The January 2010
edition
of the International Association of Risk and
Compliance Professionals (IARCP) newsletter
Dear Member,
I want to extend my best wishes for a safe, prosperous
and blessed year to all.
I do
hope that you will transform the difficulties around
into opportunities.
The Wall Street Reform and Consumer Protection Act of 2009
This is comprehensive legislation to overhaul
regulations in the
financial sector.
It would establish a new Consumer Financial Protection Agency
to
regulate products like home mortgages, car loans and credit cards,
give the Treasury Department new authority to place non-bank
financial firms, like insurance companies into receivership and
regulate the over-the-counter derivatives market.
The House Financial Services Committee has responded to the US
financial crisis by crafting a comprehensive set of measures that
will change financial regulations and hold Wall Street
accountable.
Once signed into law, this package of reforms will work together
to address the myriad causes – from predatory lending to
unregulated derivatives – that led to last year’s meltdown.
The Wall Street Reform and Consumer Protection Act includes the
following major provisions:
Consumer Protections:
Creates the Consumer Financial Protection
Agency (CFPA),
a new, independent federal agency solely devoted to protecting
Americans from
unfair and abusive financial products and services.
Financial Stability Council:
Creates an inter-agency oversight
council that will
identify and regulate financial firms that are so large,
interconnected, or risky that
their collapse would put the entire financial system at risk.
These systemically risky
firms will be subject to heightened oversight, standards, and
regulation.
Dissolution Authority and Ending “Too Big to Fail”:
Establishes an
orderly
process for dismantling large, failing financial institutions like
AIG or Lehman
Brothers in a way that ends bailouts, protects taxpayers, and
prevents contagion to the
rest of the financial system.
Executive Compensation:
Gives shareholders a “say on pay” – an
advisory vote on
pay practices including executive compensation and golden
parachutes.
It also
enables regulators to ban inappropriate or imprudently risky
compensation practices,
and it requires financial firms to disclose any compensation
structures that include
incentive-based elements.
Investor Protections:
Strengthens the SEC’s powers so that it can
better protect
investors and regulate the securities markets.
It
responds to the failures to
detect the Madoff and Stanford Financial frauds by ordering a
study of the entire
securities industry that will identify needed reforms and force
the SEC and other
entities to further improve investor protection.
Regulation of Derivatives:
Regulates, for the first time ever, the
over-the-counter
(OTC) derivatives marketplace.
Under the bill, all standardized
swap transactions
between dealers and “major swap participants” would have to be
cleared and traded
on an exchange or electronic platform.
The bill defines a major
swap participant as
anyone that maintains a substantial net position in swaps,
exclusive of hedging for
commercial risk, or whose positions create such significant
exposure to others that it
requires monitoring.
Mortgage Reform and Anti-Predatory Lending:
Would incorporate the
tough
mortgage reform and anti-predatory lending bill the House passed
earlier this year.
The legislation outlaws many of the egregious industry practices
that marked the
subprime lending boom, and it would ensure that mortgage lenders
make loans that
benefit the consumer.
It would establish a simple standard for all
home loans:
institutions must ensure that borrowers can repay the loans they
are sold.
Reform of Credit Rating Agencies:
Addresses the role that credit
rating agencies
played in the economic crisis, and takes strong steps to reduce
conflicts of interest,
reduce market reliance on credit rating agencies, and impose a
liability standard on
the agencies.
Hedge Fund, Private Equity and Private Pools of Capital
Registration:
Fills a
regulatory hole that allows hedge funds and their advisors to
escape any and all
regulation.
This bill requires almost all advisers to private
pools of capital to register
with the SEC, and they will be subject to systemic risk regulation
by the Financial
Stability regulator.
Office of Insurance:
Creates a Federal Insurance Office that will
monitor all aspects
of the insurance industry, including identifying issues or gaps in
the regulation of
insurers that could contribute to a systemic crisis and undermine
the entire financial
system.
Sarbanes Oxley Update
Today we will discuss one important report
about the implementation of Auditing Standards No 5.
- from the Public Company Accounting Oversight Board (PCAOB).
The PCAOB Release
No. 2009-006
REPORT ON THE FIRST-YEAR
IMPLEMENTATION OF AUDITING STANDARD NO. 5
This report describes the most common or noteworthy
observations that were derived from inspections
conducted during 2008 regarding registered audit
firms' first year implementation of the Board's
standard governing integrated audits,
Auditing
Standard No. 5, An Audit of Internal Control Over
Financial Reporting That Is Integrated with An Audit
of Financial Statements ("AS No. 5").
Background
On June 12, 2007, the Public Company Accounting
Oversight Board ("PCAOB"or "the Board") adopted AS No.
5 as part of the Board's plan to improve
implementation of the provisions of the Sarbanes-Oxley
Act of 2002 ("the Act") relating to audits of
internal control over financial reporting ("ICFR").
The Board had
four basic objectives in
issuing AS No. 5:
•
Focusing auditors on the most important matters in the
audit of ICFR,
• Eliminating unnecessary audit procedures,
• Making the audit scalable to the size and complexity
of the business, and
• Simplifying the text of the predecessor standard on
audits of ICFR.
AS No. 5 became effective for audits for fiscal years
ended on or after November 15, 2007.
The PCAOB's 2008 inspections of the eight largest
domestic annually inspected registered public
accounting firms
[Specifically, BDO Seidman, LLP; Crowe Horwath LLP;
Deloitte & Touche LLP; Ernst & Young LLP; Grant
Thornton LLP; KPMG LLP; McGladrey & Pullen, LLP; and
PricewaterhouseCoopers LLP]
included the
review of over 250 audits of ICFR that the firms had
conducted during 2007 and 2008.
Those years were,
for auditors and preparers of financial statements, a
period of learning and transition, as auditors
responded to the issuance of AS No. 5 and preparers of
financial statements received guidance from the
Securities and Exchange Commission to facilitate their
assessment of ICFR.
The 2008 inspections of ICFR audits were focused on
whether auditors were effectively transitioning to AS
No. 5. Accordingly, the
2008 inspections process included several procedures
designed to monitor and improve the quality of the
firms'
implementation of AS No. 5.
During inspection
fieldwork, the inspections staff
reviewed aspects of the firms' application of AS No. 5
to selected integrated audits.
As described
below, the inspectors selected several significant
aspects of AS No. 5, and considered whether, in the
engagements reviewed, the auditors had applied those
aspects appropriately in the process they used to
reach their conclusions.
The inspections
were not designed to evaluate the design or
effectiveness of the issuers' controls or to draw
conclusions regarding the quality of managements'
assessments of those controls.
Engagements were selected without regard to whether
the ICFR audits resulted in adverse or unqualified
opinions and without regard to the number or extent of
internal control deficiencies identified by the
engagement team during the audit.
During the
fieldwork, the inspection teams communicated to the
specific engagement teams whether the inspectors had
observed that the teams had implemented effectively
the aspects of AS No. 5 that had been reviewed, or
whether, and in what respects, their implementation
needed improvement.
