The profound impact of the global financial crisis prompted G20 leaders to seek an agreement on a set of international rules designed to improve both the quantity and quality of bank capital, and to discourage excessive leverage.
It is recognised that these rules should be phased in as the global economic situation improves. These new rules will become enshrined in the national legislation and subsequently codified in the issuance of a set of new international regulatory and capital adequacy standards — Basel III. The aim is to have Basel III fully implemented by 2019 with significant changes to the liquidity, capital adequacy and governance of all financial institutions.
A significant question highlights the road ahead for many banks: ‘What position would banks have been in if Basel III was applicable in 2009?’ The answer is shocking — banks would have been EUR577 billion (US$746 billion) short of capital and EUR1.73 trillion (US$2.23 trillion) short of liquid assets.
Origins and causes of the financial crisis
Basel II was a necessary and material refinement of the original accord but with the benefit of hindsight it was lacking in some key areas. However, it would be wrong to apportion too much of the blame to regulatory shortcomings. The business models and behaviour of some market participants, along with a lack of robust corporate governance, had a material impact.
These factors combined to allow a significant number of financial institutions to build up excessive and leveraged risk concentrations in the years preceding the financial crisis. These banks were not adequately assessing, pricing or stressing these risks. Neither were they compensating for the inherent risks they were exposed too. There were also instances of failures by rating agencies and credit insurance providers in assessing and enhancing the credit worthiness of asset-backed securities and synthetic structures, many of which had limited social or economic benefit.
How Basel III seeks to achieve greater market stability
Basel III should be seen as a series of key and phased enhancements that address the shortcomings in Basel II but which fit into framework of the current regime. The key elements include:-
Capital adequacy: There must be more capital, and more high quality capital, in the banking system. Fundamentally, all Tier 1 capital must be fully effective at absorbing losses and Tier 2 capital must be far more loss absorbent to remain in the capital structure.
Liquidity: Strengthened liquidity disciplines that examine the robustness of a bank’s funding profile and adequacy of liquid asset reserves through the use of extreme stress tests.
Leverage ratio: A back-stop measure to control banks unduly increasing their absolute leverage and level of model risk while retaining a high capital ratio.
Counterparty credit risk:
Implementation of a capital charge based on a stress test volatility assessment of counterparty pre-settlement risks emanating from over-the-counter derivative contracts.
Ahead of these measures, the Basel Committee for Banking Supervision (BCBS) has already taken steps to require banks to calculate a stressed value at risk over a year-long observation period. The
BCBS estimates that market risk capital requirements will increase by some three to four times their current levels for internationally active banks.
Basel III and international accounting standards
Separately, the Basel Committee is working with the International Accounting Standards Board (IASB) to ensure that regulatory and accounting standards are adequately aligned for example longer term general provisioning to reduce procyclicality risk.
The BCBS has also announced higher global minimum capital standard with the minimum common equity requirement being increased from 2% to 4.5% by 1st January 2015 at the latest. In parallel, the BCBS is introducing stricter regulatory deductions (e.g. for minority interests) and tighter Tier 1 criteria for capital instruments which are not common equity. Furthermore, the structure of Tier 2 capital is to be simplified and Tier 3 capital is to be phased out.
In addition to these minimum capital requirements, two common equity-based capital buffers will be introduced — a capital conservation buffer equivalent to 2.5% of risk weighted assets and a countercyclical buffer of an additional 0% to 2.5% of risk weighted assets.
The effect of these measures will be to increase the common equity (Tier 1) component of bank capital from 2% to 7% of risk weighted assets. Additionally, national regulators will have the right to require banks to maintain a countercyclical buffer that can be grown in periods of prosperity and released in an economic downturn.
Looking at these measures as a whole, the increase in minimum capital standards is designed to provide adequate loss absorbency resources in normal market and operating conditions, whereas the capital conservation buffer and countercyclical buffer look to limit systemic and procyclicality risks over the longer term.
The BCBS is looking to implement the leverage ratio during a preliminary period commencing in January 2013. It will be a requirement for banks to operate under a minimum Tier 1 leverage ratio of 3% where the latter is measured against the total non-weighted assets and off-balance sheet exposures of a bank.
New liquidity standards
The impact of the new liquidity standards must not be underestimated. Under Basel II a relatively small part of the accord was dedicated to the liability and liquidity aspects of banks’ balance sheets. Basel III includes two new standards — a liquidity coverage ratio (LCR) requiring banks to hold sufficient liquidity to deal with severe market shocks and a net stable funding ratio (NSFR) that deals with the adequacy of bank’s longer term and structural funding profiles.
In the European arena, often a benchmark for global regulation, parliamentary bodies are embracing key Basel III principles but are requesting much more preparatory work be undertaken before the new standards are transposed into law.
