May 14, 2011
Basel III & Gulf Banks Challenges & Opportunities
The recently concluded 4th Annual Middle East Risk Management forum in Doha, Qatar (Download conference agenda here) was focused on the impending regulatory changes of Basel III. Debates on the relevance of these regulations were quite useful and I thought it would be useful to capture these discussions here for those who were not part of the conference proceedings.
Capital Standards
In general, Basel III contains various measures aimed at improving the quality of the capital with the ultimate aim of improving the loss absorption capacity in both going concern and liquidation scenarios. Under Basel III, common equity will form the predominant part of Tier 1 capital. Tier 2 capital will be simplified and Tier 3 will be phased out completely. The committee also has stricter definitions for what counts as capital. There are no changes in standardized approach for risk weighting assets.
Most of the Gulf based banks are comfortably placed with respect to these changes. Tier 1 capital has been the predominant form of bank capitalization in the region, although a few banks have issued Tier 2 subordinated debt.
One question that was debated was what constitutes an adequate level of capital adequacy. Most Gulf Countries have a minimum CAR of between 10% to 12% which is way above the Basel standards of 8%. Adding the counter cyclical buffer would raise the minimum level to 14.5%. Participants felt that this level could adversely affect growth.
Qatars Central Bank has said in January 2011 said that Islamic Banks are likely to be governed by a set of rules that are different from those applied to the conventional Banks. Participants were interested in knowing how different these would be from the Basel III regulations.
Liquidity Standards
Basel III Liquidity Ratios will concentrate on improving both the short term and long term liquidity profiles of banks. The Liquidity Coverage Ratio, measures a bank's ability to convert assets into cash within a 30-day window, and would need to be a minimum of 100%. In addition, banks are required to better match the tenors of their liabilities with their assets using a Net Stable Funding Ratio. This would be calculated as available amount of stable funding divided by the required amount of stable funding, and would need to be a minimum of 100%.
Both regulators and participants felt that the extreme stress scenario used for the Liquidity Coverage Ratio, combined with the definition of high quality liquid assets, may prove problematic for Gulf based banks, as many of the markets were intrinsically small.
It was pointed that in January 2011, Qatar’s Central Bank issued specific directives to the conventional banks that have Islamic branches, directing them to stop opening new Islamic branches, accepting Islamic deposits and dispensing new Islamic finance operations.
These directives also affect the liquidity management of the Islamic banks in two ways. Firstly, the lack of a developed Islamic money market, and especially an Islamic interbank market, of the kind seen in conventional finance affects the short term liquidity management of the Islamic banks. Secondly, the shortage of short term, liquid Islamic investment instruments with limited capital risk and predictable returns also hampers the development of liquidity management as required under Basel III.
Conclusions
Improved capital standards under Basel III are not likely to impose too much of a burden on Gulf based Banks. It is quite likely that Gulf regulators would fast track these changes ahead of their counterparts in the western markets where Banks are likely to go through a capital raising process. Readers will recall that Kuwait was one of the earliest jurisdictions in the world to implement Basel II capital standards in 2005.
However, Liquidity Standards do pose a challenge in terms of implementation especially for Islamic Banks. Given the current state of development, Islamic finance is a still a relatively small part of the total financial services industry in many Gulf markets; and therefore it may be difficult to create a local Islamic liquidity market of worthwhile size.
Therefore it has been proposed that the implementation of the liquidity proposals needs to be progressive and in line with the development of Shariah compliant money /capital market in that jurisdiction.
Tailpiece: One of the speakers gave an insight on the working of BCBS’s Liquidity sub group in Basel – she was meeting the officials from time to time in Switzerland. Her take is that the members hardly understood liquidity. The feedback with BCBS is that retail commercial banks - which in no way contributed to the crisis – were being made to pay for through the NSFR – also known colloquially as the Northern Gate ratio!
Posted by aaaaaaa at 03:33 PM
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November 19, 2010
Can Basel III prevent Systemic Crises?
During an interaction in a risk management conference, the CEO of a Bahrain based Investment Bank asked me innocently whether the proposed Basel III regulations would prevent another systemic crisis that the financial world witnessed in 2008. In fact this CEO is not alone in this regard; many bankers carry the impression that Basel III is a kind of permanent fix (however costly it might be) and if diligently implemented the world will not see another crisis yet again.
Looking back, has Basel I, II mitigated systemic risks?
The answer is self evident.
The Basel accord began as an attempt to harmonise the capital base of internationally active banks and create a level playing field. For want of a better perspective on bank regulation, most countries adopted the Basel standard as this was the easiest way to convince banks to hold additional capital.
