Moving Toward Global Banking Compliance _____________________ By Roberto G. Manabat
Following is an excerpt from the speech given by the author in a recent general membership meeting of the Bankers Institute of the Philippines (BAIPHIL)
The Financial Reform Agenda Recent accounting and auditing scandals have led to a new resolve on the part of regulators and business leaders to reinforce and improve standard-setting processes and require sound accounting, auditing, and disclosure practices by companies and their auditors. The unprecedented problems in the recent past have prompted efforts to restore investor confidence in our capital markets through regulatory reforms affecting both the accounting profession and corporate management. These efforts led to, for example, the enactment of the now famous Sarbanes-Oxley Act in the United States which set the stage for a new audit oversight board to regulate, inspect, report on, and in some cases enforce penalties against auditors and led to new requirements for corporate management to maintain strong internal controls and report thereon. Steps were also taken to strengthen the international accounting and audit standard-setting processes. In the local scene, the financial regulators (Securities and Exchange Commission, Bangko Sentral ng Pilipinas and Insurance Commission) have come up with their own rules as a result of the Asian financial crisis, our own set of corporate scandals and pressure from the multilaterals like the World Bank, Asian Development Bank and International Monetary Fund as well as from big investor groups like CalPERs & private equity firms. So we now have rules on corporate governance, accreditation of external auditors and for banks, risk management guidelines. Corporate Governance Corporate governance is a broad concept which includes financial reporting and auditing. The focus on corporate governance today has highlighted the role and importance of the accounting profession. If you look at the Code of Corporate Governance, the bulk of it deals with accountability and audit. The most important board committee is the Audit Committee. Corporate governance is really about fairness, accountability and transparency which are the hallmarks of financial reporting. Let me now go to the key issues of corporate governance in the Philippines. The international agenda for corporate governance is being driven mainly from the US, Western Europe and other developed economies. Many experts from the developing countries have questioned the applicability of the internationally accepted governance principles as their situations differ very much from those in developed countries. Foremost among these differences is the widespread ownership of listed companies in developed economies, while in countries like the Philippines, a dominant group, usually a family, controls 70% or more of the voting stock. In effect, the public ownership or float is usually 30% or less. Having independent directors is considered a good practice. Since they are elected by the shareholders, they are effectively chosen by the controlling group or family. To be imbued with the true spirit of independence, all directors have to look after the interest of the corporation, and not only that of the controlling group. This is easier said than done, as certain decisions may involve conflicts of interest such as related party transactions. There is therefore a need to professionalize the job of corporate directors. This means that directors, especially those considered independent, must undergo proper training. Organizations such as the Institute of Corporate Directors, are now sponsoring training programs of this nature. To ensure that the spirit of corporate governance is followed by listed entities, rigorous reinforcement of established rules must be done by our regulators. The challenge for the Philippines is how to convince controlling groups or families in listed companies to buy into good corporate governance. They must be convinced that while there is a cost to being transparent in reporting and opening up to outsiders, it will ultimately redound to their benefit in terms of higher market value and a better reputation for the company. A lot of studies have shown that companies which practice good corporate governance enjoy a premium of as high as 30% in the market price of their shares. If corporate governance is to succeed, banks must play a leading role. Banks control around 80%-90% of financing in the country. Credit policies followed by the bank therefore influence the corporate governance practices of bank borrowers. This has been amply demonstrated in the BSP circular prescribing SEC-accredited auditors to audit the financial statement of borrowers with assets of Php15 million or more. That BSP circular has gone a long way in ensuring reliable financial reporting for a significant portion of our business community. IFRS The implementation in 2005 of International Financing Reporting Standards (IFRS) as the accounting language for many countries has been the biggest revolution in the history of the profession. With stricter rules in classifying, measuring and reporting of financial assets and liabilities, certain flexibilities in financial reporting are no longer allowed. The most complex standards adopted in 2005 were PAS 32 and PAS 39 which had a big impact on the banking industry. These two standards deal with the recognition, measurement, presentation and disclosures of financial instruments. In 2007, the banking industry is again required to adopt PFRS 7, Financial Instrument Disclosures. This new PFRS, which is effective for financial statements with accounting period beginning January 1, 2007, requires extensive disclosures about the significance of financial instruments for an entity’s financial position and performance, quantitative and qualitative disclosures on the nature and extent of risks. For each type of risk, a bank is required to disclose (1) the exposures to risk and how they arise; (2) its objectives, policies and processes for managing the risk and the methods used to measure the risk; and (3) any changes therein. Examples of disclosures include the breakdown of its financial assets into credit grade rating, into the type of collateral held to support the exposure, concentration of risk by sector, and/or geographic location. Basel Accords Central banks and bankers all over the world have taken steps to enhance their focus on accounting and auditing matters that affect the institutions they supervise. Thus, during the mid-1990s, the Basel Committee on Banking Supervision (or Basel Committee for short) started to devote more resources to developing principles that would help shape and improve bank disclosures, supervisory reporting, and accounting practices. The Basel Committee provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision. There is an intimate relationship between IFRS and global banking standards. The two as a matter of fact go hand in hand. We