Basel III – What’s new? Putting Basel III into perspective (Part I)

The Central Bank of Sri Lanka. Many Asian banks are state-owned, thus the urgency to raise large capital cushions is not as imperative as the European case

The capital dogmas and the Basel Committee – Sri Lanka, like the rest of the world and our Asian neighbours, have, hitherto, been governed by the capital dogmas laid down by the global standard-setters and indeed the global watchdog – the Basel Committee. 

Over the last two decades we have been through Basel I, Basel II and currently are in the throes of Basel III. In fact Deputy Minister Eran Wickramaratne, a highly-respected veteran banker himself, stressed in this regard that, in his opinion, the greatest challenge for the banking sector would be the shortage of capital. 

More recently, Fitch has decided that they should downgrade the Sri Lankan banking industry to ‘negative outlook’ on what they think are, inter alia, the industry’s bleak prospects for Basel III in 2019! Just last week, we read that the Basel III capital directive will come into effect for all banks, to be able to meet the international timelines and benchmarks for 2017.

Looking at the three fundamental components to this directive viz. the common equity Tier I (CET 1) and total capital ratios; the Capital Conservation Buffer (CCB) and the short-term Liquidity Coverage Ratio (LCR) it became very apparent that it was a case of déjà vu since all of these components have been an integral part of the sound prudential regulatory framework in this country, as they have been in the Asian region, from the inception of the bank regulation! So what’s new with Basel III? Let me explain…

Putting Basel III into the perspective of the existing regulatory framework for banks in Sri Lanka

Basel III emerged post GFC with its proclamation that the Common Equity Tier I (CET 1) requirement for capital adequacy would be increased to 7% from 2% under Basel II. With CE being the mandatory norm for all banks in Sri Lanka for Tier I capital since the inception of bank regulation in this country, all banks in Sri Lanka found themselves immediately compliant well ahead of the 2017 and 2019 timelines set by the BC. This was the case with the other two components as well, all of which were integral to the strong regulatory system that has prevailed in this country for over half a decade.

To the layman this may come as a surprise but to those of us regulators in Sri Lanka and in most S. East Asian countries, it was apparent that the Basel Committee was only now recognising the importance of the most fundamental, key, prudential requirements for deposit taking financial institutions! Let me explain the three measures in greater detail.

As for common equity or (CET 1) in Basel jargon – it is just pure, paid up capital and permanent reserves. This is sacrosanct in the definition of bank capital and no dilution of this capital component would ever have been permitted. Tier I capital in almost all banks in Sri Lanka were well in excess of the 7% and invariably the Tier I capital component of total bank capital i.e. Tiers I and II were made up primarily of Tier 1 capital so invariably it was 10% or more.

Regarding the Capital Conservation Buffer (CCB) – again Basel jargon for the mandatory capital reserve to be built up, to cover potential losses and established by all banks since the inception of regulation in this country as the Statutory Reserve Fund (SRF) with most of the SRFs now being at a very comfortable level to support Tier I capital. This was a key regulatory requirement in most S.E. Asian countries, so much so that in Singapore the MAS was considering the release of the SRF funds to the banks which had met the targets specified for the annual transfers. Here again the Basel Committee is almost half a century late with this measure – something fundamental to the prudent regulation of deposit taking banks and financial institutions!

Regarding the short-term liquidity coverage ratio – it is in simple jargon, the mandatory liquid assets ratio imposed on all banks to be not less than 20% of total liabilities; a common sense prudential requirement to ensure that the banks in particular, would be at all times, liquidity solvent which was considered more important in the short term, than capital solvency in the long term and which therefore had to be a statutory requirement, replete with deterrent sanctions for non-compliance. These measures are adequately supplemented and reinforced by the access to the lender-of-last resort facility from the Central Bank to ensure the smooth flow of banking business and to avoid systemic risk.

