A Building Block Approach. Financial Sector Regulation and Supervision in Emerging Markets and Developing Economies

Transcription

1 A Building Block Approach Financial Sector Regulation and Supervision in Emerging Markets and Developing Economies

2 Imprint Published by: Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH Registered Offices Bonn and Eschborn, Germany Dag-Hammarskjöld-Weg Eschborn, Germany Phone: Fax: Internet: Responsible Authors: Achim Deuchert, Thomas Foerch Pictures: Cover: canstockphoto.com/sqback; p. 3: canstockphoto.com/voronin76; p. 4: canstockphoto.com/cico; p. 7: canstockphoto.com/yurmary; p. 9: canstockphoto.com/elenathewise Design: Alexandra Müller Printed by: Top-Kopie, Frankfurt Eschborn, November 2012 GIZ 2012

3 Contents Abstract 03 1 Reform in the wake of the financial crisis 04 2 The evolution of the financial system 05 3 The relationship between the various Basel banking standards 08 4 Strengthening banking supervision compliance with BCPs 11 5 Should EMDEs implement Basel I, II or III? 12 6 A sequential approach to implementing the Basel standards 15 7 Conclusion 19 Reference literature 20

4 Table of figures Figure 1: llustrative linear development path of financial systems 06 Figure 2: Assessment of BCP (2012) compliance by region, including 42 countries all told 11 Figure 3: Progress in implementing Basel II and III in selected EMDEs 12 Figure 4: Capital requirements and supervisory capacity 13 Figure 5: Building block approach (BCP 2012) 17

5 Abstract Reform is in the air. The G20, responding to the world financial crisis, have instilled a new sense of urgency to implement international financial standards designed to enhance global banking stability. Yet, the need to introduce international standards does not imply off-the-shelf solutions, but offers instead a range of policy options. The limited resources available to regulatory and supervisory institutions necessitate prioritisation of the reform agenda. This paper provides an illustrative framework for matching international standards with the actual capacities of banking supervisors and the given state of financial system development. We suggest an individualised, piecemeal approach to implementing international regulatory and supervisory standards depending on the country-specific context and stage of financial sector development, instead of applying rules wholesale as a one-size-fits-all solution.

6 4 I Reform in the wake of the financial crisis 1 Reform in the wake of the financial crisis As the global economic crisis continues, financial regulatory and supervisory reforms have become a top priority in advanced economies as well as in emerging markets and developing economies (EMDE)1. In response to the weaknesses revealed by the financial crisis, policy-makers are pushing forward with efforts to implement the financial stability agenda worldwide. So far, financial systems in most EMDEs have proven relatively resilient in the face of the global crisis and current European financial struggles. Underlying this resilience are several distinct factors, including stronger macroeconomic fundamentals, low exposure to European bank funding, and minimal exposure to US subprime mortgage assets. However, most prominently, in recent years EMDEs have considerably improved their financial sector regulatory and supervisory framework. Most EMDEs have strengthened their banking and insurance supervision and enhanced the quality of securities regulation over the past decade, helping them to withstand the effects of current financial turmoil. Despite the rapid global integration of financial markets, banking regulation is still a fully national responsibility. In the absence of a global regulator, the G20 and especially the Financial Stability Board (FSB) provide an overarching framework and forum for policy coordination. The international reform agenda has instilled a new 1 EMDEs comprise a large and diverse group whose financial systems have grown in importance over the last decade. Based on the classification of countries used by the IMF in its World Economic Outlook (WEO), 150 economies are classified as EMDEs, including 10 members of the G20. They differ substantially in terms of economic size, level of development, legal and institutional frameworks, and other factors that affect financial systems.