cannot have one at the exclusion of the other. Sound and internationally harmonized accounting standards are important for a well functioning and stable financial system: sound accounting standards provide integrity of financial disclosures; international financial reporting standards encourage a common understanding and interpretation of financial information. These elements make it possible for the markets to more effectively monitor the performance of financial entities. There are three important reasons why we need to have global banking standards in the same manner as we need to have international accounting and auditing standards. First, global banking can function efficiently and effectively only in an environment of financial stability. Effective cross-border cooperation arrangements will provide strength and stability to financial systems nationally and globally. Second, adoption of sound corporate governance practices by all banks in the financial system will improve the robustness of national and global financial systems. Third, accounting standard setters and prudential standard setters need to develop an understanding of each other's approaches. Their cooperation will contribute towards maintaining financial stability. Basel I It was in 2001 when our own BSP adopted the original Basel 1 framework through BSP Circular No. 280. This Circular provided the guidelines for the computation of risk-based capital for credit risk. The BSP’s risk-based capital adequacy framework was further enhanced with the issuance of Circular No. 360 in December 2002 which incorporated market risk into the risk-based capital framework. The regulator’s effort to focus on risk management is intended to give banks greater flexibility to respond to changing opportunities under a deregulated environment and at a time of rapid technological advances. Traditional bank supervision tended to instruct banks to avoid risks that seem too high. The new approach to supervision favors assessment of the quality of risk-management practices and generally allows banks to take risks so long as the banks demonstrate the ability to manage and price for those risks. In Basel I, the BSP has underscored the responsibility of the banks’ board of directors and senior management to ensure the soundness and stability of their respective banks. The regulators’ role is primarily to evaluate the quality of oversight and management provided by these parties – that is, the quality of corporate governance. Basel II A highly anticipated development is the forthcoming transition to Basel II in July 2007. While Basel 1 covers only credit risk and market risk, Basel 2 also covers operational risk. Hence, under Basel II, the risk capital charge has been extended to cover all risks: The MB has decided to maintain the present minimum overall capital adequacy ratio (CAR) of banks and quasi-banks at 10 percent. However, consistent with Basel II recommendations, the MB approved major revisions to the calculation of minimum capital that universal banks, commercial banks and their subsidiary banks and quasi-banks should hold against actual credit risk exposures. In addition, while Basel 1 uses a rather crude risk weighing system for credit risk, Basel 2 maps external or internal ratings into appropriate risk weights, thus making the new framework more risk sensitive. Major changes have also been introduced with respect to credit risk. Basel II presents three options: 1.) Standardized approach (a modified version of the existing Accord)- assigns risk weights applicable to sovereign, bank, corporate, and retail exposures depending on the external credit risk ratings. 2.) Foundation Internal Rating Based (IRB) approach- allows banks to use their internal ratings assessment to determine the appropriate capital charge of their exposures. 3.) The advanced IRB approach- very similar to the foundation IRB. The only difference is that under the advanced IRB, banks are allowed even greater discretion in using their internal ratings model to calculate capital requirements. Capital treatment for market risk as currently implemented through BSP Circular No. 360 remains generally unchanged except for some minor changes in the standardized computation of specific risk charges. Whereas, specific risk weights in the current market risk framework depend on the type of issuer, Basel II requires that these now depend on the external ratings of the issue to be consistent with the credit risk standardized approach. An explicit change for operational risk is a new element. Basel II presents three options: 1.) Basic Indicator Approach- a bank’s operational risk charge is computed as a fraction of its gross income. 2.) Standardized Approach- banks’ operations are divided into specific business lines. Operational risk charge for each business line is determined as a fraction of gross income attributed to each line. 3.) Advanced Measurement Approach- operational risk charge would depend on statistics-based measurement models developed by banks themselves or by outside vendors. The guidelines for allocating minimum capital to cover market risk (BSP Circular No. 360 dated 3 December 2002) was also amended to some extent, primarily to align specific market risk charges on trading book assets with the revised credit risk exposure guidelines. A completely new feature is the introduction of bank capital charge for operational risk. The required disclosures to the public of bank capital structure and risk exposures are also enhanced to promote greater market discipline in line with the so-called Pillar 3 of the Basel II recommendations. The Monetary Board’s approval of the implementing guidelines for Basel II underscores the BSP’s commitment to deep and far-reaching banking reforms to strengthen the banking industry. It also reflects our basic confidence in the fundamental soundness and ability of the industry to make the necessary adjustments to be fully compliant with international standards. Necessarily, the implementing guidelines have been tailor-fitted to Philippine conditions including pragmatic timing of adjustments. Conclusion These are challenging times both for banks and for bank regulators. On the one hand, new technologies and markets create for us exciting opportunities to meaningfully strengthen the risk management capabilities of our financial institutions. On the other hand, the risks of getting it wrong - of failing to keep banks' risk management practices up-to-date - can only grow as banking becomes ever more complex and sophisticated and as banking systems become more concentrated. This will increase the importance of capital adequacy, risk management, effective supervision, and transparency in fostering and maintaining financial stability in an increasingly integrated and interconnected global financial system. The challenge is for everyone to see all these not merely as regulatory requirements but as tools that bank management can use to improve their operations and profitability. |