The Road to Basel III: Navigating the Curves Ahead

Financial institutions in Europe and North America will be eager to turn the page on August.  Far from the anticipated doldrums of summer, we witnessed a return to stomach-churning market volatility, fueled in part by growing concerns about sovereign solvency and banks’ exposure to sovereign debt.

The return to volatility, coming on the heels of the latest round of stress tests in Europe, has led some to voice concerns as to whether Basel III can provide adequate protection – especially in such unprecedented times. 

Even before the events of the last few weeks, banks faced uncertainty around how the accord’s various provisions would be interpreted and enforced by regulators in different jurisdictions.  That uncertainty has multiplied, with some provisions themselves being called into question. 

Planning for compliance in today’s environment is a lot like navigating a winding road with a fogged windshield.  Regardless of the challenges presented by such opacity, financial institutions can and must continue to drive forward.  A good place to start is on solid footings…by first considering the “new reality” of the post-financial crisis:

1. Stress testing will become the "norm.”  It will go far beyond the standardized and sweeping industry-wide tests ordered in the wake of the financial crisis.  Instead, the industry will see a move to institution-specific stress testing that becomes a follow-up to regularly scheduled periodic reports.  Financial institutions can expect regulators to increasingly respond to their periodic reports with requests to execute stress tests based on the results of the vulnerabilities identified in the reports. 
2. Institutions will continue to reassess their risk appetite.  Financial institutions will need to be able to facilitate compliance and promote sound operating practices by clearly identifying and assessing enterprise-wide liquidity risk under normal and extreme market conditions, and developing strategies to effectively bridge liquidity gaps.
3. Risk and finance will increasingly intersect.  In the new reality, we are beginning to witness a move toward greater alignment between the risk and finance functions within financial services organizations.  As part of this integration, we can expect to see an increased focus on risk-adjusted performance, which is the performance of a security or investment relative to its risk. 

From there, best practices will point the way ahead, beginning with assessment, as well as key processes, systems, and organizational structures that will be required to meet more rigorous liquidity risk, stress testing, and reporting requirements.

This blog will be the first installment in a multi-part “Road to Basel III” series, focusing on best practices in addressing the many compliance challenges.  We’ll start with a look at where we are today, beginning with assessing what needs to be done to prepare for the processes and resources required to advance on the road to Basel III compliance.

Best Practice #1:  Conduct a comprehensive assessment.

Raising additional capital in the current environment is a growing challenge for financial institutions.  As new capital increasingly scarce and expensive, existing capital will have to be deployed in a much more efficient manner.  This will involve capital allocation based on a thorough assessment of risk adjusted performance of business lines and products. 

Institutions will need to adopt a comprehensive risk-adjusted performance and risk-based pricing program to maximize returns per unit of capital.  Viability of existing and new business will need to be assessed based on the capital it consumes.  The assessment phase will be critical to maintaining profitability margins, which would otherwise be adversely impacted due to restrictions on the derivatives business and increased focus on stable sources of funding.  Shifting trades to a centralized exchange will release capital which would otherwise be tied up in addressing counterparty risk on trading book. 

It’s clear that Basel III will impact the way in which banking institutions evaluate and manage their businesses.  Risk management will play a greater role than ever in the strategic decision making process, as financial institutions begin to assess various business lines and seek to strike the optimal balance between low-risk/low-yield and high-risk/high-return lines.

In next week’s installment, we’ll move beyond the assessment phase and take a look at what’s needed to support both internal and external requirements of on-demand stress testing, as it relates to Basel III compliance. 

This blog was contributed by Rohit Verma, Director of Product Management and Strategy, Oracle Financial Services Analytical Applications.