Proposed enhancements to the Basel II framework

Enhancements to Pillar 1 (minimum capital requirements)

In addition to the IRC and other trading book proposals noted above, the Committee is proposing other Pillar 1 enhancements that focus on strengthening the risk capture of the framework. The crisis has clearly shown that collateralised debt obligations comprised of asset-backed securities (ie CDOs of ABS - so-called "resecuritisations") are more highly correlated with systematic risk than are traditional securitisations. Resecuritisations, therefore, warrant a higher capital charge.

Prior to the onset of the financial crisis, banks built up significant exposures to off-balance sheet conduits, which were not adequately reflected in the capital regime. In response, the Committee proposes to increase capital requirements for liquidity lines extended to support asset-backed commercial paper (ABCP) conduits by eliminating the distinction between short-term and long-term liquidity facilities.

The Committee also proposes to require that banks obtain comprehensive information about the underlying exposure characteristics of their externally-rated securitisation positions, both within and across structures. Failure to obtain such information would result in higher capital requirements.

Enhancements to Pillar 2 (supervisory review process)

The purpose of this supplemental Pillar 2 guidance is to address the flaws in risk management practices revealed by the crisis, which in many cases were symptoms of more fundamental shortcomings in governance structures at financial institutions. The industry has taken a number of steps to develop sound principles to address these weaknesses. Pillar 2 of the Basel II capital framework presents supervisors with a stronger tool to ensure that these efforts by the industry are in fact implemented over the long term. This can be reinforced through reviews of banks' risk governance and capital planning processes under Pillar 2 and the adequacy of capital buffers above the regulatory minimum to reflect the unique risk profile of a particular institution.  

In support of this objective, the Committee proposes to strengthen its supervisory guidance and the links to the Pillar 2 review process in the following ways:

• Firm-wide governance and risk management: The Committee's enhanced guidance sets clear expectations for boards of directors and senior management to understand the firm-wide risk profile; to aggregate firm-wide exposure information in a timely manner using easy to understand and multiple metrics; to define the risk appetite in a manner that considers long-term performance over the cycle; and to set clear incentives across the firm to control risk exposures and concentrations in accordance with the stated risk appetite.
• Capturing the risk of off-balance sheet exposures and securitisation activities: The Committee's proposed enhanced guidance will strengthen supervisory expectations for capturing firm-wide risk concentrations arising from both on- and off-balance sheet exposures and securitisation activities. This includes both contractual risks, as well as the potential impact on risk exposures, capital, and liquidity of non-contractual commitments, implicit support, and reputation risk.
• Incentives to manage risk and returns over the long-term: The Committee's enhanced Pillar 2 guidance will set the expectation that banks establish appropriate incentives throughout the firm to reflect the long-term risks and rewards associated with their respective business models. The supplemental Pillar 2 guidance will be a key tool for supervisors to reinforce sound compensation schemes as part of the risk management and capital planning process.

The supplemental Pillar 2 guidance also incorporates key recommendations from the following Basel Committee initiatives:

• Principles for Sound Liquidity Risk Management and Supervision (September 2008);
• Supervisory guidance for assessing banks' financial instrument fair value practices (issued for comment on 28 November 2008); and

Principles for sound stress testing practices and supervision (issued for comment on 6 January 2009).

Enhancements to Pillar 3 (market discipline)

After a careful assessment of leading disclosure practices, the Basel Committee has developed proposed revisions to the existing Pillar 3 requirements, focusing on the following six areas:

• securitisation exposures in the trading book;
• sponsorship of off-balance sheet vehicles;
• the Internal Assessment Approach (IAA) for securitisations and other ABCP liquidity facilities;
• resecuritisation exposures;
• valuation with regard to securitisation exposures; and
• pipeline and warehousing risks with regard to securitisation exposures.

These disclosures are intended to complement the other two pillars of the Basel II framework by allowing market participants to assess capital adequacy of a bank through key pieces of information on the scope of application, capital, risk exposure and risk assessment process.

The Committee's proposal includes certain disclosure requirements that are not solely related to the understanding of Pillar 1 capital requirements (eg disclosures concerning a bank's sponsorship of off-balance sheet vehicles). These are intended to help market participants better understand a bank's overall risk profile. The Committee believes that these proposed enhanced disclosure requirements will help to avoid a recurrence of market uncertainties about the strength of banks' balance sheets related to their securitisation activities.