Basel III: Capital efficiency and challenges for banks

Basel III, the latest capital and liquidity standards for banks prescribed by the Bank for International Settlements (BIS), emerged in 2010 as the guideline of Basel II, the previous version of capital standard, failed to maintain financial stability during the global financial crisis in 2008.On that ground, Basel III guideline has been formulated for improving shock resilience capacity of the banks and preventing recurrence of such financial and economic crisis with an aim to ensure financial stability of banks through increasing the quality and quantity of the base of capital as well as maintaining global liquidity standards.
BIRTH OF BASEL: The notion and necessity of Basel emerged long before its coming into being formally as Basel Committee. In the early 1970s, the central banks used to supervise the inland activities of the banks. However, with the increase in globalisation of financial markets and cross border transactions, the lack of efficiency in supervisory role of the central banks was figured out and the need for a greater supervisory role arose with the passage of time. Meanwhile, the collapse of the Breton Woods system, the Herstatt Bank of Germany and the Franklin National Bank in the USA called for a strong regulatory framework for strengthening the global financial infrastructure, financial stability and quality banking supervision. Perceiving that need, the central bank governors of G10 countries hit upon an idea of formulating a supervisory entity and established a Committee on Banking Regulations and Supervisory Practices at the end of 1974,which, later on, was renamed as Basel Committee for Banking Supervision (BCBS).
BCBS formulated a set of rules and regulations which is generally known as Basel Accord. BCBS has introduced three accords: Basel I (in 1988), Basel II (in 2004) and Basel III (in 2010). Presently, the global banking sector is passing through the Basel III era. In accordance with Basel III, issued by BCBS in 2010, Bangladesh Bank (BB) issued 'Guidelines on Risk Based Capital Adequacy' a revised regulatory capital framework for banks in December 2014, which has come into play in January 2015 and will be fully implemented by 2019.
NEW FEATURES IN BASEL III: As discussed earlier, Basel III has come up with new features addressing the shortcoming of Basel II and tried to get a firm grip on quality and quantity of capital, liquidity and leverage ratio. Banks were advised to operate their functions in a way that satisfactorily complies with the Basel III guidelines and helps the central bank in ensuring the stability of financial sectors.
n Common Equity Tier1 (CET1):  It is the core capital of banks, which comprises mainly paid up capital, general reserve, statutory reserve and retained earnings. It will be minimum 4.5 per cent of Risk Weighted Assets (RWA) as per guidelines of Basel III.
n  Liquidity: BCBS introduced two new standards for liquidity -- Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) in Basel III. LCR measures the short-term liquidity and indicates bank's sufficiency/insufficiency in possessing high quality liquid resources to survive in an acute stress scenario lasting for one month. NSFR measures the long-term liquidity, and is designed to encourage banks to use stable sources to fund their activities and to reduce the dependency on short-term wholesale funding.
n Capital Conservation Buffer (CCB): It prompts to avoid the breach of minimum capital requirement (10 per cent). Banks are required to maintain additional 2.5 per cent capital of its RWA comprising CET1 as CCB in excess of minimum capital requirement of 10 per cent by 2019 in a gradual manner.
n Countercyclical Buffer (CB): It was introduced as a forward looking approach which mandates a bank to build a buffer capital when in a good position so that it can be used in stress scenario and protect the banking sector in period of excess aggregate credit growth. Normally, the CB is set at zero and will increase with the growth of economy. Capital requirement against CB is 0 -2.5 per cent which will be fixed by the central bank.
n  Based on the concept 'Too Big to fail', Basel III acknowledged Systematically Important Financial Institutions (SIFI), which are much more interconnected with financial system and economy. In this connection, the Bangladesh Bank is developing quantitative and qualitative tools to define Domestic Systematically Important Bank (DSIB) and Global Systematically Important Bank (GSIB) and capital surcharge, supervision and monitoring policy.
n Leverage ratio: It is one of the major additions of Basel III and was introduced to control the aggressive credit expansion. Banks have to maintain the amount of Tier1 capital which will be not less than 3 per cent of its total On and Off balance sheet. The ratio signifies that without increasing the quality capital, banks could not expand their business.
n To ensure the maintenance of quality capital base, restriction was imposed on profit distribution under Basel III accord. The policy states that no banks will be allowed to distribute its profit in the form of dividend, share buybacks and discretionary bonus until and unless they fulfill the 7 per cent Common Equity Tier-1 (Min. 4.5 per cent + CCB 2.5 per cent) to risk weighted asset ratio requirement.
n  Market disclosure under Pillar III has enhanced in Basel III to establish more transparent and well-organised banking sector so that stakeholders can easily analyse the banks' position on various aspects. Liquidity indicators and remuneration policy, structure of remuneration processes, performance measurement process, linkage between performance and remuneration etc. are the major additions under market disclosure.
n Moreover, regulatory adjustments for capital calculation have been made stricter in Basel III.
