The global banking system has gone through turbulence over the past few years due to diverse macroeconomic changes. Subsequently, banks have experienced inadequate high levels of capital. Strong capital requirements comprise one of the fundamental conditions in promoting stability within the banking industry (Barth, Caprio & Levine 2006, p. 5). Krivoy (2008, p. 122) asserts that the lack of ‘capital is a frequent source of banks’ weakness in emerging market economies. This situation may arise from the integration of inadequate capital requirements and low-quality capital. Subsequently, banks must reinforce their liquidity through the integration of strong supervisory standards (Adams 2009). Additionally, it is imperative for regulators within the banking sector to promote effective capitalisation within the industry (Putnis 2014).In only 3 hours we’ll deliver a custom Capital Adequacy Regulation in Banking: ICAAP and SREP essay written 100% from scratch Get help
To promote their resilience, banks are obliged to adopt Internal Capital Adequate Assessment Process [ICAAP] in their banking system (Bank of England 2013). The ICAAP entail a set of requirements that banks must adhere to in assessing the amount, type, and capital distribution. This assessment is essential in determining the banks’ capacity to cope with risks (Adams 2009). The ICAAP must be updated continuously to assess the banks’ capital adequacy level. Thus, it is possible for the national regulatory authority, in a specific country, in collaboration with individual banks to determine the necessary changes in their capital management to align with the prevailing business environment.
The effective implementation of the ICAAP is achieved by incorporating the Supervisory Review and Evaluation Process [SREP], which involves reviewing the implemented strategies, mechanisms, and processes coupled with assessing the risk that a particular bank is exposed to according to Pillar II of the Basel Accord. The implementation of the ICAAP and the SREP should be a collaborative effort amongst different parties. Such an approach will play a fundamental role in the effective formulation of supervisory and regulatory frameworks. The Basel framework has played a fundamental role in assisting different countries to improve their banking systems. The framework has undergone considerable changes over the years to assist banks to improve their regulatory capital requirements by taking into account the risks faced in their operations.
This paper reviews the application of ICAAP and SREP in the US, Canada, Brazil, Peru, Chile, Venezuela, and Argentina. The methodology applied by the individual country is outlined. The conclusion will be drawn from the findings of the respective country in order to determine the efficacy of the countries in applying the ICAAP and SREP.
The functioning of ICAAP in individual countries
The United States of America
The US is characterised by a unique and complex banking system. First, banks operating within the country hold relatively fewer assets due to the strict regulations imposed by the federal government. Additionally, the sector is characterised by a dual banking system, whereby banks can obtain a charter from the state or the federal government. Szulczyk (2015, par. 8) posits that banks that obtain a charter from the national government are subject to regulation by three main agencies, which include ‘the Federal Deposit Insurance Corporation [FDIC], the Federal Reserve [Central Bank], and the Comptroller of the Currency. The complexity within the sector arises from the need to promote the banks’ level of stability and efficiency in the financial intermediation processes (Szulczyk 2015).
The industry is controlled by five big banks, which include the Bank of America, JPMorgan Chase, US Bancorp, Wells Fargo, and Citigroup (Schaefer 2015). The five banks collectively hold over $ 6.8 trillion of the total assets in the industry. The industry’s growth has been spurred by increased consolidation through the formation of mergers. The recent collapse of the sector has motivated the government to increase controls in the banking industry.
The internal capital-adequacy assessment process at the US banks
The US government recognises the importance of the capital adequacy process in the governance and control of the banking sector. The bank’s senior management and boards are obliged to institute a comprehensive, effective, and integrated Capital Adequacy Process [CAP]. The CAP should be aligned with the organisations’ risk management practices. Furthermore, the regulatory authorities must ensure that the management of capital adequacy within the banks is linked to Basel III internal capital management.Academic experts
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In 2008, the US Federal Banking Supervisory Agency [FBSA] published comprehensive supervisory guidance that contained the standards that banks should follow to attain capital adequacy per Pillar 2 of Basel II. In its implementation of the ICAAP, the regulatory authorities in the banking sector pressurise banks to incorporate three main measures of capital (AMA Group Document 2009).
First, the bank’s capital should be comprised of the minimum regulatory capital requirement. This capital entails compliance with Pillar I capital requirement, which entails an estimate of the minimum capital adequacy. PricewaterhouseCoopers (2012, p. 4) emphasises that
While new minimum capital requirements are 4.5%, 6.0% and 8% for common equity tier 1 capital [CET1], tier I capital [Tier 1] and total capital respectively, the requirement for an additional 2.5% of CET1 for the capital conservation buffer increases minimum capital requirements to 7% for CET1, 8.5% for Tier 1 and 10.5% for total capital
Adherence to minimum capital requirement also depends on the degree to which banks integrate a wide array of risks such a liquidity risk (AMA Group Document 2009). The implementation of ICAAP in the banks’ operations further requires banks to assess their economic capital and book capital level. The determination of the book capital level enables financial institutions to assess their level of resources, hence determining the capacity to absorb the loss of net liabilities. Furthermore, the US commitment to the implementation of the ICAAP is clear given the establishment of higher risk-weighted assets [RWA], restrictive capital definitions, and the integration of tough capital standards and maintenance of higher minimum capital ratios.