Inspite of this wide spread acceptance of Basel, the world has seen numerous crisis across all parts of the globe the S&L crisis in the United States, the banking crisis in Scandinavian countries, the failure of LTCM and the default by Russia. In fact crises have occurred at an alarmingly consistent rate, and going by the past trends, we should expect another crisis in the next 7-10 years!
So where does that leave Basel and systemic risks?
It would appear that Basel I, II have not really addressed this problem but for valid reasons. Systemic risks pose a challenge for several reasons. First, they are not easy to detect with confidence, and are even more difficult to prove. Second, going by the past history of financial crises, predicting the exact timing of a break point (when bubbles burst, markets lock up, and credit freezes) is well neigh impossible. Finally, crises are highly non-linear events, which mean that they occur without much warning.
Basel III is on the same lines: the definition of core capital has been strengthened considerably and new capital buffers introduced. This will, it is hoped, ensure that banks are better able to withstand periods of economic and financial stress and create a less procyclical banking system that is better able to support long-term economic growth.
So Basel I, II, III or IV or whatever is designed to limit each institution's risk seen in isolation; they are not sufficiently focused on systemic risk even though systemic risk is often the rationale provided for such regulation. As a result, while individual risks may be properly dealt with in normal times, the system itself remains fragile and vulnerable to large macroeconomic shocks.
Where Basel standards have failed is to recognise that one size fits all does not really help especially systemically important financial institutions (SIFI) that are so big, or interconnected, or unique that they pose a risk of taking down the entire financial system should they fail. If we can identify these institutions and why they are risky then mitigate those risks we might be able to prevent the next big financial meltdown.
The definition of SIFIs is changing as an IMF study suggests. Pre-crisis, the general consensus was that size posed the biggest risk for the systemic relevance of banks. Interconnectedness was ranked the second and third most important systemic risk factor for institutions. Other factors considered were concentration risk, leverage and the correlation of exposures.
Post-crisis, assessments of the factors contributing to the systemic importance of financial institutions have changed with interconnectedness, leverage or maturity mismatches to be the main risks. Size is considered to be less important factor.
The G20 Seoul Summit in November has endorsed the Financial Stability Boards (FSB) policy framework for regulating SIFIs in five areas:
Improvements in the resolution regimes to ensure that SIFI failure can be resolved without disruptions to the financial system.
SIFIs should have additional loss absorption capacity beyond the Basel III standards.
Intensive supervisory oversight of SIFIs.
Robust standards for core financial infrastructure to reduce contagion risks.
Peer review of the effectiveness and consistency of national policy measures for G-SIFIs.
It is hoped that the delivery of two key elements of regulatory reform viz., a materially strengthened global framework for bank capital and liquidity, and a comprehensive policy framework to address SIFIs will create a sounder financial system and reduce systemic risk globally.
For the more academically inclined, it is interesting to note the recent advancements in measurements of systemic risk. The RISK page of the Volatility Laboratory of NYU Stern presents a variety of risk measures for top US Financial Firms including systemic risk or SRISK. The Systemic Risk Contribution, SRISK%, is the percentage of all capital shortfall that would be experienced by a firm in the event of a crisis. Firms with a high percentage of capital shortfalls in a crisis are not only the biggest losers but also are the firms that create or extend the crisis.
Based on this methodology, NYU Stern has identified the 32 largest SIFIs in the United States. Guess what? many of them are already under Government protection!
Posted by aaaaaaa at 02:06 PM
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December 10, 2008
The Circle of Financial Innovation and Regulation
The recent events in the global financial system have kindled a debate which has periodically come to the fore. Some of the blame of the current predicament is being put on the unbridled growth of financial innovation and also the fact that regulation has not been pro-active in taming the growth of financial innovation.
Financial Innovation = Financial Instability?
One of root causes of the current financial instability is ascribed to the growth of financial innovation in mortgage structured products over the last decade. This has lead to the development of products which are complex, illiquid and hard to value in normal market conditions, let alone in the abnormal conditions as it is now. Banks which brought these products had little understanding of the inherent risks, and the rating agencies understood them even less when they rated products which were sliced and diced by smart investment bankers driven by greed and ambition. When default rates in the underlying mortgages went up, the result was that the mortgage markets went awry, and the series of collapses resulted in systemic shocks which are being felt across the globe.
The history of the financial markets indicates that there are periodic booms and busts with a financial disaster lurking around every now and then. Over the past decade one saw key events such as the collapse of LTCM and the Asian financial crisis, all of which focused the need for the regulators to have an adequate and reliable early warning system.
The cycle of periodic booms and busts has a theoretical perspective and is euphemistically called as a state of ferment by Joseph Schumpeter. According to this theory, capitalism itself is in a creative destruction mode with spurts of innovation destroying established enterprises and yielding new ones. Unfortunately, this theory did not focus on the resulting financial instability that could result from an overdose of innovation from all stakeholders.
