Read the Tea Leaves…
Volume 13, Number 8
August 23, 2023
Advocacy News You Can Use
Here at the World Council, we always get questions about how the Basel Committee on Banking Supervision goes about setting international standards. We all observe their activities hopefully—with an insight as to how the regulatory landscape will change for credit unions. Yes, there is some mystery, as a lot of the work happens behind the scenes, building consensus among the various countries and their respective supervisors. However, they really are quite transparent in their activities, and if you pay attention to what they say you can gain a tremendous amount of insight.
I offer a few things to help you look at what is on the horizon. First, look at the organizational structure. This will tell you what you need to know about the key constituencies, the influential countries, supervisors and leadership. Second, look at their workplan. It tells you the key issues that will be worked on for the upcoming year and beyond. The third item is a little trickier but look at the macroprudential analyses that they publish. Those issues really drive the work and direction taken by the Basel Committee—items such as financial stability, credit risk and others.
Recently, the Committee published its newsletter on credit risk, noting the difficulties and challenges faced by banks in assessing the credit quality of customers due to the effects of COVID-19 and other economic uncertainties. In light of the Silicon Valley Bank and Credit Suisse failures, you can tell what vulnerabilities are on the minds of the Basel Committee members. It is not hard, from there, to look for potential regulatory changes on supervisory expectations, liquidity management, asset liability management and others. Read the tea leaves, it is all there.
Basel Committee Consults on Core Principles
The Basel Committee on Banking Supervision has issued a public consultation on revisions to the Core Principles for Effective Banking Supervision ("Core Principles").
The Core Principles are the de facto minimum standards for the sound prudential regulation and supervision of banks and banking systems. They are universally applicable and accommodate a range of banking systems and a broad spectrum of banks. The Core Principles are used by supervisors to assess the effectiveness of their regulatory and supervisory frameworks. They are also used by the International Monetary Fund (IMF) and World Bank as part of the Financial Sector Assessment Program (FSAP) to evaluate the effectiveness of countries' banking supervisory systems and practices.
Originally issued by the Committee in 1997, the Core Principles were last substantively updated in 2012. The Committee commenced a review of the Core Principles in April 2022, with the objective of reflecting supervisory and regulatory developments, structural changes affecting the banking system, and lessons learnt from FSAPs since the last update.
Changes are proposed to both the structure and contents of the Core Principles standard. The proposed amendments have been informed by several thematic topics reflecting regulatory and supervisory developments in: (i) financial risks; (ii) operational resilience; (iii) systemic risk and macroprudential aspects of supervision; (iv) new risks, including climate-related financial risks and the digitalization of finance; (v) non-bank financial intermediation; and (vi) risk management practices.
The proposals were developed by a Task Force comprised of both Committee and non-Committee member jurisdictions, as well as the IMF and World Bank.
A copy of the consultation can be viewed here.
Why this matters to your credit union: The core principles set out the standards for the regulatory expectations that supervisory authorities will require of credit unions. These changes, if adopted, will directly affect supervision, examinations and regulatory frameworks.
Basel Committee Issues Newsletter on Credit Risk Issues
The recent Newsletter issued by the Basel Committee highlights the following points:
- Ongoing economic uncertainty continues to pose challenges for banks when assessing the credit quality of borrowers and vulnerable sectors.
- Sound provisioning practices enable banks identify any deterioration in credit risk in a consistent and timely way, thus forming an integral part of credit risk management.
- Supervisors continue to observe a range of practices on internal ratings-based (IRB) models and provisioning across banks and have taken supervisory action, including thematic deep dives, onsite investigations, issuing guidance and bank-specific actions.
- The Committee intends to continue monitoring bank practices in assessing credit risk and setting provisions, as the global economy continues to evolve.
Since the Newsletter on COVID-19 related credit risk issues was published in March 2022, credit risk continues to be a key area of focus for the Committee, amid the ongoing macroeconomic uncertainty and the potential impact on borrowers from rising interest rates, high inflation and market volatility. Failure to identify and measure deterioration in credit risk in a timely and consistent way may lead to higher future bank losses and capital inadequacy that could undermine confidence in the banking sector. Against this backdrop, supervisors remain cautious on banks' practices, given the challenges banks face in capturing any potential deterioration in the credit quality of borrowers and counterparties, considering model and data limitations.
Supervisors consider it crucial that banks adopt a high-quality and robust approach to credit risk modelling that can be applied consistently over time. The COVID-19 pandemic has increased the challenges banks face when assessing the credit quality of borrowers. The Committee has been monitoring and sharing supervisory observations on banks' policies and practices in relation to credit risk modelling, focusing on issues exposed by the pandemic that may remain relevant in the current risk environment. The work highlighted:
- The credit quality assessment of borrowers has become increasingly challenging for banks in the light of the pandemic. A range of practices have been observed in expected credit losses (ECL) provisioning and credit risk internal ratings-based (IRB) models, and there remains scope for further developing robust practices across banks.
- Supervisors continue to observe three main challenges that warrant further monitoring, namely (i) governance controls around model risk management including judgment-based overlay and model performance; (ii) capturing economic uncertainty; and (iii) identifying credit deterioration in vulnerable sectors and borrowers. Together, these challenges could affect banks' ability to recognize changes in credit risk in a timely manner.
- Banks continue to apply sizeable judgment-based adjustments to compensate for model and data limitations to reflect credit risk expectations. Due to the scale of government support measures, some of credit risks have become disconnected from the actual risks of the portfolios, which may still materialize in the future.
- The Committee recognizes the role played by judgment-based adjustments related to model performance and emphasizes that these adjustments should be subject to robust governance and supported by appropriate documentation and methodologies. Banks should monitor and continuously enhance controls around model risk management and development to ensure they remain fit for purpose.