Inspections
leadership summarized the observations for each firm
and discussed them with the firm's leadership
periodically.
Observations on the First-Year Implementation of AS
No. 5
In order to comply with the provisions of AS No. 5,
the auditor
should use a "top down" approach to the
audit of ICFR to select the controls to test.
This approach
begins with understanding the
overall risks to internal control over financial
reporting, including the risk of fraud.
The auditor then focuses on
identifying entity-level controls, and then moves to
identifying significant accounts and disclosures
and their relevant assertions, understanding likely
sources of misstatement, and selecting controls to
test.
Risk assessment underlies the entire AS No. 5 audit
process, including the identification of significant
accounts and disclosures and relevant assertions, the
selection of controls to test, and the determination
of the audit evidence necessary for a
given control.
The auditor should
focus more of his or her attention on the areas of
highest risk.
Also, in planning
and performing the audit of ICFR, the auditor should
evaluate the extent to which he or she will use the
work of others.
In light of these concepts, the inspectors' review of
the firms' implementation of AS No. 5 focused on the
following areas:
• Risk Assessment,
• Risk of Fraud,
• Using the Work of Others,
• Entity-Level Controls,
• Nature, Timing, and Extent of Controls Testing, and
• Evaluating and Communicating Deficiencies.
The inspectors' most common or noteworthy
observations, including descriptions of certain of the
instances in which the inspectors observed that the
auditors' transition to AS No. 5 was particularly
effective or where it was less than effective, are
described below.
The inspectors'
observations varied both across and within the firms.
In each of the
areas that inspectors reviewed, inspectors observed
instances of
inappropriate application of the standard.
In general, the
areas where inappropriate application was most
frequently observed were risk assessment, the
evaluation of entity-level controls, and the nature,
timing, and extent of the controls testing.
Although the
observations described in this report were derived
from the performance of various engagement teams at
certain firms – who constitute a subset of the
auditors who performed integrated audits in 2007 and
early 2008 – the Board believes that the observations
described in this report can benefit auditors
generally, whether they are experienced in performing
integrated audits or are performing their first such
audits
Risk Assessment
In the selected areas of the engagements reviewed,
the
inspectors evaluated whether auditors adequately
assessed risk, including when determining significant
accounts and disclosures and relevant assertions,
selecting controls to test, and
determining the extent of audit evidence necessary for
a given control.
In the majority of
engagements reviewed, the inspectors did not identify
deficiencies in the auditors' assessment of risk.
In some instances,
the inspectors observed that the
auditors appropriately modified the nature, timing,
and extent of their tests of controls where they had
assessed the related risk as lower.
The inspectors, however, observed other instances
where the auditors failed to adequately assess risk in
certain relevant aspects of the audit.
These instances
included the failure to
(i) identify
certain components of an account or certain locations
in a multi-location environment that presented
different risks of material misstatement of the
financial statements than other components of the same
account or other locations, respectively,
(ii) evaluate both
the qualitative and quantitative factors when
determining whether to perform tests of controls at a
location,
(iii) identify all
relevant assertions, and
(iv) consider the effects of control deficiencies
identified during the audit (including deficiencies in
pervasive controls such as information technology
general controls) on the risk assessment.
Risk of Fraud
In the selected areas of the engagements reviewed,
inspectors evaluated whether the auditors applied
their considerations of the risk of fraud throughout
the audit, identified controls that addressed the
assessed risk of fraud, and adequately evaluated the
control environment and the period-end financial
reporting process.
In the majority of
engagements reviewed, the inspectors did not identify
noteworthy deficiencies in the auditors' assessments
of fraud risks and their consideration of the results
of those assessments when performing the audit of ICFR.
Inspectors
observed certain instances in which auditors were
particularly effective in identifying and testing
companies' controls that address fraud risk, including
the risk of management override.
For example, inspectors observed instances where
auditors focused more of their attention on audit
areas or locations that they had assessed as more
susceptible to material misstatement due to fraud, or
where auditors had involved firm personnel with
special skills and knowledge regarding fraud to assist
them in their fraud risk assessment and controls
evaluation.
There were instances, however, where the nature,
timing, and extent of auditors' tests of controls were
not sufficiently responsive to an identified fraud
risk because auditors either failed to alter the
extent of testing in areas of greater risk, or they
failed to identify and test compensating controls when
the controls identified and tested did not completely
address the identified risk.
The inspectors
also observed instances where auditors either did not
evaluate all the relevant processes of the company's
period-end financial reporting process or did not
appropriately test the design or operating
effectiveness of controls to address the risk of
management override.
Using the Work of Others
AS No. 5 provides that the auditor may use the work of
others to reduce his or her own work, but the extent
to which the auditor does so should depend on the risk
associated with the controls being tested, as well as
on the
competence and objectivity
of the individuals performing the work.
In the selected
areas of the engagements reviewed, the inspectors
observed that auditors generally used the work of
others in a
manner that was related to their assessments of the
degree of risk associated with the controls being
tested, particularly in lower-risk areas.
Similarly, the
auditors' use of the work of others in the majority of
instances reviewed was consistent with the auditors'
assessment of the competence and objectivity of those
individuals.
The inspectors
observed certain instances where, consistent with AS
No. 5, the auditors used the work of company personnel
other than internal auditors, when they determined
that those performing the work on behalf of management
were sufficiently competent and objective.
The inspectors also
identified several instances that
presented further opportunities for the auditors to
use the work of others when the assessed level of risk
was lower, including when testing certain system
reports and application controls.
The inspectors
observed other instances, though, where the extent of
the auditor's use of the work of others to reduce the
auditor's own work was greater than was appropriate
under AS No. 5 considering the level of risk
associated with the control being tested (e.g., in the
area of controls over journal entries, which generally
would be considered higher risk because of the risk of
management override or other risk of fraud).
In certain instances, the auditors performed few or no
procedures to assess the competence of the others
relative to the task being performed, or they did not
adequately assess the objectivity of the others,
particularly where the work was performed by company
personnel other than internal auditors.
In addition, the
inspectors observed numerous instances where the
extent of the auditors' retesting of the work of
others was seemingly unrelated to the risks involved
(e.g., a uniform approach to retesting of 20 percent
of the controls tested).
Entity-Level Controls
The auditor's evaluation of entity-level controls is
important to the auditor's ability to appropriately
tailor the audit by identifying and testing the most
important controls and, when appropriate, reducing the
testing of controls at the process level.
The standard
requires the auditor to test those entity-level
controls that are important to the auditor's
conclusion about whether the company has effective
ICFR.
In the selected
areas of the engagements reviewed, the inspectors
observed significant variance in the effectiveness of
the auditors' efforts to identify and test
entity-level controls and to use the results of those
tests to tailor the audit.
