Governance Key to Basel III

In November, world leaders will consider yet another round of bank capital regulations aimed at stimulating the economy. Proponents say the so-called “Basel III Framework” will restore consumer confidence by stabilizing the financial system and closing risk-based capital loopholes that allowed banks to hide significant exposure in trading accounts.

Critics, however, warn the effort could actually hurt the economy by reducing money supply at a time when the market is already strapped for cash. Worse, they say it could drive up credit costs, as banks increase fees to offset lost investment income. Some cynics suggest Basel III may be a magician’s trick to direct attention away from the next looming catastrophe: the potential default of “low-risk” sovereign debt — a lending category that would become even more attractive under the proposed rules. Others predict fewer banking choices as banks struggling to meet the tougher standards seek to merge with stronger partners.

Details of the new capital regulations — which would be phased in over the next nine years — are complex, all the more so considering most banks haven’t fully implemented the changes outlined in Basel II. And banks in the United States must contend with the added requirements of the just-passed Dodd-Frank Wall Street Reform and Consumer Protection Act.

Basel III incorporates all of the requirements of Basel II, increasing the Tier I Capital Ratio requirement to 6 percent, from 4 percent and the Core Tier I Capital Ratio (common equity after deductions) to 4.5 percent, from 2 percent, in phases, beginning with 3.5 percent January 2013, with full implementation by January 2015. In addition, the new framework adds several new shock-proofing requirements, including:
  • Capital conservation buffer. Once the Tier I capital requirement has been met, banks will be required to set aside a rainy day fund of an addition 2.5 percent equity cushion to guard against future stress. The phasing of this requirement, which would effectively increase the common equity requirement to 7 percent, would begin in 2016, with full implementation by Jan. 1, 2019.
  • Countercyclical capital buffer. The world banking community’s antidote for “irrational exuberance,” beginning in 2016, Basel III would require banks to maintain an additional capital cushion of up to 2.5 percent to cover the risk of banks overextending themselves in times of prosperity. This requirement also would be fully phased in by the Jan. 1, 2019.
  • Capital for “systematically important” banks only. Bankers might balk at calling this the too-big-to-fail surcharge. But that’s what it is. The Financial Standards Board and the Basel Committee are still working on this part, but the goal is to come up with an integrated solution that would require additional reserves and safeguards from banks deemed to be so large that their failure could send financial markets into a tailspin.
    Banks falling short of the new requirements would be prohibited from paying dividends to shareholders until they raised additional capital. Stress tests, capital risk assessments — it’s all very complicated, which is why regulators are increasingly looking to internal auditors to ensure that systems are in place and that the rules are being followed. And that, perhaps more than anything else, may be the enduring legacy to come from this round of banking reforms. Basel III does not specifically address internal auditing, but the implications are clear.

“The biggest impact of Basel III, Basel II, and Dodd-Frank, is going to be in improving how capital risk is measured and how well your internal audit function works relative to assessing those processes,” says Hugh Kelly, principle and national lead partner in the bank regulatory advisory practice at KPMG. “Regulators expect internal auditing to challenge assumptions and take a more active role in risk management.”

The importance of internal auditing as a so-called “third-line” of defense — after management policy and risk management practice — was outlined in a 2008 white paper, “Bringing Back Best Practices in Risk Management,” published by global management consultants Booz & Company. The report, published in the heat of the global liquidity crunch, has proven to be prescient.

The three-tier governance structure outlined in the report is essentially the same one Kelly says regulators are using as a benchmark for sound banking practices. Specifically:

First line: management. Does top management promote a culture of adhering to limits and managing risk exposure?
Second line: risk management. Does the risk management function have the authority and ability to adequately enforce the bank’s policies?
Third line: internal auditing. Do the bank’s policies and practices hold up under stress and scrutiny?
With words like “moral hazard” and “systemic risk” being thrown around, auditing has become a primary focus of the regulators.

“I would go so far as to say that, if internal auditing is deemed to be unsatisfactory, that could be a qualification negative [on an examination report],” Kelly says.The Basel Committee on Banking Supervision, the international policy board populated by top central bankers, is primarily concerned with the international activities of the world’s biggest banks. But what happens in Basel has a way of trickling down to the bank on the corner, as individual committee members apply Basel principles within their jurisdictions back home.

Jackie Roesser, a senior consultant and manager of internal audit services at Young & Associates in Kent, Ohio, is developing community bank management policies that specifically address Basel III requirements. “Our role in internal audit is to facilitate the control risk assessments that consider how community bank clients address all the regulatory requirements they must comply with, and then test for adherence to these standards,” she said. “We must stay current on these developments and ensure that corporate governance by the board of directors and its audit committee is promoted through effective audit programs that appropriately address matters relating to strategies and activities for funds management, liquidity, investments, loan portfolio management, and asset quality considerations, as well as the capital components.”

KPMG’s Kelly said the likely increased internal audit responsibilities created by Basel III’s stress-testing and capital risk analysis are good examples of the kinds of specialized knowledge that will be required of internal auditors going forward.“There is an increased focus on bringing in subject matter experts, whether it be internally, or bringing in third parties,” Kelly says – not just for Basel III, but in general. “Some institutions will look to have a rotation through audit, from other business functions. Others will go out and hire.”

Basel III standards, as proposed, would be phased in over the next nine years, but institutions need to be working on their response plans now. Regardless of how the final regulations are worded, the rules adopted in November are not likely to change significantly from what the Basel Committee presented in September. The issue is governance, and regulators will be looking to internal auditors to make sure institutions have the proper controls in place to protect themselves, and the financial markets as a whole, from a repeat of what’s happened over the last few years.

Brad Kuhn is a freelance writer based in Orlando, Fla.

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