4th Annual BSP‐UP Professorial Chair Lectures 21 – 23 February 2011 

Bangko Sentral ng Pilipinas Malate, Manila 

 

Lecture No. 1  

Basel III and Risk Mitigation in the Banking Sector 

 by   

Dr. Sergio Cao BSP‐UP Centennial Professor 

of Accounting   

Basel III and Risk Mitigation in the Banking Sector1

Sergio S. Cao, PhD Professor of Finance

College of Business Administration University of the Philippines Diliman

sergio.s.cao@gmail.com Abstract: The paper discusses Basel III. It explains the general principles of the new set of rules and the changes in comparison with Basel II. It also includes a discussion on the likely effects of the new rules on the banking sector and possible effects on the economy. 1. On November 11-12, 2010 at the Leaders' Summit of the G20 countries in

Seoul, tougher new capital and liquidity requirements for banks were approved. These new requirements are included in what is called Basel III.

2. While the new rules are expected to lead to banks being better prepared for

financial crises like what we recently experienced, there are also indications that Basel III will have negative effects on the economy in general. Jose Ackermann, Chief Executive of Deutsche Bank and Chairman of the Institute of International Finance (IIF) warned that "forcing financial institutions to meet new capital requirements too quickly could hurt economies worldwide. . . The IIF calculated that the economies of the US and Europe will be 3% smaller after 5 years than if Basel III were adopted"2

3. Basel III is a set of proposed new rules on capital and liquidity requirements

and some areas of banking supervision. Basel III follows Basel II, itself a set of revisions of an original set of rules known as Basel I introduced in 1988 by the Basel Committee on Banking Supervision (Basel Committee)3. The Basel Committee was tasked to finalize Basel III for approval by the G20 leaders in their meeting in Seoul in November 2010. The implementation of Basel III is set to start by end of 2012.

4. Let us first review the current rules. The basic principle in the Basel rules is that

banks should have capital sufficient to cover for risks with the required level of capital being based on the riskiness of the bank's assets.

1 BSP-UP Centennial Professorial Chair Lecture, February 21, 2011 2 Douglas J. Elliot, “Basel III, the Banks. and the Economy,” The Brookings Institution, July 23, 2010.

See the "Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework" (2010) published by the IIF.

3 The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee is comprised of central bank and supervisory authority representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. The Committee's Secretariat is based at the Bank for International Settlements in Basel, Switzerland

The Basel Committee's governing body is the Group of Central Bank Governors and Heads of Supervisors, which is comprised of central bank governors and (non-central bank) heads of supervisor from member countries. (Source: BIS)

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This principle is captured in Basel I. However, while the capital requirement in

Basel I are risk-based, the classification, assignment and measurement of assets and risk weights are simple and straightforward. Moreover, only credit risk was accounted for until the inclusion of market risk in 1996. In the Philippines, in compliance with Basel I, the Bangko Sentral ng Pilipinas (BSP) issued BSP Circular No. 280 (effective July 1, 2001, covering credit risk only) and BSP Circular No. 360 (effective July 1, 2003, that already included market risk).

Basel II, proposed in 1999, attempted to improve on Basel I by providing better

classification and assignment of risk weights. In addition, it included operational risk.4 Basel II also provided for what is called "risk-based supervisory framework" in addition to risk-based capital framework. In compliance with the Basel II framework, BSP issued BSP Circular No. 538 dated August 4, 2006 to be effective July 1, 2007.

5. Basel II is based on the three principles (called "pillars") that:5

• Pillar 1. Banks should have capital appropriate for their risk-taking activities;

• Pillar 2. Banks should be able to properly assess the risks they are taking and supervisors should be able to evaluate the soundness of these assessments; and

• Pillar 3. Banks should be disclosing pertinent information necessary

to enable market mechanisms to complement the supervisory oversight function.

