Basel II does not need to be overhauled – it is adaptable to rapid financial innovation and moreover, is designed to help steer banks through extreme market conditions, says Nout Wellink.
Possibly the greatest challenge in banking regulation is to ensure that fundamental changes in the structure of financial markets are accompanied by upgrades in risk management, regulation and supervision. Basel I served us well for many years but ultimately failed to keep pace with an increasingly complex financial environment. Basel II takes a major step towards setting the right incentives. Its minimum capital requirements are more risk sensitive, it better captures all different types of risk, encourages sound risk management practices and enhances market discipline. And, it is able to adapt to rapid financial innovation over time.
The minimum capital requirements under pillar 1 have received considerable attention in the past few years. However, minimum regulatory capital requirements will never completely keep up with changing financial markets. It is therefore important to focus on the supervisory review of pillar 2. The primary objective is for banks to understand their risk profiles. All risks should be considered, including traditional types relating to concentration, liquidity and interest rates. Risks stemming from the use of new financial instruments should also be considered, such as those inherent in securitisations. In the future, as financial markets evolve and other risks become relevant, these too should be considered in the internal capital adequacy assessment process and subjected to supervisory review. This provides the Basel II framework with the flexibility to adjust to financial innovations.
Stress tests
An important element of pillar 2 is to determine, through stress tests, whether capital cushions held above the minimum capital requirements are sufficient to allow banks to survive severely adverse scenarios. Bank management may be tempted to keep stress scenarios moderate but recent events have demonstrated the need to test for unlikely, but possible, extreme scenarios. Banks should execute extreme stress tests on a regular basis and use the insight gained to evaluate their business/funding strategies and risk mitigation policies.
Market discipline
Another force that will encourage banks to improve their risk management is market discipline. This is enhanced through the pillar 3 disclosure requirements. Without supervisory intervention in this area, we face a market failure: risk disclosure is far from optimal. Pillar 3 provides opportunities to enhance the quality and consistency of information on banks’ risks. It requires banks to periodically disclose information on their risk profile. They must reveal material changes as soon as is practicable. The Basel Committee encourages initiatives by the international banking community to investigate which information should be disclosed. The templates adopted by the Japanese banking industry can serve as a good example. Concerted action can greatly enhance the usefulness of pillar 3 disclosures regarding securitisation.
Ultimately, Basel II is not the answer to all the issues but it does constitute a major improvement and a robust framework for dealing with the ever-changing risk landscape. It can contribute to better risk management and differentiation, improved transparency, and more risk-sensitive capital buffers. Alongside these, liquidity buffers are also vital. Financial innovation and global market developments have transformed the nature of liquidity risk in recent years. With respect to liquidity risk, it is also important that these changes are accompanied by appropriate upgrades in risk management, regulation and supervision. This year, the BCBS is revising the 2000 Sound Practices for Managing Liquidity in Banking Organisations (http://www.bis.org/publ/bcbsc135.pdf).
Particular attention will be paid to areas that have found themselves under the most strain in the recent market turmoil – developments which underlined the importance of stress testing. Sound practice guidelines will put greater emphasis on market-wide stress conditions, including the effects of (similar) reactions by other market participants. This calls for an assessment of the liquidity characteristics of key assets and liquidity cushions. Other areas that will receive special attention are liquidity risks inherent to off-balance sheet vehicles, contingent claims on liquidity, complex instruments and intra-day liquidity risks. The Contingency Funding Plan, will receive particular attention as an essential tool in managing these areas in stressed situations.
Nout Wellink is chairman of the Basel Committee on Banking Supervision and president of the Dutch central bank.
