Bank Compliance

Banks hold capital to protect depositors and other creditors against potential losses. Capital is typically in the form of shareholders’ equity and long-term subordinated debt.

The amount held is proportionate to the level of risk on the bank’s balance sheet. Most banks have adopted the Basel II rules for capital allocation. The latest regulations attempt to link more closely the level of risk associated with an asset to the amount of capital which must be held against it.

The Basel II framework consists of three pillars:

Pillar 1 – The minimum capital requirement

Rules-based approach which allocates capital for:

  • Credit risk

  • Market risk

  • Operational risk

Pillar 2 – Supervisory review

Banks prepare an Internal Capital Adequacy Assessment (ICAAP) which sets out the firm’s internal view of ‘adequate capital’. This is based on risk aggregation, diversification and other factors not considered in Pillar 1. This is agreed with the bank’s supervisors who may impose additional Pillar 2 capital charges.

Pillar 3 – Market discipline

Banks must publish an annual Pillar 3 disclosure to allow depositors and other counterparties to make an informed decision about the banks inherent risks. This is intended to promote better risk management through market discipline.

Credit Risk Capital Requirement (CRCR)

The latest Basel III regulations have increased the core tier-one capital ratio to 4.5%, effectively increasing the amount of capital required to be held by financial institutions. These changes will start to take effect from January 2013.

There are two approaches to calculating the CRCR – The Standardised Approach (TSA) and the Internal Ratings Based approach (IRB). By default, firms must use TSA unless they have a waiver (regulatory approval) from their supervisor to use IRB. The Risk Weighted Assets (RWA) figure is multiplied by the bank’s capital ratio to determine the CRCR. Specific rules determine the eligibility of credit risk mitigation (collateral and security held) for regulatory capital relief.
 

FACT Compliance Diagram

Compliance Diagram

 

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