Many banks, even those perceived as the most sophisticated, may not yet have sufficiently transparent, auditable or replicable systems in place to efficiently allocate regulatory capital among individual business units and will face challenges implementing Pillar 2, according to Standard & Poor's Risk Solutions, a leading provider of integrated credit risk solutions.
Until recently, for most banks adopting an Internal Ratings Based-approach, the focus of Basle was Pillar 1.
"Developing, validating and creating a user-test history has been a huge investment in time and money for the major international banks," said Paul Waterhouse, Standard & Poor's Risk Solutions. "But now, Pillar 2 looms large and has the potential to undermine investment to date. Of course, for those banks that work through Pillar 2 successfully, the regulatory hurdle it represents for others can be a profound source of competitive advantage."
Executing an enterprise-wide, transparent risk capital system and firm-wide portfolio approach were among the key challenges faced by banks as they move to adopt Pillar 2, Paul Waterhouse said.
"The irony for some of the more sophisticated banks that moved early to more complex economic capital management is that business unit or department-specific execution may actually now challenge meeting Pillar 2 as central to Pillar 2 is firm-wide, transparent and consistent implementation of risk capital management," Paul Waterhouse said. "Internal Rating Based banks will need to demonstrate a robust and objective approach to an integrated risk capital calculation. This includes having an effective, codified and transparent system for evaluating the impact of guarantees, group structures, inter-asset class correlations, pricing and limit setting and management."
"While process has been key for Pillar 1, much of it is related to the technical execution of executing and validating probability of default (PD), Loss Given Default (LGD) and Exposure At Default (EAD) measures," said Waterhouse. "With Pillar 2's focus on firm-wide overall capital adequacy, the focus switches to ensuring a 'top down', integrated risk position and a strategy around this. Issues such as liquidity risk and legal risk become much more central and, hence, so do the processes for managing and calculating these."
Standard & Poor's Risk Solutions and Pillar 2
Standard & Poor's Risk Solutions has been providing solutions required to satisfy Pillar 2 for some time but has recently codified its offering into a comprehensive suite of services. This suite is, built on the many aspects of Standard & Poor's credit rating methodologies and data relevant to the challenges outlined above and includes:
• Pillar 2 "best practice" Framework (guidance manual).
• Training and Advice
• Risk Quantification
• Data Collection
• Stress Testing and Scenario Analysis
• Establishment of a top down view of Capital based on robust methodologies
• Validation of Pillar 2 models and processes