Progress on Basel II implementation, new workstreams and outreach

Last October the Committee restructured its subcommittees to better reflect its strategic objectives going forward. These objectives seek to:

• promote a strong capital foundation at banks;
• strengthen supervision and risk management practices in the face of rapid financial innovation;
• promote understanding of the links between risk management, disclosure and accounting practices; and
• strengthen outreach to non-member countries, industry participants and other constituents.

For further information regarding the work of the Committee and its subcommittees please visit www.bis.org/bcbs.

This Newsletter discusses the Committee's recent progress and new initiatives to achieve these objectives.

Progress on Basel II implementation

Implementation of the Basel II Framework continues to move forward around the globe. A significant number of countries and banks already implemented the standardised and foundation approaches as of the beginning of this year. In many other jurisdictions, the necessary infrastructure (legislation, regulation, supervisory guidance, etc) to implement the Framework is either in place or in process, which will allow a growing number of countries to proceed with implementation of Basel II's advanced approaches in 2008 and 2009. This progress is taking place in both Basel Committee member and non-member countries. The Committee's Accord Implementation Group (AIG) and its working groups on validation, operational risk and trading book issues continue to actively share supervisory experiences in Basel II implementation, thereby promoting consistency across jurisdictions.

Supervisors also have made strong progress to coordinate home-host implementation issues at the level of individual banks, particularly for Pillar 1 (minimum capital requirements). The Committee's AIG is now focusing its attention on Pillar 2 (supervisory review process) and it also will begin work on Pillar 3 (market discipline). Many of the home-host issues that are under review by the AIG are not new but have come to the fore as a result of the rapid globalisation of the banking sector. Basel II has served as a catalyst to encourage greater cooperation and communication between jurisdictions and the industry. The input, both formal and informal, from industry groups, individual firms, and other constituents is particularly helpful in guiding this process.

Pillar 1

The Basel Committee and its AIG have concluded that supervisory coordination efforts are working well in practice to address institution-specific implementation issues. The Committee notes that the High-level principles for the cross-border implementation of the New Accord have been particularly helpful in shaping the discussions among supervisors and with the industry.

Supervisory and industry feedback about the workings of the colleges of supervisors, which are tailored to the circumstances of individual institutions, has been positive. Other forums involving bilateral discussions among supervisors have also proven to be beneficial in addressing Basel II home-host issues. Supervisors have been sharing information in an effective manner to minimise burden on the industry and themselves. Banks have found the process to be helpful and reports from participants in supervisory colleges have been positive. Both home and host supervisors report that they have achieved practical approaches to sharing the type of information needed to meet their responsibilities. Host supervisors report that banks' local managements are improving their ability to provide information concerning the institutions' Basel II implementation.

The AIG continues to monitor progress at supervisory colleges. It regularly reports such progress and results to the Committee.

Pillar 2

The challenges of coordination between home and host supervisors go beyond Pillar 1 and have clear Pillar 2 implications, particularly around topics like global risk management, diversification effects and the treatment of risks beyond those captured in Pillar 1 (eg risk concentrations and interest rate risk). The Committee and its AIG are now devoting significant resources to the Pillar 2 implementation process. While there are differences in supervisory approaches across countries, it is not yet clear how these will impact individual institutions in practice. In an important measure for promoting communication and transparency, a large and growing number of countries have put in place and made available to the public their Pillar 2 evaluation processes for a bank's internal capital adequacy and assessment process (ICAAP).

Basel Committee members approach these identified issues and challenges in various ways. These include:

• Sharing various ICAAP approaches across countries;
• Supervisory sharing of case studies on how these approaches are applied in practice at the level of individual institutions;
• Improving coordination and communication with non-member countries;
• Sharing case studies of firms' internal approaches;
• Focusing on the treatment of specific topics such as concentrations, diversification, stress testing and the treatment of interest rate risk;
• Discussing different approaches to validation;
• Working on home-host coordination of the advanced measurement approaches for operational risk implementation and supervisory considerations in the assessment of allocation methodologies.

The Basel Committee believes these processes provide a sound framework to ensure a balanced implementation of Pillar 2. It notes that the discussions around Pillar 2 have been particularly beneficial for both firms and supervisors to discuss emerging risk management and internal capital issues.

