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Strong Corporate Governance - Banks' Passport to Basel 2

Date: 07.21.2004

Place: Shangri-La Hotel, Makati City

Occasion: General Membership Meeting Banker's Institute of the Philippines

Speaker: Governor Rafael Buenaventura

Ladies and gentlemen, good afternoon.

I am very pleased to be here this afternoon to speak before the officers and members of the Bankers Institute of the Philippines, inc. (BAIPHIL).  In line with your theme, I would like to talk this afternoon on the close relationship between corporate governance and Basel 2 compliance.  By the way, Basel 2 was formally unveiled last June 26 after an extended period of development and consultations.

Basel 2 has potentially major implication for the banking industry and on how banking supervision is done.  Our progress towards meeting its expectations is viewed by the BSP as a journey which the Philippine banking system will soon embark. But before presenting you with our latest itinerary, let me first describe to you, as a background, the initial preparatory journey we had already taken. 

The initial journey

In 1995, the BSP recognized the greater risk exposure in the system brought about by derivatives activities. To mitigate this, the BSP issued Circular No. 102 prescribing the minimum standards for risk management of derivatives.  This was probably the first BSP regulation that specifically focused on banks’ risk taking activities and risk management practices.

In 1997, the thrust of bank supervision started to shift its focus to measurement of banks’ risk-exposures and to how banks manage risks, instead of just mainly performing financial audit and compliance review.

In March 2001, the BSP adopted the original Basel 1 framework through Circular No. 280. This Circular provided the guidelines for the computation of risk-based capital for credit risk. The BSP’s risk-based capital adequacy framework was further enhanced with the issuance of Circular No. 360 in December 2002.  Circular No. 360 incorporated market risk into the risk-based capital framework.

The BSP’s effort to focus on risk management is really ultimately intended to give banks greater flexibility to respond to changing opportunities under a more deregulated environment and at a time of rapid technological advances.

Traditional bank supervision tended to instruct banks to avoid risks that seem too high.    The new approach to supervision favors 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 and price for those risks.

In carefully loosening the regulatory grip on banks’ risk-taking activities in order to give them more elbow room for success, 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. The regulators’ role is primarily to evaluate the quality of oversight and management provided by these parties – that is, the quality of corporate governance.

Strengthening banks’ corporate governance has been the theme of a number of BSP regulations. In June 1997, Circular No. 130 requiring the Board of Directors of banks to, among others, adopt and maintain adequate risk management policy was issued.  A few months after, or in October 1997, the BSP also issued Circular No. 145 requiring banks to develop and implement a compliance system and to appoint/designate a compliance officer to oversee its implementation. In September 2001, the BSP issued Circular No. 296 which implemented the fit and proper standards for directors and officers of banks and non-banks. The same circular also prescribed a mandatory orientation program on corporate governance for banks’ board of directors. Moreover, the BSP issued in October 2003 Circular No. 410 which provided the accreditation guidelines for banks’ external auditors.

This year, the BSP has continued to issue a number of guidelines that aimed to further enhance governance practices in banks.  In January, the BSP issued the guidelines for the management of banks’ large exposures (Circular No. 414).  Last March, the BSP has strengthened the DOSRI rules by expanding the definition of related interests (Circular No. 423).    In may, the BSP issued Circular No. 429 which aimed to further strengthen banks’ compliance function.  Finally, just a couple of weeks ago, the BSP issued the guidelines for the development and implementation of banks’ internal credit risk rating systems (Circular No. 439). The guidelines emphasize the oversight function of the board of directors over these systems.

We have already traveled quite a distance. Our productive initial journey us the confidence to embark on an even more challenging journey – Basel 2.    Strong corporate governance will be banks’ passport to be able to join and even enjoy the ride. 

The next journey

So what is Basel 2?

Basel 2 is a set of proposals that aim to revise Basel 1 to make regulatory capital more risk sensitive and reflective of all, or at least most of the risks banks are exposed to.

As such, Basel 2 is structured as a three-pronged approach that transcends regulatory capital requirements. That is, Basel 2 not only presents us a risk-based capital framework, but an entire risk-based supervisory framework. The three pillars of Basel 2 are (1) minimum capital requirements (pillar 1), (2) supervisory review process (pillar 2), and (3) market discipline (pillar 3).

Pillar 1 sets out the detailed guidelines for computing regulatory capital for credit risk, market risk, and operational risk.

Major changes are introduced with respect to credit risk. Basel 2 presents three options: the Standardized Approach, the Foundation Internal Ratings Based Approach, and the advanced Internal Ratings Based (IRB) approach. The standardized approach assigns risk weights applicable to sovereign, bank, corporate, and retail exposures. Depending on the external credit risk ratings. The foundation IRB approach, on the other hand, allows banks to use their internal ratings assessment to determine the appropriate capital charge of their exposures. The advanced IRB approach is very similar to the foundation IRB.  The only difference is that under the advanced IRB, banks are allowed even greater discretion in using their internal ratings model to calculate capital requirements.

Capital treatment for market risk as currently implemented through Circular No. 360, remains generally unchanged except for some minor changes in the standardized computation of specific risk charges. Whereas, specific risk weights in the current market risk framework depend on the type of issuer, Basel 2 requires that these now depend on the external ratings of the issue to be consistent with the credit risk standardized approach.

