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Basel ii Accord
Sections 778 to 807 |
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C.
Operational
risk
778.
Gross income, used in the Basic Indicator and
Standardised Approaches for
operational
risk, is only a proxy for the scale of
operational risk exposure of a bank and
can
in
some cases (e.g. for banks with low margins or
profitability) underestimate the need
for
capital
for operational risk.
With
reference to the Committee document on Sound
Practices for the Management
and Supervision of Operational Risk
(February 2003), the
supervisor
should consider whether the capital requirement
generated by the Pillar 1 calculation gives a
consistent picture of the individual bank’s
operational risk exposure, for example in
comparison with other banks of similar size and
with similar operations.
D.
Market risk
1.
Policies and procedures for trading book
eligibility
778
(i). Clear policies and procedures used to
determine the exposures that may
be
included
in, and those that should be excluded from, the
trading book for purposes of
calculating
regulatory capital are critical to ensure the
consistency and integrity of
firms’
trading
book.
Such
policies must conform to paragraph 687 (i) of
this Framework.
Supervisors
should be satisfied that the policies and
procedures clearly delineate
the
boundaries
of the firm’s trading book, in compliance with
the general principles set forth
in
paragraphs
684 to 689 (iii) of this Framework, and
consistent with the bank’s risk
management
capabilities and practices.
Supervisors
should also be satisfied that transfers of
positions between banking and trading books can
only occur in a very limited set of
circumstances. A supervisor will require a firm
to modify its policies and procedures when they
prove insufficient for preventing the booking in
the trading book of positions that are not
compliant with the general principles set forth
in paragraphs 684 to 689 (iii) of this
Framework, or not consistent with the bank’s
risk management capabilities and
practices.
2.
Valuation
778
(ii). Prudent valuation policies and procedures
form the foundation on which any
robust
assessment
of market risk capital adequacy should be built.
For a well diversified
portfolio
consisting
of highly liquid cash instruments, and without
market concentration, the
valuation
of
the portfolio, combined with the minimum
quantitative standards set out in the Market
Risk Amendment, as revised in this section, may
deliver sufficient capital to enable a bank, in
adverse market conditions, to close out or hedge
its positions within 10 days in an
orderly
fashion.
However,
for less well diversified portfolios, for
portfolios containing less
liquid
instruments,
for portfolios with concentrations in relation
to market turnover, and/or for
portfolios
which contain large numbers of positions that
are marked-to-model this is
less
likely
to be the case. In such circumstances,
supervisors will consider whether a bank
has
sufficient
capital.
To
the extent there is a shortfall the supervisor
will react appropriately. This will usually
require the bank to reduce its risks and/or hold
additional amount of capital.
3.
Stress testing under the internal models
approach
778
(iii). A bank must ensure that it has sufficient
capital to meet the minimum
capital
requirements
set out in the Market Risk Amendment and to
cover the results of its stress
testing
required by that amendment (paragraph B.2(g),
taking into account the principles set forth in
paragraphs 738 (ii) and 740). Supervisors will
consider whether a bank has sufficient capital
for these purposes, taking into account the
nature and scale of the bank’s trading
activities and any other relevant factors such
as valuation adjustments made by the bank.
To
the extent that there is a shortfall, or if
supervisors are not satisfied with the premise
upon
which
the bank’s assessment of internal market risk
capital adequacy is based,
supervisors
will
take the appropriate measures. This will usually
involve requiring the bank to reduce
its
risk
exposures and/or to hold an additional amount of
capital, so that its overall
capital
resources
at least cover the Pillar 1 requirements plus
the result of a stress test
acceptable
to
the supervisor.
4.
Specific risk modelling under the internal
models
approach
778
(iv). For banks wishing to model the specific
risk arising from their trading
activities,
additional
criteria have been set out in the revised
section B.8, paragraph 2 of the
Market
Risk
Amendment, including conservatively assessing
the risk arising from less
liquid
positions
and/or positions with limited price transparency
under realistic market
scenarios.
