Achieving financial stability in banking sector with Basel III

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Why is banking sector stability important? Financial sector crisis experienced around the world in the recent decade and the resultant macroeconomic damages signify the importance of maintaining financial stability in the banking sector. Although maintenance of financial stability starts with the regulatory framework, the Basel Committee on Banking Supervision has clearly established the responsibility of bank boards, senior management and risk managers in contributing to stability in each financial institution thus contributing to the overall stability of a country’s financial sector as a whole.

Many agree that the world has experienced the recent financial crisis mainly due to business cycle boom followed by over investment, resulting in price bubbles. The key contributory factors for the crisis being hyper credit growth, fuelled by poor lending standards. In simple terms, imprudent, non proactive risk management in banks has resulted in colossal losses and adverse consequences across major economies in the world. Historically, it has been seen that risks in financial or banking sector could create a contagion effect when one or few banks are in a crisis. Institutions which are directly or indirectly having exposures with the troubled institution would also lose market confidence. If this situation is not resurrected in a timely manner, the contagion effect can spread rapidly leading to a huge liquidity crisis in the entire banking system and the economy as a whole. One of the key objectives of creating financial stability in any country is to support the role of financial intermediation facilitated by the banks. Simply, if the banks are not robust, depositors would not risk their money in a vulnerable banking sector which in turn hampers allocation of savings to investments in the country’s development. Stability in the financial system also contributes in proper transmission of monitory policy to create price stability, which controls high inflation. As a rapidly developing country, stable macroeconomic factors such as low inflation, exchange rates, interest rate etc., too will support Sri Lanka in its future course. Role of risk management in creating financial stability Financial stability in banks is created through reliability, robustness and proactive risk management. While the regular day to day risks are analysed by various conformities to frameworks/procedures, sufficient buffers are required to be maintained to meet any contingencies. In order to attain financial stability in the banking sector, certain risk factors should be monitored and managed in a proactive manner. These traditional risk factors, commonly known as ‘Pillar I risks in Basel II,’ are credit risk, market risk, liquidity risk and operational risk, etc. In addition to these, according to Pillar II requirements of Basel II, the banks are also required to assess the adequacy of their capital covering additional risk factors such as credit concentration risk, reputational risk, strategic risk, etc. This is termed as Internal Capital Adequacy Assessment Process or ICAAP, which is periodically reviewed by the regulator to evaluate a bank’s capital adequacy and soundness of the risk management system compared to the risk profile of the particular bank. A bank which is committed to manage its risks in a consolidated and proactive manner could effectively make use of their own ICAAP as a strategic tool rather than a mere regulatory compliance document. Some of the areas would be:

Evaluating the required capital compared to future business plan thus setting target levels of capital over time.
Integrating strategic plans and risk management plans with the capital plan in a meaningful manner.
Profit optimisation through proactive decisions on exposures/potential exposures while mitigating risks to minimise losses.
Measure vulnerabilities by carrying out stress testing and scenario analysis to support proactive decision making.
Identify gaps in managing qualitative yet important risks such as reputational risks and strategic risks which are not captured under Pillar I.

