Speech by Ms Teo Swee Lian, Deputy Managing Director, Prudential Supervision, MAS at Risk Minds Asia Conference 2008, 4 Mar 2008
Basel II and Beyond: Financial Supervision in Times of Globalisation
Part I: Introduction
1 Good morning, distinguished guests, ladies and gentlemen. I would like to thank Risk Minds Asia for organising this important and timely conference, which I am sure will provide valuable lessons on enhancing risk management during this period of heightened uncertainty in markets and also in the operational environment.
2 Today I will share with you Singapore’s experience in implementing Basel II and more broadly, about the financial supervision of banks in view of the increasing globalisation of banking and financial activities.
Part II: Basel II & Principles of Financial Supervision
3 While everyone has been pre-occupied in the last few years with the nuts and bolts of Basel II, let us not lose sight of the bigger picture. We have to remind ourselves that “International Convergence of Capital Measurement and Capital Standards”, which was the original title of the Basel text, should be viewed as a component of the overall regulatory oversight of a stable financial system. Improved risk management, both at the individual institutional level and at the overall industry level, must be the continued goal for both industry players and supervisors.
4 How does Basel II then fit in with the overall supervisory framework that we have here in Singapore? Our supervisory philosophy is guided by four main principles, namely that we should be “Risk-Focused”, “Stakeholder-Reliant”, “Disclosure-Based” and “Business-Friendly”. Let me elaborate on where the different pillars underpinning the Basel II methodology fit in with this framework.
5 The first principle of MAS’ supervisory framework is to be “Risk-Focused”. By this, we mean that MAS will assess the risk profile of the institution, taking into account the quality of the institution’s management oversight and internal risk management systems and processes. The supervisory intensity applied will depend on both this assessed risk rating and the potential impact the institution has on the financial system as a whole in the event of a significant mishap. The emphasis is on risk-focused supervision, rather than prescriptive one-size-fits-all rules. Hence Pillar I of Basel II, which prescribes that the capital that financial institutions hold should be aligned to the risk sensitivity of its assets, reinforces our “Risk-Focused” principle.
6 In the second principle of MAS’ supervisory framework, to be “Stakeholder-Reliant”, we acknowledge and encourage the positive roles that financial institutions individually, the financial industry collectively and all other stakeholders can play in ensuring a smooth functioning of the financial market. The principal responsibility for risk oversight lies with the institution’s board and management. Where the risks are assessed to be properly managed, we will minimise the need to interfere with the institutions’ business decisions. This is in line with the proposals set forth in Pillar II of Basel II where institutions are to demonstrate their ability to manage their risks through their own internal capital adequacy evaluations. Regulators may look for supervisory solutions if it is assessed that these are inadequate.
7 The third underpinning principle in MAS’ supervisory philosophy, i.e. to be “Disclosure-Based”, advocates the disclosure of relevant information by financial institutions in a timely and adequate manner so that informed financial analysis and decisions can be made by advisers, investors, creditors and depositors. This is of course what Pillar III of Basel II, which fosters market discipline through a set of disclosure requirements, is designed to do.
8 The fourth and last principle, “Business Friendly”, expresses our belief that due regard has to be given to the impact of supervision and regulation on competitiveness, business efficiency and innovation in the financial services industry. We have to be responsive to the changing business environment and adopt a consultative approach in regulating the industry. Similarly, the Basel rules have undergone extensive consultations which have resulted in revisions and refinements over the years from 2004 to 2006. No doubt the framework will continue to evolve and take into account developments in the financial industry and risk measurement methods.
9 Basel II is commonly regarded as a journey. If I may, I will now speak about where we in Singapore are in terms of this journey. Over the past few years, we at MAS have been working closely with the banks on adopting the capital measurement standards advocated in Basel II. Banks have invested a substantial amount of resources in coming up with the appropriate risk management models and systems. But more importantly, over and above the capital measurement models and systems, we have also advocated enhanced risk management oversight, procedures and standards. Banks have to demonstrate that they possess the corporate governance and infrastructure appropriate for their risk profile before they are allowed to use Basel II for capital purposes.
