Home-Host Challenges in the Implementation of Basel II: A Global Perspective

1. Home-Host Challenges in the Implementation of Basel II: A Global Perspective 3rd SEACEN Seminar on Basel II Preparation for the Implementation in the Asia-Pacific Region Kota Kinabalu 20 July 2006 Mushana Azlan Mustafa Basel II Project Team

2. Outline • Main challenges to banks & regulators • Example & lessons from a recent supervisory college

3. Addressing home-host issues requires the balancing of objectives • An effective & efficient implementation of Basel II for banks with cross-border operations seek to • Ensure that concerns of regulators are sufficiently addressed • Minimise regulatory burden on banks

4. Burden on banks?

5. Implementation schedules vary by country • Roll-out timetable & transitional schedules • Some with lengthened window periods • Add to complexity in managing compliance, both from regulator & bank perspective • Some IRB, some under SA, some still Basel I • Result in variances between parent & subsidiary capital calculations

6. Possible permutations

7. Illustrative timetable for a global bank If we include Pillar 2, Pillar 3, transitional arrangements, parallel calculation, capital floors, etc, it will be a very complex table!

8. National discretions also vary by country • For internationally active banks, this is an operational nightmare • Most emerging regulators have not finalised their requirements or issued any guidance or communication • Potential adjustments & variations maybe required in areas such as model development, rating operation & internal reporting • Investments in IT systems very hard to reverse or change (Parent bank already invested due to earlier implementation schedule by home regulator) • Some rules (not discretions) interpreted differently between different regulators • For eg requirements for use

9. Approximate time needed for significant change for a global bank Design functional specification Release of new rule. Review & write new business requirement Make system changes System & integration testing User acceptance training & implementation 4 mths 3 mths 2 mths 2 mths 4 mths

10. Example of discretions by country

11. Potential reporting requirements would also vary • Multiple reporting arrangements needed • Some global banks have resorted to centralised, off-shore reporting unit • Some regulators may insist on relevant data sources to be located within country for verification purposes • Made worse with different accounting & regulatory reporting requirements • Basel II default & provision vs accounting impairment

12. Duplicating application & review process • Single application & review process is already onerous & extensive • Require proof & demonstration of compliance • Rigorous self-assessment requirements by several regulators • Naturally, banks don’t want to go through the same process with all regulators at different times • Increases the cost of compliance

13. But regulators have their share of problems…

14. Basel II need to be localised • Basel II was developed with the global banks in mind • Tailored to the circumstances of the BCBS founding members • Although the non-G10 countries received the proposals, they were not directly ‘involved’ in the deliberations • CPLG came late into the picture

15. Paragraph 3 of the Revised Framework

16. Plight of the non G10 • Mix of emerging & developed economies • Mainly host, not home • Only a few internationally active banks • Foreign banks play significant role in host system, usually as retail players • Some even dominate the host system

17. Gaps between developed & emerging markets are significant issues • Different levels of maturity of banking system • Data availability, quality, capture & retention • lack of historical data & sophisticated data collection system • validation would be a serious challenge  can one rely on external ratings for comparison? • Integration of risk management with business processes (use test) • Internal rating system a relatively new practice • Collateral management system • No comprehensive collateral information may lead to inaccurate calculation of loss • Depth of market • Limits options available for credit mitigation techniques (eg. due to less sophisticated & developed credit derivatives market & illiquid markets)

18. Supervisory framework in some emerging markets may not be as robust • Varying levels of supervisory capabilities • Expertise & experience in model review especially advanced models is limited amongst many emerging market supervisors • Significant enhancement to skills required to create larger pool of specialised expertise to form credible supervisory team • Undertake specific analytical work • Assess overall readiness of BIs internal policies, processes & models • More rigorous supervisory review process • Understand application of sound risk management practices in local context

19. G10 timeline adds pressure on banks & supervisors in emerging markets • Approaching deadline of 2007 for G10 countries creates a timing issue as emerging markets have later deadlines • Later deadlines for implementation in emerging markets to cater for local readiness • Emerging markets still grappling with fundamental issues such as NPLs, risk management culture, capacity building, legislative changes (eg. for implementing differentiated capital framework) before full implementation can be effected • Despite time flexibility, the supervisory capacity building efforts in emerging markets are being accelerated to accommodate global implementation of banks from G10 economies

20. Some emerging markets still grappling with the Core Principles • Operational independence of regulators : CP1 50% non-compliance • Formal remedial powers of supervisors : CP22 55% non-compliance • Consolidated supervision (banks + securities + insurance co): CP 20 53% non-compliance Source: World Bank Survey, June 3, 2004: Basel II – The international Banking System at the Crossroads, First Risk Management & Second Capital Accord Transition Considerations for Emerging Markets The challenge is to ensure Basel II implementation in emerging markets achieve the desired outcome (financial stability & more robust banking system).