Where
supervisors consider that limited liquidity or
price transparency undermines
the
effectiveness
of a bank’s model to capture the specific risk,
they will take appropriate
measures,
including requiring the exclusion of positions
from the bank’s specific risk
model.
Supervisors
should review the adequacy of the bank’s measure
of the default risk surcharge;
where
the bank’s approach is inadequate, the use of
the standardised specific risk
charges
will
be required.
IV. Other aspects of
the supervisory review
process
A.
Supervisory transparency and
accountability
779.
The supervision of banks is not an exact
science, and therefore,
discretionary
elements
within the supervisory review process are
inevitable. Supervisors must take care
to
carry
out their obligations in a transparent and
accountable manner. Supervisors
should
make
publicly available the criteria to be used in
the review of banks’ internal
capital
assessments.
If
a supervisor chooses to set target or trigger
ratios or to set categories of capital in excess
of the regulatory minimum, factors that may be
considered in doing so should be publicly
available. Where the capital requirements are
set above the minimum for an individual bank,
the supervisor should explain to the bank the
risk characteristics specific to the bank which
resulted in the requirement and any remedial
action necessary.
B.
Enhanced cross-border communication and
cooperation
780.
Effective supervision of large banking
organisations necessarily entails a close
and
continuous
dialogue between industry participants and
supervisors. In addition, the
Framework
will require enhanced cooperation between
supervisors, on a practical
basis,
especially
for the cross-border supervision of complex
international banking groups.
781.
The Framework will not change the legal
responsibilities of national supervisors
for
the
regulation of their domestic institutions or the
arrangements for consolidated
supervision
as
set out in the existing Basel Committee
standards. The home country supervisor
is
responsible
for the oversight of the implementation of the
Framework for a banking group
on
a
consolidated basis; host country supervisors are
responsible for supervision of
those
entities
operating in their countries.
In
order to reduce the compliance burden and avoid
regulatory arbitrage, the methods and approval
processes used by a bank at the group level may
be accepted by the host country supervisor at
the local level, provided that they adequately
meet the local supervisor’s requirements.
Wherever possible, supervisors should avoid
performing redundant and uncoordinated approval
and validation work in order to reduce the
implementation burden on banks, and conserve
supervisory resources.
782.
In implementing the Framework, supervisors
should communicate the
respective
roles
of home country and host country supervisors as
clearly as possible to banking
groups
with
significant cross-border operations in multiple
jurisdictions.
The
home country supervisor would lead this
coordination effort in cooperation with the host
country supervisors. In communicating the
respective supervisory roles, supervisors will
take care to clarify that existing supervisory
legal responsibilities remain
unchanged.
783.
The Committee supports a pragmatic approach of
mutual recognition for
internationally
active banks as a key basis for international
supervisory co-operation. This
approach
implies recognising common capital adequacy
approaches when considering the
entities
of internationally active banks in host
jurisdictions, as well as the desirability
of
minimising
differences in the national capital adequacy
regulations between home and
host
jurisdictions
so that subsidiary banks are not subjected to
excessive burden.
V.
Supervisory review process for
securitisation
784.
Further to the Pillar 1 principle that banks
should take account of the
economic
substance
of transactions in their determination of
capital adequacy, supervisory
authorities
will
monitor, as appropriate, whether banks have done
so adequately.
As
a result, regulatory capital treatments for
specific securitisation exposures might differ
from those specified in Pillar 1 of the
Framework, particularly in instances where the
general capital requirement would not adequately
and sufficiently reflect the risks to which an
individual banking organisation is
exposed.
785.
Amongst other things, supervisory authorities
may review where relevant a
bank’s
own
assessment of its capital needs and how that has
been reflected in the capital
calculation
as well as the documentation of certain
transactions to determine whether
the
capital
requirements accord with the risk profile (e.g.
substitution clauses).
Supervisors
will also review the manner in which banks have
addressed the issue of maturity mismatch in
relation to retained positions in their economic
capital calculations. In particular, they will
be vigilant in monitoring for the structuring of
maturity mismatches in transactions to
artificially reduce capital requirements.