While these efforts have focused on addressing Basel II-related coordination issues, they also help reinforce supervisory cross-border relationships more generally, with longer term benefits in areas such as crisis management during less benign financial market conditions.

New workstreams

Liquidity risk

After a sound capital foundation, strong liquidity risk management practices are a key element of a resilient banking system. The Basel Committee recently initiated a review of jurisdictions' approaches to supervising and regulating funding liquidity risk. Its Working Group on Liquidity is currently conducting a survey of regulatory and supervisory practices and will present its findings to the Committee for consideration. The survey also will assess how liquidity risk is being managed under the assumption of stressed market conditions. Based on the results of the project, the Basel Committee will determine what, if any, further action is needed.

Definition of capital initiative

In recent years, there have been remarkable advances in banks' economic capital management frameworks as well as the development of the markets for various capital instruments, notably hybrid capital products. In light of these developments the Basel Committee has launched an initiative to review the definition of regulatory capital across jurisdictions. The Committee's Definition of Capital subgroup is initially starting with a stock-take of the current definition of capital in member jurisdictions as well as fact-finding on how market participants, including rating agencies, perceive and value the equity-like characteristics of various capital instruments. This fact finding work will focus on the fundamental aspects of capital such as its loss absorbency. The subgroup will also look at the role of accounting in the calculation of regulatory capital and the relationships between regulatory definitions and firms' own definitions of capital in their internal economic capital models. Upon completion of its work, the subgroup will present its findings to the Committee for its discussion.

Economic capital initiative

At its March meeting, the Basel Committee gave its Risk Management and Modelling Group the mandate to assess the range of practice of banks' approaches to economic capital measurement and management. This effort supports supervisors' objective to stay on top of evolving risk management techniques and reinforces the AIG's work on Pillar 2. Areas of potential emphasis include:

• new measurement approaches for credit risk,
• the treatment of diversification effects,
• the assessment of complex counterparty credit risks,
• the treatment of interest rate risk, and
• firms' approaches to validation of internal capital assessments.

Accounting and auditing work

The Basel Committee's Accounting Task Force (ATF) focuses on promoting high quality international accounting and audit standards, which support sound risk management practices. The ATF currently is engaged in several areas of work related to accounting and audit standards, which have a potentially large impact on financial institutions. The ATF is initiating work with the Committee's Risk Management and Modelling Group to evaluate practices related to fair value estimates that rely on models.

The ATF recently reviewed a discussion paper on fair value measurements issued by the International Accounting Standards Board (IASB). In its comment, it noted that as internationally active banks continue to increase their cross border activities, it is important that the IASB and the FASB develop consistent fair value measurement guidance. The ATF also reviewed an exposure draft related to audits of accounting estimates, which includes fair value estimates, issued by the International Auditing and Assurance Standards Board. In its comment, the Committee noted that the current exposure draft does not sufficiently address the need for additional audit guidance for fair value estimates, particularly those derived through the use of models.

Outreach to non-member countries and the industry

The Basel Committee continues to expand its cooperation with the broader supervisory community and the industry. The combined effects of rapid globalisation of banks, the pace of financial innovation and changes in risk management practices require a redoubling of efforts to deepen outreach to non-member supervisors and the industry.

Outreach to non-member countries

The Committee recently established the International Liaison Group (ILG) to provide a forum for deepening its engagement with supervisors around the world on a broad range of issues. It provides a platform for non-member countries to contribute to new Committee initiatives early in the process and to develop new proposals that are of particular interest to ILG members.

The ILG has initiated new workstreams on the following:

• a project to assess the range of practice on approaches to risk-based supervision;
• an information exchange on jurisdictions' approaches to achieving sound provisioning and reserving practices; and
• an assessment of how the rapidly growing area of microfinance fits into existing supervisory frameworks.

In addition, the Committee is in the process of identifying practical ways to increase participation of non-member countries in the work of its other subcommittees.

Outreach to industry

The Committee has derived important benefit in seeking input from industry participants on its workstreams and proposed supervisory or regulatory initiatives. It will engage the industry on financial market, risk management, supervisory, and regulatory developments that are forward looking and of common interest to supervisors and industry. Input from a range of constituents on these issues is an important contribution to shaping the Committee's future agenda.