Prescribing Limits?
This brings us to the central question of this blog: Should financial regulation prescribe limits on the growth of financial innovation? Or should financial regulation adopt a laissez-faire approach which allows participants to self regulate and market forces to play out?
History of Financial Innovations
Let us try to put some perspective in order to answer these questions. Financial innovations are not necessarily a bad idea. In fact the history of financial sector is replete with innovations which are driven by the invisible hand of the entrepreneur in search of personal gain. Examples quoted here include an entrepreneurial bank that extended loans to individuals and small business in the aftermath of the San Francisco earthquake in 1906. The concept of retail banking was thus born and the bank grew by establishing a network of retail branches all over California. Today, we know this entity as the Bank of America.
Other important financial innovations that have promoted efficient allocation of capital resources are the access to the junk bond markets and the securitization of illiquid loans. In the former case, access to capital drove a series of M&A deals which resulted in inefficient firm being taken over and in the latter case it resulted in dispersion of risks across a wider cross section of participants.
Let us also not forget that risk management itself is the beneficiary of the process of financial innovation. In fact the need to measure risk of all trading positions on a daily basis and communicate to the top management on the same day by 4:15 PM lead to the development of the concept of value of risk (VaR). This innovation was found so useful that the Basel Committee recommended its usage in the Market Risk Amendment to the Capital Accord in 1996.
Objectives of Financial Regulation
To answer the laissez-faire approach question first, Governments and regulators will continue play an important role in the regulation of the financial sector. As Joseph Stiglitz, says there are limits to a self regulating and self correcting system of free markets as there are always imperfections in the markets in the form of externalities. A humbled Alan Greenspan recently admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending. In his words: Those of us who have looked to the self-interest of lending institutions to protect shareholders equity, myself included, are in a state of shocked disbelief.
In addressing the risks that financial innovation may create, we should also always keep in view the economic benefits that flow from a healthy and innovative financial sector. As we have seen above, some innovations promote efficient capital allocation and enables greater resilience of the system. When proposing regulation, the intent should be to encourage financial innovation as before while seeking to address the risks that may accompany that innovation. The real challenge is to find a balance which encourages innovation on the one hand, while also discouraging excessive risk taking.
A policy of regulating specific products (which are deemed risky or complex) or singling out institutions for greater regulatory oversight may not be workable since moral hazard concerns may well follow.
The alternative, i.e. an across the board regulatory oversight framework based on principles is preferable. Such a system will have three principal objectives (1) financial stability, (2) investor protection, and (3) market integrity. These objectives have been the bedrock of regulation ever since central banks came into existence and are even more so in these troubled times .
The actual implementation of financial regulation has been a mix of both a rule based and a principle based approach. In fact the rule book issued by regulators around the world (the FSAs rule book runs into 8,500 pages) seems to suggest that the regulators have put a microscope to the banks under their jurisdiction.
In practice, given the dearth of resources (both in qualitative and quantitative terms) in Central Banks, regulators will adopt a risk based supervisory approach: greater the risk posed by the bank, greater the supervisory attention and resources devoted to the review of that bank.
Conclusion
The title of the blog suggests a circular link between financial innovation and regulation. Does excessive financial innovation (and the resulting risk taking) lead to excessive regulation? Will excessive financial regulation lead to a different kind of financial innovation in order to get over the restricting regulations?
As I completed this blog, I received an alert from the Mckinsey Quarterly which had an article which answered some of the issues that I had raised in my blog.
I found the answer in my mailbox!
Mckinsey on Creative Destruction and the Financial Crisis:
The article is an interview with Richard Foster, a senior Director with Mckinsey who is also the Co-author of the book Creative Destruction: Why Some Companies That Are..... The Authors argue that much of the regulations and the financial institutions that we see today have evolved as a response to financial crisis over the past century. In the long term these have proved beneficial to markets and its participants.
Equally the Authors also argue that the regulations also force any self respecting entrepreneur to get over the restrictions by finding a way out...The example given here is that of the phenomenal growth of credit default swaps which was because other options were regulated.
The full article can be downloaded here:
Download file
Some Excellent Reading
The Washington Post examines how Wall Street innovation outpaced Washington regulation
How did the most dynamic and sophisticated financial markets in the world come to the brink of collapse?
The NY Times examines what went wrong in Risk Mismanagement
The great housing-fueled market bubble couldn’t burst, could it? The best Wall Street minds and their best risk-management tools failed to see the crash coming.
Posted by aaaaaaa at 08:22 AM
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