It is therefore very important to put the record straight in the minds of the lay public and the consumers that these most basic prudential requirements are not something that the Sri Lankan banking system has had, perforce, to comply with as a result of the wisdom of the Basel Committee. On the contrary the Basel Committee is telling us something that we in our wisdom realised was fundamental to the prudent regulation of banks, more than half a century ago. The hallowed principles of which were either non-existent, or seriously compromised by our peers in the west?

It is strange that the Sri Lankan regulators have not thought it fit to give due publicity to the status quo of Sri Lanka’s banking system vis-à-vis Basel III. Is it that the present generation of bank regulators in particular do not possess the institutional memory of the history of bank regulation in Sri Lanka, or is it their haste to get on board the Basel bandwagon come what may, regardless of its effect on the banking system or of the economy of Sri Lanka? 

In my mind the relevance of Basel III, in the context of Sri Lanka’s existing strong regulatory system, is not a sine qua non for a stronger banking system by any measure. The rating agencies in particular need to do a more in-depth analysis of the directive in the perspective of the existing regulatory framework and its antecedents.

It is thus imperative that the regulators give due regard to our status on Basel III, particularly when we are in such a distinctly favourable position vis-à-vis our peers in the more developed economies of the West. I am confident that our neighbours in the S. East Asian region are equally compliant due to strong regulatory regimes in their respective countries as well. 

With regard to the liquidity requirements of Basel III, the position is the same as we have had mandatory liquidity requirements from the inception, which deals with the short-term Liquidity Coverage Ratio (LCR). However, the long-term Net Stable Funding Ratio (NSFR) may be a bone of contention and will need to be considered for its impact on the funding of long-term project and infrastructure lending. 

Which makes it very apparent that there is, evidently, an uncanny faith in the ability of the Basel Committee to make Basel III the panacea for all ills relating to financial soundness in banks. This is despite its own miserable track record of failure with Basel II, to provide the capital buffers necessary to prevent the failures, en masse, of several internationally active banks in particular, across the globe and indeed of domestic, systematically important, banks in various countries, predominantly in the UK, and in Europe. Even if Basel II was a ‘work-in-progress’ at the time, its complexity caused it to be a major pre-occupation with most central bank regulatory staff, to the detriment of dealing with more fundamental macro- prudential problems unfolding in the market.

It is important therefore to be able to understand what these capital dogmas preach and how they have performed historically, to be able, notwithstanding, to justify and renew our faith, in their ability to continue to be accepted as international best regulatory practice.

Regulatory capital standards – What do they prescribe? 

Fundamentally, the regulatory capital, as opposed to shareholders’ capital, that banks need to hold against their risk weighted assets, i.e. the perceived risk in banking assets. This is the operational capital they need to maintain, over and above the minimum capital prescribed by the home country regulator at the point of licensing and which is revised at the discretion of the regulator, generally upwards, from time to time. 

Regulatory capital thus represents the absolute minimum, or floor, and is prescribed, internationally, to be 8%, although Sri Lanka, as with most Asian countries have been more conservative, and in their wisdom, mandated it at 10%, allowing for a comfortable margin to cover risks that may not be captured by the pre-determined formulas. It is composed of two Tiers – I and II, Tier I representing the capital strength of the Bank, composed of pure or core capital of a permanent nature and Tier II being supplementary capital made up mostly of debt capital which is impermanent.

The aftermath of the global financial crisis (GFC) and the practicality of Basel II was, if anything, a glaring indictment on the ability of the Basel Committee to continue to carry the mantle as the global standard-setter and watchdog for banking prudential standards. The profound failure of Basel II to mitigate the risks of excessive leverage building up in the international banks in particular and more importantly, the concentration risks in the real estate sector, across many Western economies, that went unnoticed, is testimony to this failure. 