10 A lot of hard work was put into improving the risk management and quantification methods for Basel II implementation. All our Basel II rules have been issued, all 500 pages of them. We also reached a milestone in Singapore’s Basel II journey on 1 January 2008, when our banks moved on to the internal ratings approach. However, this does not mark an end to the journey.
11 Two immediate challenges lie ahead. First, implementation of Pillar II and second, finetuning the capital requirements under Basel II. Let me elaborate.
12 Under Pillar II, the primary responsibility is on the institution to develop an internal capital adequacy assessment process (“ICAAP”) and set capital targets commensurate with its risk profile. The ICAAP should also be a forward-looking process that is capable of timely response to changes in the risk profile and business strategies as well as the external environment. Supervisors will assess the banks’ ICAAP and take supervisory action, including raising capital requirements, if the ICAAP is not sufficiently comprehensive or robust. The challenge is that unlike Pillar I, there is no widely recognised standard in terms of what constitutes a good ICAAP.
13 Supervisors have come out with some guidelines on expectations of ICAAP comprehensiveness but generally speaking, most have refrained from being overly prescriptive since the onus is on the institution to study and understand what suits their risk profile best. There is no “one-size-fits-all” formula and the requirements of ICAAP will differ from bank to bank according to the nature of their business and risk profile. Hence what constitutes an adequate and robust ICAAP could be the subject of some debate. The important thing is for all concerned to remember that the interests of the key stakeholders, i.e. the Board and management of the banks together with the financial authorities, are aligned in their objective. This is to try and do what is in the best interest of the bank in terms of identifying capital risk management gaps that need to be closed. There are already some quite robust discussions going on between banks and supervisors and I anticipate that there will be more. Despite all the many person hours put in by PhD’s and various mathematical geniuses on both sides of the fence, we have to remember that in the end, this is NOT an exact science. Judgement will have to be exercised and indeed, we should be thankful that this is so. Otherwise both bank management (I think there are many of you in the audience) as well as financial supervisors (like me) could be replaced by machines.
14 The second challenge is that there has been some criticism of the capital computation methods under Basel II arising from the subprime turmoil. The criticism has centred on a few main themes, such as whether capital risk charges are appropriate and the lack of focus on other risks, such as liquidity and asset-liability risk. The BCBS’ various work groups have been busy reviewing these issues and we ourselves have been actively participating in discussions at these working groups but there are no easy solutions.
Part III: Globalisation of Markets and Regulatory Responses
15 It is interesting that not that long ago, before the sub-prime crisis, the buzzwords in the financial industry were “principles-based regulation”, “less prescription”, “more room for innovation”, “cost-benefit analysis of regulation” and “proportionality”. What a difference a year makes. Now the same commentators are asking how everyone could have missed the elephant in the room, why did financial authorities not act more quickly to curb risky lending practices and why did they not have better oversight of the CDO markets.
16 Indeed, the sub-prime turmoil has many lessons for all of us. What should have been a localised problem in the US has transcended national boundaries through risk transfers facilitated by securitisations and credit derivatives. Although Asian financial institutions, compared to their counterparts in the US and in Europe, had more limited exposures to the US sub-prime market and related credit derivatives, the effects of the crisis have reverberated through our markets as well. Heightened risk aversion and re-pricing of risks did lead to a widening of credit spreads in Asia and periodic sell-offs in equity markets. A severe US slowdown will also ultimately affect Asian exports and growth.
17 There have been increased calls for global supervisory coordination to match the increasing integration of the financial system. While there are merits in better convergence and harmonisation of global regulation, there are of course limitations to coming up with a global model. It should, however, be possible to have better home and host regulator cooperation in the oversight of large internationally active banks. Some good positive steps have already been taken on cooperation, for example, the supervisory colleges that were organised to facilitate dialogue and the sharing of information on Basel II implementation in these large international banks. One possible way forward is to extend the principles and modalities of cooperation employed in these colleges to other areas of day-to-day supervision.
