The road to Basel III compliance may be getting significantly shorter for some banks.  Just last week, the Australian Prudential Regulation Authority announced a proposal that would require Australian banks to adopt the minimum capital requirement ratio by 2013, two years ahead of the timetable under Basel III’s phase-in agreement, and would implement the additional capital conservation buffer three years ahead of Basel III’s schedule.  This shot heard round the world is still being analyzed and debated.  Regardless, it drives home the point that Basel III is moving forward, and banks need to begin preparations. 

The news out of Australia provides a perfect jumping off point for the final installment of my “Road to Basel III” series, which looks at best practices that banks can adopt today to ease the transition in the coming years.  We started the first blog by looking at the need for enterprise-wide assessment.  In this blog, I offer three additional best practices that can guide banks on their compliance journey.

Best Practice #2:  Build an agile environment to support on-demand stress tests.

Due to the increased focus on stress testing under Basel III, financial institutions will have to develop a transparent and auditable stress testing process that provides them with the ability to rapidly respond on an on-demand basis to regulatory requirements and market events.  Current management, analytical and resolution approaches to risk management are not transparent, responsive or flexible.  Stress testing is often carried out as a standalone exercise, and the results not used in the strategic decision making process.  Additionally, stress scenarios are not uniformly applied and do not take into account the varying degrees of events across all risk silos.

Institutions will need to build a comprehensive library of stress scenarios that are consistent with enterprise use and regulations in responding to market-wide requirements.  A comprehensive library must have two key components – identification of all risk factors that have a potential impact on income and the balance sheet; and assessment of extreme but plausible scenarios for each risk factor.  These scenarios need to be based on quantitative and qualitative assessment of potential future market conditions. 

In the new risk environment, institutions will require a unified analytical platform that allows them to “host” risk models that exist across the organization in disparate systems, to ensure an effective and timely response to regulator-specified stress tests.  A single environment for all risk models will allow risk managers to carry out complex calculations that assess the inter-dependence across risk categories.

Best Practice #3:  Pursue a unified analytical approach.

As regulators focus on traceability and auditability of risk management systems, a single unified analytical platform for risk and performance, coupled with unified data storage will ensure effective compliance with Basel III.  It will also provide executive teams with accurate and timely information that drives business decisions to maintain profitability and growth.  For example, a unified analytical platform will be able to calculate accurate, enterprise-wide risk adjusted performance numbers on a timely basis.  This will provide decision-makers with information required to allocate capital in a manner that maximizes returns. 

Capital management frameworks need to be enhanced to cater to new calculations for counter-cyclical capital, credit valuation adjustments, leverage ratios, etc.  For these requirements, a single analytical platform will also enable risk managers to understand and analyze the risk numbers and underlying assumptions, where the results have come from, and where they are being used.

Best Practice #4:  Elevate importance of liquidity risk.

New regulations will require significant changes in management and measurement of liquidity risk.  Historically a treasury-managed process, liquidity risk becomes an enterprise concern that illuminates disconnects with other risks and company-wide business practices.  Liquidity risk management systems need to be geared up to address increased ad-hoc stress testing requirements, liquidity ratio calculations and contingency planning.  Institutions will need to develop funding strategies based on anticipated market conditions and associate those with various stress scenarios.  In addition, financial institutions need to develop a framework for formal materiality assessment of liquidity risk, to categorize the severity of liquidity risk in the organization.  Such an assessment will require enterprise-wide involvement – line managers, research teams, and treasury and risk management departments.

Now it’s your turn.  What are your thoughts on an accelerated time table? How is your institution preparing?  And, what additional best practices would you like to add to the mix?  Join the discussion.

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