The decision of the US to reform the internal capital management practices in banks is motivated by the need to ensure that banks comply with Basel III standards. Capital adequacy amongst the US banks is further promoted by the integration of the Dodd-Frank Act of 2010, which accentuates the importance of addressing capital reserve requirements amongst banks (Getter 2014).
The Overall Organisation of the Supervisory Review and Evaluation Process
The supervisory role amongst financial institutions in the US falls under the mandate of the Federal Reserve. The Fed requires banks to maintain their capital level above the minimum risk-based level. The supervisors assess the banks’ overall capital adequacy level progressively by considering all the pertinent qualitative and quantitative information. In deciding on the degree to which a bank can hold a higher capital, the supervisors consider the quality and results of the banks’ ICAAP, the implemented control structures, risk management practices, and risk profile. Additionally, the Federal Supervisor has the discretion to undertake the necessary adjustments if the internal capital adequacy within individual banks is effective (Dugan 2009).
The regulatory authorities in the US banking industry are largely concerned with risk in their SREP. Subsequently, the implementation of the ICAAP is undertaken by identifying and reviewing all the material risks faced by banks. Dugan (2009, p. 11) posits that the ‘core risks considered during the SREP include the market risks, credit risks, interest rate risks, liquidity risks, and operational risks. Apart from these risk categories, the regulatory authorities further take into account other forms of risks, viz. business, country, and reputational risks. The consideration of broad risk categories will improve the efficiency with which the SREP contributes to the effective management of capital adequacy.15% OFF Get your very first custom-written academic paper with 15% off Get discount
SREP: Methodological focus areas
In its quest to promote internal capital adequacy amongst banks, the Federal banking agencies have integrated the advanced approach rule, which is a risk-based capital framework. According to the Basel II Association (2014, par. 6), ‘the supervisory authorities assess the banks’ minimum risk-based capital requirement, the supervisory review, and the promotion of market discipline through public disclosure of banks financial performance. The supervisory authorities ensure that the SREP is implemented continuously to assess the banks’ capital adequacy levels.
The evaluation of risks amongst banks is further undertaken by integrating the stress-testing model to deter the material risks. Using the stress-testing model enables the Fed to determine the resilience of the banks under stressful situations.
Despite the turmoil experienced in the global financial sector, the Canadian banking sector continues to depict a relatively high degree of resilience due to the integration of strong governance practices. The sector has 81 banks, but six main banks dominate the industry and they include The Bank of Montreal, TD Canada Trust, Royal Bank, The Bank of Nova Scotia, The National Bank of Canada, and the Canadian Imperial Bank of Commerce. The six banks control 90% of the industry (PricewaterhouseCoopers 2014). All the banks are regulated under the Canadian Banking Act. The Act is reviewed every 5 years in order to assess its significance in promoting a strong banking system (KPMG 2015). It is projected that the sector will experience challenges originating from the multiplicity of fronts such as economic changes. A considerable number of banks have turned around from the negative effects of the recession, which is evidenced by the increase in the level of their profitability. The Canadian banks’ ability to sustain their dominant market position will depend on their regulatory effectiveness (Cognizant 2011).
Internal Capital Adequacy Assessment Process at Canadian banks
Canadian banks are focused on improving their resilience to environmental changes. The Office of Superintendent of Financial Institutions [OSFI] published its observations on ICAAP. The federally regulated deposit-taking entities are required to formulate their own ICAAP in order to improve their effectiveness in determining the most optimal internal capital targets. Additionally, individual entities are required to formulate effective strategies that will contribute to the attainment of the set internal targets. The report was issued to all banks in the country. The OSFI requires all the deposit-taking institutions in the country to submit a complete and accurate Basel Capital Adequacy Report [BCAR] and the firms’ ICAAP (CIBC Mellon 2015). Moreover, the Office of the Superintendent of Financial Institutions (2010, par. 8) posits that the ‘OSFI demands that all federally regulated deposit-taking entities institute an ICAAP that considers the banks consolidated operations’. This approach is aimed at ensuring that banks do not risk the clients’ investments due to their international and domestic operations.
Amongst the areas of concern relates to capital management. The ‘Big Six’ banks have outlined their commitment to increase their CET1 ratio by 1% by 2016. In the recent past, the big six banks have experienced a significant decline in their capital level. Between 2012 and 2013, the tier 1 capital ratio declined from 12.96% to 11.38% due to the stringent regulations associated with the adoption of Basel III. The integration of Basel III was intended to minimise the assets that increase the likelihood of a financial crisis. The success of the big six banks in Canada has arisen from the fact that they are well capitalised. Furthermore, the banks are progressively increasing their capital level. For example, TD Canada Trust and Royal Bank of Canada increased their buffer from 2.52% to 3.2% and over 8.5% respectively by January 2014 (PricewaterhouseCoopers 2014, p. 25).