Additionally,
supervisors may review the bank’s economic
capital assessment of actual correlation between
assets in the pool and how they have reflected
that in the calculation. Where supervisors
consider that a bank’s approach is not adequate,
they will take appropriate action. Such action
might include denying or reducing capital relief
in the case of originated assets, or increasing
the capital required against securitisation
exposures acquired.
A.
Significance of risk
transfer
786.
Securitisation transactions may be carried out
for purposes other than credit
risk
transfer
(e.g. funding). Where this is the case, there
might still be a limited transfer of
credit
risk.
However, for an originating bank to achieve
reductions in capital requirements, the
risk
transfer
arising from a securitisation has to be deemed
significant by the national
supervisory
authority.
If
the risk transfer is considered to be
insufficient or non existent, the
supervisory
authority
can require the application of a higher capital
requirement than prescribed
under
Pillar
1 or, alternatively, may deny a bank from
obtaining any capital relief from
the
securitisations.
Therefore, the capital relief that can be
achieved will correspond to the
amount
of credit risk that is effectively transferred.
The following includes a set of
examples
where
supervisors may have concerns about the degree
of risk transfer, such as retaining
or
repurchasing
significant amounts of risk or “cherry picking”
the exposures to be transferred
via
a securitisation.
787.
Retaining or repurchasing significant
securitisation exposures, depending on
the
proportion
of risk held by the originator, might undermine
the intent of a securitisation
to
transfer
credit risk. Specifically, supervisory
authorities might expect that a significant
portion of the credit risk and of the nominal
value of the pool be transferred to at least
one
independent
third party at inception and on an ongoing
basis.
Where
banks repurchase risk for market making
purposes, supervisors could find it appropriate
for an originator to buy part of a transaction
but not, for example, to repurchase a whole
tranche. Supervisors would expect that where
positions have been bought for market making
purposes, these positions should be resold
within an appropriate period, thereby remaining
true to the initial intention to transfer
risk.
788.
Another implication of realising only a
non-significant risk transfer, especially
if
related
to good quality unrated exposures, is that both
the poorer quality unrated assets
and
most
of the credit risk embedded in the exposures
underlying the securitised transaction
are
likely
to remain with the originator.
Accordingly,
and depending on the outcome of the supervisory
review process, the supervisory authority may
increase the capital requirement for particular
exposures or even increase the overall level of
capital the bank is required to
hold.
B.
Market
innovations
789.
As the minimum capital requirements for
securitisation may not be able to
address
all
potential issues, supervisory authorities are
expected to consider new features
of
securitisation
transactions as they arise. Such assessments
would include reviewing the
impact
new features may have on credit risk transfer
and, where appropriate, supervisors
will
be
expected to take appropriate action under Pillar
2. A Pillar 1 response may be
formulated
to
take account of market innovations. Such a
response may take the form of a set
of
operational
requirements and/or a specific capital
treatment.
C. Provision of
implicit support
790.
Support to a transaction, whether contractual
(i.e. credit enhancements provided
at
the
inception of a securitised transaction) or
non-contractual (implicit support) can
take
numerous
forms.
For
instance, contractual support can include over
collateralisation, credit derivatives, spread
accounts, contractual recourse obligations,
subordinated notes, credit risk mitigants
provided to a specific tranche, the
subordination of fee or interest income or the
deferral of margin income, and clean-up calls
that exceed 10 percent of the initial
issuance.
Examples
of implicit support include the purchase of
deteriorating credit risk exposures from the
underlying pool, the sale of discounted credit
risk exposures into the pool of securitised
credit risk exposures, the purchase of
underlying exposures at above market price or an
increase in the first loss position according to
the deterioration of the underlying
exposures.
791.
The provision of implicit (or non-contractual)
support, as opposed to
contractual
credit
support (i.e. credit enhancements), raises
significant supervisory concerns.
For
traditional
securitisation structures the provision of
implicit support undermines the
clean
break
criteria, which when satisfied would allow banks
to exclude the securitised assets
from
regulatory
capital calculations.
