In response to the recent financial turmoil, the international body of financial regulators, the Basel Committee on Banking Supervision has released new regulatory guidelines which member nations are expected to implement over the coming two years
While the changes are extensive, what follows is a summary of the most crucial developments. For a more comprehensive overview of the forthcoming changes, contact your FIIG representative.
- Focus Areas
The financial crisis highlighted several key areas which regulators believe expose banks to unacceptable risk; this package is targeted at addressing the weaknesses the crisis revealed. Specifically, it focuses on:
- Incentive based remuneration practice
- The high-risk nature of resecuritization exposure
- Adequately capturing the full extent of market ris
- Ensuring that banks can retain liquidity even in times of stres
- Improving the quality of the capital bas
- Avoiding excessive leveraging of financial institutions
- Making the international regulatory environment more consistent
- Timetable for Implementation
The reforms are set to be implemented in two phases. The first, a more targeted package dealing with how to account for market risk, adjusting the treatment of resecuritization exposures, and reforming compensation arrangements is to be in force by year end 2010. The second, a broader reform package touching almost all areas of prudential supervision to be implemented by year end 2012. Admittedly, not all countries are likely to stick to this timetable, but Australia is currently on track.
- Stronger Capital Bases
Capital adequacy requirements are the cornerstone of prudential supervision in Australia, and the proposed changes will significantly alter the composition of the capital base.
Most significantly, Tier 1 capital will be more heavily comprised of common equity, with less allowance for innovative features (like step-ups and call options). The details of how this will be calibrated are being considered at the moment, with more information to be available later this year, but in particular, it is expected that exceptions will be made to account for mutuals (such as building societies and credit unions).
- Better Risk Recognition
As well as changes to the capital base, changes are also proposed which will levy additional capital charges to account for risks which were previously underestimated.
Specifically, it is proposed to require banks to hold more capital to account for market risk, resecuritized exposures (such as CDOs or ABSs), counterparties, collateral, and credit-valuation adjustments. In assessing the risks associated with many securities the new regulations will require the consideration of stressed inputs which will effectively result in higher capital charges as well.
- Improving Liquidity
In order to ensure that financial institutions can stay liquid during times of stress, they will now be required to hold higher quality liquid assets, and conduct a range of stress tests.
With respect to liquid assets, banks will be required to hold assets specifically and exclusively for the purpose of providing emergency liquidity. These assets will have to have private market liquidity even when markets are under stress, which rules out anything issued by financial institutions.
To determine the level of liquid assets that will have to be held, banks will be required to assess their liquidity requirements under three scenarios: a going concern basis; a one month ‘name-crisis'; and a three month ‘market disruption'.
- Reducing Leverage
The new regulations would impose a new, non risk-adjusted backstop to capital adequacy ensuring that banks do not over-leverage themselves. It should be noted that the details of this proposal are still being developed; what measure of capital will be used, what will contribute to exposures, and what level the ratio will be limited to are all to be determined over the coming year.
- Reducing Dependence on Systematically Important Institutions
Accepting that a considerable proportion of derivative transactions are conducted over the counter, and that this increases interdependence on certain institutions - making them potentially ‘too big to fail' - the new regulations promote the multilateral clearing of derivative contracts through central counterparties. This will likely result in increased risk weights attached to bi-lateral derivative transactions and zero risk weight for collateral, margins and mark-to-market exposures relating to transactions conducted through central counterparties.
- Increased Administrative Burden
The new regulations propose new disclosure requirements and more rigorous risk evaluation practices which will result in a greater administrative burden and higher compliance costs for regulated institutions. It is important to note though that regulators are aware of this problem and will try to minimize its effect, particularly with respect to smaller institutions such as credit unions and building societies.
- Moving Towards International Consistency
As well as seeking to account for newly identified risks, this package of reforms is also aimed at improving the international consistency of banking regulations. This is a good thing for two key reasons: firstly, so that investors can compare apples with apples, whereby a Tier One ratio of 9.4% in Australia means the same thing in the US or the UK or Dubai; and secondly, to reduce instances of regulatory arbitrage, where banking business gets conducted in the most loosely regulated jurisdictions. Australia already has some of the toughest prudential regulations in the world; bringing the world closer to our standard can only help Australian banks' competitiveness.
- Stay Informed
Most of these proposed regulations are still being refined, with their final form subject to both general calibration, and APRA tailoring them to an Australian context incorporating any industry feedback that is received. Accordingly, it's important to recognize that they're a work in progress.