The Overall Organisation of the Supervisory Review and Evaluation Process
The supervisory role in the Canadian banking industry is undertaken by three main institutions, which include the OSFI, the Bank of Canada, and the Department of Finance. The multifaceted approach aims at ensuring optimal regulation amongst the deposit-taking institutions in the country. Because individual banks are required to implement their own ICAAP, the supervisory and evaluation role rests with the banks’ board and the senior management (Office of the Superintendent of Financial Institutions 2010).
Effective assessment of the banks’ capital adequacy requires the banks to formulate an optimal risk management process. Furthermore, banks are required by OSFI to assess their capital requirement based on their strategic objectives. The board in collaboration with the banks’ senior management should develop detailed policies outlining the institution-wide controls in line with the risk-taking capacity. The policies should be communicated throughout the institution and a risk assessment framework developed. This approach will improve the banks’ ICAAP remarkably (Office of the Superintendent of Financial Institutions 2010).Get your customised and 100% plagiarism-free paper on any subject done for only $16.00 $11/page Let us help you
The Canadian supervisory review in the banking sector focuses primarily on the banks’ risk management and internal control frameworks. The implementation of the SREP aims at ensuring that the different risk categories facing banks are considered adequately. Subsequently, the risks that might not be captured fully in determining the minimum regulatory capital requirement are considered. The types of risks considered include credit risk, liquidity risk, interest rate risk, risk concentration, market risk, risk diversification, operational risk, and the risks that emanate from cross-border lending. In addition to these risks, banks are also required to assess the impact of other risk categories such as reputational and strategic risks. These risks are essential to improving the organisations’ capital stability.
SREP: Methodological focus area
The Canadian banks have instituted diverse risk assessment methodologies according to their risk exposure. One of the methodologies applied entails the stress-testing method. The adoption of this method enables financial institutions to assess the potential impact of the diverse risk events on the banks’ financial condition. In the course of applying the stress-testing method, financial institutions are required to adopt the forward-looking stress testing approach. This approach is critical in evaluating possible risk events and their effect on the organisations’ capital stability (Bank for International Settlements 2014, p.14).
In addition to stress testing, the SREP is further undertaken by integrating different methodologies such as the internal rating-based approach [IRB] and the standardised approach in assessing credit risk. The standardised approach is aligned with the Basel standards (Bank for International Settlements 2010). On the other hand, market risk is assessed using the standardised measurement method while the operational risk may be evaluated using the basic indicator approach, advanced measurement approach, and the standardised approach (Bank for International Settlements 2014, p. 16).
The banking industry in Brazil is comprised of domestic and foreign banks. Domestic institutions account for 49.06% while foreign banks account for 35.22% of the banking system. The Brazilian banking system has become highly consolidated due to increased cases of mergers and acquisition activities. The industry is dominated by six banks that account for over 80% of the total assets in the industry. Recently, Brazil has embarked on a process aimed at improving operations within the industry. For example, in 2013, the country engaged in the Regulatory Consistency Assessment Program [RCAP], which is one of the programs integrated by the Basel Committee on Banking Supervision [BCBS] (EMIS 2013, p. 1). The objective of the program is to assess the banks’ adherence to prudential regulation concerning the minimum standards. Brazil ranks amongst the leading countries regarding the efficiency of the financial system (KPMG 2014, p. 1).
Despite the past success, the Brazilian banking industry is experiencing challenges arising from global economic changes, which has led to a slowdown in the country’s economic activity. The global financial crisis has stimulated the Central Bank of Brazil [BCB] to tighten its operations to address financial stability in the banking sector. Recently, Moody’s lowered the outlook of the Brazilian banking industry from stable to negative due to a slump in the country’s economic performance, hence making it difficult for banks to offer credit services in addition to controlling loan defaults (Parra-Bernal 2014, par. 1).
Despite the high liquidity within the banks, the low level of economic growth might compromise the capacity of the banking system to bolster capital. Parra-Bernal (2014) asserts that ensuring robust capital in the banking system is fundamental in assisting banks to deal with cases of financial stress. The banking sector is regulated continuously by the BCB. The regulation is being undertaken through the integration of the Basel II Accord (Bank for International Settlements 2011).
Internal Capital Adequacy Assessment Process at Brazilian banks
Banks in Brazil are obliged to maintain adequate capital in their operations. The minimum capital must correspond with the banks’ risk profile according to Resolution No. 3444 and 3490, which stipulate the procedures that banks must comply with in determining their compliance with the regulatory capital. Under Resolution No. 3444, banks are required to maintain their minimum capital adequacy ratio at 11% (International Monetary Fund 2012a, p. 30). Moreover, the implementation of the ICAAP amongst banks is further achieved through the integration of Resolution 3988, which obliges all banks in Brazil to formulate an effective capital management framework. Similarly, the framework must be aligned with the individual bank’s risk profile. The integration of the capital management framework requires the financial institutions to plan, evaluate, control, and monitor their capital needs, which are critical components of the ICAAP (International Monetary Fund 2012a, p. 35).
