Tuesday May 07, 2024
Tuesday May 07, 2024
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The strong position of Asian banks with respect to Basel III requirements can be attributed to the build-up of capital and liquidity buffers after the Asian Financial Crisis of 1997-8. More importantly, Asian banks rely on less leverage and fewer hybrid capital instruments than their western counterparts, resulting in both higher levels and quality of capital.
This gives rise to an uneven playing field where the Asian countries are, by default, already compliant with the Basel III capital requirements and their peers in the advanced economies, where the crisis really crystallised, will not be, till 2019. So what happens in the interim?
It therefore behoves us to question the clarion call from the trendsetters – the Basel Committee (albeit after the fact) – the IFIs, the Ratings Agencies, the politicians and indeed the regulators, for capital enhancement, in the aftermath of the GFC.
The question that arises is: Are we not capable of deciding for ourselves how best the solvency risk, as measured by the CAR, should be managed? We never permitted capital to be compromised by hybrids which did not have these basic characteristics, but were still admitted as Tier I capital by the Basel Committee and which was the cause of the failure of many banks in the GFC.
The Basel Committee was seriously negligent here in permitting common equity or pure capital to be only at an insignificant level of 2%! On this count alone, it is my view that the Basel Committee lost its mandate to be the international standard-setter for capital adequacy. They have, to date, not been held accountable for the abject failure of Basel II as exemplified by many bank failures in the GFC.
What about the financial institutions themselves – Have they not demonstrated their ability for prudent capital management? The adequacy and strength of capital is fundamental to their responsibility to make the entity they govern or manage, a robust financial entity for the long term, to support their growth strategy and to provide adequate resilience against internal and external shocks? This is what sustainability in banking business should mean and nothing less.
Which brings us to the question of measuring a bank’s own ability indeed to make a reasonable assessment of a sustainable level of capital for the medium and long term and not just for the short term, to meet regulatory requirements.
With regard to the Budget proposal to raise the minimum capital of banks from Rs. 10 billion to Rs. 20 billion for the commercial banks, here too, apart from a few small banks, the larger domestic banks – the six systematically important banks which represent 75% of total LCB sector assets, have capital levels far in excess of the proposed minimum and have built up adequate capital buffers through organic capital growth and prudent profit retention policies.
It is reiterated that these capital buffers have also been facilitated by the regulators with the imposition of a mandatory transfer of a minimum percentage of annual profits to a reserve fund, as a cushion against potential losses, before bank profits are distributed.
It is heartening to note that the larger and stronger domestic SIBs have dividend policies that encourage internal capital generation through the build-up of capital reserves and profit retention.
The regulators would do well to defend the capital strength of the banks in Sri Lanka, purely on their own assessment of the risk
profiles of the banks, against their risk exposures and on the specificities of our own markets, rather than basing them on international benchmarks which cater to the excesses of the advanced economies, none of which are prevalent in most Asian countries.
Regulators should also be mindful of valuable time spent on meeting international benchmarks which are hardly relevant to our market characteristics and the fundamentally traditional banking business the banks are engaged in. We are, thankfully, still in the traditional banking business mode and, apart from a few interest rate swaps and exchange hedges, the risk exposures of banks are not opaque and are within the capacity of the regulators and the banks themselves to identify and mitigate.
Besides, Basel III reflects the existing regulatory standards applicable to the industry and which have been in force for well over half a century! The banks just need to inculcate a capital planning mindset to ensure that capital and asset expansion move in sync and that they are not overleveraged.
The emphasis may, very well move to the banks’ exposure to the construction industry and to real estate, which sector is seeing a boom today as is evident, if indeed the banks are exposed – a concern expressed by the Governor of the Central Bank that a sharp increase in lending to the real estate sector was observed and that it was receiving the attention of the Monetary Board.
The need to build prudential reserves against their sectoral exposure to the property /real estate sector, through a higher capital charge, is an imperative, as are prudent profit retention policies to support the internal generation of capital for the future. This is not difficult to enforce in a situation where the banks are flush with profits despite declining GDP growth in the economy!
This obvious disconnect was first commented on by corporate guru Hilmy Cader, when he said despite the downturn in the economy, the banks are posting significant increases in profitability. This contradiction may be explained thus – the primary contributory factor is the unproductive, but highly remunerative, personal or consumption lending engaged in by most banks. In the distribution of credit, it is unfortunate that there are no statistics on the trend in household debt vs. business credit which, if available, will be quite telling.
There is also the recent phenomenon of IFRS which gives the banks the ability to significantly reduce the impairment provision against NPA, which is a charge on profits. The Central Bank’s Annual Report 2016 also refers to the (unexplained), highest ever decline in NPA in 2016 – the year when IFRS raised its ugly head!
As emphasised by Sheng, Asian regulators and banks need to look beyond Basel III. Financial stability and soundness of the banking system depends very much on the growth of the economy. The Asian economies are already struggling to grow amidst managing the repercussions of quantitative easing and decline in external demand on the domestic economy.
Judicious exercise of national discretion among Asian regulators is therefore important in tailoring Basel III implementation that is fit for purpose for Asian economies. The aim is not to dilute prudential rules but to focus attention on risk exposures (that are different for each country), and minimise unintended consequences.