7 2 The evolution of the financial system 5 sense of urgency to foster convergence towards international financial standards. The G20 have decided to phase-in Basel III at the national level in 2013 with the goal of full implementation in all G20 countries by This process could create pressure on non-g20 EMDEs to comply with international standards. Large banking groups might prefer to operate under the same regulations across borders rather than adhering to differing standards. Moreover, investors might regard the level of banking regulation to be a key component of financial stability, driving their investment decision-making. However, international standards do not fit everyone. There is a mismatch between the requirements of international standards and the capacities of regulators and supervisors in EMDEs, especially among non-g20 EMDEs. Current reform initiatives have mainly been shaped by the most advanced G20 economies. The most recent reforms, such as Basel III, impose new challenges for most EMDEs. Adopting advanced international standards without the required level of preparedness might overstretch the capacities of some EMDEs. The principal challenges in this area relate to supervisory capacity constraints and to incomplete legal frameworks. EMDEs need to carefully weigh the advantages and disadvantages of implementing advanced capital adequacy standards. Supervisors might need to take into consideration the institutional capacities and limited financial resources of their banking industries and the challenges they face before moving to implement these standards. For this reason, countries need to adopt international standards at a pace consistent with their level of financial sector development. Limited resources call for a rigorous prioritisation of regulatory reforms for there is no one-sizefits-all solution to financial sector regulation and supervision. Countries need to adopt international standards commensurate with their local capacities and their specific context and stage of financial sector development. Against this background, this paper seeks to highlight the dialogue on banking regulation and supervision in EMDEs. It is intended to enrich this discussion by examining a roadmap for prioritising and sequencing international regulatory and supervisory reforms according to local capacities. 2 2 The evolution of the financial system The fundamental idea of this paper is that international standards could be prioritised and sequenced according to the various stages and capacities of financial sector development in EMDEs. Implementation of advanced standards entails significant costs for banks and supervisors alike, especially in non-g20 EDMEs. Banks need to upgrade their risk management practices, while supervisors need to expand their supervisory expertise, for supervisory capacities need to match with the degree of sophistication of the international standards. The capacities of supervisory power and the functioning of all aspects of financial sector regulation and supervision build on certain preconditions. These preconditions 3 comprise e.g. the existence of a functioning financial 2 In EMDEs, banking assets make up the overwhelming majority of total financial sector assets, hence banks pose the largest systemic risk to local financial systems. For this reason, this paper will focus on regulatory and supervisory reforms in the banking sector. 3 These preconditions are listed in the lead text of the Basel Core Principles, versions 2006 and 2012, namely: i) sound and sustainable macroeconomic policies, ii) a well established framework for financial stability policy formulation, iii) a well developed public infrastructure, iv) a clear framework for crisis management, recovery and resolution, v) an appropriate level of systemic protection, and vi) effective market discipline.

8 6 2 The evolution of the financial system infrastructure, such as credit reference bureaus, deposit insurance schemes, sound macroeconomic policies, and effective market discipline. Although these preconditions lie outside the scope of supervisory tasks and duties, they have a direct impact on the effectiveness of supervisory practices. The more firmly these preconditions are in place, the more effectively supervisors are able to exert their discretionary power of financial laws. We propose a three-step model (see figure 1) for matching local supervisory capacities with the given level of financial sector development. This analytical model is purely illustrative. Every stage of financial sector development requires authorities to acquire a new and different set of supervisory skills, such that differing priorities in banking regulation and supervision need to be defined accordingly. Financial Systems Sophistication and required suvervisory Capacities Sophisticated Banking Advanced Banking Fundamental Banking Time Foundation Advanced Sophistication Figure 1: Illustrative linear development path of financial systems

9 The three-step model on the left depicts the evolution of the financial system from community-based microfinance structures to state-of-the-art derivative markets. It starts with the foundation phase, continues with the advanced phase and ranges all the way to the sophistication phase. The foundation phase reflects the assumption that, at an early stage, the financial system exhibits rather informal community-based microfinance structures. During the advanced phase, banks mature and expand their range of services. Finally, in the sophistication phase, banks grow more complex and international in their activities. At a very early stage of financial sector development, priority should be given to upgrading the basic capacities of supervisors. The key elements of such upgrading are codified in the Basel Core Principles for Effective Banking Supervision (BCP) 4. The BCPs define the core, fundamental aspects of banking supervision. Closely linked to the BCPs are the Basel Capital Adequacy Accords (Basel I III). These standards regulate all essential aspects of banking operations aimed at minimising financial risk. The following section will explore the relationship between the various Basel standards, and then detail which aspects of regulation and supervision should be implemented at which stage of financial sector development. 4 This paper uses the 2012 BCP version.