The ICAAP results are submitted to the bank’s board of directors. This approach provides banks with an opportunity to assess their risk exposure, hence providing insight into the necessary adjustments. Furthermore, the implementation of ICAAP amongst Brazilian banks is achieved by complying with the Supervision Manual, which is used in assessing the quality of the ICAAP. According to the International Monetary Fund (2012a, p. 36), ‘quality assessment is achieved by evaluating the institutions’ risk profile, complexity, size, and business strategy. The supervision process further examines whether the financial institutions have instituted a policy that outlines the minimum desired capital. The policy should take into account the financial institutions’ risk-taking capacity.
The Overall Organisation of the Supervisory Review and Evaluation Process
Regulation in the Brazilian banking industry is undertaken by the country’s Central Bank. BCB undertakes a thorough and intrusive risk-based supervision. The supervisory process is customised to the individual. According to the International Monetary Fund (2012a, p. 10), ‘each institution is on a 12 or 24-month supervisory cycle, which is planned and guided by the plan set out by the Risk and Control Assessment System [SRC]’.
The International Monetary Fund (2012a, p. 73) adds, ‘The SRC entails an effective methodology that enables the financial institutions to identify and measure the relevant risks and examine the effectiveness of the implemented internal control systems. The SREP is undertaken by following a supervisory plan, which is comprised of both onsite activities and continuous monitoring (International Monetary Fund 2012a, p.10).
Additionally, the supervisory process is achieved by leveraging the banks’ information systems, which improves the effectiveness and efficiency with which quantitative analysis is undertaken (Ferran 2012). The inclusion of the quantitative analysis plays a fundamental role in undertaking risk rating amongst the various banks. According to the International Monetary Fund (2012a, p. 10), ‘the supervisory process further entails a qualitative overview of the banks’ operation using the detailed analysis of their risk management and corporate governance. The process of continuous monitoring is achieved by sourcing information from different sources.
All banks in Brazil are required to register their financial instruments with the BCB, which means that the BCB can assess the banks’ liquidity position and market risk exposures (International Monetary Fund 2012a, p. 11). The SREP is undertaken under the watch of an onsite department that is comprised of experienced teams that evaluate the banks’ risks. The teams are charged with the responsibility of undertaking a continuous evaluation of the banks’ operations.
The implementation of the SREP in the Brazilian banking industry is based on the risks faced by the banks. Subsequently, the SREP is based on a multifaceted approach to address the various risks that might affect the banks’ operational efficiency. The adoption of the multifaceted approach is necessitated by the need to ensure that banks adopt effective risk management strategies. The core risks considered in the SREP include contagion risks, liquidity risks, business operational risks, credit risk, market risk, legal risk, corporate operational risk, information technology risk, strategic risk, and money laundering risk (International Monetary Fund 2012a, p. 34). The BCB undertakes continuous risk monitoring to assess the changes in risk and the potential impact on banks.
SREP: Methodological focus area
In the course of implementing the SREP, the BCB integrates the stress-testing methodology in order to examine the impact of risk trends on banks operations. The stress testing methodology is further executed through the integration of the going concern approach, which provides an opportunity to assess the banks’ effectiveness in aligning with the prevailing environment. Additionally, the SREP is undertaken by integrating the qualitative methodology. Under this methodology, the BCB has integrated four-grade assessment systems, which include the non-compliant, largely compliant, compliant, and materially non-compliant (International Monetary Fund 2012a, p. 4).
Furthermore, the determination of risk is further achieved through the integration of other methodologies such as the standardised approach, internal model approach, the standardised measurement method, and the advanced measurement approach. The integration of these methods improves the banks’ capacity to assess their exposure to different risk categories (Bank for International Settlements 2013, p. 10).
The Chilean banking sector has undergone considerable changes over the past few years due to the numerous reforms implemented by the government. Some of the notable changes in the Chilean banking structure entail the entry of foreign banks and an increase in the number of mergers and acquisitions. Currently, there are 26 banks in Chile. Fourteen of the banks are domestically owned, while 12 are foreign-owned. Furthermore, the banking sector is highly concentrated due to the large conglomerates operating in the industry. Most of the conglomerates are domestically owned. The sector is dominated by 10 conglomerates, which control over 77% of the total assets in the sector. Despite the negative impact associated with the recent crisis, the banking sector remains adequately capitalised, profitable, and liquid. Most of the industry players ensure that the amount of capital is maintained within the Basel III standards. However, banks mainly depend on deposits as the core source of their funding.
To promote stability within the sector, the Chilean banks are in the process of implementing new liquidity and capital requirements according to the Basel III framework. It is expected that the new capital requirements will be due for implementation between 2015 and 2019. A study conducted by the Central Bank of Chile [BCCh] in collaboration with the Superintendence of Banks and Financial Institutions [SBFI] asserts that most Chilean banks are ready to comply with the new capital requirement. Furthermore, it is estimated that the new capital requirement will not be restrictive amongst the Chilean banks.
Internal Capital adequacy assessment process at Chilean banks
The BCG and SBIF are focused on ensuring that banks within the country have adequate resources to support their daily operations. However, in a bid to achieve this goal, the regulatory authorities will conduct stress tests periodically to assess the banks’ ability to cope with severe macroeconomic shocks. One of the aspects that the regulatory authorities will focus on in conducting the stress tests entails the liquidity coverage ratio.
