Basel II – APRA release supervisory review process

Just before the Christmas break, the Australian Prudential Regulation Authority (APRA) released an information paper on its approach to the supervisory review process under the new Basel II capital adequacy regime.

The review process is intended to ensure that institutions have adequate capital to support all the risks and to encourage them to develop and use better risk management techniques in monitoring and managing their risks. APRA stress that the Basel II supervisory review framework that they have developed is “largely consistent with the Pillar 2 requirements” and that the APS 110 Capital Adequacy brings APRA’s approach fully into line with Basel II. APRA will adopt a proportional approach to Pillar 2 in order to ensure that the capital assessment process is appropriate to the nature, scope and complexity of the activities of the institution under review.

The paper re-emphasises the possibility that regulatory capital may not equate to that calculated in the Pillar 1 process but that “there may also be considerable differences in both the absolute and relative riskiness of different [institutions] due to their exposures to Pillar 2 risks and qualitative factors such as governance, management and control, that are not reflected in the Pillar 1 risk estimates.”

APRA plan to use their own internal risk assessment model called PAIRS. This is a structured framework for supervisory judgment built on three building blocks: the inherent risks facing the institution from its products and services, strategies and risk appetite; the effectiveness of management and controls; and the extent of capital support to meet unexpected losses. These elements are weighted and scored to produce an overall risk of failure score.

The release of these guidelines follows the release, on 30th November 2007, of the full suite of prudential standards (listed here) that will give effect to the implementation of Basel II in Australia. Basel II came into force in Australia on 1st January.