The Australian PrudentialRegulation Authority (APRA) has angered banks by insisting that boards of directors, not management, sign off on Basel II accreditation applications.
At present APRA is assessing applications from six banks for accreditation to adopt the advanced approach to Basel II, the global capital accord aimed at shoring up operational risk practices in the global banking industry. While many banks argued that involving the board in signing off the applications blurred the line between management and board responsibilities, APRA said it is essential that boards understand and support the economic capital model used to manage their banks as part of the Basel II process.
“We required the application for accreditation to be signed off by the respective bank boards,” said Dr John Laker, APRA chairman. “We gave careful thought to whether the sign-off should be by the chief executive officer, the risk committee of the board, or the full board. While a bank’s management might have more detailed direct knowledge of the institution’s risk measurement and management processes and, in that sense, might be better placed to sign off, ultimate responsibility for risk management lies with the board. Since the adoption of the more sophisticated Basel II approaches is a major initiative and requires a significant commitment by a bank, including the closing of ‘compliance’ gaps, it is reasonable to expect board sign-off.”
He added that the regulator’s decision had been vindicated by the reaction of boards themselves. “We believe that our stance has been vindicated by the level of board buy-in to the Basel II process,”Laker said. “Boards have told us that their Basel II involvement has been demanding but none has said it was not the wiser for it. The buy-in has also had a positive effect in making the Basel II work in banks, in our opinion, more robust and better focused and resourced.”
Laker added that while banks are well underway, and very busy with, work on their economic capital models – used to make sure their risk estimates meet Basel II requirements – work on documentation is lagging.
“At this point, the tempo of modelling work in our applicant banks is not letting up, and some are substantially revamping their models,” Laker said. “It may be that the level of robustness required by supervisors is higher than that required by the banks themselves. It may also be that the models are still being ingrained into the day-to-day management of the business. Either way, Basel II project teams, including our own, are stretched. We are finding that documentation tends to lag model development. The culture of supervisors places considerable importance on documentation, and Basel II has raised the bar on the level of documentation and oversight that is required.”
Elsewhere, the independent validation of operational risk modeling and measurement is causing a few headaches, Laker said. “Because operational risk measurement and modelling is so new, the requisite skills are in short supply. This shortage is exacerbated within a bank if the available skills have already been involved in model development, and are therefore precluded from the independent validation process.”
Laker also confirmed that APRA expects Australian banks to be granted a reduction in the amount of regulatory capital, despite the Basel Committee’s insistence that the level of regulatory capital in the global banking system will remain unchanged post Basel II.
“Banks adopting the advanced Basel II approaches, and spending many millions of dollars to do so, will continue to question whether they will be ‘rewarded’ for this investment through a lower regulatory capital charge and whether the regulatory complexity of Basel II will be worth the effort,” Laker said. “In our view, and one we hope the banks share, the real reward is a better matching between regulatory capital and risk-based economic reality. True, the advanced Basel II approaches rely on complex modelling that in some areas is still being developed, and they depend on long-run data that are often not available. Even so, the larger globally operating banks have been developing and using such techniques in their own internal capital modelling for several years now and their drive for sharper risk measurement and management has real momentum. And it is clear to us that the regulatory overlay of Basel II is adding a degree of robustness that the banks did not necessarily have.”
For more on Basel II, see p14