Overall Organisation of the Supervisory Review and Evaluation Process
The Chilean government has made considerable progress regarding the integration of a robust supervisory framework within the banking sector. Different bodies such as the BCG and the SBIF undertake the SREP. These bodies adopt a risk-based supervision approach, whose foundation is a well-established bank rating system. Additionally, the supervision and regulation of the sector are achieved by ensuring the effective definition of the minimum capital requirement in the banking policies according to Basel III requirements.
In the quest to strengthen the SREP, the Chilean government has integrated a market risk limit that banks should observe. Other aspects integrated into the SREP entail issuing comprehensive regulations concerning liquidity risk and derivatives.
Since 2009, banks in Chile are required to adhere to new accounting and financial reporting standards. Additionally, the SBIF issued new corporate governance principles that were recently recommended by the Basel Committee on Banking Supervision [BCBS]. In its quest to promote a stable banking sector, the SBIF periodically publishes the CAR for all banks. The CAR is adjusted according to the individual bank’s exposure to market risks. The supervision process has further integrated different elements outlined under Pillar II and III of Basel III. Some of these elements relate to disclosure requirements, supervisory assessment of the banks’ capital, and operations.
The effectiveness of the SREP in the Chilean banking sector is also achieved by integrating it within the legal framework according to Basel III. For example, banking laws require banks to maintain a systematic capital surcharge and a leverage ratio that is higher than 3% of the bank’s total assets. Authorities in Chile are working progressively towards ensuring that the various Basel II and III elements are incorporated within the SREP framework. The SBIF in collaboration with the SBIF and the BCCh holds monthly meetings to assess the health of all banks in Chile. The results obtained during the meeting culminated in the issuance of effective regulations.
Banks in Chile have identified risk as one of the critical issues in implementing the ICAAP. Subsequently, the banks have integrated the risk approach. The banks are mainly concerned about the new forms of risks currently being encountered in the contemporary banking industry. The pursuit for new forms of risks has arisen from the recognition of the high rate of contagion and volatility within the banking sector. Chile has become increasingly integrated into the global economy due to interbank payment, hence increasing the probability of risk originating from different banking systems.
Additionally, banks in Chile are required to integrate advanced techniques in their ICAAP in order to determine the impact of the emerging risks on their capital adequacy effectively. The SBIF has been mandated to request all banks in Chile to provide relevant qualitative and quantitative information in order to assess the banks’ risk exposure.
SREP: Methodological focus area
Risk measurement amongst the Chilean banks will be undertaken by integrating diverse methodologies. One of the essential methodologies entails stress tests. The tests will be conducted through a collaborative effort between different teams derived from the BCCh, the FSAP, and the SBIF. The stress tests will be conducted by taking into account different types of risk. Banks in Chile are pressurised to incorporate different scenario tests in their internal capital adequacy assessment processes in order to assess the banks’ preparedness for risks.
In the course of assessing credit risk using the stress tests, banks will be required to integrate the nonlinear vector auto-regression [VAR] method. This method will enable the banks to determine if they are adequately capitalised and their resilience under different scenarios. In the course of undertaking stress tests, the Chilean banks will be required to take into account different scenarios such as severe risk and baseline scenario. The severe scenario is mainly used to assess the banks’ capacity to deal with severe macroeconomic changes. Additionally, banks must examine single factor shock and liquidity stress tests. The liquidity stress tests are essential in determining the health of the individual bank’s funding base and the impact of shocks such as sudden or panic withdrawals.
The Peruvian banking sector is characterised by a high degree of concentration. The high concentration has led to a decline in the number of industry players. The industry is dominated by four major banks, which include Banco de Credito del Peru, Interbank, Scotiabank Peru, and Banco Continental. The four banks hold over 80% of the total deposits and loans in the sector. Despite the high concentration, the sector has depicted robust performance over the past decade (Financial Stability Institute 2013, p. 16).
The sector’s positive performance despite the recent financial crisis has been spurred by the entry of foreign banks such as Santander, Industrial Commercial Bank of China, Banco Azteca, Banco Falabella, Banco Ripley, Deutsche Bank, and GNB Sudameris (Lonergan 2014, par. 5). Additionally, the performance of the banking sector has been promoted by the integration of prudential regulations, which are aligned with the Basel III Accord. The adoption of Basel III will ensure that the banks’ operations comply with international standards.
Internal Capital Adequacy Assessment Process at Peru
The Peruvian government has undertaken several reforms in the banking laws to promote capital adequacy in the banking sector. The reforms are being undertaken under the watch of the Superintendencia de Banca Seguros [SBS], which is the core regulatory authority in the banking sector. The reforms have largely focused on the banks’ minimum capital requirement concerning the operational, market, and credit risks as outlined under Pillar I of Basel II. The reforms have further led to an increment in banks’ minimum capital ratio. The Peruvian banks are obliged to assess their capital adequacy according to their risk profile. Additionally, banks should hold sufficient capital buffers to deal with all the material risks that might be encountered in the businesses cycles (HelgiLibrary 2015, p. 1). The process of implementing the ICAAP amongst the Peruvian banks further advocates a high level of informational transparency in the banks’ capital management processes.