The more stringent Basel III requirements for liquid assets may also trigger unintended consequences in terms of reallocation of funds at the sectoral level, that penalise bank lending for trade finance, Small and Medium-sized Enterprises (SMEs) and infrastructure projects – all critical to Asia’s future growth. For example, the requirement on a higher level and quality of equity capital will squeeze banks’ capacity to lend to SMEs.
Banks may be dis-incentivised to hold such long-term assets under Basel III, given the higher capital and Net Stable Funding Ratio (NSFR) requirements. Moreover, the type of collateral, for example, land, that supports this type of funding, is often subject to heavy haircuts. The ROE for project finance and other critical sectors may decrease under Basel III regulations making it not worthwhile to finance these sectors. This could impact infrastructure investments for Asian economies.
Whilst endeavouring therefore to make our banks internationally comparable vis-à-vis espoused best regulatory practice, we should not place too much importance on the complexities of Basel III, to the detriment of focusing on matters of more regulatory importance such as the core risk exposure of banks, credit risk, particularly in the context of IFRS which has caused the prudent impairment norms set by the regulators to be considerably compromised, without as much as a frown by the regulators.
While Asian banks and, indeed the Sri Lankan banks, are not capital-constrained in the immediate term, their ability to support growth and credit demand may be impaired in the medium term as credit demand continues to expand, underpinned by ongoing economic development and infrastructure financial needs.
For this purpose I cannot emphasise enough the importance of the ICAAP and the economic capital discipline which needs to be the only test of a bank’s real capital strength, which invariably will be in excess of the mandatory regulatory minimum.
To quote from the many criticisms of the Basel Committee’s dogmas on capital adequacy, “Basel III is designed essentially for global systemically important banks or national banks with nationally systemic international exposure. The Sri Lankan banks have still to enter this space and even where it may be more relevant in neighbouring India and Singapore which have large internationally active banks, for the purposes of peer review, it does not fit the description of most South East Asian banks in emerging markets. Certainly not in Sri Lanka. It is not meaningful thus from a global perspective to require a small economy, with a relatively less globalised banking system, to adopt highly complex financial regulations. The scarce resources should be used more appropriately for domestic development.”
In a notable speech, Andrew Haldane, Bank of England Executive Director, described the intricate structure of Basel III, arguing that the new prudential provisions resulted in:
n“A ballooning in the number of estimated risk weights. For a large, complex bank, this has meant a rise in the number of calculations required from single figures a generation ago to several million today (Haldane (2011)).
nThat increases opacity. It also raises questions about regulatory robustness since it places reliance on a large number of estimated parameters. Across the banking book, a large bank might need to estimate several thousand default probability and loss-given-default parameters. To turn these into regulatory capital requirements, the number of parameters increases by another order of magnitude…
With Asian economies having existing capital regulations more stringent than Basel III requirements, they start off on a stronger footing to meet the new capital and liquidity standards. Singapore is an example of these stricter capital standards. In June 2011, the Monetary Authority of Singapore announced that it would require locally incorporated banks to meet a minimum CET1 ratio of 6.5%, Tier 1 capital ratio of 8% and Total capital ratio of 10% from 1 January 2015. These standards are higher than the Basel III minimum requirements of 4.5%, 6.0% and 8.0% for CET1, Tier 1 Capital Ratios and Total Capital Ratios, respectively.
Furthermore, a number of Asian economies have enforced tighter standards governing capital calculations. Examples include full deduction of deferred tax assets from Tier 1 capital and exclusion of revaluation reserves (i.e., unrealised gains on revaluations of land and building) from Tier 2 capital.
In addition to Sri Lanka, a number of Asian economies, such as China, Hong Kong, India, Malaysia, Singapore, South Korea, Thailand, and Taiwan, have had prudential liquidity standards in place very much prior to Basel III.
Therefore, as with everything else, the Basel III requirements are almost half a century late and is its response to the serious liquidity crunch experienced by the internationally active banks during the GFC.
With many banks exceeding these new standards, Asia appears to be at the forefront of creating a safer global banking system. (Source – Basel II Implementation in Full Swing: Global Overview and Credit Implications. Moody’s Investors Service.)
Ravi Menon, the Managing Director of the MAS, summed up the concerns on Basel III very aptly when he stressed the importance of taking a holistic perspective in this final stage of the Basel III capital reforms and cautioned that:
If we do this right, we would have made more progress than ever before – towards a banking system that:
Finally, Andrew Sheng, quite appropriately, poses a longer-term question – whether Asia could eventually seek out its own solutions, for example, in the form of an Asian Monetary Fund (AMF) first mooted by the Japanese during the AFC. The idea for an AMF was first conceived during the Asian Financial Crisis of 1997-1998 but was quickly rejected by the International Monetary Fund (IMF) and the US Treasury.
I may add that we should also work towards an Asian Regulatory Committee on the lines of the Basel Committee which would address the specific risks that are peculiar to the Asian economies and markets instead of catering to the excesses of the Western markets that are required to be reined in.
In the alternative, the Asian representation on the Basel Committee should be fair and representative of the Asian perspective to make the Basel Committee, indeed, a truly democratic and credible institution worthy of its position on the global regulatory landscape.