Whilst the banks in Ireland were highly exposed to Real Estate (RE) as were the Spanish banks, the banks in the UK like Northern Rock, and Royal Bank of Scotland (RBS) too had significant exposures to RE, in the case of the former, as much as 90% of their loan book! In 2005 an Irish Central Bank report raised concerns about the fact that in five of the 13 credit institutions surveyed, over 80% of the loan book related to real estate. Similarly, in 2007 the total debt of real estate companies in Spain amounted to €1.5 trillion and 70% of the lending of the (savings banks) was related to construction. Spanish banks were among the most energetic users of mortgage securitisation and mortgage covered bonds in the EU.

However, without any apologies for the failure of Basel II, the BC now proceeds to impose Basel III on the whole world. In characteristic fashion, as with anything imposed by the West, we in the Asian economies are only too eager to get on board the bandwagon, notwithstanding that we proved our resilience to the crisis to which Basel III is the post crisis response of the Basel Committee, primarily, if not entirely, due to our demonstrated, superior, regulatory wisdom that respected the sanctity of pure capital or common equity that it is now called, as the only measure of the capital strength of a bank. In adopting Basel II in 2007, we held our own and did not permit the dilution of the minimum Tier I capital requirements consisting of only common equity of a minimum of 5 %, within which there was no room for hybrids which were permitted by the BC and admissible under Basel II.

This leads us to the conclusion that it would do well for the advanced economies and indeed the Basel Committee itself, to emulate and learn from best regulatory practices prevalent in the Asian economies. However, on the contrary, we find ourselves, quite audaciously, being dictated to by them despite the failure of their financial systems (and indeed of their regulatory ability) that reverberated throughout the world as a result of their global interconnectedness.

As elaborated above, what is all the fuss about anyway? All our banks in Sri Lanka are Basel III compliant on the capital formulas – both on the Common Equity Tier I (CET1) and on the Capital Conservation Buffer (CCB) well before the specified timelines – by default. If one looks at the published accounts of the banks for the financial year 2016, Tier I capital which is mandated to be 5% is invariably at 10% or over! The industry ratio for total Tier I capital is at 11.4% which is higher than the prescribed 8.5% in 2019! 

Individually, however, a few smaller banks may be short of the prescriptions, but what is important is that the domestic SIBs which represent over 70% of the banking industry, are all well within the required norms, much before 2019. As Fitch says, these ratios can come under pressure, if the growth of risk weighted assets (loan growth) and capital do not move in sync. However, what is important to note is that this needs to be managed through the ICAAP which is the most important capital management tool in the hands of the regulators to enforce.

The capital discipline – Internal Capital Adequacy Assessment Plan (ICAAP)

The simple remedy is capital discipline by the banks themselves and indeed the deposit taking NBFIs – the ICAAP – predicated on the common-sense maxim – “cut your coat according to your cloth”.

The banks’ growth strategy and the increasing risk profile that goes intrinsically with that growth strategy, needs capital support which is an imperative, without which the bank will find itself deficient in regulatory capital which, in the absence of a capital infusion strategy, will require the bank to curtail its asset expansion or to shrink its assets.

The ICAAP introduced under Pillar 2 of Basel II, has been mandated to take into consideration such sources of risk that are not part of Pillar 1 and may be difficult to quantify. Large organisations are already required to develop a comprehensive framework to assess the overall adequacy of their capital allocation with regards to the key risks their business model is exposed to and to elaborate a capital planning process aligned with their strategic and business plan. 

The time horizon for such capital planning is usually between three and five years, and is comprised of a base case with at least three different stress scenarios, including an identified worst case. This is to test the resilience of the bank’s capital base (loss absorption capacity) under severe stress conditions. Last but not least, banks have to demonstrate that the ICAAP framework is embedded in their decision-making process and that it is not a one-time compliance exercise but rather a critical governance tool for top management. It is imperative, therefore, that the focus of the regulators must move to the ICAAP and its enforcement as the most effective capital management tool. 