The challenge for regulators and governments will be to calibrate these new measures and time their implementation such that global economic recovery is not put at risk. It is hoped that this will result in increased levels of tangible economic and socially responsible banking business. For example, the role of conventional and Islamic banking in facilitating economically crucial trade finance business must not be put at risk by overzealous regulation that could stifle overall economic growth.
The era of cheap money seems to be over for both banks and their customers. There is shift back towards more traditional and tangible customer banking. The additional capital and liquidity costs borne by banks will undoubtedly lead to higher borrowing costs for customers and institutions and returns on equity are likely to reduce.
Ahead of implementation, much preparation and agreement, both at national and international levels, needs to take place. How might Islamic finance be impacted?
Islamic banks were not immune to the financial crisis, and a good number have unsurprisingly been exposed to frenzied expansion and excessive risk concentrations, notably in the real estate sector. Along with the still fragmented structure of Islamic finance and the relative lack of liquidity instruments, such issues remain at the forefront of the challenges faced.
In assessing the impact of Basel III, this analysis looks at the issues surrounding Shariah compliant banks only. Islamic windows have been excluded due to their use of conventional liquidity and risk management instruments.
At a macro level, and compared to their conventional counterparts, Islamic banks tend to be small, and with limited cross-border dependencies and international networks. Notwithstanding the continued growth in Shariah compliant banking, these institutions, with a small number of exceptions, are unlikely to become the dominant financial institutions in their country of domicile. Using this narrow definition and applying the BCBS guidelines that systemically important financial institutions (SIFIs) are banks with assets in excess of US$100 billion, it can be concluded that Islamic banks are unlikely to pose meaningful levels of systemic risk.
Looking at the critical matter of capital adequacy as defined by Basel III, financial institutions must have more and higher quality Tier 1 capital which includes common equity and certain minority interests, as well as deferred tax assets. Tier 1 capital must be fully effective at absorbing losses and Tier 2 capital which includes undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt must absorb more losses in order to protect capital. Tier 2 capital, which is additional to minimum capital requirements, is needed to address systemic and procyclicality risks.
The first point to note is that the capital structures of the significant majority of Shariah compliant banks are dominated by Tier 1 capital in common equity form, often in excess of 80% of capital resources. In addition, most have capital adequacy ratios noticeably higher than those seen in the conventional banking sector. The reasons for this can be explained by a combination of complexities and Shariah prohibitions in raising alternative and lower quality forms of capital which result in:
The lack of Islamic subordinated debt.
The lack of hybrid and callable capital structures due to the prohibition of gharar (conditionality and uncertainty).
The lack of meaningful levels of preference shares, even in Shariah jurisdictions that permit this form of capital.
As a consequence of these factors, the capital structures and above average capital ratios of Shariah financial institutions put them in a favourable position relative to many of their conventional counterparts.
In comparative and competitive terms, the capital adequacy positions of Islamic banks will also benefit from:
The modest role of trading book businesses as Shariah principles prohibit short selling and impose strict limitations on the use of derivatives. Consequently, Shariah financial institutions will be negligibly impacted by the higher capital charges for such operations.
The modest and very limited use of derivatives and securitised structures by Islamic banks will result in such institutions not being adversely impacted by the additional capital charges that are being applied to address the inherent risks in such products (e.g. transactions collateralised by their own or by related party shares).
The lack of leverage and contingent risks, including the restrictions applicable to margin-based businesses, auger well for Islamic banks in so far as the new leverage ratio is unlikely to have anything more than a very modest impact.
Liquidity is however one area where both conventional and Islamic banks are likely to be impacted to a meaningful extent by Basel III, albeit in different ways. Firstly, in most jurisdictions there remains a dearth of liquid Islamic instruments.
Despite progress in the deepening of Islamic liquidity markets, notably the increased sukuk issuance by the ‘AAA’ rated IDB, there is a lack of eligible liquidity instruments and central bank facilities.
However, these limitations are offset by the relative lack of contingent and leveraged liquidity risk; a generally low reliance on interbank funding; and for many banks, including BLME strong depositor loyalty.
Basel III is unlikely to materially change the existing challenges faced by Islamic banks. It is, however, expected to dominate the agenda of many conventional financial institutions, particularly more speculative and leveraged banks. As a result, the stronger and better managed Islamic banks will see Basel III as an opportunity prosper and strengthen their competitive positions. Many conventional banks may not have this chance.
Mike Kennedy is the head of risk management at Bank of London and The Middle East.
This article first appeared in the Islamic Finance News (11 January 2012, Volume 9, Issue 1, Page 19 – 21). For more information, please visit www.islamicfinancenews.com.