The capital buffer requirement differs depending on the type of deposit-taking institution. For example, commercial banks are required to maintain an additional buffer of 2.5% while microfinance institutions should maintain a 6% buffer. The consideration of additional capital enables banks to comply with Pillar II requirements (Financial Stability Institute 2013, p. 16). Since 2009, banks in Peru are obliged to develop an annual report outlining their internal capital assessment process.
The SBS is continuously committed to reinforcing the sector’s regulatory framework. Subsequently, banks are in a position to identify, evaluate, treat, and control various risks. Peru has set a capital adequacy ratio at 10%, which is higher than the 8% requirement of Basel II (Torre, Ize & Schmukler 2012, p. 168). However, the SBS is focused on improving the CAR continuously. For example, in 2014, the CAR was estimated to be 14% (HelgiLibrary 2015, p. 1). Recent stress tests in the sector show that the Peruvian banking sector has adequate capacity to cope with severe shocks (Bank for International Settlements 2014).
The Overall Organisation of the Supervisory Review and Evaluation Process
Regulation and supervision within the Peruvian banking sector are undertaken by the SBC. The SBC has been empowered by the Peruvian laws and constitution, which improves its autonomy in undertaking banking supervision. The SREP involves assessing the quality of the banks’ portfolio in addition to reviewing the credit methodology to ensure that it is applied effectively. Furthermore, the supervision and evaluation of banks’ operations are further undertaken through collaboration amongst the various SBS departments. The supervision process involves monitoring major banking reporting requirements. The SREP involves assessing the interest rate charged, monthly financial statement reports, and semi-monthly reports on the banks’ reserve position.
One of the fundamental aspects considered in implementing the SREP amongst the Peruvian banks entails a continuous assessment of the banks’ risk profile. Thus, in its implementation of the ICAAP amongst the Peruvian banks, the SBS stresses the importance of effective risk assessment. The objective of focusing on risks arises from the need to evaluate the banks’ solvency, future liquidity, and profitability potential. The SBS mainly focuses on the risks outlined under Basel II, Pillar I. The SBS requires all banks to ensure that their operations are aligned with business risks and strategies. The SBS requires banks to assess different types of risk to determine their exposure. Some of the major risks considered include market risk the credit risk, operational risk, liquidity risk, and market risk (Bank for International Settlements 2004).
SREP: Methodological Focus Areas
The Peruvian regulator requires banks to assess their capital requirements progressively by undertaking the ICAAP. In its review of the banks’ compliance with the ICAAP, the regulatory authorities integrate different methodologies. In determining the capital requirements regarding market risks, banks are required to adopt two main methodologies, which include the internal models and the standardised methods. Banks may integrate both the internal models and standardised methods. On the other hand, the assessment of the operational risk may be achieved by incorporating the Alternative Standardised Approach [ASA], Basic Indicator Approach [BIA], and the Advanced Measurement Approach [AMA].
A report released by Moody’s, which is a renowned rating agency, shows that the Argentine banking system is characterised by negative performance due to the country’s poor economic performance. Subsequently, the rating of the country’s banking system was downgraded from stable to negative in 2013. However, the Argentinian government is focused on improving the sector, which is evidenced by the imposition of diverse policy changes. It is projected that the sector will experience negative performance in the future due to the negative economic performance before rebounding.
Despite the negative outlook, the Argentinian banking system is capitalised adequately and it has sufficient reserves, hence improving its capacity to absorb shocks and extraordinary losses (Moody’s 2013, par. 5). The bank’s capacity to absorb shocks has arisen from the recent regulations imposed by the Central Bank. One of the core regulations involves increasing the minimum capital requirements for all banks. Subsequently, it is projected that most banks in Argentina will be in a position to maintain adequate liquidity levels hence promoting their operational efficiency.
Internal Capital Adequacy Assessment Process at Argentine banks
In 2006, the Central Bank of the Republic of Argentina (BCRA) announced its decision to integrate the Basel Core principles. This move was adopted after recognising that the adoption of the Basel core principles would improve significantly banks’ ability to cope with risks. Subsequently, over the past few years, the BCRA has been focused on ensuring that banks operations are aligned with Basel I. First, banks are required to maintain a capital conservation buffer, which is equivalent to 30 per cent of the total capital requirement. Additionally, banks are allowed to maintain a risk weight lower than Basel I requirement for some risks such as interbank exposure. However, there is no capital requirement, which applies to operational risks (International Monetary Fund 2012b).
Despite the above provisions, supervisors within the Argentine banking industry are required to establish a prudent minimum capital adequacy requirement. Moreover, banks are required to ensure that the minimum capital adequacy requirement reflects the element of risk. The minimum requirement must also include the banks’ capacity to cope with possible losses. Another requirement stipulates that banks must maintain additional capital to improve their capacity to deal with risks according to Pillar II of Basel II (International Monetary Fund 2012b).