Declining trend in CARs

The declining trend in CARs from 2013, from a ratio of 16.3% to 14.3 in Q4 2016 for total capital and from 13.7% to 11.4% for Tier I capital, very clearly signifies that the ICAAP is not being monitored closely enough by the regulators, nor by the banks concerned that contributed to this trend. Hence the deteriorating capital ratios where the expansion of Risk Weighted Assets (RWA) is not moving in tandem with capital growth. This is what the IMF is talking about. The capital numerator is not in sync with the increasing risk weighted assets (RWA) denominator, leading to a declining capital ratio. While RWA increased by 43.6% (Q3-2016) Tier I and Total capital increased by only 17.4 and 19% respectively.

What is profound here is the ability of the regulators to hold the banks to account on the ICAAP and to give it the attention it deserves, to make it an adequate reflection of the bank’s growth strategy and its risk profile and more importantly, that they have factored in the capital needed for this purpose; the ability of the regulators to ensure that the periodical offsite data received, reflects this discipline and to take prompt corrective action to restrain the bank, if it is not. 

Is capital management an important part of the onsite examination process, where bank examiners devote adequate attention to the bank’s ICAAP and their ability to review it on the basis of the bank’s examination findings, to make it a more realistic reflection of the assessment?

The leverage ratio under Basel III which complements and is integral to the ICAAP, is a measure that is non risk-based , and applies to the absolute amount of a bank’s exposure, i.e., it is not risk-weighted. The objective is to limit the absolute level of business and exposures – both on and off balance sheet – that an organisation may adopt in relation to its capital base. As its name suggests, the leverage ratio should constrain the leverage capability that some banks were able to wield before the crisis. Examples of such extreme leverages include the aggressive increase of the debt-to-equity ratio on balance sheet, and off balance sheet by securitising significant portions of their “not so good” loan portfolios.

It therefore behoves the regulators to shift the emphasis of Basel III, to the phasing in of the leverage ratio for the Sri Lankan banking system as well, which is less liable to be gamed by the regulated institutions, unlike the Basel III capital adequacy formulas based on risk models developed by the banks themselves. It would be useful to assess the existing level of leverage in the banking system and to decide on an appropriate ratio in consultation with the industry, taking into account the prospects for the growth of the banking industry and the Central Bank’s policy objectives, from a macro-economic perspective; on the national modification needed to mitigate the impact of Basel III on SMEs, on trade finance and on project and infrastructure lending, key economic sectors in the national interest; to ensure that banks are not dis-incentivised to hold such long-term assets under Basel III, given the higher capital and Net Stable Funding Ratio (NSFR) liquidity requirements, is profound.

Already the advanced economies are adopting different implementation phases with different interpretations and treatments for Basel III. For example, the European Parliament had recognised the low-risk and self-liquidating nature of trade finance and approved exemptions to the Basel III rules, which effectively enable EU banks to offer trade finance at lower cost. If Asia adheres strictly to Basel III, this raises the question of whether a level playing field exists for Asian banks and those operating under different markets.

Regulatory discretion

This raises the question of whether national regulators should be given more discretion to adjust their regulatory and supervisory guidelines in line with the Basel principles in a manner that suits their national banking development agenda and time frame. Some of the very pertinent issues raised by Andrew Sheng, the eminent former central banker and financial regulator, in a study carried out by him on the impact of Basel III on Asian economies, are worthy of consideration:-

The Basel III risk-weightings are based on current sovereign credit ratings. Asian economies (and by definition, Asian banks) have lower credit ratings, even though their sovereign debt has high foreign exchange backing (up to 50%) and Asian economies have higher savings and lower fiscal debt. Many Asian banks are state-owned, thus the urgency to raise large capital cushions is not as imperative as the European case. 

Solution: Asia should consider creating mutual (owned by users and industry) not-for-profit, Credit Rating Agencies that can give ratings that are more objectively based. This will provide competition to the current top three that have become Too Big To Fail (TBTF).

Whether regulatory resources should be focused on developing a banking system that supports and fits Asian realities, rather than “one-size-fits-all” rules designed for implementation by advanced countries. Global banks have the capacity to absorb these costs but not the smaller national banks in Asia, which are at different stages of development.

