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Shortcomings of Basel II framework
Published in 2004, the second Base Accords, which has a slow progress, was noted to have a few shortcomings.
While it was noted to have poor management of on and off-balance sheet leverage, it had capital that was actually not loss-absorbing along with insufficient liquidity buffers and inadequate group and system-wide risk management.
The need for a new global financial stability framework
SyCip, Gorres, Velayo & Co. Partner Francisco R. Lumbres speaking on ‘Basel III: Facing up new Regulatory Challenge’ pointed out that new global financial stability framework is essential for a number of reasons.
With the financial crisis having revealed the need for a new global financial stability framework, Lumbres stated that it should be based on five principles.
The first is to have a system-wide view by taking into account interactions between the financial system and macro economy. The second is to have countercyclical policies by building buffers during good times to get through the rainy days. The third is to employ symmetrical macroeconomic policies during boom and bust cycles. The fourth is to have a long term view by taking account of gaps between risk build-up and its occurrence and finally to use a holistic and complementary approach that include prudential, monetary and fiscal policies.
Objective Basel III
While the primary objective of Basel III is to strengthen the global capital and liquidity regulations with the goal of promoting a more resilient banking sector, it attempts to improve the banking sector’s ability to absorb shocks arising from financial and economic stress and reduce the risk of spill-over from the financial sector to the real economy.
“Basel III was issued as a way of enhancing the existing Basel II framework and to strengthen the ability of global banking sector in the wake of the global financial crisis,” noted Lumbres.
He shared that the key Basel III changes are that it has higher capital ratios and enhanced quality and quantity of capital, expanded risk coverage for trading book exposures, introduction of conservation and pro-cyclicality buffers, introduction of leverage ratio as safety net, new liquidity requirements, and enhanced market discipline.
When looking at the capital planning, Lumbres shared that the process should be embedded in the ICAAP of the bank where it is essential that the capital planning at the institutional (i.e., bank wide) level and at the business unit level meets the ’use-test’ requirement in the ICAAP.
How are global banks responding to Basel III?
In an EY & IIF survey of major financial institutions it was observed that with regard to capital changes, institutions are reinvesting earnings. They are issuing convertible loan stock to give access to incremental capital subject to certain triggers in a downturn and offering rights issues.
While they are selling assets to comply with Tier 1 capital requirements, institutions are also looking at RWA by product and geography and keeping shareholders, investors and analysts confident with more transparency of reporting and communication.
Long with improving the transparency of internal reporting, they are actively educating businesses to make certain capital costs are integrated into strategy and business line management.
On changes in funding, institutions are diversifying funding from deposits, investors and markets to reduce dependency on one area. Incentivising longer-term deposits, they are pricing more aggressively to encourage longer-term funding.
Institutions are observed to be increasing loan pricing to reflect liquidity costs, de-risking the sources of funding and liquidity by tapping into new markets around the world and building US dollar funding base by attracting funding from US corporates through wholesale and transactional services.
Looking at business model changes, the major financial institutions are exiting countries based upon local regulations to avoid liquidity and capital.
While they are also exiting certain businesses, adjusting product offerings, they are readjusting legal and operating models to improve efficiency, purchasing retail banks to access long-term deposit bases and decreasing the level of degrees of transformation on the balance sheet.
Along with reducing complexity, branch by branch and subsidiary by subsidiary, it is noted these institutions are shedding non-core businesses and regions to focus on core businesses and are focusing more strictly on risk-return basis profit of the business to cover higher capital costs, he said.
How can institutions face the new regulatory challenge?
According to Lumbres, tightened capital standards will compel banks to have additional capital discipline. “If banks are unable to raise new capital, the alternative is to reduce assets, which could hit the broader economy by capping credit availability. The higher capital requirements, the leverage requirements and the calculation of the new liquidity rules will affect banks’ existing business models and push up the overall cost of funding that could lead to negative impact on ROE and CAR,” he said.
Lumbres added that with increasing cost of capital and pressures to maintain capital buffers, bank strategies must be considered in light of these rules and constraints. They should continue to strengthen focus on stress testing, governance while attributing capital and liquidity costs and benefits within performance measurements.
“Close coordination and oversight of risk and capital initiatives are needed to align the objectives of profitability and solvency. It is expected that banks will now be safer, but more expensive, with large implications to the economy,” opined Lumbres.
Implications of Basel for SL banking sector
ICRA Management Consultants India Chief Operating Officer V. Sriram when speaking on ‘Optimising Capital Requirements under Basel’, said that in terms of the Capital Conservation Buffer (CCB), this will negatively impact banks with core Tier I less than 7% since banks will be required to hold a CCB of 2.5% RWA inform of common equity to withstand future period of stress. For this, bank can use CCB in times of stress to meet the minimum capital requirement and once accessed, the bank would be restrained in using its earnings to make discretionary payouts.
