Demystifying Basel II and bank risk management

Daily News Egypt
7 Min Read

We have all heard about — and probably even been impacted by — the economic crisis and the bank failures around the world that caused it. Many of us have wondered how this could happen and how a recurrence can be prevented in the future. This is important to us as we trust banks to safeguard our deposits and provide services that enable us to use money to go about our daily lives. The simple answer to our concerns is that safe practices, good management, and investment in running banking systems are in all of our interests.

What should be happening to ensure the safety of our money and the economy? A key issue that requires attention is risk management, where banks should invest in their processes, skills and information systems. These steps will assist in promoting greater understanding of the potential factors that can go wrong and lead to losses — and implementing them enables banks to conduct more accurate risk assessments while helping them to protect themselves from unexpected adverse scenarios.

However, not all banks place a high enough value on investing in risk management — after all, it is often expensive and complex, and doesn’t necessarily lead to profits in the short term. Despite having seen widespread bank failures, there may still be some complacency and a feeling that, well, we know what we’re doing and it won’t happen to us.

After the crisis, bank regulators and governments in most parts of the world want to strengthen the rules to minimize the chances of a repeat experience. The main global guidelines for bank risk management come from a document called Basel II. Most bankers will be familiar with the term Basel, but for readers who are not — yes, Basel is the name of a nice town in Switzerland. It is also the location of the Bank for International Settlements (BIS), which has as a key objective the promotion of global monetary and financial stability. The BIS provides guidelines for central banks and regulators, who often base their countries’ banking regulations on this guidance.

The Basel Accord of 1988 was the first step towards establishing international guidelines for a consistent measure of banks’ capital adequacy. The ultimate objective of capital adequacy is to ensure that banks hold sufficient capital to support the risks they undertake and, thus, reduce the chances of bank failure.

This first accord established a measure of credit risk (the risk of losses from unexpected loan losses) and set a capital adequacy ratio of 8 percent. That is to say, banks had to set aside LE 8 of capital for every LE 100 of credit risk. It was always understood that there are further risks in banking and that good risk management involves more than just a bank’s capital adequacy ratio. This understanding gathered momentum in the late 1990’s and the process to design the first major upgrade of the accord commenced.

In 2006, after much consultation, Basel II was finalized. This accord introduced broader measures of risk and, importantly, required banks to demonstrate that they have sound risk management practices in place. In addition, Basel II outlined specific responsibilities for bank boards and executives, and mandated greater public disclosure of banks’ risks.

The upgraded accord makes it clear that the responsibility for the implementation of sound risk management practices and controls starts with the board and executive of a bank. Under Basel II, banks also need to analyze their situations and demonstrate to regulators both that they have enough capital to support future business and that they can withstand periods of stressful market conditions.

Regulators were also instructed to take action if they were not satisfied with a bank’s condition, including moves such as requiring an increase in a bank’s capital (or for it not to pay dividends), restricting business and demanding improvements in risk management.

Before the crisis many banks had not actually taken action to critically examine their capabilities and to improve the areas where they were deficient. Some saw doing so as just a regulatory compliance exercise that cost money, assuming that they already managed risk well or could access funds at any time. I encountered these attitudes while directing a Basel II program in a large commercial bank, as well as working as a banking risk consultant.

Regulators, too, have come under scrutiny in many countries. Some have been criticized for not being rigorous in their bank examinations, not having sufficient resources and for not upgrading their regulations quickly enough.

And now the Basel guidelines have been strengthened once again. The upgrade has not officially been called Basel III, but the BIS released new recommendations at the end of 2009 to further improve the Basel II framework. These are aimed at strengthening the definition of capital and providing stronger conditions for managing liquidity, closing holes that allowed some activities to avoid regulation and more rigorous stress testing.

These enhancements, however, do not change the fundamental concepts of banking, such as knowing your risks well, providing high quality capital and liquidity, and implementing sound risk management practices. These steps are not a guarantee against future bank failures, but if all stakeholders apply the practices properly it should help reduce the chances of their occurrence.

Cameron Evans is a Principal Financial Officer at the International Finance Corporation in the Client Risk Advisory and Economic Capital business line. He is based in Cairo and covers Africa and the Middle East. He has over 20 years experience in the areas of treasury, capital and risk management as a banker and as a consultant. This article was written exclusively for Daily News Egypt.

The findings, interpretations and conclusions expressed in this article are the author’s own and do not necessarily reflect the views of IFC, a member of the World Bank Group.

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