In addition to the above aspects, banks are obliged to adopt a forward-looking approach in their internal capital management. The regulatory and supervisory authorities believe that this approach will enable banks to be prepared adequately at all times, hence improving their ability to deal with emergent issues such as economic downturns. The Superintendence of Financial Entities [SEFyC] is required to adopt an active role in evaluating the banks’ capital levels according to the individual bank risk profile (International Monetary Fund 2012b).
The Overall Organisation of the Supervisory Review and Evaluation Process
The process of evaluating the banks’ ICAAP is achieved by undertaking a complete self-assessment. This aspect means that banks in Argentina are required to integrate their own ICAAP. However, the implementation must be aligned with the procedures outlined by the BCRA. During the SREP, the BCRA staff members undertake extensive interviews involving the individual banks’ staff. Moreover, the SREP is conducted by reviewing the implemented rules and regulations and other documents that might be considered relevant in the Argentinian banking sector.
Furthermore, the SREP is undertaken as a collaborative bank between the Banking Associations, External Auditors, the Ministry of Economy and Public Finance, and other financial think tanks in the banking sector. During the assessment process, it is ensured that the Basel Core Principles are followed.
The SREP is further conducted by undertaking onsite and offsite supervision through the SEFyC. According to the International Monetary Fund (2012b, p. 22), ‘the SEFyC is organised into four departments, which include the supervision, analysis and audit, information regime, and control and compliance departments’. The supervision department oversees the overall SREP, which is comprised of offsite and onsite supervisory activities.
The other departments offer the necessary support in the SREP. For example, the audit and analysis department assesses the risks within the sector and the prevailing trends. This goal is achieved by undertaking bottom-up stress tests on the different risks faced by the bank. Subsequently, the department is in a position to offer specialised support in the SREP (International Monetary Fund 2012b).
A bank’s ICAAP approach must be in line with the BCRA guidelines concerning risk. Banks are required to adopt a multifaceted approach to assessing the risks that might affect their stability. The SREP is focused on all the material risks outlined under Pillar I and Pillar II of the Basel Accord (International Monetary Fund 2012b). In assessing the risks, banks are obliged to implement new risk management regulations in addition to strengthening their offsite monitoring techniques (Brose et al. 2014). The adoption of a new risk monitoring technique is aimed at improving the banks’ ability to identify emerging risks. Subsequently, the likelihood of making the necessary adjustments will be improved considerably (International Monetary Fund 2012b).
SREP: Methodological focus areas
The BCRA has integrated international standards in entrenching the risk-based approach in supervising operations within the banking sector. One of the methodologies adopted in undertaking the SREP entails a rating system, which is commonly referred to as the CAMELBIG. The system assesses different components, which include market, assets, capital, earnings, business, management, internal controls, and liquidity. This system enables the supervisors to incorporate both qualitative and quantitative analysis, hence improving the effectiveness with which they assess the implemented management and control systems. Additionally, the methodology further provides banks with an opportunity to determine the extent to which they comply with the implemented rules and regulations (Mayes & Stremmel 2012, p. 4).
Another methodology applied in undertaking the SREP entails the stress tests. These tests are undertaken in an effort to evaluate the banks’ capital adequacy in different scenarios. Subsequently, banks can formulate an effective contingency plan, hence improving their resilience to different macroeconomic shocks (International Monetary Fund 2012b).
The Venezuelan banking sector has undergone a considerable transformation over the past decades. One of the notable transformations entails a high rate of consolidation, which has led to a significant reduction in the number of banks (Powell 2004, p. 7). The sector is comprised of three state-owned banks, 31 commercial banks, and one development bank. However, the sector is controlled by five banks, which account for 55% of the total market share (Blavy 2006). The banking sector in Venezuela continues to be susceptible to macroeconomic changes, hence increasing the degree of instability. Subsequently, the need to improve the sustainability of the country’s banking sector should not be ignored. The sector has experienced an increment in the level of government control, which has arisen from the need to ensure adequate supervision within the sector. The regulations focus on several aspects such as interest rate and new prudential requirements.
The Internal Capital Adequacy Assessment Process at Venezuela banks
Unlike most banks in Latin America, which are increasing their capital adequacy level, Venezuela seems to be moving in the opposite direction. Failure to take into account the importance of internal capital adequacy within the banking sector has exposed the country to a severe banking crisis. The Venezuelan banking sector has been exposed to different macroeconomic shocks such as high oil prices and political instability. In 2005, the country announced its decision to reduce the capital adequacy ratio amongst financial institutions. This move is likely to increase risks within the sector substantially. Moreover, the move is likely to position Venezuela further away from the standards outlined in Basel II. Therefore, credibility within the country’s banking system and its ability to cope with macroeconomic shocks will be reduced significantly (Rumsey 2015).
In 2005, Venezuela reduced the capital adequacy ratio to 8% from the previous level of 10%. Even though the country is still within the minimum capital adequacy requirement, the movie exposes the banking industry to negative economic changes and risks. Additionally, banks in Venezuela are experiencing intense pressure from the government concerning the provision of credit services. The government is compelling banks to issue loan services to designated economic sectors such as tourism and agriculture (Robertson 2013). For example, banks in Venezuela are required to allocate 40% of their total lending capacity to these economic sectors (Rumsey 2015).