6. Under Basel rules, capital adequacy, captured by Capital Adequacy Ratio

(CAR), is computed by dividing "qualified" capital by the total risk-weighted assets. What is "qualified capital? How are the risk-weighted assets computed? Qualified capital are classified as either Tier 1 or Tier 2 in both Basel I and Basel II. Tier 1 capital is mainly composed of common stocks and preferred stock that are almost common and is referred to as capital of the highest quality. Preferred stock that are very much like common stock than debt and some subordinated debt are called Tier 2 capital. Tier 1 and Tier 2 qualifying capital ensure that banks have enough good quality capital to cover for risks. While banks generally have more Tier 2 capital than Tier 1 capital, they should have enough Tier 1 capital. There are required deductions, particularly goodwill, from the capital being offered by banks for qualifying capital for CAR requirements.6

4 Defined as the "risk of loss resulting from inadequate or failed internal processes, people and

systems, or from external events. This does not include business or strategies risks but includes external fraud, security breaches, regulatory effects or natural disasters." (Source: "Operational Risk: A guide to Basel II Capital Requirements, Models and Analysis (OR)", Anna Chermobai, Svetlozar Rachev, and Frank Fabozzi, John Wiley, 2007)

5 5 Taken from "Financial Regulation and the Central Bank" by Nestor A. Espenilla, Jr., Central Banking in Challenging Times, The Philippine Experience, BSP, 2009

6 See BSP Circular No. 280 issued in 2001

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7. To compute CAR, charges for credit risk, market risk and operational risk are computed. The approaches for such computations are shown in the following table:

Types of Measurement7

Measurement Types/Approaches

Internal Ratings-Based (IRB) Credit Risk The Standardized Approach

Foundation IRB Advance IRB

Market risk Standardized Measurement

International Models Approach

Operational risk Basic Indicator Approach (BIA)

The Standardized Approach (TSA)

Advance Measurement Approach (AMA)

Under Basel requirements, international standards require that CAR for banks

must not be lower than 8%. In the Philippines, the CAR requirement is more strict set by the BSP at 10%.

The data below describes the CAR of a number of banks in the country. In a

related news report, it was noted that "the central bank said that as of end - March 2010, the banking system's CARs stood at 14.90 percent on solo basis and 15.95 percent on consolidated basis, both of which were slightly higher than those recorded in the previous quarter."8

The following table shows the CAR of some selected banks (in 2009):9

Bank

CAR (%)

Metrobank

12.40*

Banco de Oro 14.20

RCBC 17.94

BPI 17.00

Landbank 17.30

PNB 16.88

* 2008 data

7 Taken from “Briefing on the BSP’s New Risk-Based Capital Adequacy Framework”, BSP, 26 August

2005 8 As reported in Business Insight Malaya, November 1, 2010 9 Data taken from various sources, e.g. Annual Reports

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The following diagram shows the timetable for implementation of Basel II:10

2005

2006

2007

2008

2009

2010

Gradual phasing in of certain Basel 2 provisions (securitization SA, past dues, highest credit quality corporates)

Credit Risk - standardized approach Operational Risk - basic indicator or standardized approach

Credit Risk - FIRB and AIRB allowed Operational Risk - AMA allowed

8. The reforms being proposed under Basel III are intended to address problems

that were made apparent by the recent financial crisis also thereby strengthening the banking sector and banking supervision. The reforms address both firm-specific as well as systemic risks. Jaime Caruana, General Manager of BIS, said that the implementation of Basel III will:11

(i) considerably increase the quality of banks' capital;

(ii) significantly increase the required level of of their capital;

(iii) reduce systemic risk; and

(iv) allow sufficient time for smooth transition to the new regime.

9. What are the general principles of Basel III? The "building blocks" of Basel III

are:12

(i) Raising the quality of capital to ensure banks are better able to absorb losses on both a going concern and a gone concern basis;

(ii) Raising the level of the minimum capital requirements, including

an increase in the minimum common equity requirement from 2% to 4.5% and a capital conservation buffer of 2.5%, bringing the total common equity requirement to 7%;

(iv) Increasing the risk coverage of the capital framework, in

particular for trading activities, securitizations, exposures to off-balance sheet vehicles and counterparty credit exposures arising from derivatives;

10 Ibid., 7. at page 3 11 Taken from his speech at the 3rd Santander International Banking Conference on 15 September,

2010, entitled "Basel II: Towards a Safer Financial System", Source: BIS 12 Taken from "The Basel Committee's response to the financial crisis: report to the G20", BCBS, BIS,

October 2010

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(v) Introducing an internationally harmonized leverage ratio to serve as a backstop to the risk-based capital measure and to contain the build-up of excessive leverage in the system;

(v) Introducing minimum global liquidity standards consisting of both

a short term liquidity coverage ratio and a longer term, structural net stable funding ratio;

(vi) Promoting the build up of capital buffers in good times that can

be drawn down in periods of stress, including both a capital conservation buffer and a countercyclical buffer to protect the banking sector from periods of excess credit growth; and

(vii) Raising standards for the supervisory review process (Pillar 2)

and public disclosure (Pillar 3), together with additional guidance in the areas of sound valuation practices, stress testing, liquidity risk management, corporate governance and compensation.