This was the experience of the Sri Lankan banks too where the cost of implementation far outweighed the advantages, if any, particularly where banks were unable to influence the pricing of credit as a result of lower capital charges to low risk borrowers. Most banks in the industry thus preferred to stay with Basel I at 100% risk weights and a higher capital charge. Particularly with the indigenous banks, this was in our favour as they had more capital than if they had used their own internal models which would have invariably been tailored to induce less capital. Our regulatory staff too were not equipped to validate these models.

Basel III is now a complex rule book of over 600 pages and has become a “one-size-fits-all” rule-book. Supervisory authorities should step in when there is supervisory judgment that the bank has not recognised the risks and may contribute to systemic risks. The Basel Committee must trust national regulators to monitor their system risks and only step in (via FSAP/FSB/IMF) if the activities of Domestic Systematically Important Financial Institutions (D-SIFIs) or global-SIFIs, contribute to global systemic development;

We need to put the Implementation of Basel III in Asia within the proper context. Basel III is designed essentially for global, systemically important, banks or national banks with nationally systemic international exposure. This picture does not fit the bulk of banks in emerging markets, particularly those in emerging Asia. Certainly not in Sri Lanka.

In other words, implementation of Basel III is not an end itself, but a means to stronger economies with healthier banking systems

There is today greater emphasis on financial inclusivity (especially financing the SMEs) to ensure greater social justice and job creation.



 

The Basel Committee on Banking Supervision (BCBS) developed Basel III to further strengthen the resilience of the international banking system. 

There needs to be an Asian voice on financial reform and regulation rather than allowing the debate on issues to be dominated by a perceived choice between American and European approaches. 

There was concern that Basel III may have unintended consequences on Asian economies and a research think tank based in Hong Kong, agreed to examine the regulatory impact of Basel III in more depth. One of its major Findings was how Asian banks differ from their Western counterparts, both on a quantitative and qualitative basis in terms of capital adequacy, liquidity and risk exposure. On all three fronts, the Asian banks emerge as having stronger financial positions than banks in Europe, UK and Australia.

There can be one-size-fits-all principles, but never one-size-fits-all rules for the whole world.

Models risk – It is important to note that even with the implementation of Basel II, the use of internal models by global banks, permitted under, and incentivised by the Basel II framework, has resulted in many spill-over effects. A number of analytical studies show how banks using these models can easily play with their own estimates in order to reduce the amount of capital required to be put aside. These internal models, in fact, do not always reflect the underlying credit risks of different exposures and may foster regulatory capital arbitrage on a massive scale. By the same token, the Basel III framework does not significantly question the reliability of the internal risk model approach to capital regulation. Internationally active banks are therefore incentivised, even under Basel III, to use their own risk models for the purpose of calculating their prudential requirements, in view of the inherent capital savings and competitive advantages. 

The undue importance given to, and the preoccupation with, Basel II compliance at the Financial Services Authority (FSA) in the UK, was a key factor attributed to the inability of the regulatory staff to devote more critical attention to the risks that were steadily unfolding in the real sector of the financial system and the consequent failure of several banks in the UK during the GFC – HBOS, RBS, Northern Rock, etc.

The requirements of the Basel II framework not only weakened controls on capital adequacy by allowing banks to calculate their own risk-weightings, but they also distracted supervisors from concerns about liquidity and credit and the supervisory neglect of asset quality exemplified in the failure of the banks in the UK – (Parliamentary Commission on Banking Standards – an accident waiting to happen – the failure of HBOS.) 

A significant part of the prevailing supervisory capital framework was effectively put on hold in 2006 and 2007, pending implementation of Basel II, which was perceived as the solution to weaknesses in the framework. Basel II took much longer to implement than expected. It was a complex and resource-intensive process, both for the FSA and the firm, and the risk crystallised before that regime had time to bed down properly. No action had been taken in the interim to deal with HBOS’s increasing risk profile.

(Part II of this article will be published in tomorrow’s Daily FT.)