Basel II introduces a three-pillar concept that seeks to align regulatory requirements with economical principles of risk management. Its capital requirements have wide-ranging implications for risk management and, thus, for corporate governance. Basel II compliance is a risk management challenge with strategic business implications rather than a pure technical issue. KPMG professionals can help cope with these new challenges.
Regulatory capital planning has always been an important aspect of banks’ compliance activities. Now, however, economic capital planning is becoming increasingly important to banks’ overall competitiveness-and with the development of the Basel II proposals for a new capital accord, understanding and measuring economic capital has also become a compliance obligation.
“Economic capital” is the capital banks set aside as a buffer against potential losses inherent in any business activity-corporate lending, for example, or currency trading. Banks’ focus on economic capital is part of an industry-wide movement to measure risks, to optimize performance measurement, to base strategic decisions on accurate information, and thus to strengthen an institution’s long-term profitability and competitiveness.
In evaluating these issues, leaders are considering questions including:
* Do we understand the nature and level of risk the bank is taking?
* How much capital is needed to support the bank’s total risk? What is the expected return on that capital?
* Is the bank over or under capitalized in relation to its risks?
* Are individual business lines creating or destroying shareholder value?
* What are the major sources of concentration and diversification on our portfolio? What opportunities for growth or diversification exist within the bank?
* How should the business’s capital be managed within constraints imposed by regulators, investors, and rating agencies?
* How do we improve our portfolio performance? Which exposures should we buy or sell and in what quantities? What is an optimal strategy for hedging/selling down risk?
* Do we need better analytics to support our discussions with rating agencies and thereby support our rating?
Although economic capital planning has been evolving for a number of years, it has attained new focus and urgency as a result of the regulatory mandates of the Basel II Capital Accord (Basel II). In a new three-pillar framework, Basel II introduces the concept of economic capital into the regulatory capital consideration by requiring banks to determine capital adequacy based on the level of risk posed by specific business activities. In emphasizing capital planning overall, Basel II overcomes a substantial shortcoming of its 1988 predecessor, which did not require banks to develop their own methods, processes, and systems to measure the capital level adequate for the risks they assume.
This white paper emphasizes the importance of banks’ evolving efforts to integrate economic capital planning into overall risk management. These efforts can help banks build value in their businesses as well as comply with Basel II.
Regulatory capital planning has always been an important aspect of banks’ compliance activities. Now, however, economic capital planning is becoming increasingly important to banks’ overall competitiveness-and with the development of the Basel II proposals for a new capital accord, understanding and measuring economic capital has also become a compliance obligation.
“Economic capital” is the capital banks set aside as a buffer against potential losses inherent in any business activity-corporate lending, for example, or currency trading. Banks’ focus on economic capital is part of an industry-wide movement to measure risks, to optimize performance measurement, to base strategic decisions on accurate information, and thus to strengthen an institution’s long-term profitability and competitiveness.
In evaluating these issues, leaders are considering questions including:
* Do we understand the nature and level of risk the bank is taking?
* How much capital is needed to support the bank’s total risk? What is the expected return on that capital?
* Is the bank over or under capitalized in relation to its risks?
* Are individual business lines creating or destroying shareholder value?
* What are the major sources of concentration and diversification on our portfolio? What opportunities for growth or diversification exist within the bank?
* How should the business’s capital be managed within constraints imposed by regulators, investors, and rating agencies?
* How do we improve our portfolio performance? Which exposures should we buy or sell and in what quantities? What is an optimal strategy for hedging/selling down risk?
* Do we need better analytics to support our discussions with rating agencies and thereby support our rating?
Although economic capital planning has been evolving for a number of years, it has attained new focus and urgency as a result of the regulatory mandates of the Basel II Capital Accord (Basel II). In a new three-pillar framework, Basel II introduces the concept of economic capital into the regulatory capital consideration by requiring banks to determine capital adequacy based on the level of risk posed by specific business activities. In emphasizing capital planning overall, Basel II overcomes a substantial shortcoming of its 1988 predecessor, which did not require banks to develop their own methods, processes, and systems to measure the capital level adequate for the risks they assume.
This white paper emphasizes the importance of banks’ evolving efforts to integrate economic capital planning into overall risk management. These efforts can help banks build value in their businesses as well as comply with Basel II.
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