In certain of the
engagements reviewed, the auditors were effective in
identifying and testing entity-level controls that
appeared to be designed and operating at a level of
precision sufficient to prevent or detect on a timely
basis misstatements to one or more relevant
assertions, which the auditors determined either
eliminated or reduced the need to test additional
controls related to those assertions.
In certain other situations, however,
the inspectors
observed that the auditors' work in the area could
have been more effective.
For example, in some
instances, auditors did not evaluate entity-level
controls beyond those associated with the control
environment and the period-end financial reporting
process.
(Inspectors were
told in certain cases that the auditors did not
evaluate other entity-level controls because the
issuer had not done so.)
Some auditors
identified entity-level controls that appeared to be
designed to operate with a high degree of precision,
but failed to obtain sufficient audit evidence of
their operating effectiveness.
There also were
instances where the auditors identified and tested
entity-level controls and found them to be designed
and
operating with a high degree of precision, but did not
alter their tests of process-level controls in
response to that assessment.
There also were
situations where auditors inappropriately reduced
their testing of process-level controls based on
reliance on entity-level controls.
In certain of
these instances, the auditors failed to consider the
precision with which the entity-level control
addressed a relevant financial statement assertion.
In other
instances, the auditors determined that the
entity-level control was not operating at a level of
precision sufficient to address the risk related to a
relevant financial statement assertion, yet they
nonetheless reduced the testing of the process-level
controls for the relevant assertion.
Nature, Timing, and Extent of
Controls Testing
The auditor should select controls for testing that
are important to the auditor's conclusion about
whether the issuer's controls sufficiently address the
assessed risk of misstatement to each relevant
assertion.
The
amount of
audit evidence necessary to persuade the auditor that
a control is operating effectively depends upon the
risk
associated with the control.
In the selected
areas of the engagements reviewed, the inspectors
evaluated whether the auditors focused their testing
on important controls, determined the amount and type
of evidence necessary based on the risk associated
with those controls, and designed and executed
appropriate control tests to obtain assurance that the
controls operated effectively.
In the
majority of
engagements reviewed, the inspectors did not identify
deficiencies in these areas.
The inspectors
noted that, in some engagements, the auditors used
prior years' knowledge, consistent with AS No. 5 when
determining the nature, timing, and extent of tests of
controls for the current year.
Opportunities for improvement also were observed.
For example, in
certain cases, the auditors did not consider the
assessed level of risk when selecting controls to be
tested, or the controls selected were not designed to
address the risk of misstatement to the relevant assertion(s).
The inspectors
also observed situations where auditors failed to test
a relevant control appropriately or, in some cases, at
all.
For example, inspectors observed instances where the
auditors' testing of controls over financially
significant applications was dependent on appropriate
segregation of duties, but the auditors did not test
to determine whether appropriate segregation of duties
existed.
Similarly, in some
instances, the auditors tested certain controls
without testing the system-generated data on which the
tested controls depended; the auditors did not test
controls over applications that processed financially
significant transactions,
including important manual spreadsheets; or the
auditors observed evidence of review and approval
controls (e.g. management sign-off evidencing review
and approval) without testing the design or operating
effectiveness of management's controls.
In some instances,
the auditors did not obtain service auditors' reports
related to controls at outside service organizations,
or the auditors failed to perform procedures related
to the necessary user controls identified in the
service auditors' reports.
Inspectors also observed instances where the evidence
gathered by the auditor was insufficient to support a
conclusion that the controls were operating
effectively, yet the audit team relied on the supposed
effectiveness of those controls to reduce the
scope of other audit procedures.
For example,
inspectors noted instances where the operating
effectiveness of higher-risk controls was tested
solely through inquiry and observation, which are
tests that ordinarily produce less audit evidence than
other tests, such as inspection of relevant
documentation or re-performance of a control.
In other
instances, auditors did not test the completeness of
the population from which items were selected for
testing. Inspectors also observed instances where the
extent of audit procedures was similar for both lower-
and higher-risk controls.
Evaluation of Deficiencies
The auditor must evaluate the severity of each control
deficiency that comes to his or her attention to
determine whether the deficiencies individually, or in
combination, are material weaknesses as of the date of
management's assessment.
The severity of a
control deficiency depends on whether there is a
reasonable possibility that a company's controls will
fail to prevent or detect a misstatement and the
magnitude of the potential misstatement.
AS No. 5 includes
examples of risk factors that could affect the
possibility that a company's controls would fail to
prevent or detect a misstatement.
Also, in evaluating whether control deficiencies are a
material weakness,
the auditor should evaluate the
effect of compensating controls, including whether
they operate at a level of precision that would
prevent or detect a misstatement that could be
material.
In the selected areas of the engagements reviewed,
inspectors found that auditors generally considered
both applicable quantitative and qualitative factors
when assessing the severity of control deficiencies.
Similarly, in
those areas of the engagements reviewed, inspectors
observed that when the auditors considered
compensating controls to have a mitigating effect, the
auditors had generally identified compensating
controls that appeared to operate at a level of
precision to prevent or detect a misstatement that
could be material, and had tested the controls
sufficiently.
Inspectors observed instances where
auditors
appropriately modified the nature, timing, and extent
of their audit procedures in response to having
determined that certain controls were ineffective.
Inspectors observed other instances, however, where
auditors inappropriately based their conclusions about
the severity of control deficiencies solely on the
materiality of the identified errors in the financial
statements.
Also, some
auditors failed to consider relevant risk factors when
evaluating the severity of identified control
deficiencies.
In addition, there
were instances where the auditors did not consider
whether certain control deficiencies identified
through using the work of others, in combination with
other identified control deficiencies, constituted a
material weakness in
controls.
In certain
instances, the compensating controls that the auditors
identified and tested were not sufficiently precise or
did not operate effectively to mitigate the risks
associated with the identified deficiencies.
In addition, the
inspectors observed that certain auditors' required
communications of identified control deficiencies to
management or the audit committee were incomplete.
In addition, in an integrated audit, the auditor is
required to evaluate the effect of the findings of the
substantive procedures on the auditors' conclusions
about the effectiveness of ICFR.
In some instances,
the inspectors observed that auditors did not consider
the possible effects of detected errors in the
financial statements on the effectiveness of controls.
Basel ii Update
Breaking News:
The Basel Committee has announced consultative
proposals to strengthen the resilience of the banking
sector
The Basel Committee on Banking Supervision has
approved for consultation
a package of proposals to
strengthen global capital and liquidity regulations
with the goal of promoting a more resilient banking
sector.
Along with the
measures taken by the Committee in July 2009 to
strengthen the Basel II Framework, the proposals
announced are part of the
Committee's comprehensive response to address the
lessons of the crisis related to the regulation,
supervision and risk management of global banks.
These reforms carry forward the 7 September 2009
mandate of the Governors and Heads of Supervision, the
oversight body of the Basel Committee.
The reform
programme has also been
endorsed by the Financial Stability Board and by the
G20 leaders at their
Pittsburgh Summit.
The Committee's consultative documents cover the
following key areas:
Raising the quality, consistency
and transparency of the capital base.