18 In the last nine months, we were very fortunate to have the opportunity to engage in many useful discussions not only with key people from the head offices of affected internationally active banks but also with their home regulators on the impact of the sub-prime turmoil. As host regulator to many foreign banks in Singapore, such cooperation has been very useful to MAS in helping us discharge our supervisory responsibilities. Better collective understanding and cooperation among regulators are essential in managing the risks of a global financial institution. Such cooperation will also help to manage the global situation in times of crisis.
19 In light of the sub-prime turmoil, there has also been a lot of debate about whether financial authorities might need to step up overall prudential measures. Yes, there are many lessons to be taken away from the crisis and these include the over-reliance of financial institutions on external ratings, better oversight of banks’ off-balance sheet exposures, the regulatory treatment of these exposures and the need to strengthen stress testing in financial institutions. So where will the regulatory pendulum swing? For those of you in the audience who are regulated by MAS, you are now bracing yourselves for me to announce that not only will it swing hard over to the conservative extreme but that maybe even the bankers too will soon be swinging (from on high). You may now breathe a little bit easier because I am not going to say this. Indeed, it would neither be desirable nor practical for financial authorities to over-react. The front–line responsibility on risk management and financial resilience of a financial institution still rests squarely on the plate of the Board and management of the financial institution. In short, financial supervisors cannot be scrutinising and dictating how financial institutions should be run. We can only be there to put in place markers to remind you of what you should be doing yourselves.
20 I started by speaking about the four principles underpinning our financial supervision framework. We will soon be publishing an accompanying monograph on MAS’ approach to regulation. Regulation here refers specifically to the establishment of rules. The same four broad principles which guide MAS’ work in overall financial supervision are embodied in our formulation and review of regulations.
21 In line with the principles of being “Risk-Focused” and “Business Friendly”, we believe that regulations should be clearly articulated in relation to the specific and material risks that they are intended to address. In designing regulations, a cost-benefit analysis should be performed so that unintended and unnecessary disruption to market practices is minimised. Of course, this does not mean that regulation should be the result of a compromise between benefits and costs.
22 Regulations should also be clearly worded to create certainty on legal obligations that institutions are subject to. This clarity will help facilitate a “Business-Friendly” operating environment.
23 The setting of regulations should also follow the principle of being “Risk-Focused”. While there can and should be a broad set of essential regulatory requirements guiding all institutions, supervisors should be empowered to set higher standards or permit exemptions depending on the particular circumstances of a financial institution. There should also be an infrastructure in place to keep regulations updated as industry and market practices change and as new risks emerge.
24 Finally, we recognise that formal regulation may not be the most effective means of achieving the regulatory outcomes we desire. Reliance will be placed, where appropriate, on financial institutions and the industry themselves to address supervisory concerns as alternatives to regulation. This resonates with the principles of “Disclosure-Based” and “Stakeholder-Reliant”.
Part IV: Conclusion
25 To sum up, let me reiterate that an effective supervisory framework extends beyond setting rules, be they Basel II or others. Financial supervision calls for a holistic understanding and management of the risks in the entire financial system. MAS aims to achieve this through the four principles of financial supervision – “Risk-Focused”, “Stakeholder-Reliant”, “Disclosure-Based” and “Business-Friendly”. That said, no financial authority can hope to foster a stable yet vibrant financial system without the help of stakeholders like yourselves, the senior management and risk professionals in the industry. International cooperation is also an essential component of an effective regulatory framework in face of the globalisation of banking and financial activities.
26 On this note, I wish all of you a fruitful discussion in the conference. For those of you who are visiting from overseas, I also wish you a most pleasant stay in Singapore.
27 Thank you.