10. We now highlight the details of the building blocks under Basel III.

BB(i). Higher quality of capital

Greater emphasis on common equity called "core capital" Tier 1 will now include common equity and other instruments under

more strict qualifying criteria In addition to requiring at least 50% of regulatory capital as Tier 1, at

least 50% of Tier 1 are now required to be common equity Deductions used to be taken from Tier 1 and Tier 2 capital under Basel

II will now be deducted from common equity Under Basel II, the ratio of common equity is at least 2% while for Tier 1

is 4%. With the more strict criteria, those ratios will effectively translate to 1% and 2%, respectively

Banks will therefore be hard pressed to increase their common equity once the rules take effect

BB(ii). Higher level of capital

Consequently, higher quality requirements will lead to higher levels of capital requirements

Minimum common equity requirement, 2% in Basel II, will now be 4.5% Tier 1 minimum capital requirement, 4% under Basel II, will now be 6% A "capital conservation buffer" which is 2.5% of common equity will be

required Minimum common equity capital requirement will therefore be 7% as

compared with just 2% under Basel II It should be pointed out that the rules impose minimum levels. In Basel

II, the minimum is 8%. In the Philippines, BSP increased this floor to 10% emphasizing the need for banks to hold capital above the minimum required

The same principle is expected for adoption by BSP under Basel III

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BB(iii). A framework that covers all material risks

Evidence brought out during the financial crisis proved that some banks held positions on complex and opaque on-and-off balance sheet derivative products for which they may not have been appropriately covered

Minimum capital requirement for complex securities and the imposition of higher risk weights for resecuritized products were introduced in July 2009

Banks were also mandated to better assess credit risks of externally rated asset-backed and other securities

New rules on capital requirement for positions in the trading book that will be stronger by three to four times than the old requirements were released in July 2009 by the Basel Committee. These rules are to be implemented by end of 2011.

Higher capital requirements will be imposed and better risk management will be required to appropriately cover for counterparty credit risk

BB(iv). Addressing too much leverage

In addition to increased capital requirement to cover for risk of off-balance sheet exposures, a non-risk-based leverage ratio will be introduced to help restrict too much leverage as a consequence, for example, of on-and-off balance sheet exposures

At least 3% Tier 1 leverage ratio, that is, ratio of Tier 1 capital to total non-weighted assets plus off-balance sheet exposures, will be required beginning 2013

BB(v). Stronger liquidity

There will also now be minimum liquidity requirements to mitigate funding liquidity risk; this was clearly a risk faced by banks as made evident by the financial crisis

A liquidity coverage ratio (LCR) and a net stable funding ratio (NSFR) were approved to be introduced by the Basel Committee after their meeting on November 30 and December 1, 2010

The LCR will require banks to put up sufficient high-quality liquid assets to address funding liquidity risk; the NSFR, on the other hand, covers all assets and will encourage banks to use "stable" sources of funding.

A common set of "metrics" to manage liquidity risks at the individual bank and system wide levels intended to improve banking supervision will be introduced

BB(vi). Addressing systemic risk

"Systemic risk is the risk of financial system disruptions that can destabilize the macroeconomy."13

For the BIS, "two key tasks must be pursued to effectively limit systemic risk. The first is to reduce procyclicality, that is, the financial systems' tendency to amplify the ups and downs of the real economy. The second task is to take account of the inter linkages and common

13 Ibid., 11. at page 4

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exposures among financial institutions, especially for those deemed systemically important."14

Re procyclicality, the build up of buffers will be required. Recall that the new required ratio for common equity is 7%; this includes the 2.5% capital conservation buffer.

