Time to think strategically about Basel capital calculations

December 15, 2015 – By Nicola Hortin, Head of Regulatory Analysis Team, EMEA, AxiomSL

As part of the ongoing Basel reforms, the Bank for International Settlements (BIS) is busy rewriting the rules that govern how Nicola Hortin - Head of Regulatory Analysis Team, EMEA, AxiomSLmuch capital banks must maintain in order to mitigate different types of risk. So far the Standardized Approach for Measuring Counterparty Credit Risk Exposures (SA-CCR) and the Fundamental Review of the Trading Book (FRTB) have garnered the most attention. However, these are just two components of a much larger package of changes to the Basel capital calculations, which banks need to think about holistically and start factoring into their technology programs now.

The reforms to the counterparty credit risk and market risk capital calculations that are being introduced by SA-CCR and the FRTB respectively will be accompanied by changes to the way banks calculate how much capital they must hold as a result of their exposures to central counterparties (CCPs), operational risk and credit risk due to securitizations. There will also be a new framework for measuring and controlling large exposures, and changes to the risk weights in the standardized approach to credit risk capital calculations. In fact, almost all of the existing Basel calculations will be affected in some way.

The new requirements will have a significant impact not only on banks’ capital planning, but also on their operations and technology. To implement the calculations, banks will need to source new and more granular data than before. For example, in order to calculate the capital requirements resulting from their exposures to other banks, they will need data about the capital adequacy and asset quality of those institutions. Once they have sourced all of this data, banks will need a transparent regulatory calculation platform that can process large volumes of data quickly and that enables users to see how the final outputs are produced.

Due to the modular nature of the Basel capital calculations and the staggered implementation timetable, there is a risk that banks may focus on each calculation separately, losing sight of the bigger picture. This would be a big mistake as many of the calculations are interdependent. For example, the outputs from the SA-CCR calculations will need to be fed into the large exposure and credit valuation adjustment (CVA) calculations. It is therefore important for banks to think strategically about the entire suite of new Basel capital calculations.

As they prepare for the changes to come, banks should consider the ability of their regulatory calculation platform to adapt quickly to change. The deadlines for the implementation of most of the requirements are yet to be set. However, it is clear that they will follow one another in close succession, leaving banks with little time to update their systems.

Banks often struggle with this type of change management because the technology they use does not allow them to implement regulatory changes without undertaking a complete software update, including full regression testing. This is an unnecessarily long and complicated iterative process, which eats into the time banks have to prepare for a regulatory change, increasing the risk of missing a deadline.

In order to keep up with the changes that are being made to the Basel capital calculations, banks should use a calculation platform that separates the regulatory functionality from the core platform functionality. This will mean that when the final version of one of the new calculations is published, a bank will be able to add it to the platform quickly without having to update its entire infrastructure, impacting other functionality and users in the process.

The ability to do parallel running of the new calculations will also be important. Consultation on many of the requirements is ongoing at the Basel level and is yet to begin at the European level. In order to identify any issues caused by the draft versions of the calculations and highlight them to regulators, banks will want to run the calculations on their systems as soon as possible based on the draft rules. Parallel running will also be important for ensuring a smooth transition to the new regime, once the calculations are finalized.

Unfortunately, some calculation platforms are not flexible enough to support parallel running and, as a result, banks are forced to rely on manual workarounds. Not only does this limit their ability to contribute to consultation processes, it also means that when the final versions of the requirements are published, banks must spend many months reconfiguring their regulatory platforms, implementing the changes they have worked out manually.

To avoid these issues, a bank should ensure it can implement proposed new regulatory calculations on its platform quickly. The platform a bank leverages should archive the logic it uses to implement the draft calculations. This will mean the bank will already have much of the groundwork saved in its platform and will be able to move quickly to production of the final results when the regulations come into force.

The new Basel capital calculations present many challenges for banks. However, by thinking strategically about the entire suite of reforms now and by using flexible calculation technology, they can adapt smoothly and efficiently to the new regulatory regime.

This article was originally published by Banking Technology.