21. Competitive impact should not be underestimated • Domestic players requires significant time & resources to enhance capability to move towards advanced approaches • Recognition of more advanced approaches for global banks could create un-level playing field • Global banks enjoys diversification benefits from global portfolio, lower capital cost • Domestic banks at a competitive disadvantage given capability gap.

22. Defining specific rules in emerging markets is more daunting • Detail specification, definitions & interpretation of Basel II documents should suit local market environment. Basel II parameters are not reflective of risk profiles of emerging markets. • Areas of national discretion requires greater deliberation • Application of 100% risk weight to all corporate exposures: Should this be considered given low rating penetration? • Application of 150% risk weights on non-past due high risk loans: What types of exposures are considered high risk? Regulators have reasons to adopt different rules. Hence, the need for home-host understanding.

23. How does Basel II affect home-host relations?

24. Home-host issues not entirely new • Main reference documents: • 1975 Concordat & the accompanying documents • Core Principles (1997) & Methodology (1999) - being updated • New documents issued as a direct result of the New Accord: • High-level principles for cross-border implementation of Basel II (2003) • Principles for the home-host recognition of AMA operational risk capital (2004) • Home-host information sharing for effective Basel II implementation (2006)

25. The high level principles for home-host • Is the guidance provided by BCBS High-level Principles for Cross-Border Implementation (2003) sufficient? • Host have ‘requirements that need to be understood and recognised’ • Need to be ‘enhanced and pragmatic cooperation’ • Should avoid ‘redundant & uncoordinated approval & validation work’ • Home country would ‘lead effort’

26. Principle of significance • Principle of significance • Significance defined from perspective of banking group & materiality of operations in host country (as per Principle 2 & 4) • Subsidiaries of global banks may be ‘insignificant’ from a global banking group’s perspective because it is small relative to the overall size of the global bank; but significant in the domestic market because it is large relative to the rest of the domestic banking system • BCBS paper on home-host information sharing (2006) provides more guidance on significance

27. Principle of significance in the 2006 home-host paper • Host regulators like to use size as indicator • As % of overall host jurisdiction’s banking industry • As % of certain critical sectors such as consumer lending • Parent of foreign banks that are outside their home regulator’s radar altogether may also be targeted

28. Information sharing process recommended by the home-host paper • Bilateral & multilateral (supervisory colleges) • Relevant & timely • Factual information • Supervisory approach & process • Group & Bank’s chosen approach, timetable etc • Judgemental information • Examination reports & assessments

29. Home-host issue mainly in IRB & AMA • SA for credit risk: • National discretions allow for variations, but most are non-negotiable • Recognition of external credit agencies • Less need for home-host communication • But in IRB & AMA: • Lots of room for regulators to vary due to principle-based nature of the requirements • Requires supervisory discretion & approval, where rationale maybe not so transparent • Difficult to maintain consistency in implementation • Huge scale of bank’s investments, so certain decisions could be costly • More need for supervisory cooperation!

30. Of regional & global models • Global banks with diversified operations tend to favor regional & global models • Especially for corporate credit portfolio • Due to inadequate number of defaults in specific countries • Achieve economies of scale by utilising a few “centres of excellence” • Inevitably, critical information regarding models will reside outside host jurisdictions • Sometimes outside home jurisdiction! • Need for home-host cooperation: • To obtain required information from other supervisors • Where confidentiality laws prevent direct access • To avoid regulatory burden on banks

31. What is a regional/ global model? • Ownership & accountability of model • Local or centralised • Does local operation has liberty to change model? • Source of data • For development • For calibration • Implementation • Is it implemented on a local platform? • Rating processes & practices • Standardised vs country-specific processes & practices • Degree of adaptation • Does it matter?