Apart from capital adequacy, performance indicators such as sustainable profitability, asset quality, liquidity and professional management, sensitivity to market variables etc. can also be used as indicators, to measure stability of a bank (e.g. CAMELS rating). While risk management techniques are adopted by using sophisticated models and tools in developed countries which have rich databases, there is no impediment for Sri Lankan banks to use simpler models with available data to manage their risks in a prudent manner. The comprehensive risk management framework established by the regulator over the past few years, could be used as a propeller for the local banks to steadily progress towards international best practices in risk management such as Basel II, Basel III and beyond. Timely investment in Basel compliant software solutions can support the local banks to build risk related databases which will enable them to migrate into more advanced approaches of the Basel accord eventually. These databases can also support such banks to take well informed business decisions with special emphasis on risk/return trade off compared to their capital. Few such measurements are Risk Adjusted Return on Capital (RAROC), Return on Risk Adjusted Capital (RORAC), etc., to name a few. To promote a sound and a stable banking sector, it is imperative to create required frameworks to promote corporate governance, risk management and effective regulatory review. The global best practices in risk management should be embraced sooner than later to make our banking sector resilient in conformity with the international standards. It has already been seen world over that the banks which are having business properly supported by prudent risk management systems and capital buffers are attractive for the depositors, investors and also could benefit from lower borrowing costs. Basel III The Basel III framework introduced by the Basel Committee broadly intends to; 1.Strengthen and enhance the risk management regulatory framework already introduced by Basel II. 2.Establish a macro prudential overlay to address systemic risk to mitigate procyclicality (i.e. the time dimension) and the interconnection/contagion. Planning for Basel III We should understand that Basel III is not a complete set of new regulations. It encompasses the entire regulatory capital framework established in Basel II and Basel 2.5 (on securitisation and market risk introduced in 2009). Basel III therefore could be named as the “booster” which enhances the comprehensive regulatory risk framework introduced by Basel II and Basel 2.5. Introduction of the new enhanced framework mainly intends in reducing both the frequency and intensity of potential financial crises. It should be noted that Basel III sets minimum requirements in strengthening the risk frameworks in banking sector to foster financial stability. Therefore, opting to introduce part of the framework could dilute the effectiveness and may not reap intended results. On the other hand, the time lines set by Basel Committee to introduce the new framework are also a “minimum”. This means each jurisdiction should plan to enhance the regulatory risk framework to meet Basel III standards within a reasonable time period without delaying to implement same till the last moment. Haphazard and inconsistencies in the implementation or weakened standards and/or overall delays in the implementation could increase the probability of a financial crisis with high level of intensity. On the other hand, a carefully planned transition would allow sufficient time for banks as well as the regulators to adopt the new standards, without a giving a rise to a major shock in the system. As discussed later in this article, Basel III demands the banks to maintain much higher capital buffers compared to traditional capital adequacy levels. Proper planning and sufficient time is therefore required for banks to attract new capital, preserve existing capital by managing dividend payouts, etc. Certain banks may also opt for consolidation to meet Basel III requirements which needs time. Further, it is important to provide sufficient time for the key stakeholders, such as regulator, board of directors, senior managers, auditors and investors to understand the new framework and its implications. Implementation of Basel III will simply achieve two things. Banks with a strong capital will create a resilient financial system which could provide credit for economic growth in a reliable and consistent manner. On the other hand capital buffers and reduction of contagion effect will allow the banks to absorb shocks without amplifying them. This type of resilience is very important for Sri Lanka which needs effective financial intermediation to support economic growth. It is therefore, important for us to understand the benefits as well as challenges in entering in to the journey of implementing Basel III in years to come. Key areas covered in Basel III The basics of risk management pivot around the simple rule i.e. to avoid or minimise a substantial damage from any event by way of either reducing the probability and/or the impact of that adverse event. In Basel III the ultimate intention too would simply be to minimise both the severity and/or the probability of a financial crisis. In order to achieve this purpose, Basel III has introduced new stringent rules covering following key areas. (i) Capital – quality and quantity Basel III has tightened the definition of “capital”, thus increasing the quality of capital buffers held by banks. Overall, more emphasis has been placed on “common equity” as the key risk absorbent in the capital structure. Phasing out of non-standard Tier – 1 over 10 years, tighter treatment of deductions, such as minority interest, investments in financial institutions are some examples. “Tier – 3” capital has been abolished in Basel III. In terms of “quantity”, Basel III greatly focuses on common equity and the minimum to be raised up to 4.5% of risk weighted assets (RWA) after deductions. Capital conservation buffer comprising of common equity of 2.5% of RWA expects to bring the total common equity to 7% from the present level of 2%. In addition, a countercyclical capital buffer ranging from 0-2.5% could be imposed by the regulator if credit growth is resulting in an unacceptable build of systematic risk. (ii) Increase in risk coverage Basel III framework targets at capturing the types of risks that were not properly covered by Basel II while Basel 2.5 was introduced to cover part of such risks including securitisation and complex derivatives held in Trading Books. Basel III extends the risk coverage to capture counterparty exposures as well. (iii) Containing leverage through introducing a “backstop leverage ratio” The leverage of the banks is to be limited to 3%. The expectation is that the capital of the bank should at least be 3% of the total assets including on and off balance sheet assets. This intends to act as a non-risk sensitive “back stop” to contain the banks from excessively leveraging their asset book, including off-balance sheet exposures. Broadly, this rule aims at containing possible system wide build-up of excessive leverage leading to financial crisis. This ratio will supplement the traditional risk based measures already adopted in measuring the regulatory capital. (iv) Liquidity standards One of the main causes of the recent global financial crisis was the excessive liquidity risks carried by the banks to increase their asset book without considering the underlying risks. Most of the banks have ignored the liquidity risk arising from tenor mismatches between assets and liabilities. Some reputed banks funded their long term assets mainly through very short term sources such as interbank borrowings. Basel III intends addressing this area by introducing two liquidity ratios.

Firstly, the Liquidity Coverage Ratio (LCR) requires the Banks to have sufficient high quality liquid assets to withstand a 30 day stressed potential liquidity crisis. This could mean that the banks may need to hold low yielding assets such as government securities to meet the LCR.
Secondly, Net Stable Funding Ratio (NSFR) intends encouraging and incentivising the banks to have stable sources of funding to reduce their dependency on short term “non sticky” sources.
In addition to the above ratios, Basel III reiterates the principles of sound liquidity risk management and a liquidity framework which includes a set of matrices to assist the regulators to monitor the liquidity risk at the individual bank level as well as system wide level.

