BCBS 239: does it allow exceptions? Trade-offs, materiality and expert judgement

BCBS 239 is too often reduced to its 14 principles and four pillars. Yet, before even detailing the principles, the Basel Committee's text sets out a set of cross-cutting requirements that are not tied to any single principle — but apply across the whole framework. Three of them deserve particular attention: trade-offs between principles, materiality, and the use of expert judgement.

Trade-offs tolerated, but never at the expense of decision-making

BCBS 239 sets a demanding starting principle: a bank must comply with all the risk data aggregation and risk reporting principles simultaneously. The text nonetheless opens a narrow door: trade-offs between principles can be accepted in exceptional circumstances, such as urgent or ad hoc requests for information on new or unknown risk areas. (BCBS 239, "Scope and initial considerations" section)

But that door closes just as quickly: no trade-off may materially affect risk management decisions. The bank's decision-makers — first and foremost the board and senior management — must be aware of these trade-offs and the resulting limitations or shortcomings. Supervisors expect banks to have policies and processes governing the use of trade-offs, and to be able to explain their impact on the decision-making process, through qualitative reports and, where possible, quantitative measures. (BCBS 239, "Scope and initial considerations" section)

Materiality: excluding information, exceptionally and with justification

The concept of materiality, as used in the text, means that data and reports may exceptionally exclude information, provided that this exclusion does not affect the bank's decision-making process — that is, decision-makers, in particular the board and senior management, would not have been influenced by the omitted information, nor would they have reached a different judgement had they had it. (BCBS 239, "Scope and initial considerations" section)

To apply this concept, a bank must take into account considerations that go beyond the mere number or size of the exposures not included — such as the type of risks involved, or the evolving and dynamic nature of banking activity. It must also take into account the potential future impact of the excluded information on its decision-making process. Supervisors expect banks to be able to explain omissions resulting from the application of the materiality concept. (BCBS 239, "Scope and initial considerations" section)

Forward-looking reporting, to anticipate rather than merely observe

The standard does not merely report on what has already happened. Banks must develop forward-looking reporting capabilities, able to provide early warnings of any potential breaches of risk limits relative to the bank's risk tolerance or appetite. These risk reporting capabilities must also allow for flexible and effective stress testing, providing forward-looking risk assessments. Supervisors expect risk management reports to enable banks to anticipate problems and provide a forward-looking assessment of risk, rather than relying solely on backward-looking data. (BCBS 239, "Scope and initial considerations" section)

Expert judgement: a documented exception, never a substitute

Faced with incomplete data, expert judgement may occasionally be applied to facilitate the aggregation process, as well as the interpretation of results within the risk reporting process. But relying on expert judgement in place of complete and accurate data must occur only on an exceptional basis, and must not materially affect the bank's compliance with the principles. (BCBS 239, "Scope and initial considerations" section)

When expert judgement is applied, supervisors expect the process to be clearly documented and transparent, so as to allow for an independent review of the approach followed and the criteria used in the decision-making process. (BCBS 239, "Scope and initial considerations" section)

Key takeaway

These cross-cutting requirements outline a framework that is both rigorous and realistic. Rigorous, because it rejects trade-offs and exclusions that alter decisions, and strictly governs the use of expert judgement. Realistic, because it accepts that, in an emergency, a bank cannot aggregate everything instantly — provided it accounts for this, documents it, and is able to explain the impact on its decisions. What matters, then, is not the absolute perfection of the data, but the reliability of the process that leads to the decision — and the ability to demonstrate that reliability to a supervisor.

This article is based exclusively on the Basel Committee's 14 BCBS 239 principles (January 2013).