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BSP Unveils Basel II Implementing Guidelines

08.09.2006

The Monetary Board approved on 2 June 2006 major revisions to the  risk-based capital adequacy framework which will take effect on 1 July 2007, to align the existing Basel I-compliant framework with the new Basel II standards.  As approved, the MB decided to maintain the present minimum overall capital adequacy ratio (CAR) of banks and quasi-banks at 10 percent.  However, consistent with Basel II recommendations, the MB approved major methodological revisions to the calculation of minimum capital that universal banks, commercial banks and their subsidiary banks and quasi-banks should hold against actual credit risk exposures.  This significantly amends BSP Circular No. 280 dated 29 March 2001 (for banks) and BSP Circular No. 400 dated 1 September 2003 (for quasi-banks).  Stand-alone thrift banks, rural banks and quasi-banks will, however, continue to be covered by existing regulations (i.e., Circular Nos. 280 and 400) insofar as credit risk measurement is concerned.

The guidelines for allocating minimum capital to cover market risk (BSP Circular No. 360 dated 3 December 2002) is also being amended to some extent, primarily to align specific market risk charges on trading book assets with the revised credit risk exposure guidelines.

A completely new feature is the introduction of bank capital charge for operational risk.  The required disclosures to the public of bank capital structure and risk exposures are also enhanced to promote greater market discipline in line with the so-called Pillar 3 of the Basel II recommendations.

Governor Amando M. Tetangco, Jr. said:  “The Monetary Board’s early approval of the implementing guidelines for Basel II underscores our commitment to deep and far-reaching banking reforms to strengthen the banking industry.  It also reflects our basic confidence in the fundamental soundness and ability of the industry to make the necessary adjustments to be fully compliant with international standards.  Necessarily, the implementing guidelines have been tailor-fitted to Philippine conditions including pragmatic timing of adjustments.  However, we have not compromised on the substance of reforms.  We fully realize that Basel II changes in a fundamental way how our banks operate in the future and, in turn, how we supervise them as a regulator.  We urge our banks to step up to the challenge and take a proactive stance of building genuinely robust and enduring financial institutions rather than just looking at the reforms as a compliance issue.”


Historical backgrounder - a confluence of events

Basel II implementation in the Philippines results from a confluence of events, both within and outside of the country.  It all started in 1995 when the BSP recognized the greater risk exposure in the system brought about by derivatives activities of banks.  To mitigate this, the BSP issued Circular No. 102 dated 29 December 1995, prescribing the minimum standards for risk management of derivatives.  This was the first BSP regulation that specifically focused on banks’ risk taking activities and risk management practices.  This was bolstered in 1997 when BSP shifted its banking supervision thrust to focus more on the measurement and management of banks’ risk exposures, instead of just mainly performing financial audit and compliance review.  The BSP’s efforts to focus on risk management are intended to give banks greater flexibility to respond to changing opportunities under a more deregulated environment and at a time of rapid technological advances.

The BSP’s new supervisory approach favors a supervisory assessment of the quality of risk management practices and generally allows banks to take risks so long as the banks demonstrate the ability to manage, absorb and price for those risks, in contrast to the traditional approach that cautioned banks against taking on risks that seem too high.  In carefully loosening the regulatory grip on banks’ risk-taking activities, the BSP must necessarily underscore the responsibility of the banks’ board of directors and senior management to ensure the soundness and stability of their respective banks.  BSP’s role is primarily to evaluate the quality of oversight and management provided by these parties, i.e., the quality of corporate governance.  Thus, strengthening banks’ corporate governance has been the theme of a number of BSP regulations.  These include regulations on fit and proper rule for bank directors and officers, director education program, compliance function, interlocking positions, DOSRI rules, etc.