10 8 3 The relationship between the various Basel banking standards 3 The relationship between the various Basel banking standards A whole set of internationally accepted standards in banking regulation and supervision has evolved over the last decades. The latest standards have been driven by the G20 in coordination with the Basel Committee on Banking Supervision (BCBS). The most prominent standards are the BCPs and the three Basel Capital Adequacy Accords (Basel I III). Basel Core Principles 2012 set out minimal standards for the way that banking supervision is organised and implemented by regulatory authorities. The core principles address key issues like the independence and enforcement powers of the regulator, criteria for allowing banks to operate in a country, and minimum requirements for financial institutions risk management processes, etc. However, as the term suggests, the Basel Core Principles are general in nature and do not provide detailed regulatory provisions. The BCPs are as follows: BCP 1: Responsibilities, objectives and powers BCP 2: Independence, accountability, resourcing and legal protection for supervisors BCP 3: Cooperation and collaboration BCP 4: Permissible activities BCP 5: Licensing criteria BCP 6: Transfer of significant ownership BCP 7: Major acquisitions BCP 8: Supervisory approach BCP 9: Supervisory techniques and tools BCP 10: Supervisory reporting BCP 11: Corrective and sanctioning powers of supervisors BCP 12: Consolidated supervision BCP 13: Home-host relationships BCP 14: Corporate governance BCP 15: Risk management process BCP 16: Capital adequacy BCP 17: Credit risk BCP 18: Problem assets, provisions and reserves BCP 19: Concentration risk and large exposure limits BCP 20: Transactions with related parties BCP 21: Country and transfer risk BCP 22: Market risk BCP 23: Interest rate risk and the banking book BCP 24: Liquidity risk BCP 25: Operational risk BCP 26: Internal control BCP 27: Financial reporting and external audit BCP 28: Disclosure and transparency BCP 29: Abuse of financial services

11 The BCPs form the foundation on which the Basel Capital Accords are constructed. The BCPs define the minimum standards for sound practices in banking supervision, and describe best practices for governance issues, supervisory resources and operational independence. The IMF and World Bank use the BCPs to assess the quality of banking supervision in the context of the Financial Sector Assessment Program (FSAP) and the Report on the Observance of Standards and Codes (ROSCs). The overall compliance rate with the BCPs is crucial to assessing the quality of status quo banking supervision and to identifying regulatory reform priorities. A strong BCP supervisory framework is a precondition for the implementation of specific banking regulations such as Basel I-III. The status of BCPs implementation provides a well-defined reference for assessing the overall capacity of supervisors and their ability to adhere to international regulatory banking standards.