(v) Global Systematically Important Financial Institutions (G-SIFIs) In addition to the standards discussed above, one of the key elements of Basel III is the requirement for “Global Systematically Important Financial Institutions” (G-SIFIs) to have a higher loss absorbent capacity to prevent the risks that they pose to the financial system as a whole. The additional buffer for G-SIFIs would be met with a progressive common equity Tier I capital requirement, ranging from 1% to 2.5%, depending on the systemic importance of each bank. Implication of Basel III on investors While strengthening the risk framework which would create financial stability in the banking sector, implementing Basel III also has some costs. In simple terms, the new rules in Basel III will negatively affect the numerator as well as the denominator of Return on Equity (ROE) which ratio being the basic and widely used indicator by the equity investors. While the profitability of banks are affected negatively by reduced lending capacity, higher cost of funds, increased cost of liquid assets, the increase in equity base ,will pull the ROE down. On top of the above reduction in ROE, banks will also curtail dividend payouts in the future to preserve and build capital buffers. This negative effect on ROE and dividend payouts could reduce the investor’s preference to invest in bank equity, compared to other options available in the stock exchange. Although, on the face of it the effects of Basel III create a rather negative impression from an investor’s perspective, we need to analyse this critically. Would a rational investor risk his/her money by investing in a highly leveraged bank which follows relaxed risk management practices? The answer is an obvious no! This model of excessive leverage/high risk has in fact wiped out billions of dollars of investors as well as governments around the world. Another important aspect we need to highlight is that an economy needs to have a balance between share holder expectations and the public interest in a safer financial intermediation. When the financial system in a country is safe, all stake holders including the investors would benefit. Therefore, the conflict between Basel III rules and the share holder interest may have been misquoted in certain forums. Although, the change in the business models of banks could create conflict in the short run in terms of “returns”, over the long term time horizon, the prudent investors would settle for more stable returns backed by a resilient and sustainable banking institution.Another aspect the investors would consider is the effect of high leverage which contributes to volatility in returns. While higher leverage could lead to higher performance in favourable market conditions, a slight negative moment could lead to a disaster. Since Basel III intends to avoid such volatility, a segment of investors could in fact be attracted to shares of banks in time to come. The fact remains that the banks which were strongly capitalised and had prudent risk management systems weathered the financial crisis better, compared to banks which adopted non-resilient business models in the past. Pillar – III of Basel encourages market discipline through sound, consistent, high quality risk disclosures. These disclosures complement the decision making and confidence of the investor community when investing in shares of banks where commitment towards stringent and well regulated risk management practices was much stronger compared to other sectors in the market place. Role of auditors and accounting standards For Basel III to be effective, it would be imperative to promote collaboration between regulators and internal/external auditors. As practically as possible, auditors need to make sure those internal control systems and risk management frameworks of the banks are functioning properly. They also need to independently review the accuracy of the risk management discourses released to public domains such as annual reports, websites, etc., to build market confidence about the risk profile of the banks. In addition to this, another impediment that could dilute the effectiveness of Basel III would be the required changes to international accounting standards. According to the Bank for International Settlement, a well capitalised bank could still be vulnerable due to poor valuations and under provisioning. These factors clearly indicate the required contribution in the role and the responsibilities of different stake holders’ with a view to increase the effectiveness of Basel III, to reap the intended benefits of a resilient financial system geared to provide credit to the economy. Conclusion In summary, the benefits of adopting Basel III for the investors, banking industry and the country as a whole will outweigh the so-called negatives in the long run especially when the market participants understand the prudency of opting for resilient, stable returns compared to volatile and vulnerable returns. Rapid economic growth and urbanisation in our country would demand a robust financial system to support development. More finances would be demanded for infrastructure development, large scale private enterprises, technological innovations, etc. These developments may not be well supported solely through traditional banking services, but securitisation structures, long term debt instruments, etc., will have to be promoted without creating unacceptable risks in the financial systems. In order for us to benefit from innovative financial instruments, it is vital to have a globally accepted risk management framework to regulate such instruments. The main intention of Basel III is to reduce the economic cost of a financial crisis which is undoubtedly important for a rapidly developing country like Sri Lanka. As discussed, it aims to achieve this by reducing both the frequency and/or the severity of potential financial crises which will increase the confidence of the depositors and investors in the entire financial system of the country. Building the robustness and resilience in the banking sector should take place sooner than later so that the country’s financial systems are well geared to face unforeseen potential negative factors. From what has been discussed in this article, it is clear that the journey towards achieving Basel III will facilitate comfort to the stakeholders when the banking institutions record positive performance. It is not feasible for the banks or the regulator to impose tighter capital and liquidity requirements prescribed in Basel III, if the banking sector is experiencing difficulties. Considering the present favourable performance of the local banking institutions, the overall business scenario can be considered to be conducive to initiate implementing the Basel III standards. The regulator’s encouragement for consolidation in the local banking sector too complements with the financial resilience advocated by Basel III rules. The General Manager of the Bank for International Settlements has once commented that “too little has been done and too late to strengthen financial institutions at the global level since the start of this crisis”. The message for the local banking sector is therefore; implementing Basel III in Sri Lanka should not be taken as “too many things to be done too soon” because delaying implementation of prudent risk management practices could not only expose the banking sector but the entire financial system and the economy to unprecedented vulnerabilities. (The writer is the Chief Risk Officer of Commercial Bank of Ceylon Plc.)

Achieving financial stability in banking sector with Basel III

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