There will also be counter-cyclical capital buffer. "This basically requires banks to automatically increase capital when the economy is on the upswing and drawdown capital on the downswing based on behavior of certain indicator macrovariables."15

The counter-cyclical capital buffer, that will be on top of the conservation buffer above when imposed, will range from 0% to 2.5%

Systematically Important Financial Institutions (SIFIs) will be required to have capital above the minimum requirements

The “excessive interlinkages” of SIFIs is also being addressed by the Basel Committee. Measures include:16

capital incentives for banks to use central counterparties for over-the-counter derivatives;

higher capital requirements for trading and derivative activities, as well as complex securitization and off-balance sheet exposures (e.g. structured investment vehicles);

higher capital requirement for inter-financial sector exposures; and

introduction of liquidity requirements that penalize excessive reliance on short term, interbank funding to support longer dated assets

(The matrix in the next page summarizes the requirements per the above-discussed building blocks.17)

BB(vii). Raising standards for risk management and supervision18

In July 2009, the Pillar 2 supervisory review process of Basel II was

reviewed to include:

Firm-wide governance and risk management; capturing the risk of off-balance sheet exposures and

securitization activities; managing risk concentrations; providing incentives for banks to better manage risk and returns

over the long term; and sound compensation practices

14 Ibid., 11. at page 4 15 Ibid., 5. at page 2 16 Ibid., 12. at page 4 17 Ibid., 5. at page 2 18 Ibid., 5. at page 2

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Additional macroprudential overlay

Common equity Tier 1 capital total capital counter-cyclical buffer

In percentage of risk-weighted assets

Minimum Conservation buffer

Required Minimum Required Minimum Required Range

additional loss-absorbing capacity for SIFIs*

2 4 8 Basel II Memo Equivalent to around 1%

for an average international bank under the new definition

Equivalent to around 2% for an average international bank under the new definition

Basel III New definition and calibration

4.5

2.5

7.0

6

8.5

8

10.5

0-2.5

Capital surcharge for SIFIs?

In addition, the following were issued to better guide supervision:

Liquidity risk management - Principles for Sound Liquidity Risk Management and Supervision (Sept. 2008)

Valuation practices - Supervisory guidance for assessing banks' financial instrument fair value practices (April 2009)

Stress testing - Principles for sound stress testing practices and supervision (May 2009)

Sound compensation practices - Compensation Principles and Standards Assessment Methodology (January 2010); Range of Methodologies for Risk and Performance Alignment of Remuneration. (October 2010)

Corporate Governance - Principles for enhancing corporate governance (October 2010)

Supervisory Colleges - Good Practice Principles on supervisory Colleges (October 2010)

Pillar 3 of Basel II on market disclosure was also revised to cover exposure to securitized and off-balance sheet products. The new requirements are for compliance by end of 2011.

The new requirements to improve transparency are rather stiff; banks are required to:

disclose all elements of the regulatory capital base, the deductions applied and a full reconciliation to the financial accounts

"a bank will need to make available on its website the full terms and conditions of all instruments included in regulatory capital"

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there is also proposed a Pillar 3 Disclosure Requirements for Renumeration "which aims to ensure that banks disclose clear, comprehensive and timely information about their renumeration practices, while not creating excessive burden or requiring disclosure of sensitive or confidential information."

11. Timetable for Implementation The new rules will be implemented on a staggered basis from 2011 up

to 2018 as shown in the following table:19

2011 2012 2013 2014 2015 2016 2017 2018 As of

1 January

2019

Leverage ratio Supervisory monitoring

Parallel run 1 Jan 2013 - 1 Jan 2017

Migration to

Pillar 1

Minimum common equity capital ratio

3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital conservation buffer

0.625% 1.25% 1.875% 2.50%

Minimum common equity plus capital conservation buffer

3.5%

4.0%

4.5%

5.125%

5.75%

6.375%

7.0%

Phase-in of deductions from CET 1 (including amounts exceeding the limit for DTAs, MSRs and financials)

20%

40%

60%

80%

100%

100%

Minimum Tier 1 capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum total capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum total capital plus conservation buffer

8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%

Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital

Phased out over 10 year horizon beginning 2013

Liquidity coverage ratio Observ

ation period begins

Introduce minimumstandard

Net stable funding ratio Observation period begins

Introduce minimum standard

19 Ibid., 5. at page 2

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12. What will be the effects of Basel III?

While there seems to be general agreement that the new rules will strengthen banks and the financial system making them better prepared against financial crises, there is evidence to the argument that there will be a negative impact on the economy as a consequence of the resulting reduction in funds that can be made available for credit that will lead to higher costs.