CAPITAL REGULATION UNDER BASEL III: Banking sector needs to maintain minimum 10.00per cent total capital ratio comprising  minimum 5.5 per cent Tier-1 capital and maximum 4.5 per cent Tier-2 capital in 2015, and the distribution will be minimum 6 per cent Tier-1 capital ratio and 4 per cent Tier-2 Capital ratio at the end of 2019. Moreover, banks are required 2.5 per cent extra capital (gradually increasing 0.625 per cent in each year) as Capital conservation buffer through the Common equity Tier1 capital at the end of 2019. As a result, at end of 2019, capital requirement for bank will be 12.5 per cent (minimum 10 per cent + CCB 2.5 per cent) of Risk weighted asset, out of which 8.5 per cent will be core capital (minimum 6 per cent + 2.5 per cent CCB). According to main Basel III accord of BCBS, minimum capital ratio for banks is 8 per cent of which 6 per cent Teir-1 capital and 2 per cent Tier-2 capital.
RESPONSES TO BASEL III - BANGLADESH POSITION: According to the Financial Stability Assessment Report - March 2015 published by the Bangladesh Bank, Capital to Risk Weighted Asset Ratio (CRAR) of the banking sector was 10.7 per cent, which is reasonably higher than the minimum requirement 10 per cent. However, compared to December 2014, overall CRAR of the banking sector has decreased by 0.7 per cent. Moreover, in the first quarter of 2015, 8 (14.28 per cent) out of 56 banks have failed to maintain the minimum requirement (10 per cent), which hold 24.4 per cent of the total assets of banking industry, whereas, 5 banks could not meet the minimum requirement at the end of 2014.           
THE ACHILLES HEELS OF BASEL III: As experts opine, liquidity and profitability are inversely correlated. As per Basel III, banks' have to possess high quality liquid resources to survive in an acute stress scenario lasting for one month. Since liquidity does not bring desired profit for banks and may adversely affect profitability, trade-off between liquidity and profitability is one of the major challenges for banks.
According to the guideline of Basel III, those banks fail to meet the capital requirement (Min.10% + CCB 2.5%) will not be allowed to distribute profit, in any form to stockholders. As getting returns, in the form of dividend yield or capital gain, is one of the major interests of stakeholders, getting no dividend or capital gain may make them unhappy and consequently, it may drag down the stock price. Moreover, under these circumstances, it will not be easy for banks to raise capital through new issue or right issue. In addition, it may instigate the elements of reputation risk as well. Furthermore, without raising a sufficient core capital, banks are not allowed to expand their loans and advances. Reducing leverage and imposing capital requirements will shrink banks' earning power in good economic times as well.
In coming days, maintaining capital requirement would be the prime concern for banking industry to continue and expand its business. Therefore, controlling non-performing loan (NPL) is very important as it directly reduces bank's profitability through reducing interest income and incurring more loan loss provision. Eventually, it deteriorates the capital retention capacity of the banks.
The core philosophy of Basel III is to ensure the quality and quantity of capital for the stability and sustainability of financial sectors in the long run. It may not necessarily certify that it will resist any future crisis with its set guidelines; however, it tries to make banks prepared for anticipated shocks. Despite having various  criticisms and shortcomings,  it  is obvious  that  the  Basel III  framework  will  definitely  heighten the risk resilient and shock absorbent capacity of banks better than ever.  However, mere time to time reporting and showing compliance are very small parts of the whole thing. The purpose of Basel III can only be served if the risk culture, risk management and risk governance are dealt with proper initiatives grasping its underlying philosophy.
Writers are associated with Risk Management Division and Research & Development Division of a private commercial bank in Bangladesh. Views shared are those of the authors and do not necessarily reflect the official position of the bank they are associated with.
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