The Virtues and Challenges of Implementing Basel III: What Every CFO and CRO Needs To Know

The Basel Committee on Banking Supervision (BCBS) is a group tasked with providing thought-leadership to the global banking industry.  Over the years, the BCBS has released volumes of guidance in an effort to promote stability within the financial sector.  By effectively communicating best-practices, the Basel Committee has influenced financial regulations worldwide.  Basel regulations are intended to help banks:

  • More easily absorb shocks due to various forms of financial-economic stress
  • Improve risk management and governance
  • Enhance regulatory reporting and transparency

In June 2011, the BCBS released Basel III: A global regulatory framework for more resilient banks and banking systems.  This new set of regulations included many enhancements to previous rules and will have both short and long term impacts on the banking industry.  Some of the key features of Basel III include:

  • A stronger capital base
    • More stringent capital standards and higher capital requirements
    • Introduction of capital buffers 
  • Additional risk coverage
    • Enhanced quantification of counterparty credit risk
    • Credit valuation adjustments 
    • Wrong  way risk 
    • Asset Value Correlation Multiplier for large financial institutions
  • Liquidity management and monitoring
  • Introduction of leverage ratio
  • Even more rigorous data requirements

To implement these features banks need to embark on a journey replete with challenges. These can be categorized into three key areas: Data, Models and Compliance.

  • Data Challenges
    • Data quality - All standard dimensions of Data Quality (DQ) have to be demonstrated.  Manual approaches are now considered too cumbersome and automation has become the norm.
    • Data lineage - Data lineage has to be documented and demonstrated.  The PPT / Excel approach to documentation is being replaced by metadata tools.  Data lineage has become dynamic due to a variety of factors, making static documentation out-dated quickly. 
    • Data dictionaries - A strong and clean business glossary is needed with proper identification of business owners for the data. 
    • Data integrity - A strong, scalable architecture with work flow tools helps demonstrate data integrity.  Manual touch points have to be minimized.  
    • Data relevance/coverage - Data must be relevant to all portfolios and storage devices must allow for sufficient data retention.  Coverage of both on and off balance sheet exposures is critical.  
  • Model Challenges
    • Model development - Requires highly trained resources with both quantitative and subject matter expertise.
    • Model validation - All Basel models need to be validated. This requires additional resources with skills that may not be readily available in the marketplace. 
    • Model documentation - All models need to be adequately documented.  Creation of document templates and model development processes/procedures is key.
    • Risk and finance integration - This integration is necessary for Basel as the Allowance for Loan and Lease Losses (ALLL) is calculated by Finance, yet Expected Loss (EL) is calculated by Risk Management – and they need to somehow be equal.  This is tricky at best from an implementation perspective. 
  • Compliance Challenges
    • Rules interpretation - Some Basel III requirements leave room for interpretation.  A misinterpretation of regulations can lead to delays in Basel compliance and undesired reprimands from supervisory authorities.
    • Gap identification and remediation - Internal identification and remediation of gaps ensures smoother Basel compliance and audit processes.  However business lines are challenged by the competing priorities which arise from regulatory compliance and business as usual work. 
    • Qualification readiness - Providing internal and external auditors with robust evidence of a thorough examination of the readiness to proceed to parallel run and Basel qualification 

In light of new regulations like Basel III and local variations such as the Dodd Frank Act (DFA) and Comprehensive Capital Analysis and Review (CCAR) in the US, banks are now forced to ask themselves many difficult questions.  For example, executives must consider:

  • How will Basel III play into their Risk Appetite?
  • How will they create project plans for Basel III when they haven’t yet finished implementing Basel II?
  • How will new regulations impact capital structure including profitability and capital distributions to shareholders?

After all, new regulations often lead to diminished profitability as well as an assortment of implementation problems as we discussed earlier in this note.  However, by requiring banks to focus on premium growth, regulators increase the potential for long-term profitability and sustainability.  And a more stable banking system:

  • Increases consumer confidence which in turn supports banking activity 
  • Ensures that adequate funding is available for individuals and companies
  • Puts regulators at ease, allowing bankers to focus on banking

Stability is intended to bring long-term profitability to banks.  Therefore, it is important that every banking institution takes the steps necessary to properly manage, monitor and disclose its risks.  This can be done with the assistance and oversight of an independent regulatory authority.  A spectrum of banks exist today wherein some continue to debate and negotiate with regulators over the implementation of new requirements, while others are simply choosing to embrace them for the benefits I highlighted above.

Do share with me how your institution is coping with and embracing these new regulations within your bank.

Dr. Varun Agarwal is a Principal in the Banking Practice for Capgemini Financial Services.  He has over 19 years experience in areas that span from enterprise risk management, credit, market, and to country risk management; financial modeling and valuation; and international financial markets research and analyses.

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