Banks in Venezuela are increasingly concerned with how to improve their sustainability to survive in an industry that is increasingly being characterised by the adoption of expansionary macroeconomic policies. The regulatory authorities must focus on promoting the banks’ resilience to different external shocks. Effective regulations are paramount in improving the soundness of the Venezuelan banking sector (Blavy 2006, p. 30).
Over the past few years, the Venezuelan government has recognised the significance of the sector in the country’s economic performance. Consequently, the government is adopting forward-looking approaches to promote soundness within the sector (Blavy 2006, p. 29). Black (2006, p. 17) asserts that the ‘average capital-to-risk-weighted-asset ratio stood above 15% in December 2005, while the capital-asset ratio was above 11%’. This ratio was relatively higher than the set ratio of 12%.
The Central Bank of Venezuela requires banks to implement effective ICAAP to be effective and efficient in their operation. However, the Central Bank is largely concerned with assessing and reviewing risks facing the banking sector. Banks are advised to implement their ICAAP into all their control and risk management structures. Additionally, banks are required to review their risk profiles continuously. The move is aimed at providing the central bank with insight on the banks’ solvency in addition to forecasting their future liquidity needs. According to Blavy (2006, p. 30), the main risks that banks are required to consider in their SREP include ‘the credit risk, liquidity risk, interest rate risk, and market risk’.
SREP: Methodological Focus Areas
The determination of capital adequacy amongst the Venezuelan banks is achieved by undertaking stress tests. Through this approach, banks are in a position to identify the financial vulnerabilities faced by the different banks. The stress testing methodology is applied by using historical data on the banking sector in projecting the possible future outcomes. Some of the historical data considered during the stress testing process include a change in international oil prices, interest rate shock, changes in credit quality, and changes in the level of confidence amongst clients (Blavy 2006, p. 27).
Another methodology considered in the SREP entails sensitivity analysis. The analysis is aimed at assessing the effect of liquidity risk, interest rate risk, and credit risk on the banks’ performance. Undertaking sensitivity analysis provides supervisors with insight into the need for additional regulatory provisions and the impact of such provisions on the banks’ capital adequacy level (Rojas-Suarez 2008, p. 27). The sensitivity analysis is conducted by integrating the bottom-up approach using the individual bank’s qualitative and quantitative data. The Venezuelan Superintendency of Banks ensures that the results of the banks’ sensitivity analysis are periodically published.
The methodology further entails undertaking scenario analysis, which is achieved by taking into account two main scenarios. The first scenario involves a cyclical economic downturn such as a change in terms of trade. The second scenario involves a drastic change in the country’s economic environment. The consideration of the two scenarios enables the Central Bank of Venezuela to adjust the capital adequacy level amongst banks.
Financial turbulence and bank failures have become real occurrences in the global banking sectors. Regulators in the global banking sector have undertaken extensive research in an effort to develop effective rules, standards, and guidelines that banks should follow in order to cope with the changing banking sector. Thus, regulation and supervision within the banking sector have become one of the fundamental aspects of promoting the banks’ resilience to macroeconomic shocks. The banking sectors in both the emerging and developed economies are facing numerous transformations due to the high rate of globalisation. Subsequently, the risks facing banks have increased considerably. This aspect underscores the importance of incorporating the guidelines and rules outlined under the Basel Accord.
Integrating the Basel requirement on capital adequacy will play an essential role in fostering the banks’ capacity to remain adequately capitalised, hence promoting their operational efficiency. However, financial reforms rest at the core of the countries’ power play. Thus, stakes and idiosyncratic factors influence the extent to which effective banking supervision and regulation are implemented.
Effective supervision and regulation within the banking sector require the supervisors to be provided with a high level of autonomy in addition to protection from political pressures through political support and provision of the necessary legal protection. Moreover, the supervisory agencies should be offered adequate resources in order to improve their effectiveness.
The above analysis shows that the US and Latin American countries are focused on improving the resilience of their banking sector. One of the aspects that the economies have focused on include capital adequacy. In a bid to promote capital adequacy, the banks are committed to implementing the Basel Accord, which underscores the importance of maintaining adequate levels of capital in order to improve the banks’ capacity to deal with external shocks.
The banks’ commitment to establish and sustain adequate levels of capital is illustrated by the individual country’s commitment to entrenching the ICAAP and SREP techniques in the banks’ capital management practices. The implementation of the ICAAP and SREP in the economies assessed in this paper is an ongoing process. This assertion means that most of the economies have not succeeded fully in promoting capital adequacy within their banking sector. Thus, the need for continuous reforms in the supervisory and regulatory processes should not be ignored. By reforming their supervisory and regulation processes, the US, Chile, Venezuela, Peru, Canada, and Argentina will be in a position to improve the resilience of their banking sector. However, the respective countries need to evaluate their risk exposure continuously to adjust their ICAAP and SREP accordingly.
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