel Committee.
The Basel Committee recommends that the revised Framework should be applied on a consolidated basis to preserve the integrity of capital in banks with subsidiaries by eliminating double gearing within banking groups. Accordingly, a distinction is drawn between a consolidating supervisor and a host country supervisor for the purposes of regulating domestic banking institutions. A consolidating supervisor is responsible for the oversight of the implementation of the revised Framework for a banking group on a consolidated basis. A host country supervisor is responsible for supervision of entities operating in their countries.
Section 1(1) of the Bill defines a "consolidating supervisor" as a supervisor in a foreign jurisdiction that is responsible for the regulation and supervision of a foreign banking institution incorporated in that foreign jurisdiction. It also empowers the Registrar of Banks ("the Registrar") to perform the functions of a consolidating supervisor. The definition of a "host supervisor" in a foreign jurisdiction is limited to the supervision and regulation of any branch, subsidiary, joint venture or related entity of a bank incorporated or operating within that foreign jurisdiction. The Registrar of Banks may regulate or supervise a foreign banking institution that is incorporated in a foreign country and has been authorised and registered as a bank within the Republic of South Africa.
Under the Basel II framework banks are permitted to choose between two broad methodologies for calculating their capital requirements for credit risk (that is, the Standardised Approach and the IRB Approach). The former measures credit risk in a standardized manner, supported by "external credit assessments" made by certain qualifying credit rating agencies. This methodology, which is subject to the explicit approval of the bank’s supervisor, would allow banks to use their internal rating systems for assessing credit risk. To enable banks to calculate their minimum required capital and reserve funds, a definition of ‘eligible institution’ and ‘external credit assessment’ is included in order to enable eligible institutions to provide external credit assessment of a bank’s credit risk. These institutions must be approved by the Registrar and the assessment or rating must meet certain prescribed requirements which may include criteria as to objectivity, sufficient resources, credibility, transparency and disclosure.
The Bill has also broadened the definition of "primary capital" and "primary unimpaired reserve funds" to include minority interests that arise from the consolidation of less than wholly owned banking institutions.
In terms of the requirements of Basel II, supervisors have to assign eligible external credit assessment institutions’ assessments to the risk weights available under the standardised risk weighting framework, that is, deciding which assessment categories correspond to which risk weights. The mapping process has to be objective and it should result in a risk weight assignment consistent with the level of credit risk reflected in the Basel II and should cover the full spectrum of risk weights. Annexure 2 of Basel II contains comprehensive information to assist supervisors with the process of assigning credit assessments to the relevant risk weights. Based on the requirements of Basel II relating to the mapping of external ratings, it is proposed that section 4 of the Act be amended to provide for such mapping process.
The Bill recognises that co-operation and the sharing of information between supervisors are prerequisites to effective supervision of a banking group on a consolidated basis. Accordingly, the Registrar may enter into cooperation arrangements with other supervisors or institutions in respect of accepting the methods and approval processes used by a foreign bank at group level. The Registrar will be able to share information with other supervisors or institutions in relation to the operations and other qualitative aspects of a banking group or controlling company.
Section 4 of the Act will be amended to impose a duty on the Registrar to implement and maintain a comprehensive supervisory review process. The supervisory process will include on-site and off-site examination, inspection or review of the risk management systems and internal methodologies used in calculating minimum capital requirements of a bank or its controlling company.
Basel II acknowledges that bank supervision is not an exact science and that discretionary elements within the supervisory process are inevitable. Accordingly, the Bill allows the Registrar to implement such regulatory or supervisory standards which he deems appropriate after consultation with the banks.
In this regard, the Bill amends section 4 of the Act by requiring the Registrar to make publicly available the criteria to be used in the review of banks’ internal capital assessments. If a supervisor chooses to set target or trigger ratios or to set categories of capital in excess of the regulatory minimum, factors that may be considered in doing so should be publicly available. Where the capital requirements are set above the minimum for an individual bank, the supervisor should explain to the bank the risk characteristics specific to the bank which resulted in the requirement and any remedial action necessary.
Currently section 6(4) of the Act, which enables the Registrar to furnish banks with guidelines regarding the application and interpretation of the provisions of the Act, has been broadened to include a controlling company, eligible institutions and auditors of banks or controlling companies in line with certain duties imposed on these institutions by Basel II.
Section 6(4) of the Act has also been amended so as to provide for a clear distinction between circulars, guidance notes and directives. Circulars may be issued by the Registrar to furnish banks with guidelines regarding the application and interpretation of the provisions of the Act. Guidance notes may be issued by the Registrar in respect of market practices that banks may or may not consider in the conduct of their business and which are not mandatory for banks to implement but merely provide banks with further information. Directives may be issued by the Registrar, after consultation with the affected parties, to prescribe certain processes or procedures to be followed by banks with regard to certain processes or procedures necessary in the administration
A crucial aspect of implementing Pillar 3 disclosure requirements is that supervisory authorities should possess the right to gather information from the cross-border banking establishments of the banks or banking groups for which they are the consolidating / host supervisor. Accordingly, the Registrar may direct a bank or controlling company to furnish him with information which he may reasonably require for the performance of his functions under the Act.
Ultimately, the implementation of the Basel II capital requirements may be a complex exercise to the extent that banks will have to review their capital calculation methods, information technology systems, risk management systems and corporate governance practices. However, there are some perceived benefits pursuant to this process. Over time it presents banks with the opportunity to gain competitive advantage by allocating capital to those markets that demonstrate a strong risk/return ratio. Developing a better understanding of the risk reward trade-off for capital supporting businesses, customers and products is one of the most important potential business benefits banks may derive from compliance. The more sophisticated and internationally active banks and other financial institutions are encouraged to implement the spirit of Basel II, where applicable, in its entirety and not only the changes envisaged by the Bill.