Basel-III: Challenges and opportunities

As part of the graduation process of capital adequacy standard, the Basel Committee on Banking Supervision (BCBS) released the global regulatory framework on Basel-III capital accord in December 2010 in view of strengthening global capital and liquidity rules with the goal of promoting a more resilient banking sector. The objective of the reforms was to improve the banking sector's ability to absorb shocks arising from financial and economic stress thus reducing the risk of spillover from the financial sector to the real economy. In line with the above, Bangladesh Bank (BB) instructed the scheduled commercial banks to implement the Basel-III capital accord with a roadmap after detailed quantitative impact studies on the banking sector. In continuation of the same, BB recently issued "Guidelines on Risk Based Capital Adequacy (Revised Regulatory Framework for banks in line with Basel-III)" which replaced the previous circulars in this regard. The major areas of the graduation process are summarised below:

MAJOR CHANGES IN BASEL-III: Basel-III is not an isolated guideline rather it is the latest refinement of Basel capital adequacy standard. The major changes are described below:

1. Strengthening capital framework: The latest capital accord focuses on raising both quality and quantity of regulatory capital and enhances the risk coverage of the capital framework. Consequently, the Tier-1 Capital (renamed as 'going-concern' capital) has been framed under two components, Common Equity Tier-1 (CET1) Capital and Additional Tier-1 Capital where the first component will be comprised of common shares and retained earnings while the later will be comprised of instruments that are subordinated, have fully discretionary noncumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. In addition, Tier-2 Capital (renamed as 'gone-concern' capital) will be harmonised with 100 per cent deduction of revaluation reserve for fixed assets, securities and equity securities from Tier-2 capital under a transitional arrangement (20 per cent in 2015 followed by 40 per cent in 2016, 60 per cent in 2017, 80 per cent in 2018 and 100 per cent in 2019).

2. Enhancing risk coverage and addressing systematic risk and interconnectedness: In view of enhancing risk coverage, the reform package includes additional capital charge for Credit Value Adjustment (CVA) risk which captures risk of mark to market losses due to deterioration in the credit worthiness of a

counterparty in addition to default risk of counterparty. Basel Committee also suggests that systematically important banks should have loss-absorbing capacity beyond the minimum standard due to their interconnectedness in the economic system. As such they have developed a proposal on a methodology comprising both quantitative and qualitative indicators to assess the systematic importance of financial institutions at global and domestic level.

3. Capital conservation buffer and phase in arrangement of minimum capital requirement: The new directive prescribes the banks to maintain Capital Conservation Buffer (CCB) @2.5 per cent, comprised of CET1, of Risk Weighted Assets (RWA) in order to address pro-cyclical (any economic quantity that is positively correlated with the overall state of the economy) and counter-cyclical (any economic quantity that is negatively correlated with the overall state of the economy) dynamics. However, the additional buffer to be gradually developed. The transitional arrangement for enhancing capital base is shown in the following table:

Banks will not be allowed to distribute dividend (either cash or stock form) in case of capital level falls below the prescribed level. If CET1 capital falls below the required level, the banks will be required to conserve a certain per cent of earnings in the subsequent financial year. However, if a bank fulfills minimum capital requirement but fails to fulfill the requirement of conservation buffer, the bank may distribute stock dividend subject to approval of Bangladesh Bank.

4. Leverage and liquidity standards: In order to address the excessive leverage in the banking system, Basel-III directive has incorporated a simple, transparent and non-risk based regulatory Leverage Ratio (LR=Tier-1 Capital/Total Exposure). The LR to be maintained at least @3 per cent and to be reported on quarterly basis. However, LR will be migrated to Pillar-1 in 2018. The new directive has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. In order to promote short term resilience of a bank's liquidity risk profile by ensuring that it has sufficient high quality liquid resources to survive an acute stress scenario lasting for one month, Liquidity Coverage Ratio (LCR=Total High Liquid Assets/Total Net Cash Outflow) has been introduced. Again, Net Stable Funding Ratio (NSFR=Available Amount of Stable Funding/Required Amount Stable Funding) has been introduced to promote resilience over a longer term horizon. The threshold limit for LCR has been fixed at ?100 per cent while the same is >100 per cent for NSFR.

CHALLENGES AND OPPORTUNITIES: Keeping in view of the above changes, the following implications might be observed in the banking industry:

1. New directive has emphasised on increasing quality capital (particularly, Tier-1 Capital). However, it might not adversely affect the banking industry as Tier-1 capital contributes the lion's share of eligible capital. Financial Stability Report (FSR) (2013) of Bangladesh Bank revealed that Tier-1 capital ratio was 9.0 per cent of RWA at YE (year ended) 2013 which is sufficient enough to address additional capital buffer.

2. Minimum total capital plus capital conservation buffer will have to be reached at 12.50 per cent of

RWA by 2019. Average Capital Adequacy Ratio (CAR) of the banking industry was 11.50 per cent (CAR of Private Commercial Banks was 12.52 per cent) at YE 2013 which reduced to 10.68 per cent (CAR of Private Commercial Banks was 12.05 per cent) at June end 2014. Again, as revaluation reserves will gradually be deducted from Tier-2 capital, there might create a vacuum in eligible capital base. The cumulative effects might put pressure on fulfilling capital requirement. The banks will either have to raise the capital base or efficiently manage the asset portfolio to reduce the RWA in line with organic capital growth. All this will require a long-term capital planning for the banks.

3. Under Basel-II directive subordinated debt was limited to 30 per cent of Tier-1 capital. New directive does not give any restriction on raising subordinated debt although Tier-2 Capital can be admitted maximum up to 4.0 per cent of total RWA or 88.89 per cent of CET1 whichever is higher. This will allow the banks to further extend capital base through issuing subordinated debt. Moreover, subordinated debt of perpetual nature (like Mudaraba Perpetual Bond of IBBL) will qualify for additional Tier-1 Capital under the new directive.

4. In terms of maintaining leverage ratio, it has been observed from the FSR (2013) that, excluding specialised banks, the banking industry is at comfort zone with 4.57 per cent leverage for state-owned commercial banks followed by 7.75 per cent for private commercial banks (excluding Islamic), 7.89 per cent Islamic banks and 27.70 per cent for foreign banks as against minimum requirement of 3.0 per cent under the new directive.

5. As systematically important banks might require capital in addition to minimum requirement (upon regulatory approval), these institutions might be under regulatory focus and will act as the driving force in the financial system.

Despite many challenges, it is quite evident that the Basel-III framework will definitely make the banks more risk-resilient and shock-absorbent than ever before. However, mere reporting and compliance are very insignificant part of the whole thing. Real benefit can only be achieved if the inherent philosophy is well understood and implemented by the practitioners.

The views expressed in the article are the author's own and not necessarily of the organisation he represents. The author, a member of ACCA, is an Assistant Vice President of Islami

Bank Bangladesh Ltd.

kmraihan@islamibankbd.com