Four key principles of supervisory review

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
1. 1. Board and senior management oversight
  1. Bank management is responsible for understanding the nature and level of risk being taken by the bank and how this risk relates to adequate capital levels.
  2. The analysis of a bank’s current and future capital requirements in relation to its strategic objectives is a vital element of the strategic planning process. The strategic plan should clearly outline the bank’s capital needs, anticipated capital expenditures, desirable capital level, and external capital sources.
  3. The bank’s board of directors has responsibility for setting the bank’s tolerance for risks. It should also ensure that management establishes a framework for assessing the various risks, develops a system to relate risk to the bank’s capital level, and establishes a method for monitoring compliance with internal policies.
2. 2. Sound capital assessment
  1. Policies and procedures designed to ensure that the bank identifies, measures, and reports all material risks;
  2. A process that relates capital to the level of risk
  3. A process that states capital adequacy goals with respect to risk, taking account of the bank’s strategic focus and business plan
  4. A process of internal controls, reviews and audit to ensure the integrity of the overall management process
3. 3. Comprehensive assessment of risks
  1. All material risks faced by the bank should be addressed in the capital assessment process. While the Committee recognises that not all risks can be measured precisely, a process should be developed to estimate risks. Therefore, the following risk exposures, which by no means constitute a comprehensive list of all risks, should be considered.
    1. Credit risk
    2. Operational risk
    3. Market risk
    4. Interest rate risk in the banking book
    5. Liquidity risk
    6. Other risks:, e.g., strategic risk
4. 4. Monitoring and reporting
  1. The bank should establish an adequate system for monitoring and reporting risk exposures and assessing how the bank’s changing risk profile affects the need for capital.
  2. The bank’s senior management or board of directors should, on a regular basis, receive reports on the bank’s risk profile and capital needs.
  3. These reports should allow senior management to:
    1. Evaluate the level and trend of material risks and their effect on capital levels
    2. Evaluate the sensitivity and reasonableness of key assumptions used in the capital assessment measurement system
    3. Determine that the bank holds sufficient capital against the various risks and is in compliance with established capital adequacy goals
    4. Assess its future capital requirements based on the bank’s reported risk profile and make necessary adjustments to the bank’s strategic plan accordingly
5. 5. Internal control review
  1. Effective control of the capital assessment process includes an independent review and, where appropriate, the involvement of internal or external audits.
  2. The bank should conduct periodic reviews of its risk management process to ensure its integrity, accuracy, and reasonableness. Areas that should be reviewed include:
    1. Appropriateness of the bank’s capital assessment process given the nature, scope and complexity of its activities
    2. Identification of large exposures and risk concentrations
    3. Accuracy and completeness of data inputs into the bank’s assessment process
    4. Reasonableness and validity of scenarios used in the assessment process
    5. Stress testing and analysis of assumptions and inputs
Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
1. 1. Review of adequacy of risk assessment
  1. Supervisors should assess the degree to which internal targets and processes incorporate the full range of material risks faced by the bank.
  2. Supervisors should also review the adequacy of risk measures used in assessing internal capital adequacy and the extent to which these risk measures are also used operationally in setting limits, evaluating business line performance, and evaluating and controlling risks more generally.
  3. Supervisors should consider the results of sensitivity analyses and stress tests conducted by the institution and how these results relate to capital plans.
2. 2. Assessment of capital adequacy
  1. Supervisors should review the bank’s processes to determine that:
    1. Target levels of capital chosen are comprehensive and relevant to the current operating environment
    2. These levels are properly monitored and reviewed by senior management
    3. The composition of capital is appropriate for the nature and scale of the bank’s business
  2. Supervisors should also consider the extent to which the bank has provided for unexpected events in setting its capital levels
    1. . This analysis should cover a wide range of external conditions and scenarios, and the sophistication of techniques and stress tests used should be commensurate with the bank’s activities.
3. 3. Assessment of the control environment
  1. Supervisors should consider the quality of the bank’s management information reporting and systems, the manner in which business risks and activities are aggregated, and management’s record in responding to emerging or changing risks
  2. In all instances, the capital level at an individual bank should be determined according to the bank’s risk profile and adequacy of its risk management process and internal controls. External factors such as business cycle effects and the macroeconomic environment should also be considered.
4. 4. Supervisory review of compliance with minimum standards
  1. In order for certain internal methodologies, credit risk mitigation techniques and asset securitisations to be recognised for regulatory capital purposes, banks will need to meet a number of requirements, including risk management standards and disclosures.
  2. There is also an important role for supervisory review of compliance with certain conditions and requirements set for standardised approaches. In this context, there will be a particular need to ensure that use of various instruments that can reduce Pillar 1 capital requirements are utilised and understood as part of a sound, tested, and properly documented risk management process.
5. 5. Supervisory response
  1. Having carried out the review process described above, supervisors should take appropriate action if they are not satisfied with the results of the bank’s own risk assessment and capital allocation.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
1. Pillar 1 capital requirements will include a buffer for uncertainties surrounding the Pillar 1 regime that affect the banking population as a whole.
  1. Supervisors will typically require (or encourage) banks to operate with a buffer, over and above the Pillar 1 standard. Banks should maintain this buffer for a combination of the following:
    1. (a) Pillar 1 minimums are anticipated to be set to achieve a level of bank creditworthiness in markets that is below the level of creditworthiness sought by many banks for their own reasons. For example, most international banks appear to prefer to be highly rated by internationally recognised rating agencies. Thus, banks are likely to choose to operate above Pillar 1 minimums for competitive reasons.
    2. (b) In the normal course of business, the type and volume of activities will change, as will the different risk exposures, causing fluctuations in the overall capital ratio.
    3. (c) It may be costly for banks to raise additional capital, especially if this needs to be done quickly or at a time when market conditions are unfavourable.
    4. (d) For banks to fall below minimum regulatory capital requirements is a serious matter. It may place banks in breach of the relevant law and/or prompt non-discretionary corrective action on the part of supervisors.
    5. (e) There may be risks, either specific to individual banks, or more generally to an economy at large, that are not taken into account in Pillar 1.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.
1. Supervisors should consider a range of options if they become concerned that a bank is not meeting the requirements embodied in the supervisory principles outlined above. These actions may include intensifying the monitoring of the bank, restricting the payment of dividends, requiring the bank to prepare and implement a satisfactory capital adequacy restoration plan, and requiring the bank to raise additional capital immediately. Supervisors should have the discretion to use the tools best suited to the circumstances of the bank and its operating environment.
2. The permanent solution to banks’ difficulties is not always increased capital. However, some of the required measures (such as improving systems and controls) may take a period of time to implement. Therefore, increased capital might be used as an interim measure while permanent measures to improve the bank’s position are being put in place. Once these permanent measures have been put in place and have been seen by supervisors to be effective, the interim increase in capital requirements can be removed.

Next up

Four key principles of supervisory review

Description

Resource summary

Similar

	Created by Jose Enrique Perez Salvador over 2 years ago