Angela Knight, chief executive of the British Bankers' Association warned Basel III "would end the ‘cheap money era’ as it becomes more expensive to run a bank, which will in turn be passed on to consumers through higher loan and mortgage costs.”20

On August 18, 2010, the Macroeconomic Assessment Group (MAG)

report, a joint interim report published by the Basel committee and the FSB estimated that "if higher requirements are phased in over four years, the level of GDP would decline by about 0.10% for each 1 percentage point increase in a bank's capital ratio once the new rules were in place. This means that the annual growth rate would be reduced by an average of just 0.04 percentage points over a period of four and a half years.”21

On the long-term economic impact, the Basel committee concludes that

"there are clear economic benefits from increasing the capital and liquidity requirements from their current levels. These benefits accrue immediately and result from reducing the probability of financial crises and the output losses associated with such crises. The output benefits substantially exceed the potential output costs for a range of higher capital and liquidity requirements. For example, with regard to the output benefits associated with reducing the probability of a financial crisis, the Committee estimates that each 1 percentage point reduction in the annual probability of a crisis yields an expected benefit per year ranging from 0.2% to 0.6 % of output depending on the assumptions used." 22

13. In December 2010, the BCBS released the results of the quantitative impact

study (QIS) on the new rules. Respondent banks were 263 including 94 Group 1 banks (with Tier 1 capital of at least 3 billion euros, are well diversified and internationally active); the others are called Group 2 banks.

The table in the next page shows the distribution of respondent banks by

countries. The key results are reported below (taken directly from the report):23

Overall impact on risk-based capital requirements

20 Taken from "Basel III: Q & A", http://www.guardian.co.uk/business/2010/Sep/13 21 Ibid., 5. at page 2 22 Ibid., 5. at page 2 23 “Results of the comprehensive quantitative impact study,” BCBS, BIS, December 2010

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Including the effect of all changes to the definition of capital and risk-weighted assets, as well as assuming full implementation, the impact of the Group of Governors and Heads of Supervision (GHOS) agreement reveals an average decrease for Group 1 banks from an 11.1% gross common equity Tier 1 (CET 1) ratio (gross of current deductions, based on current risk-weighted assets) to an average net CET 1 ratio of 5.7%, a decline of 5.4 percentage points. Comparing gross to net CET 1 for Group 2 banks reveals an average decline in ratios from 10.7% to 7.8%, or just 2.9 percentage points, which is considerably less than the decline seen in Group 1 banks.

Respondent banks in the QIS:

Jurisdiction

Group 1 Group 2

Australia 4 1

Belgium 2 2

Brazil 2 0

Canada 6 2

China 5 5

France 5 6

Germany 9 59

Hong Kong 0 7

India 3 6

Italy 2 20

Japan 9 7

Korea 5 3

Luxembourg 0 1

Mexico 0 3

Netherlands 4 14

Saudi Arabia 3 0

Singapore 3 0

South Africa 3 3

Spain 2 5

Sweden 4 2

Switzerland 2 6

United Kingdom 5 6

United States 13 0

Total 91 158

Calculated on the same basis, the capital shortfall for Group 1 banks in the QIS sample is estimated to be between ∈165 billion for the CET 1

minimum requirement of 4.5% and ∈577 billion for CET 1 target level of

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7.0% had the Basel III requirements been in place at the end of 2009. As a point of reference, the sum of profits after tax prior to distribution across the same sample of Group 1 banks in 2009 was ∈209 billion. The amount of additional CET1 capital required for Group 2 banks in the QIS sample is estimated at ∈8 billion in order to reach the CET 1 minimum of 4.5%. For a CET 1 target level of 7%, Group 2 banks would need an additional ∈25 billion; the sum of their profits after tax prior to

distributions in 2009 was ∈20 billion.

Definition of capital

CET 1 capital of Group 1 banks would fall by an average of 41.3%. Group 2 banks, on average, would experience a decline of 24.7% in CET 1 capital. The Tier 1 capital ratios of Group 1 banks would on average decline from 10.5% to 6.3%, while total capital ratios would decline from 14.0% to 8.4%. The decline in other capital ratios is also less pronounced for Group 2 banks. Tier 1 capital ratios would decline from 9.8% to 8.1% and total capital ratios would decline from 12.8% to 10.3%

Changes in risk-weighted assets

Overall risk-weighted assets would increase by 23.0% for Group 1 banks. The main drivers of this increase are charges against counterparty credit risk and trading book exposures.

