1. PBBA 301: INTRODUCTION TO RISK MANAGEMENT AND INSURANCE
LECTURE NINE
RISK AND REGULATION

2. Outline
This lecture compares the latest prudential and corporate regulations on Risk Management
and identifies common and emerging regulatory best practices.

3. The Basel Accords
The Basel Accords refer to the banking supervision Accords (recommendations on banking laws and regulations)
Basel I and Basel II have been issued and Basel III On the 12th of November 2010, the G20 leaders officially endorsed the BASEL 3.
They are called the Basel Accords as the Basel Committee on Banking Supervision (BCBS) maintains its secretariat at the Bank of International Settlements in Basel, Switzerland and the committee normally meets there.

4. Cont.
The Committee is often referred to as the BIS Committee after its meeting location. However, the BIS and the Basel Committee remain two distinct entities.
The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise.

5. Bank for International Settlements (BIS)
Set up in 1930, the BIS is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability.
It is the “central banks’ central bank” and “lender of last resort.”
You will know more about this in level 400 when you take PRINCIPLES OF INTERNATIONAL TRADE AND FINANCE.

6. The Basel Committee
The Basel Committee on Banking Supervision is an institution created by the Central bank Governors of the Group of Ten nations. It was created in 1974 and meets regularly four times a year.
Formerly, the Basel committee consisted of representatives from central banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. Since 2009, all of the other G-20 major economies are represented as well as some other major banking locales.

7. Cont. The committee’s members come from:
1. Argentina, 2. Australia, 3. Belgium, 4. Brazil, 5. Canada, 6. China, 7. France, 8.Germany, 9. Hong Kong SAR, 10. India,
11. Indonesia, 12. Italy, 13. Japan, 14. Korea, 15. Luxembourg, 16. Mexico, 17. The Netherlands, 18. Russia, 19. Saudi Arabia, 20. Singapore,
21. South Africa, 22. Spain, 23. Sweden, 25.Switzerland, 26. Turkey, 27. the United Kingdom and the 28. United States.

8. Cont.
The committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement the Committee's policies.
Thus the recommendations are enforced through national laws and regulations, rather than as a result of the committee's recommendations
Thus some time may pass between recommendations and implementation as laws are implemented at the national level.

9. Cont.
The Basel committee along with its sister organizations, the International Organization of Securities Commission and International Association of Insurance Supervisors together make up the Joint Forum of International Financial Regulators.

10. Basel Accord I, II
Basel II replaces the original Basel Capital Accord (Basel I accord), which came into effect in 1988.
Basel I assesses regulatory capital based on a bank’s risk assets and on its market risk.
Basel II bases the calculation on: The estimated amount of credit risk in the various risk assets, The market risk and interest rate risk associated with the banking book, Operational risk and other considerations which the regulator may have, based on the nature of the bank’s activity and the quality of the bank’s risk management (Ghana Banking Survey, 2006).

11. Cont.
According to Bessis (2002), The New Basel II Accord is the set of consultative documents
that describes recommended rules for enhancing credit risk measures,
extending the scope of capital requirements to operational risk,
providing various enhancements to the existing accord and detailing the supervision and market discipline pillars.
The accord allows for a 3 year transition period before full enforcement, when all requirements are met by banks.

12. Basel II
Basel II presents the concept of three pillars as the basis of the new regulatory capital approach.
Pillar 1 measures the amount of credit and operational risk on which regulatory capital should be assessed. For credit risk measurement, this translates to a measure of Risk Weighted Assets (RWAs).
What Does Risk-Weighted Assets Mean? In terms of the minimum amount of capital that is required within banks and other institutions, based on a percentage of the assets, weighted by risk.

13. Cont.
The idea of risk-weighted assets is a move away from having a static requirement for capital. Instead, it is based on the riskiness of a bank's assets. For example, loans that are secured by a letter of credit would be weighted riskier than a mortgage loan that is secured with collateral.
The new capital adequacy computation as required by the Bank of Ghana takes into consideration some of the requirements of Basel II especially in the area of Risk Weighted Assets (RWAs) and it is said to include some element of operational risk (computed as three years average annual gross income)

14. Cont.
Pillar 2 reviews the Pillar 1 data and extends the process in several stages: The bank must demonstrate that it can both calculate its regulatory capital in line with Pillar 1 and that it regularly reviews its capital position in light of various scenarios for market risk, operational risk and credit risk.
This requires stress testing. The bank must review any further sources of risk and assess any extra capital required to meet them. (outlines what banks should do and what regulators must do)
The Regulators are to review the bank’s own capital assessment and the robustness of its overall risk measurement and control systems.

