Opening Address at the 2004 ISDA Regional Conference: "Basel and Beyond"Tuesday, 26 October 2004, Marina MandarinBy Mr Ong Chong Tee, Assistant Managing DirectorMonetary Authority of Singapore
1 Mr Robert Pickel, ladies and gentlemen. Good morning and thank you for inviting me to this ISDA Regional Conference.
2 Firstly, allow me to acknowledge ISDA for the initiatives it has pioneered in the derivatives and risk management areas since its charter in 1985. A primary contribution was the development of the ISDA Master Agreement and other related documentation, which served to reduce legal risk, as well as credit risks through netting and margin arrangements. Another equally important contribution is its role in promoting sound risk-management practices. For instance, ISDA's focus and work relating to the Basel II capital framework. ISDA has spearheaded industry efforts to respond effectively to the Basel Committee's initiatives. Its members' participation in various working groups including those of the Basel Committee, illustrates the close partnership between industry practitioners and regulators.
3 The theme of this conference, "Basel and Beyond", is an appropriate one. With the finalization of the New Capital Framework, or Basel II as it is commonly known, it is timely for us to also think ahead beyond the implementation issues. I am sure that during your conference today, there will be extensive discussions on this subject from the industry's perspective. Allow me therefore to share with you MAS' perspectives as a regulator. In the first part of my comments, I will briefly describe what we believe is the essence of Basel II and the MAS' approach to it. In the second part, I will highlight some of its impact and future trends.
The Thrust of Basel II
4 When one consider the intricacies relating to implementation of Basel II, one can appreciate the concerns of many, about the resource demands required of individual institutions. It is helpful to take a step back to remind ourselves what Basel II is all about. By calling the New Capital Framework "Basel II", it is easy to overlook the thrust of the framework, which is captured in its official title: "International Convergence of Capital Measurement and Capital Standards". "Convergence" is the key word, and it can be found in the titles of both Basel I and Basel II documents.
5 Basel I started the process of international convergence of capital standards. As we all know, it is not as risk sensitive as the industry would like it to be. Since the introduction of Basel I in 1988, international banks have moved ahead to develop more sophisticated techniques to manage their risks and to allocate capital. With advances in computing technology, banks are better able to estimate economic capital requirements to commensurate with the risks that they are exposed to, in the various business lines. In other words, Basel II is the result of regulators updating regulatory requirements to keep pace with developments in the industry. It is another step towards convergence as we seek to move regulatory capital requirements closer to banks' estimates of economic capital.
6 Economic capital models are still being refined and still tested, to assure that they are able to measure economic capital as accurately as possible. I do not think we are quite there yet, but I am certain that the more advanced banks will continue to push the envelope. Some are already saying that Basel II does not go far enough to recognize the risk management techniques that the most advanced institutions are employing.
7 At the other extreme, however, the more advanced approaches in Basel II can be an onerous imposition of overly complex rules to the smaller and less sophisticated banks. That is why regulators have adopted a practical stance by making available a range of approaches, from the most basic Standardised Approach to the most advanced Internal Ratings Based Approach for measuring credit risk. The same format is adopted for measuring market risk and operational risk. Banks should consider which of the approaches best suit their respective institutions, taking into account the complexity and risk profile of their businesses. At the heart of Basel II, is the desire of regulators to encourage improvements in risk management throughout the banking sector, as this will contribute to greater stability of the financial system.
MAS' Implementation Approach
8 In Singapore, we have similarly adopted a practical stance. We have made all approaches available and banks are encouraged to adopt the approach that will best match their risk profiles. At the same time, we encourage our banks to continually upgrade their risk management practices and benchmark themselves against the best practices of international banks.
9 For Singapore banks - given the differing levels of sophistication, we do not expect our local banks to employ the most sophisticated techniques at the outset. Indeed, we do not wish to see banks adopting the most advanced approaches in a hasty manner. It is more important that local banks ensure that their risk management practices keep pace with the increasing sophistication of their businesses. They should only adopt the most advanced approaches for capital measurement if they can do so meaningfully and when it is consistent with their risk management culture and systems. We have therefore suggested to the local banks that progress towards the more sophisticated approaches for market and operational risk should accompany progress towards adopting the Advanced IRB Approach.
