4th Annual BSP‐UP Professorial Chair Lecture

LECTURE NO. 1LECTURE NO. 1LECTURE NO. 1

Basel III and Risk Mitigationin the Banking Sector

Dr. Sergio CaoBSP‐UP Centennial Professor

of Accounting

Basel III and Risk Mitigation in the Banking Sector

BSP-UP Centennial Professorial Chair Lecture

Sergio S. Cao, PhDProfessor of Finance

College of Business Administration UP Diliman

February 21, 2011

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•"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."[1]

[1] Zinnia B. Dela Peña, "Metrobank prices rights offer at P50", the Philippine Star, Dec. 14, 2010

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•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.

•The implementation of Basel III is set to start by end of 2012.

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Historical backgrounder - a confluence of events

•It all started in 1995 when the BSP recognized the greater risk exposure in the system brought about by derivatives activities of banks.

•To mitigate this, the BSP issued Circular No. 102 dated 29 December 1995, prescribing the minimum standards for risk management of derivatives.

The following are taken from the BSP Media Release dated August 9, 2006 entitled “BSP Unveils Basel II Implementing Guidelines.”

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•This was the first BSP regulation that specifically focused on banks’ risk taking activities and risk management practices.

•This was bolstered in 1997 when BSP shifted its banking supervision thrust to focus more on the measurement and management of banks’ risk exposures, instead of just mainly performing financial audit and compliance review.

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•The BSP’s new supervisory approach favors a supervisory assessment of the quality of risk management practices and generally allows banks to take risks so long as the banks demonstrate the ability to manage, absorb and price for those risks

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•In carefully loosening the regulatory grip on banks’ risk-taking activities, the BSP must necessarily underscore the responsibility of the banks’ board of directors and senior management to ensure the soundness and stability of their respective banks.

•BSP’s role is primarily to evaluate the quality of oversight and management provided by these parties, i.e., the quality of corporate governance.

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•Loosening the regulatory grip on banks’ risk-taking activities also entails that the BSP has to ensure that banks have sufficient buffer whenever these risks turn into losses.

•This buffer comes in the form of capital which protects a bank from earnings volatility. Ideally therefore, the more risks a bank takes (i.e., the more potential for earnings volatility) the more capital it should hold.

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•However, capital is viewed as generally more costly than other sources of funding. Hence, banks may try to economize on capital that is not commensurate to the risks that they take.

•This is the reason why bank supervisors, including the BSP, impose minimum capital regulations.

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•Basel Committee on Banking Supervision (BCBS 1 ) in the mid-80s saw the need to align regulatory capital regulations across countries so as to have comparable measurement of financial strength especially for banks that operate across jurisdictions.

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•Thus in 1988 the BCBS issued the original “International Convergence of Capital Measurement and Capital Standards”, now known as Basel I.

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•Basel I was the first international supervisory effort to relate capital requirements to, initially, credit risk.

•In 1996, the BCBS issued an amendment to the Basel Capital Accord to incorporate capital requirements for market risk.

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BSP’s Basel I implementation

•In 2001 the BSP issued Circular No. 280 which served as the implementing guidelines for Basel Capital Accord in the Philippines.

•This was followed in 2002 with the issuance of Circular No. 360 which adopted the 1996 amendments for market risk.

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Why revise Basel I?

•The main criticism of Basel I is that the assignment of risk weights is rather crude and not based on any measurement, whether quantitative or qualitative, of probability of default.

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•For example, all corporate loans –whether loans to a blue-chip company or to a fledgling enterprise – are all given a risk weight of 100%.

•In addition, Basel I only accounts for credit risk (albeit crudely) and market risk but not other forms of risk that may also be important.

•The Basel II proposals were born in 1999.

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Basel II

•Basel II is a set of proposals that aim to revise Basel I to make regulatory capital requirements more risk sensitive and reflective of all, or at least most of the risks banks are exposed to.

•In addition, Basel II also puts emphasis on banks’ own risk assessment, supervisory review, and the important role that disclosures play.

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Basel II

•As such, Basel II is structured as a three-pillar approach that transcends regulatory capital requirements.

•That is, Basel II not only prescribes a risk-based capital framework, but an entire risk-based supervisory framework.

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• These three pillars are based on the principles that

• (1) banks should have capital appropriate for their risk-taking activities

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• (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

• (3) banks should be disclosing pertinent information necessary to enable market mechanism to complement the supervisory oversight function.