12 10 3 The relationship between the various Basel banking standards Basel I, as the first capital standard to be issued, originally targeted banks undertaking international business. Over time it has been broadly implemented by most countries and for all kinds of banks. In that sense, Basel I can be regarded as an important step in strengthening capital requirements in financial systems with various levels of complexity, as well as for the first time providing a standard method of comparison of banks soundness worldwide. Basel II was designed to provide a more risk-sensitive approach to calculating minimum capital requirements. Basel II offered a range of options with increasing levels of sophistication and complexity, with applicability to a variety of banks and banking systems worldwide. Based on a threepillar framework, Basel II reflected the BCBS understanding that capital requirements alone were not enough to ensure the soundness and stability of financial systems. While it broadened capital requirements (Pillar 1) beyond credit and market risk by incorporating operational risk capital charges, it also recognised the role played by banks themselves and bank supervisors in ensuring the appropriate levels of capital beyond minimum capital requirements (Pillar 2), as well as market discipline in promoting the safety and soundness of financial systems (Pillar 3). The BCBS, however, stated clearly that implementation of Basel II might not be a priority for non-member countries and that each supervisor should consider its benefits with regard to local conditions. The Basel II approaches have to be chosen in light of particular circumstances in local jurisdictions and should not be expected to be implemented in the same way in every jurisdiction. Basel III was introduced as a complement to Basel I and Basel II, and in principle its elements are expected to be relevant to banks and financial systems of all kinds. Basel III was designed to address the lessons of the financial crisis by enhancing banking sector resilience, reducing the probability and severity of banking crises through a series of measures comprising macroprudential and microprudential elements. Enhancements to the prior framework include a significant increase in the level and quality of capital, a leverage ratio, capital buffers, and a liquidity framework. In contrast to the BCPs, which determine best practices and guidelines for supervisors, the Basel capital frameworks I-III define specific regulatory practices for the banking industry. There is a direct link between the BCPs and the Basel I-III frameworks. Basically, the BCPs and the Basel Capital Accords deal with the same range of topics. However, the BCPs constitute best practices for bank supervisors while the Basel Capital Accords are best practices for the banking industry itself. For example, BCP 16 (all BCPs refer to the 2012 version) defines adequate capital levels across banks from a supervisory perspective. At the same time, the Basel Capital Accords specify the techniques for banks to determine their adequate capital levels.

13 4 Strengthening banking suversion compliance with BCPs 11 4 Strengthening banking supervision compliance with BCPs In general, the BCPs are seen as minimum standards for banking regulation and supervision. The banking supervisory systems in EMDEs exhibit a high degree of compliance in most areas. Based on FSAP assessment in 42 countries (FSB, 2011) the majority of EMDEs (over 60 percent) are compliant with 75 percent of the principles. The areas of high compliance (over 80 percent of countries) include strong supervisory techniques and capital adequacy frameworks. However, specific areas in banking supervision exhibit a notable level of non-compliance in EMDEs. These areas are consolidated supervision, risk management and supervisory independency, accountability and transparency. Especially in low-income countries, BCP compliance is low compared to their higher-income peers Consolited Suvervision (BCP 12) Risk Management (BCP 15) Independendance, Accountability and Transparency (BCP 2) Africa Asia Pacific Europe Middle East Western Hemisphere Figure 2: Assessment of BCP (2012) compliance by region, including 42 countries all told (Source: FSB, 2011) For example, 85 percent of the countries 5 assessed in the Western Hemisphere are non-compliant or materially non-compliant with BCP 12, consolidated supervision. Also, about 60 percent of countries in the Middle East and 40 percent of assessed countries in Africa are non-compliant or materially non-compliant with state-of-theart risk management practices (BCP 15). Furthermore, across all regions, rates of non-compliance with fundamental principles are also high, such as the independence of the supervisory authority from government interference (BCP 2). Therefore, the global perspective of BCP compliance masks considerable variation in regional performance with respect to specific core principles. EMDEs exhibit a truly varying degree of compliance with the 5 Sample size is 42 countries, based on IMF-World Bank missions and BCP asessments (FSAP)

