Phillip Straley: Capital and liquidity management in the wake of the crisis

The banking industry has been talking for years about what comes after Basel II, even as banks remain focused on ongoing Basel II implementation. Prior to the global financial crisis, the Basel Committee (“the Committee”) and national regulators were already looking at what would come next, particularly in the area of liquidity risk. The crisis clearly highlighted a number of vulnerabilities in capital and liquidity risk management in many banks, and on a systemic basis, which regulators around the world are now busy addressing. 

With the last two years of market stress and dislocation as background, the Committee issued in December 2009 two consultative papers: Strengthening the resilience of the banking sector¹ which addresses an enhanced capital framework, and International framework for liquidity risk measurement, standards and monitoring² which introduces new global liquidity standards. These papers, which we will be discussing below, represent the second part of the Committee’s response to the financial crisis, following the July 2009 revisions to Basel II to modify the approach for trading book and securitization exposures. Comments are due on the two papers by mid April 2010 and banks are undergoing Quantitative Impact Studies (QIS) concurrently to assess impacts of the proposed changes on capital and liquidity positions.

Banks based in and operating in Asia will be impacted by these new standards which will be implemented locally, and they should now begin to understand likely impacts and to influence final Basel guidelines. The recent broadening of the Committee’s membership to include more Asian participation (e.g., China, Hong Kong, Singapore and South Korea) should also give the region a bigger voice in such discussions.

New Basel capital and liquidity proposals

The Basel Committee’s goal in the proposed changes is to improve the banking sector’s ability to absorb shocks from financial and economic stress, and to mitigate the risk of spillover effects from the financial sector into the real economy. 

A key aspect of the Committee’s efforts is bringing greater consistency in liquidity management to banks around the world, and moving away from the current situation where liquidity standards differ hugely from country to country. Examples of this are the often more prescriptive liquidity requirements seen in many Asian jurisdictions vis-a-vis historical standards in parts of the West. In addition to introducing a global liquidity standard, new standards are proposed to implement four primary recommendations with respect to bank capital:

   1. Strengthen the quality, consistency and transparency of the capital base
   2. Strengthen risk coverage of capital via capital requirements surrounding counterparty credit risk exposures (in particular, for derivatives, repurchase agreements (repos) and securities lending)
   3. Introduce a formal leverage ratio
   4. Promote a countercyclical approach to building capital buffers

While details of final standards will be known only in late 2010, Table 1 outlines some of the expected implications of these four recommendations and the new liquidity standard.

Table 1 – Expected implications of new Basel proposals

At a higher level, Table 2 provides a summary of the key changes that have been proposed by the Committee.

Table 2 – Summary of changes from new Basel proposals

The new proposals have met with significant controversy in the industry. Some of these examples include the best means to achieve countercyclical capital without unintended results, and the proposed full deduction from common equity of investments in other financial institutions. Nonetheless, it is unlikely there will be significant structural changes to the proposed standards, given that most of the changes have been discussed widely since 2008. Final fully calibrated standards will be released in late 2010. 
 
Impacts in Asia

At a macro level, the outlook in Asia was much different than in the West. Many economies in this region went through exceptionally tough times during the Asia Crisis of the late 1990s and took years to recover. Many banks (often at the behest of regulators) made subsequent changes to bank risk management and balance sheet management that have helped in limiting the direct impact of this global crisis. And from a systemic perspective, banking systems in Asia are generally in a much stronger position than they were in the late 1990s. 

This being said, while the impact on Asia-based banks in the recent global economic crisis was much lesser than the banks in the West, the thrust of the new Basel proposals is as applicable in Asia as elsewhere. We expect to see differences in local implementations, both in timing and deadlines by country, and in local market calibration and qualitative expectations for risk management practices and reporting. However, these differences will be at the edges and Asia-based banks should begin preparing based on what has been issued. Many banks have already started boosting tier 1 ratios, as well as working with local regulators on how the new proposals should be interpreted in light of ongoing Basel II implementation, particularly in the area of pillar 2 capital measurement and management standards. Liquidity standards have also received increased attention since the second half of 2009, with some regional regulators, for instance the Financial Supervisory Commission in Korea, issuing new prescriptive liquidity risk management standards to banks.

Current priorities

The first point to be clear on in understanding current priorities is that the new proposals invalidate very little of the ongoing Basel II implementation work of banks in the region. While some changes will be required in the configuration of the risk weighted assets (RWA)/capital calculation systems, this will not be applicable until the end of 2012 at the earliest. Other proposals represent additive or new expectations.  As such, ongoing Basel II work will need to continue. Beyond this, the key priorities for banks over the next year related to the new proposals are:

    * Engaging actively with local regulators on QIS and influencing the final standards
    * Conducting an internal impact assessment on data/system infrastructure and risk management and governance structures
    * Starting Board and senior management discussions at a strategic level on capital and liquidity levels, and how these will be impacted by the proposals and by ratings agency/investor expectations
    * Launching initial implementation efforts in areas where there is limited controversy – for instance, enhanced liquidity risk analysis and management practices

So, while things do look different in Asia, areas of focus around risk management for Asia's banks in the next year are largely in line with banks globally: better risk and capital assessments, more rigor around liquidity risk management, more active and integrated stress testing, new responsibilities and accountabilities for bank directors and senior management, and stronger data and technology infrastructure to support all of these. The specifics of the new Basel proposals have added additional considerations to this list of priorities.

¹Basel Committee on Banking Supervision- Consultative Document- “Strengthening the resilience of the banking sector". Issued for comment by 16 April 2010, Bank for International Settlement, www.bis.org, December 2009. 
²Basel Committee on Banking Supervision- Consultative Document- “International framework for liquidity risk measurement, standards and monitoring”. Issued for comment by 16 April 2010, Bank for International Settlement, www.bis.org, December 2009. 

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