Accordingly, banks that have significant exposures in these areas influence the average increase in risk-weighted assets heavily. Some banks also experience a larger than average increase in risk-weighted assets due to securitisation exposures in their banking books. Since Group 2 banks are less affected by the revised counterparty credit risk and trading book rules, their risk-weighted assets would increase by an average of just 4.0%. As a whole, the changes in risk-weighted assets have less impact on banks' capital positions than changes to the definition of capital.

Leverage ratio

The weighted average leverage ratio using the new definition of Tier 1 capital and the measure of exposure agreed by the GHOS for testing during the parallel run period is 2.8% for Group 1 banks and 3.8% for Group 2 banks.

Liquidity standards

The new liquidity standards result in an average liquidity coverage ratio of 83% and 98% for Group 1 and Group 2 banks, respectively. The average net stable funding ratio is 93% and 103%, respectively.

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14. "Basel III overlooks Asian banks"24

Reacting to the QIS results, Chopra said that the QIS was “more about western banks' future rather than Asian ones." As the table of respondent banks shows, Asian banks were "grossly underrepresented" in the study. Moreover, half of the Asian banks included fall into Group 2.

The Japanese banking system could be impacted the most but that is not surprising given the fact that the country's banks had the lowest capital levels in the region to begin with. According to BCBS, nine of them could face a gross CET 1 drop of 5.4 percentage points while another seven could face a 2.9 percentage point decline.

Chinese banks, which have been raising capital recently, have five banks in each of the two groups while Korea is a little better off with only three banks in Group 2. Woori has the lowest Tier 1 among the banks in Korea, but it could use funds selling two regional banks that it owns to make up for the shortfall, although the government which currently owns the bank, has not reached a decision on it yet.

The results do not change materially past assessment of the impact the

new rules might have on Asia's banking landscape. The development is unlikely to create a rush to raise capital in Asia, especially in countries such as China, Hong Kong, Singapore, Korea and India, where the top lenders have anything between four to eight percent Tier 1 capital.

Although the BCBS has not looked at banks in Indonesia and Thailand,

it should be noted that they are well capitalized and have ample liquidity, and are also well positioned for Basel III. With their large deposit franchises, and with high profitability allowing them to use retained earnings to full effect, they are in good stead to respond to these demands.

Malaysia, a non-member country, stands to be more heavily impacted

than the others by this rule change mainly because of the popularity of hybrid Tier 1 equity in their overall capital structures. Public Bank, in particular, could see capital drop below the stipulated levels with the new standards, and has already indicated the possibility of raising capital rather than reducing capital wastage by building capital-light business models and lowering dividend payments.

More generally, as banks will need to hold more capital and liquidity, the

net effect on impeded lending activities would be to lower return on equity (ROE). Banks in the region - especially Australian lenders, which tend to have huge portfolios of low yielding, relatively low risk, residential mortgages will need to adjust the focus of their businesses.

It is quite likely that banks might want to shift their portfolio balance

away from these low-yielding assets towards high-yielding assets in 24 Taken from "Basel III overlooks Asian Banks" by Arush Chopra, as reported in The Philippine Star,

January 4, 2011

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order to boost the ROE; ironically, this could have the effect of moderating them towards more risk business activities that seek additional gain, a mindset that would seem familiar to North American institutions in the Greenspan era of low interest rates that weren't making any money from simply lending it out and sought opportunities for gain through financial innovation.

Also, lenders may reconsider being in certain business lines such as

extending credit to SMEs, and start pushing into less capital intensive activities such as wealth management, especially targeting the wealthy in Asia's booming economies, as the cost of doing business goes up.

The coming weeks and months should see these developments unfold,

making 2011 an interesting year for banking in the region.

15. Closer to home, the same observations pointed out as to decisions and directions that must be taken by Asian banks apply to banks in the Philippines.