14 12 5 Should EMDEs implement Basel I, II or III? BCPs. For this reason, countries that are not fully compliant need to prioritise which BCP should be implemented first. Against this background, local supervisors need to pick those BCPs that are of highest priority within their specific level of financial sector development, taking into consideration its risk profile and local capacities. 5 Should EMDEs implement Basel I, II or III? To resist financial turmoil, institutions need to rely on solid risk management practices and adequate capital levels. Official compliance assessment of the BCP through the FSAP provides the benchmark against which the capacities of EMDEs are measured. Even though the BCPs form the bedrock of international standards, the Basel capital adequacy frameworks I-III deliver an important complement to the official assessment. However, in contrast to the predefined compliance assessment of the BCPs, Basel I-III standards are less rigid and EMDEs have more discretionary power to implement these standards according to their local priorities. For non-g20 countries, all three frameworks of Basel I-III are not compulsory. Nevertheless, these nations often aspire to compliance with these standards, and there is a certain element of peer pressure. However, the picture is different for large G20 emerging markets, whose countries need to adhere to international standards in accordance with the official G20 timeline, which requests implementation of Basel III by Against this backdrop, the level of compliance across EMDEs with Basel standards I-III varies widely. Compliance with Basel II among EMDEs is high, as demonstrated below (Figure 3), with the largest emerging markets in particular having almost fully implemented Basel II. The situation is of course different for Basel III. As the requested deadline for implementation of Basel III within the G20 economies is not until 2019, none of the large G20 countries - including their emerging markets - have fully implemented Basel III already, and there is much work yet to do. 4 completed progress completed completed 3 progress 2 progress Basel II 1 Basel III 0 Argentina Brazil China India Indonesia South Africa 1 = draft regulation not published; 2 = draft regulation published; 3 = final rule published; 4 = final rule in force Figure 3: Progress in implementing Basel II and III in selected EMDEs (Source: BIS (2012): Report to G20 Leaders on Basel III Implementation)

15 5 Should EMDEs implement Basel I, II or III? 13 Non-G20 EDMEs in particular face a number of constraints and challenges in meeting the preconditions necessary to effectively implement advanced capital standards in their jurisdictions. Implementing Basel II and III carries significant costs for banks and regulators alike. On the one hand, banks are confronted both with one-off costs to prepare implementation (such as technology) and with the running costs of operations. At the same time, supervisors have to build additional capacities to assess the level of compliance of banks with these advanced standards. Banks as well as regulators and supervisors need to expand their analytical expertise in risk management, technological sophistication and human resources. Hence, supervisors and regulators must make wise decisions in order to allocate their scarce resources most effectively to enhance financial sector stability. Worldwide, the Basel capital frameworks I-III rest on two essential pillars that determine financial sector stability: firstly, the capital requirements of banks, and secondly, the risk management capacities of supervisors and banks. Capital requirements provide buffers against shocks and ensure financial sector stability. From the perspective of supervisors, capital requirements are straightforward to implement. Supervisors need merely to heighten capital requirements with relatively simple instruments, such as done under Basel I, or using other clear-cut instruments, such as those available under Basel III (for example the leverage ratio). However, the picture looks different for risk management capacities. Supervisors need to upgrade their capacities in order to make sure that banks comply with more sophisticated risk management practices, such as those available under Basel II (Pillar 1). Whether supervisors decide to concentrate on capital requirements or to upgrade supervisory risk management capacities has significant implications. Basel I Basel II Basel III High High Required Capital Low A-IRB Required Supervisory Capacities Low Figure 4: Capital requirements and supervisory capacity (Source: Fuchs, Losse-Müller, Witte (2010))