When looking at the countercyclical buffers, banks with Core Tier I less than 7% would be negatively impacted. Furthermore, as the buffer has to be set annually by CBSL, this could introduce an element of variation in lending rates and/or the ROE of banks. “Closing these gaps will have a substantial impact on profitability,” cautioned Sriram.
Going back to the definition of ‘capital’, assessing major banks in Sri Lanka he noted that composition of Tier I capital consists mainly of ordinary share capital and share premium (35%), retained profits (30%) and general reserves (35%).
Tier I capital maintained by banks under Base III is largely concomitant to common equity Tier I and additional Tier I under Basel III as no major bank has sued non-cumulative, non-redeemable preference shares.
In terms of leverage ratio of the banking industry, it stands at 4.3% which meets Basel requirements of 3%. However, liquidity coverage ratios are noted to remain high due to more than mandated investment in level 1 assets, mostly government securities.
As per Basel III, all deductions should be from core capital which would lead to reduction of a mount in core capital for Sri Lankan Banks. There will be pressure to raise new capital.
On the RWA requirements, impact on banks is limited by low exposure to trading book. Banks with significant trading book and off balance sheet derivative exposures will be impacted due to increased risk coverage (on account of counter party credit risk.
On liquidity coverage and net stable funding ratio Sriram said: “On the former (liquidity coverage) implementation from 2015 can lead local banks to maintain additional liquidity as the liquidity coverage ratio as per Basel III is more stringent, whereas for the latter (net stable funding) currently, there is no norm issued by CBSL for NSFR which is likely to be implemented from 2019.
Impact of Basel III on major banks
On capital adequacy the overall CRAR and Tier I capital ratios remain at 15% and 13.3%. Major banks are adequately capitalised and maintain Tier capital ratios above that mandated under Basel III. According to Sririam, quality of capital is also high with 89% of the capital base being composed of core capital and banks would however have to raise fresh funds to meet requirements in future.
With regard to profitability, wide diversity in capacity of banks to maintain profitability in light of increased requirements under Basel III. While there could be possibility of impact on ROE going ahead, impact likely to be larger on private sector banks as compared to governments’ sector banks
Challenges and opportunities for local banks under Basel III
Sririam pointed out that the typical challenges for local banks under Basel III include cost of raising additional capital, additional investment in IT and risk management processes which could upset strategy and capital budgeting. Furthermore there also could be a possible impact on RoE.
However, along with challenges, Basel III brings a number of opportunities which include the advantage of already high capitalisation, improved risk management practice critical for resiliency and incentive to migrate to advanced approaches to reduce RWA.
Sriram noted that strong economic growth environment of 6% plus, is a key positive for banks to meet additional capital requirements with internal accruals supported by fresh issues. “Narrow debt markets for market instruments are a significant constraint and consolidation of smaller banks with well capitalised banks is a possibility. However, retaining proportionate stake in PSU banks will cost the Government,” he added.
Challenges from additional capital requirements
Under the Basel III requirements, the increase in minimum capital requirement is skewed towards high quality capital as the increase in common equity drives the increase in Tier I and Total Tier Capital ratios.
Sriram pointed out that analysis of historical trends indicates that capital accumulation has over the long term kept pace with RWA growth leading to high capitalised levels. However RWA trend shave revealed a wide year-on-year variation and tendency to rise faster during times of sustained credit expansion.
“CBSL mandates a quantum for minimum share capital requirement for LCBs to $10 billion and LSBs to $ 5 billion by 2016. The additional capital requirements for this purpose vary by the bank. Among the six major banks, three banks would require to double or raise by a third their share capital in the next three years for the same purpose.
“Assuming a growth rate for macro economy and banking assets based on historical trends, both leverage and CRAR ratio is projected to be under pressure in case of no fresh in flow of capital. A rough estimate of additional capital required by 2018 would be in the range of LKR 110-140 billion,” he noted.
Challenges from cost of raising capital
With the high loan to deposit ratios and a stagnating savings rate standing at around 23%, along with a narrow debt market, this scenario would significantly impact the cost of raising capital in the coming few years, said Sriram.
“Sri Lankan non-government bond market remains underdeveloped. Number of issues per year has been around four or below in the past five years. In 2012, for example, two banking institutions were responsible for all nine listings for a mobilisation of Rs. 12.5 billion.
“Sri Lankan banks are increasingly looking at overseas borrowing to raise capital and the proportion of overseas debt in the capital base has increased on 15% in 2009 to around a third at present. Increasing exposure to foreign markets brings with it renewed uncertainties caused by foreign exchange movements, rate changes and the constraints imposed by allows over reign rating,” he added.
Leverage ratio – Objective and computation
The Basel Committee has put forward that the numerator comprise high quality capital, and the denominator integrate off-balance sheet assets with on-balance sheet assets where a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1 January 2013 to 1 January 2017 has been proposed.
Providing a detailed outlook on the leverage ratio, KPMG India Partner S. Kuntal during his presentation on ‘Liquidity, leverage and Capital Buffers of Basel III’ noted that while embedded leverage is the most difficult to measure, most structured credit products have high levels of embedded leverage, resulting in an overall exposure to loss that is a multiple of a direct investment in the underlying portfolio.