This will ensure
that the banking system is in a better position to
absorb losses on both a going concern and a gone
concern basis.
In addition to
raising the quality of the Tier
1 capital base, the Committee is also
harmonising the other elements of the capital
structure.
Strengthening the risk coverage
of the capital framework.
In addition to the
trading book and securitisation reforms announced in
July 2009, the Committee is proposing to strengthen
the capital requirements for counterparty credit risk
exposures arising from derivatives, repos and
securities financing activities.
The strengthened
counterparty capital requirements will also increase
incentives to move OTC derivative exposures to central
counterparties and exchanges.
The Committee will
also promote further convergence in the measurement,
management and supervision of operational risk.
Introducing a leverage ratio as
a supplementary measure to the Basel II risk-based
framework with a view to migrating to a Pillar 1
treatment based on appropriate review and calibration.
The leverage ratio
will help contain the build-up of excessive leverage
in the banking system, and introduce additional
safeguards against model risk and measurement error.
To ensure
comparability, the details of the leverage ratio will
be harmonised internationally, fully adjusting for any
remaining differences in accounting.
Introducing a series of measures
to promote the build-up of capital buffers in good
times that can be drawn upon in periods of stress.
A
countercyclical capital
framework will contribute to a more stable banking
system, which will help dampen, instead of amplify,
economic and financial shocks.
In addition, the
Committee is promoting more forward-looking
provisioning based on expected losses, which captures
actual losses more transparently and is also
less procyclical than the current "incurred loss"
provisioning model.
Introducing a global minimum
liquidity standard for internationally active banks
that includes a 30-day liquidity coverage ratio
requirement underpinned by a longer-term structural
liquidity ratio.
The framework also
includes a common set of monitoring metrics to assist
supervisors in identifying and analysing liquidity
risk trends at both the bank and system wide level.
These standards
and monitoring metrics complement the Committee's
Principles for sound liquidity risk management and
supervision issued in September 2008.
The Committee is also reviewing the need for
additional capital, liquidity or other supervisory
measures to reduce the externalities created by
systemically important institutions.
The Committee is mindful of the need to
introduce these measures in a
manner that raises the resilience of the banking
sector over the longer term, while avoiding
negative effects on bank lending activity that could
impair the economic recovery.
To this end, the
Committee is
initiating a comprehensive impact assessment of the capital
and liquidity standards proposed in the consultative
documents.
In a number of
proposals, the Committee is still considering
different options, which will be included in the
impact assessment.
The impact assessment will be carried out in the first
half of 2010.
On the basis of
this assessment, the Committee will then review the
regulatory minimum level of capital and the reforms
proposed in this document to arrive at an
appropriately calibrated total level and quality of
capital.
The calibration
will consider all the elements of the Committee's
reform package and will not be conducted on a
piecemeal basis.
The fully calibrated set of standards will be
developed by the end of 2010 to be phased in as
financial conditions improve and the economic recovery
is assured, with the aim of implementation by end-2012
The Committee will
put in place appropriate phase-in measures and
grandfathering arrangements for a sufficiently long
period to ensure a smooth transition to the new
standards.
We will discuss
some important parts of the
proposals to strengthen global capital and liquidity
regulations with the goal of promoting a more
resilient banking sector.
Stress
testing
Stress testing is an important risk management tool
and this is especially true for
counterparty credit
risk management.
Despite
the importance of this tool, the development of stress
testing for counterparty credit lags the development
of stress testing for market risk or for traditional
credit risk.
Stress
testing of counterparty credit risk faces several
difficulties that have hindered its development.
The
multiplicity of counterparties makes it
difficult to
develop easily understood stress tests.
Furthermore, exposure measures are
still developing.
For example, the use of
CVA
[Credit Valuation Adjustments]
which allows banks to
encapsulate credit rating and exposure into a single
measure of counterparty credit risk is a recent
development.
Fundamentally,
counterparty credit stress testing must be done at the
individual counterparty level.
Lists of
counterparty exposures under stress scenarios are the
key element of all successful stress testing programs.
However,
stresses of CVA now allow aggregation to a firm-wide
level, as well as joint stresses of counterparty
creditworthiness
and exposure.
The Committee is proposing to
revise the Basel II text by replacing the existing
paragraph 56, Annex 4, of the Basel II text with the
following:
Banks must have a comprehensive
stress testing program for
counterparty credit risk.
The
stress testing program must include the following
elements:
• Banks must ensure complete trade capture and
exposure aggregation across all forms of counterparty
credit risk (not just OTC derivatives) at the
counterparty-specific level in a sufficient time frame
to conduct regular stress testing.
• For all counterparties, banks should produce,
at
least monthly, exposure stress testing of principal
market risk factors (eg, interest rates, FX, equities,
credit spreads, and commodity prices) in order to
proactively identify, and when necessary, reduce
outsized concentrations to specific directional
sensitivities.
• Banks should apply
multifactor stress testing
scenarios and assess material non-directional risks (ie
yield curve exposure, basis risks, etc) at least
quarterly.
Multiple-factor stress tests should,
at a minimum, aim
to address scenarios in which
a)
severe economic or market events have occurred;
b) broad
market liquidity has decreased significantly; and
c) the
market impact of liquidating positions of a large
financial intermediary.
These
stress tests may be part of firm wide stress testing.
• Stressed market movements have an impact not only on
counterparty exposures, but also on the
credit quality
of counterparties.
At least quarterly,
banks should conduct stress testing applying stressed
conditions to the joint movement of exposures and
counterparty creditworthiness.
• Exposure stress testing
—including single factor,
multifactor and material non-directional risks— and
joint stressing of exposure and creditworthiness
should be performed at the
counterparty-specific,
counterparty group (eg industry and region), and
aggregate firm-wide CCR levels.
• Stress tests results should be
integrated into
regular reporting to senior management.
The
analysis should capture the largest counterparty-level
impacts across the portfolio, material concentrations
within segments of the portfolio (within the same
industry or region), and relevant portfolio and
counterparty specific trends.
• The severity of factor shocks should be consistent
with the purpose of the stress test.
When
evaluating solvency under stress,
factor shocks should be severe
enough to capture historical extreme market
environments and/or extreme but plausible stressed
market conditions.
The
impact of such shocks on capital resources should be
evaluated, as well as the impact on capital
requirements and earnings.
For the
purpose of day-to-day portfolio monitoring, hedging,
and management of concentrations, banks should also
consider
scenarios of
lesser severity and higher probability.
• Banks should consider reverse stress tests
to
identify extreme, but plausible, scenarios that could
result in significant adverse outcomes.
• Senior Management must take a lead role in the
integration of stress testing into the risk management
framework and risk culture of the firm and ensure that
the results are meaningful and proactively used to
manage counterparty credit risk.
At a
minimum, the results of stress testing for significant
exposures should be compared to guidelines that
express the bank’s risk appetite and elevated for
discussion and action when excessive or concentrated
risks are present.