"Metropolitan Bank and Trust Co., the country's second largest lender

by assets, said it would issue a total of 200 million common shares, to raise around P10 billion. The offer will increase Metrobanks' capital adequacy in anticipation of the higher capital standards to be imposed on banks next year."25

Mr. Anton Montinola III, Bankers Association of the Philippines and BPI President said that banks have "relatively good numbers and a moratorium on capital raising won't be a problem . . . If you look at it relative to Basel II, banks hare are very well capitalized. Even relating to Basel III, most of the banks have comfortable numbers."26

Montinola, in another report said that “domestic banks are already

observing higher capital adequacy standards and are not in a hurry to boost their capital base anytime soon. The banks here are very well capitalized."27

“BSP Governor Armando Tetangco, Jr. said that the BSP will be drafting

guidelines, which would include appropriate traditional arrangements. He bared the central bank's plan after the US authorities adopted more stringent rules on bank capital to curb future excessive risk-taking that led to the financial meltdown whose after effects continue to be felt at present. ‘A better risk infrastructure [would be] to better allocate existing capital resources, perhaps coupled with some internal discussions with the bank on its own adjusted assessment of risks [under the Internal Capital Adequacy Assessment Program or ICAAP, for example],’ Tetangco added. With ICAAP, banks are encouraged to think more deeply of their business in terms of assessing the risks they typically encounter in pursuit of business plans.”28

25 Zinnia B. Dela Peña, "Metrobank prices rights offer at P50", the Philippine Star, Dec. 14, 2010 26 Ibid., 8. at page 3 27 Taken from JE/VS, "Banks not positioning to raise capital base-BAP",

http://www.gmanews.tv/story/204626 28 Taken from JE/VS, "Basel III guidelines in the works -Tetangco,"

hppt://www.gmanews.tv/story/200940

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16. Conclusion

Basel III will help make banks better prepared for a financial crisis although at the price of a more expensive compliance with capital and other regulatory requirements that could translate to higher cost of borrowing and lower profitability for the banks that will ultimately impact on the general economy. In the end, the question is: Is Basel III enough to save us from another financial crisis? Together with better capital and liquidity requirements, of course, should be better internal risk management systems at the bank level and better supervision of the banking sector by regulators. The article “Third time’s the charm?” concludes “the sad truth is that there is no set of rules that will ensure the solvency of the banking system, or its resilience in a crisis. In a competitive market, banks have no choice but to seize any available opportunity to increase their return on capital. That means that regulators need to be dynamic in their response to changes in the market place, and anything that appears to generate returns with low risk should raise a red flag. In other words, if Basel III appears to be working – and banks are lending healthy amounts, generating good returns, and running less risk than ever – that’s exactly what should make us worry.”29

In the end, the “back to basic” principle that high return means high risk should help signal to and protect banks from a financial crisis.

References: 1. "Basel III overlooks Asian banks", Arush Chopra, The Philippine Star, 4 January

2011 2. "Results of the comprehensive quantitative impact study", Basel Committee on

Banking Supervision, BIS, December 2010, 3. "The Basel Committee's response to the financial crisis: report to the G20",

Basel Committee on Banking Supervision, BIS, October 2010, 4. "Basel III: towards a safer financial system", Speech by Mr. Jaime Caruana General Manager of the Bank for International Settlements, 3rd Santander

International Banking Conference, Madrid, 15 September 2010 5. "Strengthening the resilience of the banking sector", Consultative Document,

Basel Committee on Banking Supervision, BIS, December 2009 6. "Enhancements to the Basel II framework", Basel Committee on Banking

Supervision, BIS, July 2009 29 http://www.economist.com/blog/freeexchange/2010/09/basel_iii

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7. "Operational Risk: A Guide to Basel II Capital Requirements, Models and Analysis (OR)", Anna Chermobai, Svetlozar Rachev, and Frank Fabozzi, John Wiley, 2007

8. "The BSP's New Risk-Based Capital Adequacy Framework", Briefing on the

BSP's New Risk-Based Capital Adequacy Framework, BSP, 26 August 2005 9. "Basel 2 and Risk-Based Supervision", A Presentation to the Officers of the

Supervision and Examination Sector, BSP, Assistant Governor Nestor A. Espenilla, Jr., Ms. Teodora San Pedro, Mr. Jeremy Y. Prenio, Bangko Sentral ng Pilipinas, 21 January 2005

10. "BSP Circular No. 280" as amended, Series of 2001 11. "Central Banking In Challenging Times, The Philippine Experience", BSP, 2009

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