Basel III: The Changing World of Banking Regulation

James Babicz, SAS - 8 February 2011

Banks need to start addressing their Basel III requirements this year. This article examines the challenges these requirements pose, and how they can best be tackled.

It is no secret that banks are now facing a regulatory landscape that is rapidly changing in new and unanticipated ways. The Basel III banking reform package, for example, represents a step change in the way national banking regulators interact and has been described as the first concrete example of 'macroprudential' regulation that seeks to moderate the economic cycle.1 As a result, banks have little prior experience to help them plan for or react to new rules as they are introduced.

Clearly in the past, banks have not had to concern themselves with macroprudential regulation and the impact this would have on their business and, consequently, the need to provide a robust firm-wide management framework to adopt and adapt to such changes was not a priority. However, going forward, it is imperative that such a firm-wide framework be put in place, in order to ensure minimal disruption to the business, and to capitalise on business opportunities that will inevitably arise from such changes.

The Requirements

Burying your head in the sand is not an option. Starting this year, banks need to begin addressing the requirements of Basel III with the measurement and reporting of the liquidity coverage ratio (LCR) and leverage ratio, followed by the net stable funding ratio (NSFR) in 2012. Following varying observation periods, these ratios may be adopted into Pillar 1 requirements, possibly after some degree of recalibration.

Basel III has also introduced changes to the trading book and treatment of securitisations, and there is a commitment to a further review of the trading book in 2011. Specifically, new guidelines have been drafted to address credit risk and wrong way risk with the introduction of the incremental credit risk charge (IRC), credit valuation adjustment (CVA) and counterparty credit risk (CCR) rules.

In terms of capital, starting in 2013 changes to the quantity and quality of capital, as well as the ratio of core Tier 1, Tier 1 and Tier 2 capital, will be phased in gradually until 2019. The net effect by 2019 will be a seven-fold increase in core Tier 1 capital, and a rise of total capital from a minimum of 8% to 10.5%, assuming the full 2.5% conservation buffer is included, and possibly 13%, if the countercyclical buffer is fully in effect.

The Challenges

Under the Basel III regulations, banks will be required to provide more accurate and up-to-date information on their capital position at any given time. However, there are numerous obstacles that prevent banks from gaining an accurate picture of their organisation’s risk and capital position as a result of inconsistencies and gaps in data.

First, one bank may well operate across a number of global locations, which not only means that its exposure to risk across the business could vary considerably, but may also lead to inconsistencies in the implementation of the agreed G20 standards. At a micro-level, even what seems like a small detail such as different methods of accounting can affect the overall quality of data used to get a view of the whole organisation. Even what seem like relatively small gaps or inaccuracies can in fact have a noticeable and detrimental effect on the bigger picture. This problem is further compounded when banks have grown by acquisition. In this scenario, there is likely to be a lack of consistency in the format and type of data, which can result in a difficult and time consuming process to firstly understand the data from various sources and then combine it in a single uniform manner which is useable for the organisation.

Second, each bank’s individual business model will have an impact on the way that it calculates risk. For example, a global universal bank will take a completely different approach to that of a small retail bank with a business model based on savings and mortgages. Each institution will subsequently have individual capital and liquidity needs, making it difficult to apply regulatory standards to all banks in the same way. In particular, where banks operate multiple business lines across multiple locations, information is often stored in silos making it difficult to bring together all the information that is needed from across the organisation to create an accurate picture of risk exposure.

Most banks still have a long way to go in order to be able to provide the timely data that is the appropriate quality required under Basel III. The different approaches taken, even within a single institution as well as across the industry, lead at best to confusion, and at worst to misleading information being circulated.

The Solutions

In order to address all these complexities, banks must first look internally. One approach is to appoint a chief data officer (CDO) who is responsible for ensuring that accurate and reliable data can be gathered from all parts of the business, and stored in a constructive format that allows senior executives to make business critical decisions. Of course, gathering the vast amount of data necessary to consolidate the balance sheet of a global institution is no easy task, therefore some banks have also tasked their CDO with constructing a centralised data model to support an overall enterprise risk management strategy.

In many cases, far from needing a complete overhaul, Basel III builds on similar principles to its predecessor. The next steps are to make a few strategic changes in order to aggregate existing data in a more streamlined, consistent and quality-focused manner. Through this approach, Basel III can ultimately help bring about some tangible business benefits as well. Implementing strategically, powerful, flexible and scalable architectures can provide the firm-wide view capability. At a tactical level, best of breed business-focused applications will provide firms with the agility they need in order to adapt and adopt changes as they occur. Typically in financial institutions, strategy and tactics have not necessarily gone hand in hand as banks’ systems have often been specially built using a bottom-up approach. For banks that are looking beyond mere compliance to achieve significant business benefits, the key is to ensure that tactical systems are seamlessly integrated with the broader enterprise framework for data management. This will enable the bank to ensure that data quality is consistent, from a top-down approach, which will in turn deliver rapid, meaningful and actionable information throughout the organisation.

1 FT.com, 10 January 2011.

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