- Banks and supervisors may not have an accurate view of credit risk if model issues are not well understood or adequately compensated for. Supervisors continue to focus on banks' ability to identify model performance issues in a timely manner, and to identify enhancements to ensure a well-controlled modelling process. Supervisors also continue to focus on banks' strategic plans to minimize and/or mitigate model risk through better capture of key risk drivers and robust data governance that are relevant to support a sound expected credit loss (ECL) process.
- Undercalibration of probability-of-default (PD) models has been observed by supervisors, and supervisory measures have led to remedial action on the part of banks, including model overlays, risk-weighted assets (RWA) overlays, PD scale-ups and RWA add-ons.
- Recent geopolitical events may have started a new cycle of credit conditions before possible effects of the pandemic have fully fed through. Focus has shifted towards adjustments to capture the impact on borrowers related to factors from rising interest rates, high inflation, and market volatility. It may be more challenging to isolate the downturn period that should be used for the ECL process and for IRB models.
- Banks have experienced difficulties in assessing how economic shocks affect different portfolios, as the risk environment has evolved rapidly and is very different from that of the recent past, leading to heightened model risk. Supervisors have observed that banks apply a range of different approaches to capture the impact of macroeconomic headwinds on borrowers, particularly when historical data may not reflect the current economic outlook. Supervisors continue to focus on: (i) how banks are using their sensitivity analysis capabilities to understand the impact of using alternative economic assumptions on provision estimates; and (ii) how effective banks' processes are in identifying vulnerable sectors and factoring sectoral risks in to provision estimates.
- The Committee stresses the importance of: (i) sensitivity analysis in assessing credit risk; and (ii) the appropriate use of data collected during the pandemic to understand how the key drivers of credit losses affect different portfolios.
- Supervisors and banks need to be prepared to address the challenges related to ECL provisioning processes and IRB models to ensure banks are able to identify any potential deterioration in the credit quality of borrowers and counterparties.
The Committee intends to continue assessing bank practices in credit risk modelling and will continue to monitor potential risks in the evolving economic environment and financial conditions.
A copy of the Newsletter can be viewed here.
Why this matters to your credit union: The Basel Committee’s focus on credit risk will portend potential regulatory changes and supervisory expectations. Their observation about the difficulties in assessing credit quality during this economic time will mean heightened attention by supervisory authorities for credit unions.
FATF Issues Targeted Update on Implementation of FATF Standards on Virtual Assets
The Financial Action Task Force has issued its Targeted Update on the Implementation of FATF Standards on Virtual assets calling for all countries to rapidly implement measures on virtual assets (VAs) and virtual asset service providers (VASPs).
In 2019, FATF extended its anti-money laundering and counter-terrorist financing (AML/CFT) measures to VAs and VASPs to prevent criminal and terrorist misuse of the sector. Since then, FATF has produced three reviews on implementation of its standards on VAs and VASPs. This report provides an update on country compliance with FATF’s Recommendation 15 and its Interpretative Note (R.15/INR.15), including the Travel Rule, and updates on emerging risks and market developments, including on Decentralized Finance (DeFi), Peer-to-Peer transactions (P2P), and Non-Fungible Tokens (NFTs), unhosted wallets and stablecoins.
FATF's report finds that jurisdictions continue to struggle with fundamental requirements such as undertaking a risk assessment, enacting legislation to regulate VASPs, and conducting a supervisory inspection. Based on 98 FATF mutual evaluation and follow-up reports since the revised R.15/INR.15 was adopted, 75% of jurisdictions are only partially or not compliant with the FATF’s requirements. In addition, jurisdictions have made insufficient progress on implementing the Travel Rule, which is a key AML/CFT measure. Of the 151 jurisdictions that responded to FATF’s 2023 Survey, more than half still have not taken any steps towards implementing the Travel Rule. This is a serious concern as the risks posed by VAs and VASPs continue to increase and that the lack of regulation creates significant loopholes for criminals to exploit. This demonstrates an urgent need for jurisdictions to accelerate implementation and enforcement of R.15/INR.15 to mitigate criminal and terrorist misuse of VAs and VASPs.
FATF’s report acknowledges collaboration among the private sector members to improve industry compliance with R.15/INR.15, including the Travel Rule, and highlights that all players need to have appropriate risk identification and mitigation measures, and continue to work towards fully compliant Travel Rule compliance tools.
While DeFi and unhosted wallets, including P2P, do not account for a large share of transactions, they are at risk of misuse, including by sanctioned actors. The FATF will therefore continue to monitor the illicit financing risks and developments in this sector.
The FATF calls on all countries to rapidly implement the FATF’s Standards on VAs and VASPs, including the FATF’s Travel Rule. In February 2023, the FATF adopted a roadmap to improve implementation of R.15. In line with this roadmap and to address the findings of this report, the FATF will:
- Continue to conduct outreach and provide assistance to low-capacity jurisdictions.
- Identify and publish steps FATF member jurisdictions and other jurisdictions with materially important VASP activities have taken towards implementing R.15/INR.15.
- Facilitate sharing of finding, experiences and challenges, including relating to DeFi, unhosted wallets and P2P, and monitor market trends in this area for material developments that may necessitate further FATF work.
- Continue to engage with member countries and the private sector on progress and challenges.
- Conduct a further review on progress and remaining challenges for implementation by June 2024.
A copy of the report can be viewed here.
Why this matters to your credit union: Virtual assets and their potential to be abused by money launderers continues to be an urgent concern. This shows the evolution of regulation in the AML/CFT area, with a call for national level supervisors to make appropriate changes in their respective jurisdictions. Credit unions can expect continual change in this area as regulations evolve.
Andrew T. Price, Esq.