Basel III and Its Implications for Asian Banks
Introduction on Basel III
1. The governing body of the Basel Committee on Banking Supervision (BCBS) made its announcement on the Basel III framework proposal on September 12, 2010. The key changes to the proposed framework consist of the following:
- The minimum core Tier-1 ratio is set at 5% for Core Tier-1 capital, 6% for Tier-1 Capital, and 8% for total capital adequacy ratio. This is intended to improve the quality, consistency and transparency of banks’ capital base.
- Banks will be required to set aside a 2.5% capital preservation buffer via common equity by 2019. This means restrictions on the outflow of profits in the form of dividends, executive bonuses, etc.
- A countercyclical buffer of up to 2.5% loss-absorbing capital will be mandated to replenish capital during economic upswings and to bring capital down during downswings in order to build a more stable financial system and to avoid risky pro-cyclicality. The size and transition period of such buffer will be left to the discretion of the regulators in each country.
- The Tier-1 Leverage Ratio is set at a minimum of 3%. The intention is to limit the build-up of leverage in the banking sector (so to reduce the market risk and liquidity risk) and to re-enforce the capital requirement with a simple, non-risk based “backstop” measure (in order to reduce ‘model risk’) based on gross exposure.
- The Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) have been introduced. The objective is to build short-term resilience of liquidity risk profile by: (1) ensuring banks will keep sufficient high quality liquid resources/assets that can be used to offset the net cash outflows that the bank would encounter a severe stress scenario lasting one month; and (2) maintaining a minimum amount of funding that is expected to be stable over 1 one-year period based on liquidity-risk factors assigned to asset/off-balance sheet liquidity exposure.
- Under the new capital framework, Pillar 1 set capital requirements/guidelines for trading book positions, complex securitization exposures, and further enhancements on counterparty credit risk measurement. Disclosure requirement under Pillar 3 were also strengthened in order to ensure banks disclose their “actual” risk profile appropriately. Such changes are made to address the needs for more transparency on securitization exposures in the trading book, sponsorship of off-balance sheet vehicles, liquidity facilities and re-securitization exposures
- The new regulatory structure requires a forward-looking bad debt provisioning with an eye to prevent substantial P&L swings from long-term economic volatility due to the increased bankruptcies during downturn. Another objective of this proposed approach is to guide banks to mitigate pro-cyclicality by factoring-in future credit costs via appropriate loan pricing.
Summary of Concerns for Asian Banks
2. The initial focus of Basel II was to enhance the risk sensitivity of banks to determine the minimum capital requirement under Pillar One, but the credit crisis and related economic crisis shifted the focus towards Pillar Two, thus increasing the uncertainty about the actual regulatory capital requirements at individual bank level and thus a potential uneven playing field across countries.
3. Though the recent Basel III announcement has drawn most of the market attentions in response to the 2008-2009 global financial tsunami, before moving on to Basel III, the ABA suggests that regulators and market players in Asian countries should re-examine the readiness and status of migration of financial institutions toward Basel II.
4. The Basel III announcement of the new capital norms and timeline came out broadly in line the market expectations. In general, with the given relaxed timeline for transition, Asia as a region may be well positioned to build up capital over the next few years for Basel III, but differences and issues exist across countries and some central banks may adopt faster implementation.
Conclusions and Recommendations
5. Basel 2 originally was meant to introduce the improvement on the risk sensitivity for the calculation of banks’ minimum capital requirement. However, with the allowed national discretions over the adoption of measurement approach and transition, Basel 2 had led to a significant increase in complexity and inequality in bank treatment and hence unfair level-playing field at national and international level.
6. Altogether, the new regulatory requirements-to-be (Basel III + IFRS + Solvency 2) will change the behavior of the financial institutions globally, and will have a long lasting effect not only on banks but also on the capital markets and a broad range of investors.
The new norm
7. The 7% minimum capital requirement (being the Common Equity Capital ratio of 4.5% plus conservation buffer of 2.5%) standard under Basel III is going to be viewed as the normal level of bank minimum capital adequacy. While the structurally profitable main stream banks are to reach the standard of 7% Core Tier-1 via retained earnings, the problematic banks with weaker capital ground would be given sufficient time for migration (2013-2019).
The benefits of long transition
8. The implementation of the Basel III’s capital adequacy standards are to be phased in by various components between 2013-2019 and thus provide banks with sufficient time to prepare for the adjustments to such new requirements. Banks shall examine carefully on the impact to not only from risk management perspective but also the long-term implications on business lines and finance management.
Regulatory overlap: Basel II/Solvency 2 + Basel III + IFRS
9. The potential for regulatory overlap is rising fast as a combined effect of capital requirements, accounting changes, region and country specific discretionary measurements become known. The implementation efforts and costs associated with all these changes could be significant and hence may further widen the disparity between financial institutions within and across nations. Regulatory communications and alignments should be encouraged and facilitated to better cultivating a level-playing field and best practice learning.
10. To sum up, the Basel II/III enhancement guidelines and the discussions/understandings and implementation activities will likely dominate the financial market players as well as regulators across nations for the years to come. The full effects and consequences, at this point in time, for banks and their business and the overall capital markets still remain uncertain.
11. In response to the newly defined Basel II/Basel III requirements to be finalized during the G20 meeting to be held on November 11th and 12th, the ABA recommends that member banks consider the following actions:
- Bank management shall re-assess the overall capability and readiness not only from capital impact, financial and risk management perspective but also on both institutional and business-line level impacts. In addition, with the prolonged transition, senior management can carefully plan for the phased implementation and redefine business priorities that would allow the bank to adapt to the upcoming regulatory changes gradually.
- Envision the importance of knowledge and experience sharing among the member banks and the efforts required to buildup the alignment under Basel II/Basel III requirements, we propose ABA to form a periodical “consortium/forum” and to promote frequent dialogue among bank practitioners and regulators across countries within the region on the sharing of Basel 2 migration and enhancement and the preparation of Basel III.
- With the takeaway learning from global financial crisis, it is extremely critical for financial institutions and regulators to work hand-in-hand to establish the “law of order” (market discipline, especially on the additional capital or liquidity surcharge for systemically important financial institutions) and to cultivate a level playing field. With the upcoming Basel III requirements, banks with strong core capital base and risk-adjusted profitability would enjoy more financial capability and bargaining power via organic expansion or M&A and hence strengthen the competitiveness.
- Strategically, financial institutions and regulators in Asia should collaborate to build an “Opinion-leader Asian Consortium” to set standards for their counterparts in US and Europe in terms of the global standards and policies setting and also to voice out our key concerns and challenges for solutions.
2 November 2010, Taipei