An explicit change for operational risk is a new element. Basel 2 presents three options: the basic indicator approach, the standardized approach, and the advanced measurement approaches. Under the basic indicator approach, a bank’s operational risk charge is computed as a fraction of its gross income. Under the standardized approach, banks operations are divided into specific business lines. Operational risk charge for each business line is determined as a fraction of gross income attributed to each line. Lastly, operational risk charge under the advanced measurement approaches would depend on statistics-based advanced measurement models developed by banks themselves or by outside vendors.

Pillar 2 of Basel 2, on the other hand, prescribes sound principles that should be followed in the process of supervisory review.  It works on the principle that banks can take on risk, but the board of directors and senior management should be responsible to assess the appropriate capital requirement in relation to its risk exposures, including exposures to risks not captured in pillar 1. Banks therefore will be asked to present to the supervisory body their internal capital allocation process. Again, this is where strong corporate governance comes into play    supervisors are then expected to be able to evaluate the process by which banks came up with their “appropriate” capital measures in order to intervene at an early stage before capital goes below what is prudently acceptable.

Pillar 3 of Basel 2, meanwhile, proposes an extensive list of bank disclosure requirements.  It recognizes that markets contain disciplinary mechanisms that can reinforce the efforts of supervisors by rewarding banks that manage risk effectively and penalizing those whose risk management is inept or imprudent. Pillar 3, therefore, is envisaged to result in well-founded counter-party risk assessments. In addition, pillar 3 is also envisaged to support efforts to foster strong corporate governance within banks.

In summary, Basel 2 is 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 risk it is 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. 

Checking out where we are going

I am assuming that we have all packed our “bags”.  However, we cannot just go rushing into the unknown. Checking out the local conditions in one’s destination is a must for all travelers.  Thus, the BSP conducted a Quantitative Impact Study (QIS) in late 2002 until early 2003 with six (6) of our largest banks. The QIS was aimed to simulate the likely changes in banks’ capital requirements once Basel 2 is adopted.  Let me highlight to the group the important findings of the study:

(1) The sample banks had an average increase in risk-weighted assets (RWA) of 25%, translating to an average 200 basis points reduction in the capital adequacy ratio (CAR) as currently measured; and

(2) Of the 25% increase in RWA, 8% was contributed by credit risk, while the remaining 17% came from the introduction of operational risk charge.

It is apparent from the results that banks’ capital requirements will surely increase with the adoption of Basel 2 since it already covers more risk types. However, given the latest capital adequacy ratio for the entire banking system of 17.8 percent, there is some buffer available, at least on average.  A more positive way of looking at things is that Basel 2 will present our banks with more opportunity to lower their capital charges, if they have the appropriate risk management systems in place. 

The itinerary

Now for our itinerary: where do we intend to go and when.

The BSP has now lined up certain projects that aim to set standards with regard to (1) the computation of banks’ capital requirements, (2) banks’ risk assessment and management, and (3) banks’ disclosures. These projects involve studying the applicability of certain Basel 2 prescribed risk weights and disclosure requirements to local conditions.  The output of the projects will be a comprehensive set of guidelines for banks. Such guidelines will be released not later than end-2006, for implementation in 2007.

Universal/commercial banks are expected to implement the standardized approaches of Basel 2 by 2007 in line with the recommended international timetable.  As a general rule, however, banks are not expected to be in a position to implement the more advanced IRB approaches until perhaps 2010. This is because it would take a minimum of 5 years of data to estimate default probabilities based on banks’ internal rating systems. As mentioned, the BSP just recently issued Circular No. 439 which adopts the Basel 2 prescribed minimum standards for such systems with respect to credit risk.

However, foreign bank branches whose head offices are using the advanced approaches, will be allowed to use them provided that they can show that their models are suited to domestic conditions.

Thrift banks and rural banks, meanwhile, are expected to stay on the existing capital adequacy framework. However, it is the BSP’s goal to make the existing framework a little bit more risk-sensitive, as well as apply pillar 2 and pillar 3 components as warranted.

Speaking of pillar 2, we will continue therefore to push banks to improve their risk management practices and risk assessment capabilities – and this implies pushing for continued improvement in corporate governance. This, of course, goes hand in hand with improving the supervisory tools and resources needed to evaluate such risk assessments.

With regard to pillar 3, appropriate disclosure requirements prescribed under Basel 2 is targeted by 2007.

The timeframes mentioned are only indicative at this stage. To be sure, we will be closely coordinating with the banking industry on the specific implementation details prior to promulgation of implementing regulations. 

On with the ride

From what I have just described, it is clear that Basel 2 is a journey that demands a lot from both the supervisors and the banks.

For the supervisors, foremost of our concerns are (1) the need to examine our existing charter to see to it that we have the necessary powers to implement the new capital standards, particularly pillar 2, and (2) the need to ensure that our supervisory personnel are up to the challenge being posed by Basel 2.

For banks, I say the primary challenge is not so much to buy the most sophisticated and the latest risk management technology, as to foster a sound risk-control environment founded on strong corporate governance.

The role of training, from basic principles to the most complex risk management processes, will be critical as never before. BAIPHIL must rapidly gear up to meet the challenges.

Ladies and gentlemen,

Our bags are packed, destination surveyed, and itinerary set.    Thus, let me just wish all of us a rewarding journey.    We will be taking off shortly…fasten your seatbelts and enjoy the ride.

Thank you very much.

(Note: General Membership Meeting, Bankers Institute of the Philippines (BAIPHIL), July 21, 2004, Shangri-La Hotel, Makati City)