Practical Insights from the Basel Commission’s proposed changes to its Core Principles

The Basel Committee on Banking Supervision (BCBS) issued a public consultation on revisions to the Core principles for effective banking supervision ("Core Principles") on 6 July 2023, reflecting supervisory developments and structural changes affecting the banking system since the previous update in 2012 in six areas: financial risks; operational resilience; systemic risk and macroprudential aspects of supervision; new risks, including climate-related financial risks and the digitalisation of finance; non-bank financial intermediation; and risk management practices.

The Core Principles serve as the essential benchmarks for maintaining a stable and secure banking industry through prudent regulation and supervision. They represent the universally accepted minimum standards that apply to all types of banks and banking systems, ensuring their effective functioning. These principles are utilized by supervisors to evaluate the adequacy of their regulatory frameworks and supervisory practices. Furthermore, they play a pivotal role in the Financial Sector Assessment Program (FSAP) conducted by the International Monetary Fund (IMF) and World Bank, enabling the assessment of banking supervisory systems and practices employed by different countries for their effectiveness.

In light of the BCBS’s proposed changes to the Core Principles, banks should proactively review and assess the practical implications of these revisions by considering what specific measures they should take to align with the proposed changes, how they can practically implement these revisions in their day-to-day activities, what concrete steps they can adopt to enhance their risk management practices, and how they can effectively navigate the evolving regulatory landscape to ensure they are well-prepared to meet the new requirements.

The 2023 version of the Core Principles includes several critical updates and changes compared to the 2012 version. For instance, the 2023 version includes new principles on climate-related financial risks, operational resilience, and anti-money laundering and countering the financing of terrorism (AML/CFT). In addition, the 2023 version also updates existing principles to reflect changes in the banking industry and regulatory landscape, such as the impact of fintech developments and the need for effective risk data aggregation and risk reporting. Besides, the 2023 version places greater emphasis on the role of the board and senior management in ensuring effective risk management and compliance with supervisory requirements. Furthermore, the 2023 version also includes more detailed guidance on supervisory practices and processes, such as stress testing and the identification and management of step-in risk.

So how does this translate into actionable steps for banks? Overall, the updated principles reflect the increasing importance of technology and digitalization in the banking industry and the need for effective supervision of these developments. The most interesting aspect of the proposed additions to the principles in the 2023 version is the impact of fintech developments on banking supervision. In particular, Principle 1 on Responsibilities, objectives and powers includes a reference to the BCBS Sound Practices paper on the implications of fintech developments for banks and banking supervisors. Also, Principle 13 on Operational resilience also includes new guidance on the need for banks to identify and manage risks related to new technologies and digitalization. In addition, Principle 17 on Risk management and supervision includes new guidance on the need for banks to have effective risk management frameworks in place for new and emerging risks, including those related to fintech.

The new principles also reflect the evolving risks and challenges facing the banking industry and the need for effective supervision and risk management in these areas. The 2023 version of the Core Principles includes new principles on climate-related financial risks, operational resilience, and anti-money laundering and countering the financing of terrorism AML/CFT. So how will this impact the day-to-day risk management activities of banks?

Principle 14 on Climate-related financial risks emphasizes the need for banks to identify, assess, and manage the financial risks associated with climate change, including physical risks, transition risks, and liability risks. The principle also highlights the importance of stress testing and scenario analysis to assess the potential impact of climate-related risks on banks' financial positions. Also, Principle 13 on Operational resilience focuses on the need for banks to have effective processes and controls in place to ensure the continuity of critical business functions in the face of operational disruptions, such as cyber-attacks, natural disasters, or other events. The principle emphasizes the importance of identifying and managing operational risks, including those related to new technologies and digitalization.

Banks should proactively embrace the proposed changes, taking practical steps to adapt and strengthen their risk management practices accordingly. In particular, Principle 16 on AML/CFT emphasizes the need for banks to have effective policies, procedures, and controls in place to prevent and detect money laundering and terrorist financing. The principle highlights the importance of risk assessments, customer due diligence, and ongoing monitoring of customer transactions, as well as the need for banks to cooperate with law enforcement and regulatory authorities to combat financial crime.

While proposing the changes, the BCBS has also emphasised the importance of strong governance and risk management frameworks in ensuring the safety and soundness of banks, and the need for effective supervision and oversight of these frameworks by both banks and supervisors. Accordingly, the 2023 version of the Core Principles places greater emphasis on the role of the board and senior management in ensuring effective risk management and compliance with supervisory requirements. Banks practically leverage this development to improve their risk management. For instance, Principle 2 on Governance emphasizes the need for banks to have effective governance frameworks in place, including clear lines of responsibility and accountability, and for the board to oversee the bank's risk management and compliance functions.