16 14 5 Should EMDEs implement Basel I, II or III? Figure 4 illustrates the relation between capital requirements and supervisory capacities across all three Basel Accords. Basel I functions on the basis of standardised and fixed risk categories, hence supervisors can handle Basel I even with relatively modest supervisory capacity. The consequence is that banks need to back up their operations with a substantial amount of capital. In contrast, the risk-sensitive capital requirements introduced by Basel II allow banks to considerably reduce their capital base, especially for internal ratings-based approaches (F-IRB and A-IRB). However, the possibility of economising on capital under Pillar 1 of the framework is supposed to go hand in hand with a corresponding and significant increase in supervisory capacity. Basel II defines these supervisory practices, including the need to assess individual bank risk management systems in Pillar 2 of Basel II (Supervisory Review and Evaluation Process SREP). It requires supervisors to exercise considerable judgment in reviewing and evaluating a bank s internal risk management practices, their exposure to risks, funding structure and overall risk profile.banks to considerably reduce their capital base, especially for internal ratings-based approaches (F-IRB and A-IRB). However, the possibility of economising on capital under Pillar 1 of the framework is supposed to go hand in hand with a corresponding and significant increase in supervisory capacity. Basel II defines these supervisory practices, including the need to assess individual bank risk management systems in Pillar 2 of Basel II (Supervisory Review and Evaluation Process SREP). It requires supervisors to exercise considerable judgment in reviewing and evaluating a bank s internal risk management practices, their exposure to risks, funding structure and overall risk profile. Any mismatch between implementation of advanced Basel standards and low supervisory capacities would threaten financial stability. In such cases, banks would be allowed to calculate and reduce their capital requirements (under Basel II, Pillar 1), while supervisors would be unable to assess if these calculations are correct (under SREP). This would destabilise the financial sector as a whole, as banks would lower their capital without tightening their risk management practices. As Figure 3 demonstrates, the move to more advanced standards such as Basel II and III should always be accompanied by an increase in supervisory capacity. At the same time, if the necessary capacities are not available, supervisors would need to enforce financial sector stability by simply adjusting their capital requirements. Having reviewed the international standards and their challenge to local capacities, the following section will analyse in greater detail which international standard should be implemented at what stage of financial sector development. However, given the current limited capacities of many EMDE supervisors, it is not feasible to implement the Basel standards wholesale. Rather, it might be advisable to adapt certain standards to local needs and capacities. One solution might be to break international standards up into suitable pieces and to use these appropriately sized and selected building blocks to sequentially build the supervisory framework according to local needs and capacities. The sequence for implementing these building blocks will follow the three-step model introduced at the beginning of this paper.

17 6 A sequential approach to implementing the Basel standards 15 6 A sequential approach to implementing the Basel standards At a very early stage of financial sector development, banks perform basic financial services, such as simply structured corporate and consumer loans. At this stage - from a supervisory perspective - priority should be given to upgrading the capacities of supervisors to ensure accurate and adequate assessment of all banking operations. In order to better access the plethora of international standards, it is useful to cluster these standards in overarching thematic categories. One good example for such a thematic category is risk management. Risk management includes elements across all standards, the BCPs, Basel I, Basel II and Basel III. Certain elements of the risk management category are relatively straightforward to implement and do not require a high level of supervisory capacity. A good example is the element risk management process of the BCPs (BCP 15). However, other elements within the risk management category require extensive expertise, such as consolidated supervision (BCP 12). For this reason, these elements should be implemented at a later stage of financial system development, where the capacities of supervisors match better with the sophistication of these standards. In order to come up with an illustrative framework of international standards, we suggest the following four thematic categories: Risk management Supervisory processes Licensing, definitions and preconditions Setup of supervisory institutions

18 16 6 A sequential approach to implementing the Basel standards Similar to the category of risk management, we use the category supervisory processes as an illustrative cluster to group together all elements across the standards that are linked to the supervisory process. While this category includes basic aspects such as supervisory approach (BCP 8), it also comprises much more advanced standards such as the review of systemically important financial institutions (SIFIS) under Basel III. What all four categories have in common is that they cluster the individual elements of international standards that cut across the various stages of financial systems development. We refer to the individual elements of the various supervisory and regulatory standards (BCPs and Basel I-III) as building blocks. These building blocks comprise for example the individual BCPs 1 to 29 and the individual elements of Basel I-III, such as the disclosure requirements of Basel II and the trading book requirements of Basel III. In a next step, we now propose sequencing and prioritising these building blocks according to the various stages of financial sector development. Of course, this task as presented here is illustrative and non-exhaustive, and does not include all possible building blocks. We summarised the three basic steps of financial system development under Section 2 above (the evolution of the financial system), i.e. the foundation phase, the advanced phase and the sophistication phase. The thematic categories help us to cluster the individual building blocks of international standards in an overarching framework of financial sector development (see Figure 5). Foundation phase During a very early stage of financial sector development, priority should be given to establishing the basic supervisory structures. Crucially important is the implementation of the second principle (BCP 2) which defines the independence, accountability, resourcing and legal protection for supervisors. Every authority should be independent and free from government intervention, and possess adequate resources. This is essential to guaranteeing effective supervision. In parallel with efforts to upgrade supervisory structures, it is equally important to upgrade the regulation of banks. For this reason, regulators need to define which financial institutions are allowed to operate within their jurisdiction (licensing criteria, BCP 5). Based on this principle, the licensing authority has the power to set criteria and to reject applications from banks that do not meet basic financial standards. The licensing process should consist of assessing the ownership structure and governance of the bank and its wider group. Closely related to this is the need to supervise permissible activities of banks (BCP 4). One top priority should be the ability of the supervisor to understand the fundamental risks within the banking system. Crucial in this respect is the general risk management process (BCP 15). This principle is complemented by the requirement to systematically understand individual banking operations and the banking system as a whole (supervisory approach, BCP 8). In order to reduce risks, supervisors should require banks to implement appropriate risk management techniques, at least through minimum capital adequacy standards (BCP 16). These standards are reflected in the regulatory capital adequacy framework of Basel I. For supervisors, a next step might then be to monitor the adequacy of these capital standards through better supervisory techniques and tools (BCP 9) especially through on-site and off-site supervision. Furthermore, authorities need to support the development of a functioning data system with internal control and auditing in order to improve the reliability and objectivity of data (BCP 26).

