RMA Research Helped to Convince The Basel Committee on Banking Supervision to Accept an Internal Risk-Based Approach for Setting Capital Requirements
Philadelphia, Pa (February 2, 2001) - U.S. banks that practice advanced risk management techniques will be able to set aside regulatory capital using an internal risk-based approach when a new international banking accord takes effect in 2004. RMA- The Risk Management Association, working with 11of its member institutions, provided research, which led to the Basel Committee on Banking Supervision recommendation. The new accord will replace the existing 1988 Basel Accord and its one-size-fits-all approach to setting capital requirements.
An earlier draft of The Consultative Paper on a New Capital Adequacy Framework, released by the Basel Committee in June 1999, did not endorse the internal risk-based approach. After receiving public comment on the proposal, the Committee issued a revised proposal on January 16, 2001, which allows advanced-practice institutions to use an internal risk-based approach for determining capital requirements. RMA's Capital Working Group, which includes 11 member institutions, was instrumental in convincing the committee that an internal risk-based (IRB) approach was needed. Smaller institutions and those that do not yet have sophisticated techniques for measuring risk across the bank's entire enterprise, would continue to set capital aside according to a standardized approach set by the Basel Committee.
"This decision could be one of the most important for the banking industry this decade," said Allen Sanborn, RMA president and CEO. "We at RMA have long argued that regulatory capital requirements should be more directly tied to individual transaction risk, both on and off the balance sheet. Allowing an internal risk-based approach is crucial as the industry focuses more closely on managing its risk across the entire enterprise. We are pleased that the Basel Committee recognizes that advanced-practice institutions are best equipped to determine what their own regulatory capital should be."
Pam Martin, RMA's director of regulatory relations agreed, noting that the original accord does not always promote prudent risk management practices within financial institutions because it sometimes provides an incentive for greater risk-taking. "It makes higher risk activities appear more profitable than lower risk ones on a regulatory capital-adjusted basis," she said. "Tying risk to capital levels will have a significant impact on all financial service providers, to the long-term benefit of everyone."
RMA's Capital Working Group, formed in December 1999, provided the Basel Committee with an analysis of how institutions use their IRB systems to assign capital. RMA conducted survey research to show how economic capital is allocated for a hypothetical asset with a one-year duration, based on two dimensions-expected default frequency (EDF) and loss given default (LGD).
"RMA's research shows that institutions do set economic capital based on numerical measurements of risk derived from their internal risk-rating systems," said Martin. "RMA did not recommend a particular IRB system that regulators should adopt. Rather, we demonstrated how IRB systems, even though they may differ greatly across banks, can be used to allocate capital for both economic and regulatory purposes. RMA also provided the Committee with its research that accounts for durations greater than one year and examines risk rating for capital allocation purposes in the commercial and retail portfolios.
In all, RMA provided the Basel Committee with six documents, each explaining in detail RMA research that showed the effectiveness of an internal risk-based approach for setting regulatory capital. Each of those documents, and their accompanying research, can be found on RMA's Web site, under the News and Updates section.
RMA is the only financial services trade association that specializes in promoting prudent and effective credit risk management practices across the entire banking and lending spectrum for institutions of all sizes. Its membership consists of more than 3,000 financial service providers. These institutions are represented in the association by more than 18,000 commercial loan and credit personnel in 50 states, Puerto Rico, Canada and numerous foreign cities, including Hong Kong, Singapore and London.
For more information, call Pam Martin, Director of Regulatory Relations and Communications, at 215-446-4092 or e-mail mailto:pmartin@rmahq.org