Basel III BizTimes Article

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Living with Basel III[2010] 22 Dec_BT

Title : Living with Basel III

Source :Business Times

Author :Alec Kourloukov

BASEL III, introduced recently by the Basel Committee on Banking Supervision, is widely

seen as a response to the failure of the current regulations to stem the global financial

crisis of 2007-08. The set of rules, outlined in a series of framework documents and

directives, aims at strengthening risk management and regulatory oversight of the banking

industry.

It should improve resilience of individual institutions and the financial system as a whole.

According to European Central Bank president Jean-Claude Trichet: 'In the present episode

of global recovery . . . uncertainty is the enemy in a way.' Basel III eliminates this '. .

.uncertainty in a large area, which is a major contribution in consolidating the global

economy'.

Key areas of risk

Basel III framework reinforces the two pillars of a banking institution: capital and funding.

The new rules seek to improve quality, consistency and transparency of the capital base,

cleaning up Tier 1 capital and harmonising Tier 2. They will increase the minimum commonequity requirement from 2 per cent to 4.5 per cent. In addition, banks will be required to

hold a countercyclical buffer of 2.5 per cent to withstand future periods of stress, bringing

the total common equity requirements to 7.0 per cent in 2019.

The other countercyclical measures will also include forward-looking provisioning,

requirement to use long-term data horizons to estimate probabilities of default, and

making the use of downturn loss-given-default estimates mandatory.

The Basel Committee developed two quantitative measures for liquidity risk supervision.

The first one, the liquidity coverage ratio, deals with sufficiency of high-quality liquid

assets to meet short-term liquidity needs under a specified acute stress scenario.

The second measure, the net stable funding ratio, addresses longer-term structural

liquidity mismatches. According to the Basel Committee, these measures should be

implemented consistently as part of a global framework to raise the resilience of banks to

potential liquidity shocks.

Basel III will also introduce minimum leverage ratio as a supplementary measure to Basel

II to limit the build-up of leverage in the banking sector.

While banks and regulators discuss Basel III around the globe, the new regulatory capital

requirements do not appear to have a great impact on banks in the Asia-Pacific region.



Asian banks in general have higher capital adequacy ratios than banks in Europe and the

United States. Capitaladequacy ratios of Indonesian banks are around 17 per cent and of

Malaysian around 14.2 per cent. Quite a few Asia-Pacific banks rushed to calculate

Common Equity and Tier 1 ratios under Basel III and declared that the new rules would

have little or virtually no impact on their capital position. Nevertheless, in some countries

there may be a need to look at Basel III more closely than in the others.

Tier 1 ratios clean-up and growth challenges

For instance, Malaysian banks may see a lowering of their Tier 1 capital ratios under the

new rules. According to the report by ECM Libra Investment Research, certain Malaysian

banks will have common equity ratio of just marginally higher than the required 7 per cent

threshold. These banks may need to adopt a more prudent stance to their common equity

capital.

Financial institutions in the region witnessed considerable growth in the past few years. In

2009, Indonesian banking assets grew by 7.5 per cent and Philippine banking assets by

9.0 per cent. As signs of recovery from the global financial crisis continue to improve,

banks will accelerate pursuing growth through acquisitions and will feel more confident in

revisiting expansion plans. Several institutions such as OCBC and DBS (Singapore) and

Maybank and CIMB Group (Malaysia) are striving to build a franchise beyond their home

markets.

It will be beneficial for such banks to make forward-looking projections of their compliance

with Basel III rules adjusting the capital ratios for expansion by the years of 2013 and

2015 (milestones when banks have to commence disclosure and parallel run under new

rules).

After completing this exercise, the banks may find their capital positions under some

pressure. Once they apply forward-looking provisions based on expected loss calculations,

which means using long-term probabilities of default and downturn loss-given default, the

perceived capital excess may be reduced to minimum.

Ongoing liquidity enhancements

It is also worth mentioning that the new governance and oversight measures for liquidity

risk as well as new quantitative benchmarks are important for strengthening liquidity risk

management. It is widely acknowledged that Asia-Pacific institutions still have a lot of

work to do in this area.

Thus, a potential for the heightened liquidity risk was stressed by the Malaysian central

bank (Bank Negara Malaysia) in its 2009 annual review of financial stability and payment

system .

Bank Negara noted the likelihood of increased exposure to liquidity mismatches due to

expansion of forex activities of the banking institutions. A centralisation of treasury

function also increases the prospect of group-wide liquidity difficulties when the institution,



serving as a key funding provider for the group, is affected by liquidity stress. In addition,

Bank Negara expressed concern about a relatively low level of sophistication of liquidity

stress tests and methodologies and a need for more granular operational limits, including

limits on funding by currency and exposures to related entities.

While addressing the fundamental issue of capital adequacy, Basel III also impacts growth

and profitability. Financial institutions may require more capital not to expand but just to

maintain the exiting business model. This will potentially lead to the dilution of banks'

earnings and loss of attractiveness of bank shares.

The impact of the new framework on banking institutions has been recently examined by a

number of studies, which produced changeable results. One of the most comprehensive

efforts was undertaken by the Bank of International Settlements (BIS).

The BIS study found that for each one per cent increase in the capital ratio, the lending

cost will increase approximately by 13 basis points, while the new liquidity requirements

increase loan costs by another 25 basis points. The study suggested that to mitigate this,

operating expenses have to be reduced by approximately 4 per cent.

To alleviate the potential impact on profitability, banks must align business and financial

management practices with the new regulations. They have to improve the efficiency of

the balance sheet and potentially consider exiting some businesses or product lines given

the future paucity of capital.

It will be important for the Asia-Pacific banks to continue looking into Basel III's detailed

requirements as well as closely following the debate around the new regulatory framework

to ponder their response.

The writer is director, Risk Consulting at Deloitte Singapore. He may be contacted

at [email protected]

Source: Business Times © Singapore Press Holdings Ltd. Permission required for

reproduction.

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