32. Degree of host regulator involvement in validation • Revolves around issue of significance: • In cases where foreign banks are significant, the host regulator would seek active involvement in validation • In cases where foreign banks are not significant, host regulator may rely more on home regulator • Host would still request information relevant to local jurisdiction • Less active in validation • Logistic issue also play a part • Esp where model resides outside home regulator • Where home lacks the necessary resources • Where retail model uses primarily local data

33. Communication with banks & amongst regulators very important • While detailed supervisory guidelines have yet to be finalised in most countries, banks should update their home & host regulators on their Basel II plans regularly • Creates awareness on banks’ efforts & home or host country intentions • Facilitates discussion on key issues well in advance to minimise possible ‘shocks’ • Facilitates planning & scheduling of supervisory resource

34. More on communication • Planning by home & host supervisors critical: • Minimize multiple approval processes • Minimize multiple information request • Facilitate future on-site visits & model validation • Clear distribution of responsibilities between both supervisors • Should work be done jointly or separately? • Can we rely on other supervisor’s work? • What work are we talking about here?

35. What do regulators want in validation? • Review approaches may vary • Some regulators may be stringent & would reserve the right to review everything themselves • Some may require specific tests to be conducted by banks, for subsequent submission • Some relies on review of validation reports from independent, external experts • Extent of information required may also vary at different stages • Initial approval • Subsequent use

36. Information sharing mechanism • Need to agree on information sharing mechanism • Oral via face-to-face meetings or tele & video conferences • Written emails & reports • Formal or informal

37. Supervisory colleges highlight many areas for common agreement • Home country supervisors must recognize environment of emerging market host supervisors while taking the lead role in discussion • Some high level concerns have been discussed at supervisory colleges • Level of accountability of local board & senior management • Role of host supervisors in checking data integrity of local subsidiaries deemed important • Who is responsible for validation of models? • Could validation of retail models be left to host supervisors? • Proper procedures & policies in maintaining confidentiality in home-host data sharing

38. Case studies by BCBS would be useful Insights from college of supervisors may be collated by AIG for the benefit of wider group of supervisors Additional thoughts

39. Example of a recent supervisory college • Gathering in a home regulator’s headquarter in Europe • Defined agenda – Credit & Ops risk Pillar 1 & 2 issues only • Over 2 days • Preparation spans a few months before, mainly sharing of info: • Between home, host, parent & subsidiary on bank’s Basel II plans & timeline • Between home & host on national Basel II plans & timeline

40. Example of a recent supervisory college • Attended by all host regulators in Asia-Pacific region • 2 reps per country • One from capital policy (usually from Basel II Team who are familiar with national plan & the technical side) & another from supervision (usually the officer-in-charge of subsidiary) • Not necessarily those with authority • From the bank side: • Group Chief Risk rep • Reps in charge of group rating systems (business & risk) • Reps from Group Basel II Implementation Office • Country reps

41. Example of a recent supervisory college • 1st day : • Morning: Briefing by parent & relevant subsidiary reps • Update on Pillar 1 group-wide implementation • Resources committed by parent • Update on rating development • Key challenges faced • Afternoon: Briefing by home regulator • Consolidated approach to supervising the Group, including approval process • Reviews completed & issues raised with parent bank • Future reviews/ visits planned

42. Example of a recent supervisory college • 2nd day: • Morning: Closed-door discussion of issues among home & host regulators • Major findings from briefing • Other areas of concerns arising from host regulator-subsidiary bank communication • Agree on future allocation of work • Afternoon: Round-up of issues between bank & regulators (led by home regulator) • Agree on course of actions to be taken & timeline

43. Common issues raised by host during college discussions • Lack of awareness by country management team • Para 14 of home-host paper

44. Common issues raised by host during college discussions • Applicability of global & regional models in host jurisdiction • Substantial off-shoring • Subsidiary IT capabilities • Key-man risk

45. Common issues raised by host during college discussions • Competency of Internal Audit • Flexibility on use test • Interpretation on downturn LGD & buffer for stress test/ cyclicality • ICAAP at Group level vs subsidiary

46. Common issues raised by host during college discussions • Regulatory capital reporting • Potential for capital arbitrage in portfolio not yet under IRB • Burden of different reporting when subsidiaries could not report IRB calculation (host jurisdiction adopts delayed IRB)

47. Follow-up • Home regulator to finalise minutes of discussion • Input from host regulators • All regulators to inform their management on the outcome of college discussions • Obtain agreement & approval where necessary • Plan for the next college • Usually after the next major implementation milestone

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