Practical Implications of Regulatory Convergence

1
Practical Implications of Regulatory Convergence
Lessons from Basel II

• Mary Frances Monroe
• Division of Banking Supervision and Regulation
• Board of Governors of the Federal Reserve System
• Presentation to CPCU Society Symposium
• Boston, Massachusetts
• June 11, 2005

2
Practical Implications of Regulatory Convergence
Goals of Basel II

• Goals of Basel II
• Greater risk sensitivity reliance on a banks
  internal assessments of capital adequacy
• Suitability reflect and support sound credit
  risk management practices
• Incentive Compatibility improve internal risk
  management practices and adapt to evolving
  markets and products
• Competitive Equity promote and enhance a level
  playing field across international boundaries

3
Practical Implications of Regulatory Convergence
Goals of Basel II

• Goals of Basel II (continued)
• Safety and Soundness ensure consistency with
  fundamental banking principles
• Balance attempts a reasonable trade-off between
  enhanced risk sensitivity and implementation
  burden
• Non-cyclicality capital charges should be
  relatively stable over the economic cycle
• Aggregate capital level roughly maintain the
  current amount of capital in the banking system

4
Practical Implications of Regulatory Convergence
Overview of Basel II

• Structure of Basel II
• Pillar I Minimum Capital Requirements
• Credit Risk, Operational Risk, and Trading Book
  components
• Importance of Qualifying Criteria for Advanced
  Approaches
• Importance of Corporate Governance Structure
• Importance of Validation

5
Practical Implications of Regulatory Convergence
Overview of Basel II (continued)

• Structure of Basel II
• Pillar II Supervisory Review
• Focus on risks not fully captured in Pillar 1,
  factors not taken into account under Pillar 1,
  and external factors
• Four key principles
• Pillar III Market Discipline/Disclosure
• Materiality
• Frequency

6
Practical Implications of Regulatory Convergence
Lessons from Basel II

• Need to balance convergence with flexibility
• Basel II goal of convergence of regulatory
  capital standards and measurement
• Reality is different national markets
• Necessitates degree of national discretion in
  implementation
• Accord Implementation Group established to
  promote consistency in application of Basel II,
  especially where national discretion exists
• Address cross-border home-host issues
• Case studies have been conducted

7
Practical Implications of Regulatory Convergence
Lessons from Basel II

• Importance of Stress Testing and Scenario
  Analysis
• Regulatory minimums are only a starting point
• Models are imperfect
• Models may not capture all material risks
• Model assumptions/parameters may understate
  degree of risk
• Models may be based on backward-looking data
• Taking stress conditions and scenarios into
  account involves both quantitative analysis and
  qualitative judgment with an enterprise-wide view

8
Practical Implications of Regulatory Convergence
Lessons from Basel II

• Need to supplement risk-based capital standards
  with other supervisory tools
• Importance of leverage ratio
• Need for mechanism for early intervention
• For U.S. banks, this is accomplished through
  prompt corrective action
• Ability of bank to engage in certain activities
  or expand operations is constrained if cushion
  above minimum capital standards is not maintained
  or bank is deemed to have engaged in unsafe and
  unsound practices

9
Practical Implications of Regulatory Convergence
Lessons from Basel II

• Importance of Enterprise-wide Risk Management
• Risks transcend legal entity/line of
  business/functional boundaries
• Need to consider impact of business line
  activities and risk-taking decisions on other
  parts of the organization
• Consolidated supervisor must assess impact of
  different prudential supervision frameworks
• Federal Reserve supervision has moved from
  historical analysis on legal entity basis to more
  forward-looking assessments of risk management
  and financial condition of consolidated
  organization

10
Practical Implications of Regulatory Convergence
Lessons from Basel II

• Importance of quantitative impact studies
• QIS 4 U.S. regulators are faced with lower than
  expected capital levels and broad divergence
  across firms
• Data limitations give rise to need to balance
  quantitative and qualitative approaches and rely
  more on the latter in the short term
• Loss data collection exercise for operational
  risk indicates more robust operational risk data
  collection and increasingly sophisticated
  approaches to measuring risk

11
Practical Implications of Regulatory Convergence
Beyond Basel II

• Joint Basel/IOSCO Working Group on Trading
  Activities and Double Default
• New option for treatment of counterparty credit
  risk
• Limited recognition of double default
• Improvements to the trading book capital regime
• Boundary between firms banking and trading books
• Prudent valuation guidance
• Capturing full range of risks of traded positions
• Consistent approach to unsettled and failed trades

12
Practical Implications of Regulatory Convergence
Beyond Basel II

• Joint Forum Working Group on Liquidity Risk
• Involves banking, securities, and insurance
  sectors
• Focus promotion of financial stability
• Developing paper for publication later this year
  along three workstreams
• Trends in liquidity risk management and
  supervision
• Stress testing and contingency funding plans
• Sources of liquidity risk (especially in stress
  environments)