Back-testing
Back-testing is the comparison of forecasts to
realised outcomes.
VaR
back-testing is a particular example of testing forecast distributions against
realised outcomes whereby a single aspect of the
distribution, the 99th
percentile, is tested.
Strengthening the global capital framework
Raising the quality, consistency and transparency
of the capital base
Introduction
One of the highest priority issues on the Basel
Committee’s regulatory reform agenda for the banking
sector is the need to strengthen the quality,
consistency and transparency of the regulatory capital
base.
This
objective has been endorsed by the FSB and the G20
Leaders.
While it
is critical that the regulatory capital framework
captures the key risks to which a bank and the banking
sector are exposed, it is equally important that
these
risks are backed by a high quality buffer of capital
which is capable of absorbing losses
when the risks identified materialise.
The global banking system entered the crisis with
capital which was of insufficient quality.
Banks
had to rebuild their capital bases in the midst of the
crisis at the point when it was most difficult to do
so.
The
result was the need for massive government support of
the banking sector in many countries and a deepening
of the economic downturn.
The existing definition of capital suffers from
certain fundamental flaws:
1. Regulatory adjustments generally are not applied to
common equity.
These adjustments are currently generally applied to
total Tier 1 capital or to a combination of Tier 1 and
Tier 2.
They are
not generally applied to the common equity component
of Tier 1.
This
allows banks to report high Tier 1 ratios, despite the
fact that they may have low levels of common equity
when considered net of regulatory adjustments.
It is
this common equity base which best absorbs losses on a
going concern basis.
2. There is
no harmonised list of regulatory
adjustments.
The way
these adjustments are applied across Basel Committee
countries varies substantially, undermining the
consistency of the regulatory capital base.
3. Weak transparency.
The
disclosure provided by banks
about their regulatory capital bases is frequently
deficient.
Often
there is insufficient detail on the components of
capital, making an accurate assessment of its quality
or a meaningful comparison with other banks difficult.
Furthermore, reconciliation to the reported accounts
is often absent.
These shortcomings resulted in the banking sector
entering the crisis with a definition of capital that
was neither harmonised nor transparent, and it allowed
a number of banks to
report high Tier 1 ratios but
with low levels of common equity net of regulatory
adjustments.
As the
crisis deepened, banks faced growing losses and write
downs which directly reduced the retained earnings
component of common equity, calling into question
fundamental solvency.
Many
market participants therefore lost confidence in the
Tier 1 measure of capital adequacy.
They
instead focused on measures such as tangible common
equity (which nets out elements like goodwill from
common equity, as these are not realisable in
insolvency).
The following sections set out proposals to
strengthen
the definition of capital, focusing on its overall
quality, consistency and transparency.
These
proposals will help ensure that banks move to a higher
capital standard that promotes long term stability and
sustainable growth.
Appropriate grandfathering and transitional
arrangements will be established which will ensure
that this process is completed without aggravating
near term stress.
Rationale and objective
There are certain overarching objectives which have
guided the development of the proposed new definition
of capital.
Tier 1 capital must help a bank to remain a going
concern
Common
equity is recognised as the highest quality component
of capital.
It is
subordinated to all other elements of funding, absorbs
losses as and when they occur, has full flexibility of
dividend payments and has no maturity date.
It is
the primary form of funding which helps ensure that
banks remain solvent.
The
framework must ensure that all instruments included in
capital as common stock truly meet the standards
intended by the
Committee.
There
can be no features which add additional leverage or
which could cause the condition of the bank to be
weakened as a going concern during periods of market
stress.
It is critical that
for non-common equity elements to
be included in Tier 1 capital, they must also absorb
losses while the bank remains a going concern.
Qualifying instruments must contribute in a meaningful
way to ensuring the going concern status of the bank
and they must be capable of absorbing losses in
practice without exacerbating a bank’s condition in a
crisis.
Certain
innovative features which over time have been
introduced to Tier 1 to lower its cost, have done so
at the expense of its quality. These elements will
need to be phased out.
Furthermore, banks must not over-rely on non-common
equity elements of capital and so the extent to which
these can be included in Tier 1 capital must be
limited.
Finally
the regime should accommodate the specific needs of
non-joint stock companies, such as mutuals and
cooperatives, which are unable to issue common stock.
Regulatory adjustments must be applied to the
appropriate component of capital
Generally, regulatory adjustments must be applied at
the level of common equity.
There are
two reasons for this:
1) If an
element of the balance sheet is of
insufficient
quality to be included in the calculation of Tier 1
capital, then it is also not adequate to be included
in the calculation of its highest quality component:
common equity; and
2)
Regulatory adjustments should be applied to that
component of capital which is affected by the
recognition of the relevant element on the balance
sheet, which is generally retained earnings.
Taken
together, these measures will help ensure that banks
cannot show strong Tier 1 capital ratios while having
low levels of tangible common equity.
Regulatory capital must be simple and harmonised
across jurisdictions
The number of tiers and sub-tiers of capital must be
limited. The definitions of Tier 1 and Tier 2 capital
should correspond to capital which absorbs losses on a
going concern basis and capital which absorbs losses
on a gone concern basis, respectively. In addition,
the minimum set of regulatory adjustments must be
harmonised internationally.
The components of regulatory capital must be clearly
disclosed
Finally, the components of regulatory capital must be
clearly disclosed and reconciled with the published
financial accounts. This will ensure that market
participants and supervisors will be in a position to
compare the capital adequacy of banks across
jurisdictions.
Key elements of proposal
Overview
The following key changes to the definition of
capital are proposed:
•
The quality and consistency of the common equity
element of Tier 1 capital will be significantly
improved, with regulatory adjustments generally
applied to this element.
• The required features for instruments to be included
in Tier 1 capital outside of the common equity element
will be strengthened.
• Tier 2 will be simplified.
There will be one set of
entry criteria, removing subcategories of Tier 2
• Tier 3 will be abolished
to ensure that market risks
are met with the same quality of capital as credit and
operational risks.
• The transparency of capital will be improved, with
all elements of capital required to be disclosed along
with a detailed reconciliation to the reported
accounts.
• Without prejudging the outcome of the calibration
work in 2010, the system of limits applied to elements
of capital will be revised to ensure that common
equity forms a greater proportion of Tier 1 than is
permitted at present.
The
current limitation on Tier 2 capital (it cannot exceed
Tier 1) will be removed and replaced with explicit
minimum Tier 1 and total capital requirements.
Tier 1 - common equity less regulatory adjustments
For banks structured as joint stock companies the
predominant form of Tier 1 capital must be common
shares and retained earnings. Regulatory adjustments
will be harmonised internationally and generally
applied at the level of common equity.
To ensure their quality and consistency, common
shares will need to meet a set of entry criteria
before being permitted to be included in the
predominant form of Tier 1 capital.
These
entry criteria will also be used to
identify
instruments of equivalent quality which non joint
stock companies, such as mutuals and cooperatives, can
include in the predominant form of Tier 1 capital.