“As a result of differences in accounting regimes, balance sheet presentation, and domestic regulatory adjustments, the measurement of leverage ratios could vary across jurisdictions and banks. Accounting regimes lead to the largest variations, particularly US GAAP and IFRS differences. Absence of a uniform application of the leverage ratio, and the calculation methodology could diminish the value of the measure,” he said.
Sharing the benefits of this ratio, Kuntal said that leverage ratio is a good countercyclical measure and empirical evidence has shown that bank leverage rises during boom times and falls during downturns.
“The leverage ratio is versatile enough to be used both as a macro-or micro-prudential policy tool. It provides for less regulatory arbitrage. A minimum leverage ratio can help dampen this perverse incentive by acting as a backstop to risk-based capital requirements. The leverage ratio can be applied regardless of the capital adequacy regime in a jurisdiction,” he noted.
Risk transformation – Trends in the market
While risk management has gone up the boardroom agenda and is a strategic issue, senior interest has increased pressure for better information, analysis and the data to support this. Risk governance is being strengthened with greater senior management involvement in risk decisions.
Kuntal shared that large Indian banks are reassessing their risk governance framework using a top down approach. “Several banks are reviewing risk governance arrangements following regulatory feedback. Several initiatives are being taken to improve risk reporting by centralising and simplifying reports. This is done in conjunction with risk architecture projects,” he said.
Adopting a holistic approach, there has been a move away from solely (credit, market, operational, insurance) risk management towards a stronger overlay identifying the linkages ensuring nothing is missed. For this stress testing, clearly articulated risk appetite, strategic risk discussions and aggregation have been a contributing factor.
“There is stress-testing, reverse stress-testing and risk appetite projects across the board and an increasing role in management reports and strategy have been observed. Major banks in the region are re-focusing its group risk function using a bottom up approach to ensure that risk appetite and limits are in line with the high level strategy. Along with this, banks are conducting a full risk assessment and creating risk aggregation mechanism to aggregate their divisional risks,” he noted.
Robust risk information for analysis and decision making
Risk is seen as a critical part of more decisions and tools and models are needed to support this. There are moves to gain more confidence in key risk models, improve systems and extensive work is being done on improving risk data.
Kuntal said that banks are undertaking project to improve systems and processes to optimise data centers, reduce cost and improve controls and invest in high priority business development. According to him many banks in the region are improving source data, where they are cleaning it, remapping and sharing same source between risk and finance.
Stress testing framework – Best practices
Stress testing is a risk management tool used to simulate an extreme but plausible event, measure how the events would impact the bank’s financial position though the assessment of Capital Adequacy Ratio, profitability and liquidity, and it brings out the hidden risks in the portfolios and acts as early warning signal for the management.
Sharing the importance of stress testing in today’s environment, Aptivaa Chief Operating Officer Sandeep Mukharjee said it has increased responsibilities on board and senior management and helps them in addressing key risk issues.
“While there is an impact of a specific stress scenario on the profit and loss statement, stress testing helps in the identification of worst-case scenario and associated loss and determines the level of concentration risk and assesses the risk appetite of the firm,” he said.
Challenges for banks in this regard are that are at three levels, the governance, framework and in implementation.
From the governance point of view, this will help encourage in board and senior management participation along with managing many cross functional; stakeholders across the firm.
From the framework level, it will bring together business and modelling expertise in stress testing teams and help choose the right modelling approach and adapting scenarios for each material risk.
At the level on implementation it will assist in collating and aggregating risk data with the requisite amount of granularity and history. Furthermore it will help Improve approaches of the underlying risk areas, and validate and benchmark the stress testing approach and individual models.
Overall regulatory requirements
Regulators in Western countries are following a supervisory approach and are emphasising on an integrated stress testing framework driven by macro-economic variables, said Mukharjee.
“The regulators in India and Malaysia have proposed a combination of sensitivity and scenario analysis. Although the RBI has recently proposed scenario based analysis for large sized banks, BNM has left it to the discretion of the Banks. However, the Central Bank of Sri Lanka has not yet published detailed guidelines on stress testing,” he noted.
Sharing his views on a likely way forward in Sri Lanka in this regard, Mukharjee said that expectations from CBSL include in having regulations similar to India and Malaysia, along with having scenario based approach for large banks.
In this challenges for banks include the lack of internal models with macro-economic factor and the lack of data for development of models.
“Our recommendation for stress testing in Sri Lanka is to continue following Sensitivity approach, prepare internal rating models and gather relevant data required. Also it is advisable to follow a top down, one stage model once sufficient data is available,” said Mukharjee.
The forum also featured an interactive session on ‘Liquidity and funding risk in Basel III world’ facilitated by HSBC Hong Kong Senior Manger Asset, Liability and Capital Management Ashantha Silva were he presented case studies of institutions who have been impacted by these risks on the past.
Basel III implementation roadmap for Sri Lanka2014 Q1
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