15. Cont.
This includes a review of the governance, independence of the credit risk reporting structure, and strength of internal controls. If the regulator feels that the self assessment is not adequate, it may require an additional element of regulatory capital.
Pillar 3 requires that banks must publicly disclose significant amounts of information regarding their risks.

16. Prospect of Bank Risk Management in Ghana
In Ghana, Bank of Ghana (BOG), in its efforts to ensure that the local banking industry meets the more rigorous requirements of the Basle II Accord, initiated the promulgation of the new Banking Act 2004 (Act 673).
This act was passed by Parliament in October 2004 to replace the Banking Law 1989 (PNDCL 225) and has subsequently been amended in 2007.
Under the new Act, the minimum capital adequacy ratio was increased from 6% to 10%,

17. Cont.
And banks operating in the local industry were expected to construct and report the risk profile of the assets they carry within the medium to long-term in order to adequately justify their capital allocation processes.
Banks in Ghana are also expected to appoint a Risk Officer. The Bank of Ghana announced to the banks that all banks are likely to adopt the full provisions of Basel II with some modifications by 2009.

18. Cont.
Furthermore, banks were expected to disclose their assessment of the risk levels of the various sectors in which they invest and to continually adjust their provisioning levels as the complexion of risk changes in those sectors.

19. Challenges Basel II Poses to Banks
Basel II will lead to the following challenges on the banks in Ghana and these would be in the form of,
Possible changes to existing business activities within banking groups due to high cost of capital,
Introduction of a formal Operational Risk Management function by the banks and
Upgrade of IT platforms thereby leading to an increased spending in training personnel (Ghana Banking Survey, 2006).

20. BASEL III
Basel III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. On the 12th of November 2010, the G20 leaders officially endorsed the BASEL 3.
The third of the Basel Accord was developed in response to the deficiencies in financial regulations revealed by the global financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage.
The new standard will reduce banks incentives to take excessive risks, lower the likelihood and severity of future crises, and enable banks to withstand-without extraordinary government support- stresses of a magnitude associated with the recent financial crisis.

21. Solvency II
Solvency II is the updated set of regulatory requirements for insurance firms that operate in the European Union.
It is scheduled to come into effect on 31 Dec [FSA's website states that the EU directive is due to be implemented on 1 November 2012].

22. Cont.
Solvency II will be based on economic principles for the measurement of assets and liabilities.
It will also be a risk-based system as risk will be measured on consistent principles and capital requirements will depend directly on this.
While the Solvency I (The solvency margin is the amount of regulatory capital an insurance undertaking is obliged to hold against unforeseen events. Solvency margin requirements have been in place since the 1970s and it was acknowledged in the third generation Insurance Directives adopted in the 1990s that the EU solvency rules should be reviewed.

23. Cont.
The Directives required the Commission to conduct a review of the solvency requirements and following this review, a limited reform was agreed by the European Parliament and the Council in This reform is known as Solvency I.)
Directive was aimed at revising and updating the current EU Solvency regime, Solvency II has a much wider scope.

24. Cont. A solvency capital requirement may have the following purposes:
To reduce the risk that an insurer would be unable to meet claims;
To reduce the losses suffered by policyholders in the event that a firm is unable to meet all claims fully;
To provide supervisors early warning so that they can intervene promptly if capital falls below the required level; and
To promote confidence in the financial stability of the insurance sector

25. Cont.
Often called "Basel for insurers," Solvency II is somewhat similar to the banking regulations of Basel II.
For example, the proposed Solvency II framework has three main areas (pillars):
Pillar 1 consists of the quantitative requirements (for example, the amount of capital an insurer should hold).
Pillar 2 sets out requirements for the governance and risk management of insurers, as well as for the effective supervision of insurers.
Pillar 3 focuses on disclosure and transparency requirements.

26. Cont.
In the proposed framework being used in consultations with the industry, the EC has defined some general conditions, including the following:
The framework should provide supervisors the ability to assess the overall solvency of individual life insurance, non-life insurance and reinsurance institutions.
This assessment of overall solvency should be based on a risk- oriented approach.
The framework should contain incentives for insurance companies to measure and properly manage risks.
Solo supervision should remain a national supervisor’s task. However, it should be a goal to harmonise supervision across member states

27. Solvency II should be compatible with valuation standards and thus with the accounting standards of the International Accounting Standards Board (IASB).
The framework should encourage a level playing field in the financial industry by being consistent and compatible with banking regulations.
Small insurance concerns should be able to comply with Solvency II without having to incur disproportionate costs.

28. In the case of Solvency II, Level 1 focused on developing the framework and should, based on current timelines, be adopted by July In the next levels, technical details will be
worked out (until 2009) followed by implementation across the countries involved. According to current timelines, Solvency II should take full effect in 2010.