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The BSP’s New Risk‐Based Capital Adequacy Framework

A Snapshot

Pillar 2 (Supervisory Review) - a continuing process

Pillar 3 (Market Discipline) -

gradual implementation starting 2007

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

Taken from “Briefing on the BSP’s New Risk-Based Capital Adequacy Framework”, 26 August 2005

23Source: Metrobank Lecture Materials on Risk

Measurement Types/Approaches

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

Market risk Standardized Measurement

Internal VaR Models Approach

Operational risk Basic Indicator Approach (BIA)

The Standardized Approach (TSA)

Advance Measurement Approach (AMA)

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Taken from “Briefing on the BSP’s New Risk-Based Capital Adequacy Framework”, 26 August 2005

CAR, Metrobank, 2008(Taken from Metrobank Annual report, 2008)

December 2008

December 2007

Tier 1 Capital P49,835.60 P43,114.80

Tier 2 Capital P16,398.40 P19,352.80

Gross Qualifying Capital P66,234.00 P62,467.60

Required Deductions P17,994.30 P16,979.10

Total Qualifying Capital

P48,239.70 P45,488.50

Risk-Weighted Assets P390,577.40 P370,180.90Tier 1 Capital Ratio 10.5% 9.4%Total Capital Ratio 12.4% 12.3%

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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."[1]

[1] As reported in Business Insight Malaya, November 1, 2010

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Bank CAR (%)

Metrobank 13.45%

Banco de Oro 13.53%

BPI 14.16%

Phil. System CAR 15.20%

Malaysia System CAR 13.00%

Korea System CAR 12.00%

Indonesia System CAR 17.10%

Thailand System CAR 18.40%

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Source: The Business Mirror, February 11, 2009

CAR of Selected Banks and Selected Banking Systems’ CAR(as of end of 2008)

What is Basel III?

•The reforms address both firm-specific as well as systemic risks

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•Jaime Caruana, General Manager of BIS, said that the implementation of Basel III will:[1]

•considerably increase the quality of banks' capital;

•significantly increase the required level of their capital;

•reduce systemic risk; and

•allow sufficient time for smooth transition to the new regime.[1] 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 29

The "building blocks" of Basel III are:[1]

(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%;

[1] Taken from "The Basel Committee's response to the financial crisis: report to the G20", BCBS, BIS, October 2010

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(iii) 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;

(iv) 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;

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(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.

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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 8Basel IIMemo

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 IIINew definition and calibration

4.5 2.5 7.0 6 8.5 8 10.5 0-2.5Capital surcharge for SIFIs?

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Source: “Basel III: towards a safer financial system", Speech by Mr. Jaime Caruana

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Contra-Cyclical Capital BuffersSource: Taken from "Financial Regulation and the Central Bank" by Nestor A. Espenilla, Jr., Central Banking in Challenging Times, The Philippine Experience, BSP, 2009

2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January

2019Leverage ratio Supervisory

monitoringParallel run

1 Jan 2013 - 1 Jan 2017Migration

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 capitalconservation 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 Observation period begins

Introduce minimumstandard

Net stable funding ratio Observation period begins

Introduce minimumstandard 35

Phase-in arrangements Source: "The Basel Committee's response to the financial crisis: report to the G20", Basel Committee on Banking Supervision, BIS, October 2010,

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.

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What will be the effects of Basel III?

•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.”[1]

[1] Taken from "Basel III: Q & A", http://www.guardian.co.uk/business/2010/Sep/1337

•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 key results are reported below (taken directly from the report):[1]

[1] “Results of the comprehensive quantitative impact study,” BCBS, BIS, December 2010

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Jurisdiction Group 1 Group 2Australia 4 1Belgium 2 2Brazil 2 0Canada 6 2China 5 5France 5 6Germany 9 59Hong Kong 0 7India 3 6Italy 2 20Japan 9 7Korea 5 3Luxembourg 0 1Mexico 0 3Netherlands 4 14Saudi Arabia 3 0Singapore 3 0South Africa 3 3Spain 2 5Sweden 4 2Switzerland 2 6United Kingdom 5 6United States 13 0Total 91 158

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•Overall impact on risk-based capital requirements

•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.

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•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 7.0% had the Basel III requirements been in place at the end of 2009.

•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%.

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•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%

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•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.

•Some banks also experience a larger than average increase in risk-weighted assets due to securitisation exposures in their banking books.

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•Changes in risk-weighted assets

•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.

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•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.

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•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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"Basel III overlooks Asian banks"[1]

•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.

[1] Taken from "Basel III overlooks Asian Banks" by Arush Chopra, as reported in The Philippine Star, January 4, 2011

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•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.

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•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.

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•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.

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•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.

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•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.

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Wednesday, 11 February 2009Capital-adequacy ratio of top 3 Philippine banks still above 13% at end-2008Erik de la Cruz The Business Mirror

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•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.

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•It is quite likely that banks might want to shift their portfolio balance away from these low-yielding assets towards high-yielding assets in 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.

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•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.

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•Mr. Aurelio 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."[1]

[1] Ibid., 8. at page 3[2] Taken from JE/VS, "Banks not positioning to raise capital base-BAP", http://www.gmanews.tv/story/204626

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•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."[2]

[1] Ibid., 8. at page 3[2] Taken from JE/VS, "Banks not positioning to raise capital base-BAP", http://www.gmanews.tv/story/204626

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•“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.

[1] Taken from JE/VS, "Basel III guidelines in the works -Tetangco," hppt://www.gmanews.tv/story/200940

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•‘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.”[1]

[1] Taken from JE/VS, "Basel III guidelines in the works -Tetangco," hppt://www.gmanews.tv/story/200940

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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.

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Conclusion

•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.

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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.

[1] http://www.economist.com/blog/freeexchange/2010/09/basel_iii

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•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.”[1]

[1] http://www.economist.com/blog/freeexchange/2010/09/basel_iii