Tier 1 – other elements
To be included in Tier 1, instruments will need to be
sufficiently loss absorbent on a going-concern basis.
To be considered loss absorbent on a going concern
basis, all instruments included in Tier 1 will, among
other things, need to be subordinated, have fully
discretionary noncumulative dividends or coupons and
neither have a maturity date nor an incentive to
redeem.
In
addition, as part of the impact assessment, the
Committee will consider the appropriate treatment in
the non-predominant element of Tier 1 capital of
instruments which have tax deductible coupons.
“Innovative” features such as step-ups, which over
time have eroded the quality of Tier 1, will be phased
out.
The use
of call options on Tier 1 capital will be subject to
strict governance arrangements which ensure that the
issuing bank is not expected to exercise a call on a
capital instrument unless it is in its own economic
interest to do so.
Payments
on Tier 1 instruments will also be considered a
distribution of earnings under the capital
conservation buffer proposal (see Section II.4.c.).
This will improve their loss absorbency on a going
concern basis by increasing the likelihood that
dividends and coupons will be cancelled in times of
stress.
Tier 2
Tier 2 capital will be simplified. There will be one
set of entry criteria, removing subcategories of Tier
2.
Under
the proposal all Tier 2 capital will need to meet the
minimum standard of being subordinated to depositors
and general creditors and have an original maturity of
at least 5 years.
Recognition in regulatory capital will be “amortised”
on a straight line basis during the final 5 years to
maturity.
Tier 3
Tier 3 capital will be
abolished.
This
will ensure that capital used to meet market risk
requirements will be of the same quality of
composition as capital used to meet credit and
operational risk requirements.
Transparency
To improve transparency and market discipline,
banks
will be required to disclose the following:
• A full reconciliation of regulatory capital elements
back to the balance sheet in the audited financial
statements;
• Separate disclosure of all regulatory adjustments;
• A description of all limits and minima, identifying
the positive and negative elements of capital to which
the limits and minima apply;
• A description of the main features of capital
instruments issued; and
• Banks which disclose ratios involving components of
regulatory capital (eg “Equity Tier 1”, “Core Tier 1”
or “Tangible Common Equity” ratios) to accompany these
with a comprehensive explanation of how these ratios
are calculated.
In addition to the full transparency requirements, a
bank will need to make available the full terms and
conditions of all instruments included in regulatory
capital on its website.
The existing requirement for the main features of
capital instruments to be easily understood and
publically disclosed will be retained.
Limits
The current system of limits is complex and makes the
maximum level of Tier 2 capital a function of how much
Tier 1 capital the bank has issued. To address this
situation the following system of limits and minima
will apply:
• Separate explicit minima will be established for the
common equity component of Tier 1 (after the
application of regulatory adjustments), total Tier 1
and total capital.
• The predominant form of Tier 1 must be its common
equity component (after the application of regulatory
adjustments).
Strengthening the resilience of the banking sector
• The restriction that Tier 2 cannot exceed Tier 1
will be removed.
The data collected in the impact assessment will be
used to calibrate the above minimum required levels
and ensure a consistent interpretation of the
predominance standard.
Grandfathering and transitional provisions
Given the significant changes proposed to the
definition of capital, the Committee recommends that
members consider the possibility of allowing the
grandfathering of instruments which have already been
issued by banks prior to the publication of this
consultative document.
The
impact assessment will be used to consider
recommendations for an appropriate grandfathering
period for instruments and an appropriate phase in
period for the new capital standards.
Detailed proposal
This section sets out the detailed proposed rules
which will govern the definition of capital.
To give
context to these proposals the following box
summarises the structure of regulatory capital under
the proposed rules.
Proposed harmonised structure of capital
Elements of capital
Total regulatory capital will consist of the sum of
the following elements:
1. Tier 1 Capital (going-concern capital)
a. Common Equity
b. Additional Going-Concern Capital
2. Tier 2 Capital (gone-concern capital)
For each of the three categories above (1a, 1b and 2)
there will be a single set of criteria which
instruments are required to meet before inclusion in
the relevant category.
Limits and minima
All elements above are net of regulatory adjustments
and are subject to the following restrictions:
• Common Equity, Tier 1 Capital and Total Capital must
always exceed explicit minima of x%, y% and z% of
risk-weighted assets, respectively, to be calibrated
following the impact assessment.
• The predominant form of Tier 1 Capital must be
Common Equity
The detailed proposals are set out in the
following sections:
• Criteria governing inclusion in the Common Equity
component of Tier 1 capital
• Criteria governing the inclusion in Tier 1
Additional Going Concern Capital
• Criteria governing the inclusion in Tier 2 Capital
• Regulatory adjustments applied to the elements of
capital and clarification of the treatment of stock
surplus and minority interest
• Limits and minima applied to the components of
capital
• Disclosure requirements
Criteria governing inclusion in the Common Equity
component of Tier 1
For an instrument to be included in the predominant
form of Tier 1 capital it
must meet all of the
criteria which follow.
The vast
majority of internationally active banks are
structured as joint stock companies18 and for these
banks the criteria must be met solely with common
shares.
In the
rare cases where banks need to issue non-voting common
shares as part of the predominant form of Tier 1, they
must be identical to voting common shares of the
issuing bank in all respects except the absence of
voting rights.
Criteria for classification as common shares for
regulatory capital purposes
1. Represents the
most subordinated claim in
liquidation of the bank.
2. Entitled to a claim of the residual assets that is
proportional with its share of issued capital, after
all senior claims have been repaid in liquidation (ie
has an unlimited and variable claim, not a fixed or
capped claim).
3. Principal is perpetual and never repaid outside of
liquidation (setting aside discretionary repurchases
or other means of effectively reducing capital in a
discretionary manner that is allowable under national
law).
4.
The bank does nothing to create an expectation at
issuance that the instrument will be bought back,
redeemed or cancelled nor do the statutory or
contractual terms provide any feature which might give
rise to such an expectation.
5. Distributions are paid out of distributable items
(retained earnings included).
The
level of distributions are not in any way tied or
linked to the amount paid in at issuance and are not
subject to a cap (except to the extent that a bank is
unable to pay distributions that exceed the level of
distributable items).
6. There are no circumstances under which the
distributions are obligatory.
Non
payment is therefore not an event of default.
7. Distributions are paid only after all legal and
contractual obligation have been met and payments on
more senior capital instruments have been made.
This
means that there are no preferential distributions,
including in respect of other elements classified as
the highest quality issued capital.
8. It is the issued capital that takes the first and
proportionately greatest share of any losses as they
occur.
Within
the highest quality capital, each instrument absorbs
losses on a going concern basis proportionately and
pari passu with all the others.
9. The paid in amount is recognised as equity capital
(ie not recognised as a liability) for determining
balance sheet insolvency.
10. The
paid in amount is classified as equity under the
relevant accounting standards.