19 6 A sequential approach to implementing the Basel standards 17 BCP Basel Core Principles (2012) Basel I Basel II Basel III Time Financial Sophistication Licensing, Definitions and Preconditions 5: Licensing Criteria 4: Permissible Activities 28: Disclosure and Transparency 6: Transfer of Significant 7: Major Acquisitions Disclosure Requirements 29: Abuse of Financial Services Setup of Supervisory Institutions 1: Responsibilities, Objectives and Powers 11: Corrective and Sanctioning Powers Supervisory Process t 0 8: Supervisory Approach 9: Supervisory Techniques 10: Supervisory Reporting Supervisory Review an Evaluation Process (SREP) 12: Consolidated Supervision 13: Home-Host Relationships SIFIS 16: Capital Adequacy Risk Management 26: Internal Control 15: Risk Management Process Basel I Capital Requirements 17: Credit Risk (incl. 18, 19 20) Internal Capital Adequacy Assessment Process (ICAAP) 24: Liquidity Risk 22: Market Risk 21: Country Risk and Transfer Risk 25: Operational Risk Trading Book Foundation Advanced Sophistication Figure 5: Building block approach (BCP 2012; Source: GIZ)

20 18 6 A sequential approach to implementing the Basel standards Advanced Phase During the advanced phase of financial sector development, national authorities are in the challenging position of having to regulate and supervise more mature and sophisticated banks. One on-going issue is capital adequacy. For the foundation phase, Basel I put forward a simple method of calculating capital adequacy for banks. In the advanced phase, as banks grow larger, supervisors must also advance to more sophisticated standards, such as the advanced capital requirements under Basel II (Pillar I, the F-IRB and the A-IRB; see Section 5). One important precondition to tracking bank operations is the implementation of strict financial information disclosure requirements which are defined in Basel II, Pillar III. In order not to overstretch technical capacities with respect to data quality requirements, supervisors might need to upgrade their information and data-processing systems. At the same time, when banks grow more mature they also expand their financial operations. In this respect, risks might arise from activities such as cross-border operations or financial takeovers. In order to reduce these risks, an important step would be to regulate the transfer of significant ownership (BCP 6) and to implement laws for major acquisitions (BCP 7). This would reduce banking system exposure to undue risks. In the advanced phase, supervisors need to identify the major risks within the financial system and to act accordingly. Risk management is complex and supervisors should be well aware of their interconnectedness (see the cross-cutting risk box in Figure 4). Two types of risk are highly important: empirically, the greatest risks are credit risk (BCP 17) and liquidity risk (BCP 24). Liquidity risks focus on the ability of banks to meet due obligations without incurring unacceptable losses. Sophistication Phase Throughout the sophistication phase, banks grow international and complex. This changes the requirements for banks with regard to managing their risks. New risks gain more importance, such as market risks (BCP 22) and operational risks (BCP 25). While market risk reflects external market conditions, such as interest rate fluctuations, operational risk describes all incalculable risks which arise from people, IT systems or operational processes of a financial institution. It is up to the banks to implement sound risk management practices. The first pillar of Basel II provides precuse definitions of the risk management practices for banks. These Basel II practices are constructed in direct reference to the BCPs. Hence, in parallel to the BCPs, Basel II focuses on implementation of credit risk, market risk, liquidity risk and operational risk practices. Basel II is a complex framework and offers good practices in advanced risk management practices for banks. Basel II, Pillar II defines the Internal capital adequacy process (ICAAP) for banks. ICAAP lays out best practices for banks for identifying major sources of risks, e.g. through internal stress tests, and helps define adequate capital levels in order to stabilise banks in times of crisis. What is true for banks is equally true for supervisors. While banks need to upgrade their internal risk management processes, supervisors need to upgrade their capacities in order to understand the advanced risk management practices of banks. For this reason, Basel II also offers best practices for supervisors to review and evaluate bank risk profiles. Specifically, Basel II defines the supervisory review and evaluation process (SREP) for supervisors designed to evaluate the ICAAP risk management practices of banks. This helps supervisors to really understand the internal risk management processes of banks and to respond with an adequate and complementary supervisory approach. Finally, as the financial sector grows deeper and more sophisticated, supervisors are confronted with more complex risks, especially with those of large banks and their subsidiaries. In order to control the risk these banks are exposed

