Basel III: Now is the Time for Asian Banks to Plan for Change

The number of countries in Asia that are now part of the Financial Stability Board (FSB) has increased dramatically since Basel II, notes Chris Matten, partner, PricewaterhouseCoopers (PwC) financial services industry practice. Along with Japan, the Basel Committee now includes Australia, China, Hong Kong, India, Indonesia, Korea and Singapore.

According to Matten, the Basel III requirement that is likely to have the biggest impact on banks is a tripling in capital requirements. The Bank for International Settlements (BIS) said that Basel III “will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5%”, as well as “a countercyclical buffer” within a range of 0% – 2.5%”.

Core Tier 1 capital of 7% plus another buffer is a big jump. These requirements will be phased in between 2011 and 2019, and the long lead-time is viewed as a political decision to give North American and European banks enough time to meet the requirements.

While banks in both regions may have difficulty meeting the standards, Matten says that banks in most of the Basel III countries in Asia have more than enough capital. However, he also notes that capital adequacy in some markets could change if lending continues to grow at the current rate of 30-40% per year. While capital at banks in China is sufficient for current asset levels, for example, it may soon not be enough if loans continue to grow so rapidly.

Banks in Europe and the US are in a far different position, says Matten, and many of them don’t meet the new capital requirements. Since it is difficult for them to increase deposits, they are very concerned about the new rules. The alternative if they can’t increase deposits may be to reduce assets, and the resultant slowdown in lending could hurt the economic recovery.

Matten also notes that it’s important to consider two key definitional changes. One is that what was deducted from total capital before will now be deducted from core equity, and the other is what qualifies as a capital instrument. For many European banks, he said, those definitional changes could reduce Tier 1 capital ratios by 1-2 percentage points. These changes have little effect on Asian banks, he says.

A second change under Basel III is in liquidity requirements. Here again, Asian banks have plenty of liquidity. However, Matten says, the method for applying the rules may have unintended consequences for multinational banks with large operations in Asia. “The new rules say you have to be self-funding, and you can’t borrow from your subsidiaries and branches overseas,” he says. Some European banks, which funnel deposits from Asia to Europe or America, would be stopped from doing that. “What this change means is that you have a wall of liquidity building up in many Asian markets,” he says, “so the reaction to the global financial crisis is itself creating an asset bubble.”

A third change is leverage ratios, and he believes that “the leverage ratio is not much of an issue for this part of the world.”

While the requirements themselves are important, a more fundamental question is whether they will actually be effective in preventing another banking crisis. For banks, the key strategic issue is how best to implement the requirements.

Some observers don’t seem to believe that the Basel III requirements will make the system safer. For example, during a recent discussion at Singapore Management University, David Connor, chief executive officer (CEO) of OCBC Bank in Singapore, argued, in a personal capacity, that Basel III doesn’t address the right issues. The fundamental cause of the banking problems in the US was a real estate bubble caused by “shoddy lending practices”, and Basel III is “not focussed on preventing a real estate bubble.” Moreover, he said, simply having rules is pro-cyclical because banks “need less capital in good times” and loans are rated less solidly in bad times.

Matten also points out that Basel III’s rules-based approach may actually have taken a step backwards from Basel II. Indeed, some other commentators have said it’s actually more like “Basel 1.5” than Basel III. Requirements that moved forward from ‘pure rules’ under Basel I to a combination of rules and ‘use-your-own-models’ under Basel II were supposed to move more towards modelling, yet have now moved back towards rules.

There are several issues with the rules-based approach. For one, simply using rules could introduce moral hazard because banks’ boards may decide they don’t have to make the risk assessments that should be part of their mandates. Further, the capital conservation and countercyclical capital buffers assume that each bank has the same business model and is equally risky. Since bank risk actually varies, a rules-based approach may be overly stringent for some banks and not sufficient enough to manage risk at other banks.

Connor also noted that “financial innovation will always be one step ahead of the regulators”, and too much focus on rules may also miss some changes in financial structures that could cause future problems.

Additionally, former US Federal Reserve Board vice chairman Alan Blinder told the Wall Street Journal that the rating agencies “that did so poorly in rating mortgage-backed securities and collateralised debt obligations will continue to play major roles in the risk-weighting process.” He argued that the “unwarranted reliance on rating agencies” should be changed.

Regardless of Basel III’s effectiveness, many banks still need to works towards implementing the new requirements. Matten says that the focus for banks should be on strategy, capital management and forecasting capital needs. A related objective should be to have sufficient data to ensure compliance and to implement the strategy.

Whereas Basel II was a complicated internal mechanical exercise, tripling capital to meet Basel III requirements could be very expensive for shareholders. Banks thus need to plan well and make sure they can meet the requirements cost-effectively. The key to success, says Matten, is the strategy and plan for positioning capital and how the bank will achieve long-term growth.

While many banks in Asia have already met many of the requirements for Basel III, the new requirements may well still have some impact and top banks should already be starting to plan for the change.

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