11. It is directly issued and paid-up.
12. The paid in amount is neither secured nor covered
by a guarantee of the issuer or related entity or
subject to any other arrangement that legally or
economically enhances the seniority of the claim.
13. It is only issued with the approval of the owners
of the issuing bank, either given directly by the
owners or, if permitted by applicable law, given by
the Board of Directors or by other persons duly
authorised by the owners.
14. It is clearly and separately disclosed on the
bank’s balance sheet.
Criteria for inclusion in Tier 1 Additional Going
Concern Capital
This element of capital allows instruments other than
common shares to be included in Tier 1 capital.
Their
inclusion will be limited by the requirement that the
predominant form of Tier 1 Capital must be Common
Equity.
To
maintain the integrity of Tier 1 capital any
instrument included must at least:
1. Help the bank avoid payment default through
payments being discretionary;
2. Help the bank avoid balance sheet insolvency by the
instrument not contributing to liabilities exceeding
assets if such a balance sheet test forms part of
applicable national insolvency law; and
3. Be able to bear losses while the firm remains a
going concern.
Based on this high level view, the following box sets
out the proposed minimum set of criteria for an
instrument to meet or exceed in order for it to be
included in Tier 1 Additional
Criteria for inclusion in Tier 1 Additional Going
Concern Capital
1. Issued and paid-in
2. Subordinated to depositors, general creditors and
subordinated debt of the bank
3. Is neither secured nor covered by a guarantee of
the issuer or related entity or other
arrangement that legally or economically enhances the
seniority of the claim vis-āvis
bank creditors
4. Is perpetual, ie there is no maturity date and
there are no incentives to redeem
5. May be callable at the initiative of the issuer
only after a minimum of five years:
a. To exercise a call option a bank must receive prior
supervisory approval; and
b. A bank must not do anything which creates an
expectation that the call will be
exercised; and
c. Banks must not exercise a call unless:
i. They replace the called instrument with capital of
the same or better
quality and the replacement of this capital is done at
conditions which are
sustainable for the income capacity of the bank; or
ii. The bank demonstrates that its capital position is
well above the minimum
capital requirements after the call option is
exercised.
6. Any repayment of principal (eg through repurchase
or redemption) must be with
prior supervisory approval and banks should not assume
or create market
expectations that supervisory approval will be given
7. Dividend/coupon discretion:
a. the bank must have full discretion at all times to
cancel distributions/payments
b. cancellation of discretionary payments must not be
an event of default
c. banks must have full access to cancelled payments
to meet obligations as
they fall due
d. cancellation of distributions/payments must not
impose restrictions on the
bank except in relation to distributions to common
stockholders.
8. Dividends/coupons must be paid out of distributable
items
9. The instrument cannot have a credit sensitive
dividend feature, that is a
dividend/coupon that is reset periodically based in
whole or in part on the banking
organisation’s current credit standing
10. The instrument cannot contribute to liabilities
exceeding assets if such a balance
sheet test forms part of national insolvency law.
11. Instruments classified as liabilities must have
principal loss absorption through either
(i) conversion to common shares at an objective
pre-specified trigger point or
(ii) a
write-down mechanism which allocates losses to the
instrument at a pre-specified
trigger point.
The write-down will have the following
effects:
a. Reduce the claim of the instrument in liquidation;
Strengthening the resilience of the banking sector
b. Reduce the amount re-paid when a call is exercised;
and
c. Partially or fully reduce coupon/dividend payments
on the instrument.
12. Neither the bank nor a related party over which
the bank exercises control or
significant influence can have purchased the
instrument, nor can the bank directly or
indirectly have funded the purchase of the instrument
13. The instrument cannot have any features that
hinder recapitalisation, such as
provisions that require the issuer to compensate
investors if a new instrument is
issued at a lower price during a specified time frame
14. If the instrument is not issued out of an
operating entity or the holding company in
the consolidated group (eg a special purpose vehicle –
“SPV”), proceeds must be
immediately available without limitation to an
operating entity or the holding
company in the consolidated group in a form which
meets or exceeds all of the other
criteria for inclusion in Tier 1 Additional Going
Concern Capital
Additional requirements
• The criteria above will also apply to instruments
which appear in the consolidated
accounts as minority interest.
• This element of capital will be net of the
appropriate corresponding deductions
related to holding of non-common equity capital
instruments in other financial
institutions.
Criteria for inclusion in Tier 2 (gone concern
capital)
The objective of Tier 2 is to provide loss
absorption on a gone-concern basis.
Based
on this objective, the following sets out the
proposed minimum set of criteria for an
instrument to meet or exceed in order for it to be
included in Tier 2 capital.
Criteria for inclusion in Tier 2 Capital
1. Issued and paid-in
2.
Subordinated to depositors and general creditors of
the bank
3. Is neither secured nor covered by a guarantee of
the issuer or related entity or other
arrangement that legally or economically enhances the
seniority of the claim vis-āvis
depositors and general bank creditors
4. Maturity:
a.
minimum original maturity of at least 5 years
b. recognition in regulatory capital in the remaining
5 years before maturity will
be amortised on a straight line basis
c. there are no incentives to redeem
5. May be callable at the initiative of the issuer
only after a minimum of five years:
a. To exercise a call option a bank must receive prior
supervisory approval; and
b. A bank must not do anything which creates an
expectation that the call will be
exercised; and
c. Banks must not exercise a call unless:
i. They replace the called instrument with capital of
the same or better
quality and the replacement of this capital is done at
conditions which are
sustainable for the income capacity of the bank; or
ii. The bank demonstrates that its capital position is
well above the minimum
capital requirements after the call option is
exercised.
6. The investor must have no rights to accelerate the
repayment of future scheduled
payments (coupon or principal), except in bankruptcy
and liquidation
7. The instrument may not have a credit sensitive
dividend feature, that is a dividend
that is reset periodically based in whole or in part
on the banking organisation’s
current credit standing
8. The bank or a related party cannot have knowingly
purchased, or directly or
indirectly have funded the purchase of, the instrument
9. If the instrument is not issued out of an operating
entity or the holding company in
the consolidated group (eg an SPV), proceeds must be
immediately available
without limitation to an operating entity or the
holding company in the consolidated
group in a form which meets or exceeds all of the
other criteria for inclusion in Tier 2
Capital
Additional requirements
• These criteria will also apply to instruments which
appear in the consolidated
accounts as minority interest.
• This element of capital will be net of the
appropriate corresponding deductions
related to holding of non-common equity capital
instruments in other financial
institutions.
In addition to the Tier 1 and Tier 2 criteria set
out in the sections above, the
Committee continues to review the role that contingent
capital, convertible capital
instruments and instruments with write-down features
should play in a regulatory capital
framework, both in the context of the entry criteria
for regulatory capital and their use as buffers over
the minimum requirement.
The Committee will discuss concrete proposals in this
area at its July 2010 meeting
The Committee would welcome feedback on whether
the safeguards introduced on
the use of call options will avoid the problem evident
in the crisis that in some jurisdictions
banks felt compelled to exercise call options, due to
the potential negative market reaction
that would have resulted if the call was not
exercised.