21 7 Conclusion 19 to, supervisors should implement practices for consolidated supervision for entire banking groups (BCP 12). Moreover, in highly advanced financial systems, banks might engage in trading book activities, such as the complex securitisation of collateralised debt obligations. For this reason, Basel III provides a trading book approach which defines capital ratios for these complex operations. However, these complex procedures are not relevant for every supervisor, and certain aspects of Basel III might go far beyond that which is actually most needed in some EMDEs. 7 Conclusion This paper argues that international standards in the area of banking supervision and regulation do not necessarily have to be implemented wholesale according to pre-defined steps. Looking at country-specific reform priorities and the limited capacities of supervisors, a customised, piecemeal approach might be more appropriate. International standards might be disaggregated and broken down into individual building blocks which could be prioritised and sequenced according to the national stage of financial sector development. The framework described above demonstrates an illustrative approach intended to contribute to the dialogue on banking regulation and supervision, and to draw the attention of policy-makers and practitioners to possible ways of sequencing and prioritising international standards. Supervisory capacities must always match the sophistication of the implemented standards. The tool presented here strives to provide an illustrative framework for setting priorities and defining critical building blocks according to local capacities. However, it should be clear that there is no standardised blueprint, and every country exhibits different capacities, political powers, financial structures and risks. Thus, every jurisdiction needs to find its own building block approach. Even if this paper provides a starting point for dialogue, it cannot replace in-depth diagnostics of local priorities for reform according to each country s specific context.

22 18 Reference literature Reference literature Basel Committee on Banking Supervision (1999) A new capital adequacy framework, Basel I. Basel Committee on Banking Supervision (2006) Basel II: Revised international capital framework Basel Committee on Banking Supervision (2012) Report to G20 Leaders on Basel III Implementation. Basel Committee on Banking Supervision (2012) International regulatory framework for banks (Basel III) Financial Stability Board (FSB) (2011) Financial Stability Issues in Emerging Market and Developing Economies, Report to the G-20 Finance Ministers and Central Bank Governors, prepared by the IMF and World Bank International Monetary Fund (2012) Global Financial Stability Report 2012 Fuchs, Michael; Losse-Mueller, Thomas and Witte, Makaio (2011): The Reform Agenda for Financial Regulation and Supervision in Africa, background paper to: Financing Africa Through the Crisis and Beyond, Worldbank Witte, Makaio; Deuchert, Achim (2012): A building Block Approach to Financial Regulation and Supervision in African Low-Income Countries, GIZ

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