10 For the MAS, Basel II actually fit quite nicely into the risk-based supervisory framework that we have evolved over the last few years. From our perspective as a supervisor, computing the minimum capital requirements under Pillar 1 is the easier part. What is more important and perhaps more difficult is the supervisory process in Pillar 2. This is the confluence of banks' risk management and our supervisory review, and judgment is required here. Pillar 2 covers a wide range of risks - including interest rate risk in the banking book, liquidity risk and concentration risk; and any other risks that are not adequately addressed in Pillar 1, for which there are no established measurement methodologies. It also requires the supervisor to make an evaluation of the banks' internal process for capital adequacy assessment. So banking supervisors will have our own challenges and roles to perform.
What Lies Beyond Basel II?
11 So what lies beyond Basel II? At the risk of over-simplicity, I would say "even more convergence." And greater convergence can be manifested in several areas.
12 First, there will be a convergence between how regulators view risks and how banks treat them. The supervisory approach of regulators will continue to shift from setting prescriptive limits on the business exposures that banks can assume, to one where greater reliance is placed on the way banks manage their own risks. In other words, banks are likely to be given more leeway to decide on the appropriate risk limits that they should set for each of their business lines as long as their risk management practices and capital allocation processes are robust. Given the rapid pace of financial innovation, it will be counter-productive for supervisors to attempt to devise new regulations to cope with the numerous variations of financial products introduced in the market.
13 Second, there will be greater convergence in the supervisory approaches of regulators around the world. Basel II is already forcing supervisors to give considerable attention to home-host supervisory cooperation. Banking supervisors have considered this issue for the past decade, but nothing significant has been achieved until more recently. Dealing with the various Basel II implementation issues will require extensive cooperation and communication between supervisors. We are likely to see greater mutual recognition of the supervisory priorities of home and host regulators. Basel II will thus encourage supervisors to adopt more consistent approaches across borders in the supervision of banks.
14 Third, there will be greater convergence between the supervision of banks - that have been the principal focus of Basel II - and the supervision of securities firms and insurers. Deregulation in many countries will further erode the distinctions that once existed between different types of financial institutions. Take the example of bancassurance, which has blurred the business boundaries between banks and insurance firms.
15 So supervisors across industries will have to review and align their regulatory requirements, to ensure consistency of similar businesses undertaken by different types of financial institutions. Basel II will hasten this process because regulators will need to ensure the new capital framework will not lead to competitive inequity between banks and non-banks, and will not result in regulatory arbitrage opportunities through credit risk migration techniques. Indeed, the Basel Committee and the International Organisation of Securities Commissions (IOSCO) have already established a joint work group to review the treatment of certain counterparty credit risk and trading book-related items.
16 In short, convergence was the main motivation for Basel I and II, and will continue to be the underlying theme beyond Basel. Let me conclude with a digression from the convergence theme. I believe that one key by-product of Basel II is that it will spur a sharp growth in the use of derivatives as banks and, subsequently, non-banks, use these instruments to manage their risks and economize on their capital requirements. The eventual outcome will be a broader range of risk mitigation products as banks become more active users of credit derivatives, structured products, etc.
17 Banks with foresight in implementing Basel II will therefore go beyond compliance requirements. These banks will aim to enhance their credit business and to better understand their clients and their portfolio risk. As banks adopt more advanced risk management techniques, they will gain the capacity to take on additional risk in a still prudent manner. This should enhance profitability,regardless of capital releases due to Basel II.
18 Even as banks seize the opportunities presented by Basel II implementation, there are also other areas that supervisors will pay attention to. With more banks using credit mitigation products, already complicated web of transactions will become even more complex. Regulators will have to address the potential contagion effect of major shocks in the financial system that can occur if these risk mitigation techniques do not work or break down under stress. I should note here that, although many credit mitigation techniques have, for the most part, worked well to date, they have not yet been fully "battle-tested".
19 Another area that requires some attention is the anticipated pro-cyclicality effects of Basel II, where the capital costs of risk-weighted assets are expected to increase during an economic downturn, depending on the choice of the rating systems employed by banks. Opinions differ as to how concerned we should be about this issue, but supervisors will be taking this into account in setting Pillar 2 requirements for banks.
20 So in sum, with Basel II, new products to transfer risks will emerge. This will undoubtedly be good news for many of you in this room. However, it will also mean more work for ISDA to upgrade its documentations and standards to take into account these new products. It will be more work for regulators to keep abreast with these developments. And as always, there will be a need for a strong industry partnership between regulators, financial institutions and industry bodies such as ISDA.
21 I trust the rest of today will see some lively discussions and let me wish you all a most fruitful conference. Thank you once again for inviting me here this morning.