The Committee would also welcome
views on whether additional safeguards such as a
lock-in mechanism is necessary to ensure
that Tier 2 capital does not need to be repaid during
a period of stress.
Counterparty
Credit Risk (CCR)
[Counterparty credit risk is the risk that the
counterparty to a transaction could default before the
final settlement of the transaction's cash flows.
An
economic loss would occur if the transactions or
portfolio of transactions with the counterparty has a
positive economic value at the time of default.
Unlike
a firm’s exposure to credit risk through a loan, where
the exposure to credit risk is unilateral and only the
lending bank faces the risk of loss, CCR creates a
bilateral risk of loss: the market value of the
transaction can be positive or negative to either
counterparty to the transaction.
The market value is uncertain and can vary over time
with the movement of underlying market factors]
(a) Introduction
In its review of the treatment of counterparty
credit risk (CCR), the Committee
engaged in a wide-ranging effort to ascertain areas
where capital requirements for CCR
need to be strengthened.
In conducting this review,
the Committee carefully considered:
• areas where the current treatment did not adequately
capitalise for the risks during
the crisis;
• the provision of incentives to move bi-lateral OTC
derivative contracts to multilateral
clearing through central counterparties;
• the provision of incentives to reduce operational
risk arising from inadequate
margining practices, back-testing and stress testing;
and
• whether the changes would contribute to
reducing procyclicality.
(b) Key problems identified
The Committee identified several areas where
capital for CCR proved to be
inadequate.
Some of the concerns about the capital
treatment of CCR have broader
consequences and the resulting recommendations may, in
some cases, affect areas outside
of counterparty credit risk.
In these cases,
counterparty credit risk was where the problems
were most apparent.
More specifically, the Committee has determined
that
the regulatory capital
treatment for counterparty credit risk was
insufficient in the following areas:
• During the recent market crisis, a key observation
was that defaults and
deteriorations in the creditworthiness of trading
counterparties occured precisely at
the time when market volatilities, and therefore
counterparty exposures, were higher
than usual.
Thus, observed generalised wrong-way risk
was not adequately incorporated into the framework.
• Mark-to-market losses due to credit valuation
adjustments (CVA) were not directly
capitalised.
Roughly two-thirds of CCR losses were due
to CVA losses and only
about one-third were due to actual defaults.
The
current framework addresses CCR
as a default and credit migration risk, but does not
fully account for market value
losses short of default.
• Large financial institutions were more
interconnected than currently reflected in the
capital framework.
As a result, when markets entered
the downturn, banks’
counterparty exposure to other financial firms also
increased.
The evidence
suggests that the asset values of financial firms are,
on a relative basis, more
correlated than those of non-financial firms.
As such,
this higher degree of
correlation with the market needs to be reflected in
the asset value correlations.
The
Committee, based on its empirical work, found evidence
that asset value
correlations were at least 25% higher for financial
firms than for non-financial firms.
• The close-out period for replacing trades with a
counterparty with large netting sets
or netting sets consisting of complex trades or
illiquid collateral extended beyond the
horizon required for the capital calculations.
• Initial margining typically was very low at the
start of the crisis and increased rapidly
during the turmoil.
This had a destabilising effect on
many market participants and
sometimes caused or precipitated defaults.
Capital
based on Effective expected
positive exposure (EPE) did not provide sufficient
incentive for adequate initial
margins to be required at all points of the cycle.
• Central Counterparties (CCPs) were not widely used
to clear trades.
• Securitisations were treated as if they had the same
risk exposure as a similarly
rated corporate debt instrument.
In the aftermath of
the crisis, securitisations have
continued to exhibit much higher price volatility than
similarly rated corporate debt.
Under the Basel framework, the standardised haircuts
currently treat corporate debt
and securitisations in the same manner.
The crisis also revealed a number of shortcomings
in banks’ risk management of
counterparty credit exposures, including in particular
the areas of back-testing, stress testing
and monitoring of wrong way risk.
• Back-testing: The difficulties in statistical
interpretation of back-testing results for
counterparty credit risk suggest that many firms did
not appropriately consider
problems that were identified by back-testing.
The use
of models with poor backtesting
results contributed to an underestimation of actual
losses.
• Stress testing: Stress testing of counterparty
credit risk was not comprehensive;
was
run infrequently, sometimes on an ad hoc basis; and,
in many banks, provided
inadequate coverage of counterparties or the
associated risks.
• Wrong way risk: Transactions with counterparties,
such as the financial guarantors,
whose credit quality is highly correlated with the
exposure amount, contributed to
the losses during the crisis.
• Use of
own estimates of Alpha:
Where Alpha is set
using an own estimate of
economic capital (numerator) to economic capital based
on EPE (denominator),
there can be significant variation in such estimates
arising from the mis-specification
of the models used for the numerator, especially for
exposures with non-linear risk
profiles.
Wrong-way risk
Wrong-way risk is typically defined as an
exposure to a counterparty that is
adversely correlated with the credit quality of that
counterparty.
Wrong way
risk arises when there is a positive expected
correlation between EAD and PD to a given
counterparty.
There are
two types of wrong-way risk,
specific wrong-way risk and general
wrong-way risk.
•
Specific wrong-way risk
typically arises from poorly constructed transactions.
For
example, consider a counterparty that
provides its own
shares as collateral.
A long
put option position on that counterparty’s shares
would put the bank at risk.
A sharp
drop in counterparty share price would increase the
exposure to that counterparty at
the same time the ability of the counterparty to meet
its obligation decreases.
•
General wrong-way risk is a term used to describe
all other possible sources of
positive correlation between an exposure and the
probability of default.
During the recent crisis, there was significant
evidence of banks’ being exposed to
substantial wrong-way risk, particularly arising from
the purchase of credit protection via
credit default swaps from monoline insurers.
In periods of stress, as correlations increase,
general wrong-way risk will present a
problem for risk models.
Regulations must ensure that
banks’ risk models properly
accounting for the possibility of increased general
wrong-way risk that may accompany a
period of stress.
Dear
member,
Visit the website of our association.
www.risk-compliance-association.com
Write in your CV, resume,
websites etc. that you are members of the International Association
of Risk and Compliance Professionals (IARCP). Take
advantage of the distance learning and online certification program
- at a cost that is unheard of:
www.risk-compliance-association.com/Distance_Learning_and_Certification.htm
Best
Regards,
George Lekatis
President of the International Association of Risk and Compliance
Professionals (IARCP)
General Manager and Chief Compliance Consultant, Compliance LLC
1200 G Street NW Suite 800, Washington DC 20005, USA
Tel: (202) 449-9750
Email:
lekatis@risk-compliance-association.com
Web:
www.risk-compliance-association.com
HQ: 1220 N. Market Street
Suite 804, Wilmington DE 19801, USA
Tel: (302) 342-8828
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