Principle 2 also highlights the importance of the board's role in setting the bank's risk appetite and ensuring that it is aligned with the bank's overall strategy. Besides, Principle 3 on Risk management and supervision emphasizes the need for banks to have comprehensive risk management policies and processes in place, and for senior management to ensure that these are being adhered to. The principle also highlights the importance of senior management's role in identifying and managing emerging risks, including those related to new technologies and digitalization. Also, Principle 4 on Supervisory review and evaluation emphasizes the need for supervisors to assess the effectiveness of banks' risk management and governance frameworks, and for banks to address any deficiencies identified. The principle also highlights the importance of supervisors' engagement with the board and senior management to ensure that they are aware of emerging risks and supervisory expectations.

In addition, the updated principles reflect the importance of effective supervisory practices and processes in ensuring the safety and soundness of banks, and the need for supervisors to use a range of tools and techniques to assess banks' risk management and compliance with supervisory requirements. In particular, the 2023 version of the Core Principles includes more detailed guidance on supervisory practices and processes, such as stress testing and the identification and management of step-in risk, in several ways. To begin with,  Principle 5 on Supervisory approach emphasizes the need for supervisors to adopt a risk-based approach to supervision, taking into account the size, complexity, and risk profile of each bank. The principle also highlights the importance of supervisors' use of a range of supervisory tools, including stress testing, to assess banks' resilience to adverse scenarios.

Furthermore, Principle 6 on Supervisory techniques and tools emphasizes the need for supervisors to use a range of supervisory techniques and tools, including on-site inspections, off-site monitoring, and data analysis, to assess banks' risk management and compliance with supervisory requirements. The principle also highlights the importance of supervisors' use of stress testing to assess banks' resilience to a range of adverse scenarios. On the other hand, Principle 22 on consolidated supervision emphasizes the need for supervisors to have a comprehensive understanding of the risks faced by banking groups, including those related to step-in risk, and to have effective processes in place to identify and manage these risks. The principle also highlights the importance of supervisors' use of stress testing to assess the resilience of banking groups to adverse scenarios.

The BCBS’s proposed updates have important implications for the banking sector, risk management in banks, compliance functions within banks, banks' business models and strategies, as well as from a supervisory perspective. As discussed above, the new principles address emerging risks and challenges faced by the banking industry, such as climate-related financial risks, operational resilience, and non-bank financial intermediation. So how will banks need to adapt their operations in response to this? Banks will need to adapt their practices and strategies to effectively manage these risks, which will require investments in technology, risk assessment frameworks, and compliance measures.

The updated principles also acknowledge the digitalization of finance, emphasizing the need for banks to identify and manage risks associated with fintech developments, ensuring the sector keeps pace with technological advancements. So the revised principles emphasize the importance of robust risk management frameworks. Banks will need to strengthen their risk identification, assessment, and mitigation processes to address new and emerging risks. This includes addressing climate-related financial risks, operational disruptions, and evolving cybersecurity threats. Stress testing and scenario analysis will play a crucial role in assessing the impact of these risks on banks' financial positions.

Besides, the new principles underscore the significance of effective compliance functions within banks. Banks will be required to have strong policies, procedures, and controls in place to prevent money laundering, terrorist financing, and other financial crimes. Customer due diligence and ongoing transaction monitoring will be essential, and banks will be expected to cooperate with law enforcement and regulatory authorities in combating financial crime. Compliance departments will need to enhance their capabilities to ensure adherence to these principles.

At the same time, the updated principles acknowledge the evolving nature of the banking industry and its business models. Banks will need to align their risk appetite, governance frameworks, and overall strategies with the new requirements. This includes considering climate-related risks and integrating operational resilience measures to ensure the continuity of critical business functions. Banks may also need to reassess their engagement in non-bank financial intermediation activities in line with the principles.

Finally, from a supervisory perspective, national agencies would be expected to adopt the updated principles to assess the effectiveness of their regulatory frameworks and supervisory practices. The principles provide a comprehensive review process, enabling supervisors to identify areas for improvement and develop plans to strengthen banking supervision frameworks. Supervisors will need to adopt a risk-based approach, utilizing a range of tools and techniques such as stress testing and on-site inspections to assess banks' risk management and compliance. Consolidated supervision will play a crucial role in understanding and managing risks faced by banking groups. In summary, the updated Core Principles will enable a comprehensive assessment of regulatory frameworks, facilitating improvements in banking supervision and ensuring the safety and soundness of the banking industry.