Loosening the regulatory grip on banks’ risk-taking activities also entails that the BSP has to ensure that banks have sufficient buffer whenever these risks turn into losses.  This buffer comes in the form of capital which protects a bank from earnings volatility.  Ideally therefore, the more risks a bank takes (i.e., the more potential for earnings volatility) the more capital it should hold.  However, capital is viewed as generally more costly than other sources of funding.  Hence, banks may try to economize on capital that is not commensurate to the risks that they take.  This is the reason why bank supervisors, including the BSP, impose minimum capital regulations.

While all these things were happening in the Philippines, the Basel Committee on Banking Supervision (BCBS 1 ) in the mid-80s saw the need to align regulatory capital regulations across countries so as to have comparable measurement of financial strength especially for banks that operate across jurisdictions.  Thus in 1988 the BCBS issued the original “International Convergence of Capital Measurement and Capital Standards”, now known as Basel I.  Basel I was the first international supervisory effort to relate capital requirements to, initially, credit risk.  In 1996, the BCBS issued an amendment to the Basel Capital Accord to incorporate capital requirements for market risk.


BSP’s Basel I implementation

The BSP would have wanted to adopt earlier the provisions of the Basel Capital Accord since this was aligned with its goal of strengthening its capital regulations as a complement to the shift in its supervisory approach.  However, the lack of enabling law then restricted the BSP from doing so.  This was solved, however, with the enactment of the General Banking Law in 2000.  Thus, in 2001 the BSP issued Circular No. 280 which served as the implementing guidelines for Basel Capital Accord in the Philippines.  This was followed in 2002 with the issuance of Circular No. 360 which adopted the 1996 amendments for market risk.   


Why revise Basel I?

Despite Basel I’s attempt to make capital requirements at least somewhat risk-based, the main criticism of Basel I is that the assignment of risk weights is rather crude and not based on any measurement, whether quantitative or qualitative, of probability of default.  For example, all corporate loans – whether loans to a blue-chip company or to a fledgling enterprise – are all given a risk weight of 100%.  In addition, Basel I only accounts for credit risk (albeit crudely) and market risk but not other forms of risk that may also be important.  It is for these reasons that calls had arisen to revise Basel I.  Hence, the Basel II proposals were born in 1999.


Basel II

Basel II is a set of proposals that aim to revise Basel I to make regulatory capital requirements more risk sensitive and reflective of all, or at least most of the risks banks are exposed to.  In addition, Basel II also puts emphasis on banks’ own risk assessment, supervisory review, and the important role that disclosures play.  As such, Basel II is structured as a three-pillar approach that transcends regulatory capital requirements.  That is, Basel II not only prescribes a risk-based capital framework, but an entire risk-based supervisory framework.

Basel II’s three pillars are: (1) minimum capital requirements; (2) supervisory review process; and (3) market discipline.  These three pillars are based on the principles that (1) banks should have capital appropriate for their risk-taking activities, (2) banks should be able to properly assess the risks they are taking and supervisors should be able to evaluate the soundness of these assessments, and (3) banks should be disclosing pertinent information necessary to enable market mechanism to complement the supervisory oversight function. 


Monetary Board-approved guidelines

Below are the changes to BSP’s risk-based capital regulations to align with Basel II, as approved by the Monetary Board:

Pillar 1

On minimum capital requirements, major changes in the revised framework include the addition of specific capital requirements for credit derivatives, securitization exposures, counterparty risk in the trading book, and operational risk.

The capital requirement for credit derivatives is an extension of Circular No. 417 dated 28 January 2004, which covers only investments in credit-linked notes.  The revised framework now covers all exposures to credit-linked notes (protection buyer and protection seller), as well as other credit derivatives, such as credit default swaps and total return swaps.  The same thing is also true for the capital requirement for securitization exposures.  The revised framework extends the coverage of Circular No. 468 dated 12 January 2005 to include capital requirements not only for investments in securitization but also other securitization exposures, such as retained interest of originators, liquidity facilities, etc.  The capital requirement for counterparty risk in the trading book, on the other hand, is a new element in the revised framework especially for repo transactions and structured products booked in the trading book. 