For
synthetic securitisation structures, it negates
the significance of risk transference. By
providing implicit support, banks signal to the
market that the risk is still with the bank and
has not in effect been transferred. The
institution’s capital calculation therefore
understates the true risk. Accordingly, national
supervisors are expected to take appropriate
action when a banking organisation provides
implicit support.
792.
When a bank has been found to provide implicit
support to a securitisation, it will
be
required
to hold capital against all of the underlying
exposures associated with the
structure
as
if they had not been securitised. It will also
be required to disclose publicly that it
was
found
to have provided non-contractual support, as
well as the resulting increase in
the
capital
charge (as noted above). The aim is to require
banks to hold capital against
exposures
for which they assume the credit risk, and to
discourage them from providing noncontractual
support.
793.
If a bank is found to have provided implicit
support on more than one occasion,
the
bank
is required to disclose its transgression
publicly and national supervisors will
take
appropriate
action that may include, but is not limited to,
one or more of the following:
•
The
bank may be prevented from gaining favourable
capital treatment on
securitised
assets
for a period of time to be determined by the
national supervisor;
•
The
bank may be required to hold capital against all
securitised assets as
though
the
bank had created a commitment to them, by
applying a conversion factor to
the
risk
weight of the underlying
assets;
•
For
purposes of capital calculations, the bank may
be required to treat all
securitised
assets
as if they remained on the balance
sheet;
•
The
bank may be required by its national supervisory
authority to hold
regulatory
capital
in excess of the minimum risk-based capital
ratios.
794.
Supervisors will be vigilant in determining
implicit support and will take
appropriate
supervisory
action to mitigate the effects. Pending any
investigation, the bank may be
prohibited
from any capital relief for planned
securitisation transactions
(moratorium).
National
supervisory response will be aimed at changing
the bank’s behaviour with regard
to
the
provision of implicit support, and to correct
market perception as to the willingness of
the
bank
to provide future recourse beyond contractual
obligations.
D.
Residual
risks
795.
As with credit risk mitigation techniques more
generally, supervisors will review
the
appropriateness
of banks’ approaches to the recognition of
credit protection. In
particular,
with
regard to securitisations, supervisors will
review the appropriateness of
protection
recognised
against first loss credit enhancements.
On
these positions, expected loss is less likely to
be a significant element of the risk and is
likely to be retained by the protection buyer
through the pricing. Therefore, supervisors will
expect banks’ policies to take account of this
in determining their economic capital. Where
supervisors do not consider the approach to
protection recognised is adequate, they will
take appropriate action. Such action may include
increasing the capital requirement against a
particular transaction or class of
transactions.
E. Call
provisions
796.
Supervisors expect a bank not to make use of
clauses that entitles it to call
the
securitisation
transaction or the coverage of credit protection
prematurely if this would
increase
the bank’s exposure to losses or deterioration
in the credit quality of the
underlying
exposures.
797.
Besides the general principle stated above,
supervisors expect banks to
only
execute
clean-up calls for economic business purposes,
such as when the cost of
servicing
the
outstanding credit exposures exceeds the
benefits of servicing the underlying
credit
exposures.
798.
Subject to national discretion, supervisory
authorities may require a review prior
to
the
bank exercising a call which can be expected to
include consideration of:
•
The
rationale for the bank’s decision to exercise
the call; and
•
The
impact of the exercise of the call on the bank’s
regulatory capital
ratio.
799.
The supervisory authority may also require the
bank to enter into a follow-up
transaction,
if necessary, depending on the bank’s overall
risk profile, and existing
market
conditions.
800.
Date related calls should be set at a date no
earlier than the duration or
the
weighted
average life of the underlying securitisation
exposures. Accordingly,
supervisory
authorities
may require a minimum period to elapse before
the first possible call date can
be
set,
given, for instance, the existence of up-front
sunk costs of a capital market
securitisation
transaction.
F. Early
amortisation
801.
Supervisors should review how banks internally
measure, monitor, and manage
risks
associated with securitisations of revolving
credit facilities, including an assessment
of
the
risk and likelihood of early amortisation of
such transactions.
