Workshop – What are the Regulators Thinking?

Canadian Conference for Credit Union Leaders May 3, 2011 

Richard Gresser

Managing Director, Bank Capital

OSFI

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Agenda

Regulatory Capital Changes

Supervisory Concerns

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Regulatory Capital Changes

What are the objectives of Basel III?

1. Macro Economic Concerns

2. Missing Parts

3. Emphasis on Capital

4. Better Risk Assessment

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The Macro ConcernsSystemic Risk and Interconnectedness• Interconnectedness among large global

systemically important financial institutions (GSIFIs) transmitted shocks across the financial system and economy

• Solutions being envisaged:– Capital surcharges– Contingent capital– Bail-in debt

• To be developed in 2011

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The Macro Concerns

Countercyclical Capital Buffer• Excessive credit growth → Period of

financial stress → bank reduce credit supply to maintain solvency → real economy affected → additional credit losses in banking system

• Countercyclical buffer to be built up capital buffer when aggregate credit growth is excessive → increasing credit cost → dampen credit growth

• Buffer 0 to 2.5% of RWA – expected to be deployed on an infrequent basis (once every 10 to 20 years)

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The Missing Pieces

• The financial crisis demonstrated that the regulatory tool box needed to be expanded -- risk-based capital requirements are essential but not sufficient

• Basel III will introduce liquidity requirements and leverage constraints

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Liquidity

• Liquidity Coverage Ratio (LCR)– To ensure enough short term liquid assets are

available– Banks to have enough high-quality liquid assets

to withstand a 30-day funding scenario specified by supervisors

• Net Stable Funding Ratio (NSFR)– To limit over-reliance on short-term wholesale

funding and encourage better assessment of liquidity risk

– Banks to have enough sources of funding over a one-year horizon

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Leverage

• Excessive build-up of on- and off-balance sheet leverage contributed to the financial crisis.

• A leverage ratio will be introduced to act as a backstop to the risk-based capital requirements

• Leverage ratio also introduces additional safeguards against model risk and measurements error risk present in the risk-based approach

• Unlike most countries, Canada already has leverage constraints

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Emphasis on Capital

• Risk-based regulatory capital is the core instrument of financial regulation but crisis highlighted deficiencies– Emphasis should be on capital of the highest

quality (i.e. truly loss absorbing) – rules emphasize common equity requirements (or equivalent for non-stock entities)

– Definition of capital should be more uniform in all countries – deductions from capital harmonized internationally

– The requirements should be higher – 7% “minimum” common equity ratio; 10.5% total capital

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Better Risk Assessment

• Another lesson from the crisis has been the need to strengthen the risk coverage of the capital framework

• Trading book and securitization rules already strengthened in 2009 (stressed VAR; higher capital requirements for resecuritizations)

• Counterparty Credit Risk rules to be improved – incentives the use of central counterparties to reduce counterparty credit risk

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Supervisory Concerns

1. Enterprise Risk Management

2. Stress Testing

3. Internal Capital Adequacy Assessment

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Enterprise Risk Management

• Continued emphasis on ERM• A framework for risk management which

involves:– identifying particular events or circumstances

relevant to the institution's objectives (risks and opportunities),

– assessing them in terms of likelihood and magnitude of impact

– determining a response strategy– monitoring progress

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Enterprise Risk Management

• A way to aggregate similar risks or exposures across the organization and get a good understanding of what the risks, based on historical experience that produces the benefit of:– Apples to apples comparison of risk adjusted

returns– Manage a complex web of risks against an

enterprise wide risk appetite (the risks may be greater or less than the sum of the parts)

• Need to do more/better stress testing– Challenge historical experience– Anticipate impact of sea change in markets

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Stress Testing

• A key risk management tool• Used to evaluate the potential effects on an

institution’s financial condition of a set of specific changes in risk factors, corresponding to exceptional but plausible events

• Financial crisis underlined the importance of stress testing and also shortcomings of stress testing practices

• OSFI Guideline on Stress Testing December 2009

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Expectations for Stress Testing

• Commensurate with the nature and complexity of the institution and with its risk profile

• Embedded in enterprise wide risk management

• Actionable• Feed into the institution’s decision making

process

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ICAAP

• Internal Capital Adequacy Assessment Process

• Capital requirements set out in the Basel Framework and in OSFI’s CAR guideline for banks are regulatory minimums that assume a highly granular and widely diversified portfolio of risks

• Guideline issued October 2010 sets out expectations for banks

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ICAAP

• Through ICAAP, an institution sets its internal capital target and develops strategies for achieving the target that are consistent with its business plan, risk profile and operating environment

• ICAAP is a vital component of a strong risk management process

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ICAAP

• Stress testing is a key part of ICAAP• The results of rigorous, forward-looking

stress testing should be considered when looking at the adequacy of an institution’s capital

• OSFI assesses institutions’ ICAAPs as part of the supervisory review process

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Proportionality in Stress Testing and ICAAP

• Formalization and sophistication of ICAAPs will differ, depending on the institution’s complexity, range of business activities risk profile, and operating environment

• The board has ultimate responsibility for the overall stress testing program and should be aware of the key findings from stress tests.

• Senior management is accountable for the program’s implementation, management and oversight and for ensuring that the institution has adequate plans to deal with remote but plausible stress scenarios.

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Rules vs. Supervisory Review

• Capital and Liquidity Rules are not a safe harbor, they are minimums

• OSFI Supervisory review assesses– Inherent risk of significant businesses and the

direction of those risks. (analog of rules quantitative standards)

– Quality of risk management and whether it mitigates or amplifies inherent risk

• Rules could be seen as a sort of baseline for inherent risk and risk management assessments

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Summary

• The financial crisis has prompted regulators to review the regulatory framework to:– Address macro economic concerns– Improve risk measurement– Require more and better quality capital– Reduce counterparty credit risk– Introduce liquidity and leverage standards– Improve internal risk management and controls

(ERM, ICAAP, Stress testing)

• How will this impact provincially regulated Credit Unions?