Operational risk capital requirement, meanwhile, is a totally new element in the revised framework. For this purpose, the Monetary Board approved a uniform basic charge of 15 percent of gross income as the simplest option.  However, banks that are able to disaggregate income by major business lines may avail of differentiated rates depending on the business line.  Of all the changes in the revised framework, operational risk capital requirement is expected to have the most significant impact on banks’ overall capital requirements.

Another major change that deserves special mention is the imposition of a capital requirement on foreign currency denominated credit exposures to the Philippine National Government.  This is best exemplified by the so-called “ROPs”.  The absence in the past of any capital requirement for these high-yield exposures has distorted market incentives, and has led to a rapid accumulation of investments in “ROPs” by banks.  This stance is aligned with what has been adopted by other Asian regulators such as those in Indonesia, Thailand and Malaysia, which have already signified their plan to link the applicable capital requirement for their banks’ foreign currency denominated exposures to their respective sovereigns with the sovereigns’ external credit risk ratings.  The adoption of this capital requirement in the Philippines, however, will be on a staggered basis in order to minimize any possible market disruption.  Only one-third of the applicable capital charge will be required for such exposures starting 1 July 2007, two-thirds starting 1 January 2008, and the full capital charge starting 1 January 2009.  This corresponds to an initial capital charge of 3.33 percent of book value, increasing to 6.66 percent by 1 January 2008, and the full 10 percent by 1 January 2009.  This is based on the present “BB-“ sovereign credit rating of the Philippines.  The capital charge may actually decline in the event the Philippines achieves investment grade status in the future.  Meanwhile, peso-denominated government securities will continue to be zero-risk weighted.

Other significant changes in the revised framework include the more granular mapping of external credit risk ratings to capital requirements, recognition of more types of financial collateral and guarantees for purposes of mitigating the credit risk exposures of banks, and the higher capital requirement for real and other properties acquired (ROPA). 

Pillar 2

Although not formally covered in the guidelines approved by the Monetary Board, BSP’s implementation of the supervisory review process has started with the gradual shift to risk-based supervision initiated in 1997.  Today, the BSP has embarked on an active capacity-building program to train supervisory personnel in risk-based supervision to better equip them to meet the demands of Basel II. 

One of the principles underlying Pillar 2 of Basel II states that supervisors should intervene at an early stage to prevent capital from falling below the minimum levels and should require rapid remedial action if capital is not maintained or restored.  To satisfy this principle, the BSP issued Circular No. 523 dated 23 March 2006, effectively overhauling BSP’s prompt corrective action framework to meet Basel II standards.


Pillar 3

On market discipline, one of the changes in the revised framework approved by the Monetary Board is the expanded list of items that banks need to disclose in their Annual Reports and in their quarterly published statement of condition.

This expanded list of disclosure requirements is aimed to support existing disclosure regulations.  It is also aimed to empower the market so it can reward banks that manage risk effectively and penalize those whose risk management is imprudent.

The expanded disclosure requirements relate to banks’ (a) capital structure and adequacy, and (b) risk management policies and processes and risk exposures, specifically on credit risk, market risk, operational risk, and interest rate risk in the banking book.

Parallel run

To test the likely impact of Basel II implementation in the Philippines prior to implementation on 1 July 2007, covered banks shall be required to conduct a parallel run of the existing and the revised frameworks starting later this year until the second quarter of 2007.  The parallel run is also aimed at preparing banks for the actual implementation of the revised framework, as well as providing an opportunity to fine-tune the revised framework as operational realities may warrant.

Glossary of Terms

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1 BCBS is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. It usually meets at the Bank for International Settlements in Basel, Switzerland where its permanent Secretariat is located. is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975.  It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States.  It usually meets at the Bank for International Settlements in Basel, Switzerland where its permanent Secretariat is located.

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