Practical Implications of Regulatory Convergence – Lessons from Basel II Mary Frances Monroe Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System Presentation to CPCU Society Symposium Boston, Massachusetts June 11, 2005

Practical Implications of Regulatory Convergence –Goals of Basel II Goals of Basel II:  Greater risk sensitivity – reliance on a bank’s internal assessments of capital adequacy  Suitability – reflect and support sound credit risk management practices  Incentive Compatibility – improve internal risk management practices and adapt to evolving markets and products  Competitive Equity – promote and enhance a level playing field across international boundaries

Practical Implications of Regulatory Convergence –Goals of Basel II Goals of Basel II (continued):  Safety and Soundness – ensure consistency with fundamental banking principles  Balance – attempts a reasonable trade-off between enhanced risk sensitivity and implementation burden  Non-cyclicality – capital charges should be relatively stable over the economic cycle  Aggregate capital level – roughly maintain the current amount of capital in the banking system

Practical Implications of Regulatory Convergence –Overview of Basel II Structure of Basel II:  Pillar I Minimum Capital Requirements Credit Risk, Operational Risk, and Trading Book components  Importance of Qualifying Criteria for Advanced Approaches  Importance of Corporate Governance Structure  Importance of Validation

Practical Implications of Regulatory Convergence –Overview of Basel II (continued) Structure of Basel II:  Pillar II Supervisory Review: Focus on risks not fully captured in Pillar 1, factors not taken into account under Pillar 1, and external factors Four key principles  Pillar III Market Discipline/Disclosure: Materiality Frequency

Practical Implications of Regulatory Convergence – Lessons from Basel II Need to balance convergence with flexibility Basel II goal of convergence of regulatory capital standards and measurement  Reality is different national markets  Necessitates degree of national discretion in implementation Accord Implementation Group established to promote consistency in application of Basel II, especially where national discretion exists  Address cross-border home-host issues  Case studies have been conducted

Practical Implications of Regulatory Convergence – Lessons from Basel II Importance of Stress Testing and Scenario Analysis  Regulatory minimums are only a starting point  Models are imperfect Models may not capture all material risks Model assumptions/parameters may understate degree of risk Models may be based on backward-looking data  Taking stress conditions and scenarios into account involves both quantitative analysis and qualitative judgment with an enterprise- wide view

Practical Implications of Regulatory Convergence – Lessons from Basel II Need to supplement risk-based capital standards with other supervisory tools  Importance of leverage ratio  Need for mechanism for early intervention For U.S. banks, this is accomplished through prompt corrective action Ability of bank to engage in certain activities or expand operations is constrained if cushion above minimum capital standards is not maintained or bank is deemed to have engaged in unsafe and unsound practices

Practical Implications of Regulatory Convergence – Lessons from Basel II Importance of Enterprise-wide Risk Management  Risks transcend legal entity/line of business/functional boundaries  Need to consider impact of business line activities and risk-taking decisions on other parts of the organization  Consolidated supervisor must assess impact of different prudential supervision frameworks  Federal Reserve supervision has moved from historical analysis on legal entity basis to more forward-looking assessments of risk management and financial condition of consolidated organization

Practical Implications of Regulatory Convergence – Lessons from Basel II Importance of quantitative impact studies  QIS 4: U.S. regulators are faced with lower than expected capital levels and broad divergence across firms  Data limitations give rise to need to balance quantitative and qualitative approaches and rely more on the latter in the short term  Loss data collection exercise for operational risk indicates more robust operational risk data collection and increasingly sophisticated approaches to measuring risk

Practical Implications of Regulatory Convergence –Beyond Basel II Joint Basel/IOSCO Working Group on Trading Activities and Double Default  New option for treatment of counterparty credit risk  Limited recognition of double default  Improvements to the trading book capital regime Boundary between firms’ banking and trading books Prudent valuation guidance Capturing full range of risks of traded positions  Consistent approach to unsettled and failed trades

Practical Implications of Regulatory Convergence –Beyond Basel II Joint Forum Working Group on Liquidity Risk  Involves banking, securities, and insurance sectors  Focus: promotion of financial stability  Developing paper for publication later this year along three workstreams: Trends in liquidity risk management and supervision Stress testing and contingency funding plans Sources of liquidity risk (especially in stress environments)