At
a minimum, supervisors should ensure that banks
have implemented reasonable methods for
allocating economic capital against the economic
substance of the credit risk arising from
revolving securitisations and should expect
banks to have adequate capital and liquidity
contingency plans that evaluate the probability
of an early amortisation occurring and address
the implications of both scheduled and early
amortisation.
In
addition, the capital contingency plan should
address the possibility that the bank will face
higher levels of required capital under the
early amortisation Pillar 1 capital
requirement.
802.
Because most early amortisation triggers are
tied to excess spread levels,
the
factors
affecting these levels should be well
understood, monitored, and managed, to
the
extent
possible (see paragraphs 790 to 794 on implicit
support), by the originating bank.
For
example, the following factors affecting excess
spread should generally be
considered:
•
Interest payments
made by borrowers on the underlying receivable
balances;
•
Other
fees and charges to be paid by the underlying
obligors (e.g. late-payment
fees,
cash advance fees, over-limit
fees);
•
Gross
charge-offs;
•
Principal
payments;
•
Recoveries on
charged-off loans;
•
Interchange
income;
•
Interest paid on
investors’
certificates;
•
Macroeconomic factors
such as bankruptcy rates, interest rate
movements,
unemployment
rates; etc.
803.
Banks should consider the effects that changes
in portfolio management or
business
strategies
may have on the levels of excess spread and on
the likelihood of an early
amortisation
event. For example, marketing strategies or
underwriting changes that result
in
lower
finance charges or higher charge-offs, might
also lower excess spread levels
and
increase
the likelihood of an early amortisation
event.
804.
Banks should use techniques such as static pool
cash collections analyses and
stress
tests to better understand pool performance.
These techniques can highlight
adverse
trends
or potential adverse impacts. Banks should have
policies in place to respond
promptly
to
adverse or unanticipated changes. Supervisors
will take appropriate action where they
do
not
consider these policies adequate. Such action
may include, but is not limited to,
directing
a
bank to obtain a dedicated liquidity line or
raising the early amortisation credit
conversion
factor,
thus, increasing the bank’s capital
requirements.
805.
While the early amortisation capital charge
described in Pillar 1 is meant to
address
potential
supervisory concerns associated with an early
amortisation event, such as the
inability
of excess spread to cover potential losses, the
policies and monitoring described
in
this
section recognise that a given level of excess
spread is not, by itself, a perfect proxy
for
credit
performance of the underlying pool of exposures.
In
some circumstances, for example, excess spread
levels may decline so rapidly as to not provide
a timely indicator of underlying credit
deterioration. Further, excess spread levels may
reside far above trigger levels, but still
exhibit a high degree of volatility which could
warrant supervisory attention.
In
addition, excess spread levels can fluctuate for
reasons unrelated to underlying credit risk,
such as a mismatch in the rate at which finance
charges reprice relative to investor certificate
rates.
Routine
fluctuations of excess spread might not generate
supervisory concerns, even when
they
result in different capital requirements. This
is particularly the case as a bank moves
in
or
out of the first step of the early amortisation
credit conversion factors. On the other
hand,
existing
excess spread levels may be maintained by adding
(or designating) an increasing
number
of new accounts to the master trust, an action
that would tend to mask
potential
deterioration
in a portfolio.
For
all of these reasons, supervisors will place
particular emphasis on internal management,
controls, and risk monitoring activities with
respect to securitisations with early
amortisation features.
806.
Supervisors expect that the sophistication of a
bank’s system in monitoring the
likelihood
and risks of an early amortisation event will be
commensurate with the size and
complexity
of the bank’s securitisation activities that
involve early amortisation
provisions.
807.
For controlled amortisations specifically,
supervisors may also review the process
by
which
a bank determines the minimum amortisation
period required to pay down 90% of
the
outstanding
balance at the point of early amortisation.
Where a supervisor does not
consider
this
adequate it will take appropriate action, such
as increasing the conversion
factor
associated
with a particular transaction or class of
transactions.
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