Basel-III challenges for risk management in banking

The objective of Basel accord is not to hinder business of banks. It is to direct the financial institutions towards sustainability for which it emphasises capital and risk mitigation through a disciplined balance-sheet. 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 resilience and shock absorbance capacity of banks better than ever.  
The banking sector needs to maintain minimum 10.00 per cent of total capital ratio comprising minimum 5.5 per cent Tier-1 capital and maximum 4.5 per cent Tier-2 capital. Moreover, banks are required to keep 2.5 per cent extra capital termed as Capital Conservation Buffer (gradually increasing 0.625 per cent each year) through Tier-1 capital at the end of 2019. As a result, at the end of 2019, capital requirement for banks 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). Besides, banks have to maintain 3 per cent leverage ratio along with Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) of 100 per cent or more. Banks are only allowed to treat general provision they kept against their business operation as CET-1 capital maximum of 1.25 per cent of total Risk Weighted Asset (RWA) instead of full. Apart from these, the Bangladesh Bank (BB) has also advised for retaining additional capital under Piller-2 of Basel-III through the ICAAP.
According to the Financial Stability Assessment Report, September-2015 published by the Bangladesh Bank, Capital to Risk Weighted Asset Ratio (CRAR) of the banking sector was 10.5 per cent, which is slightly higher than the minimum requirement of 10 per cent but still lower than 10.625 per cent as to be required in 2016. However, compared to December 2015, overall CRAR of the banking sector has decreased by 0.2 per cent. Moreover, in the third quarter of 2015, 09 (16.07 per cent) out of 56 banks failed to maintain the minimum requirement (10  per cent), which hold 35 per cent of the total assets of the banking industry, which indicates more than one-third of banking sector assets are managed by non-CRAR-compliant banks. The decisive question is whether banks can continue the growth of capital at 0.625 per cent in the coming years steadily.
  The key challenges banks have to overcome lie with liquidity, capital and profitability. The traditional belief is that a bank is a highly leverage company by nature and inverse correlation prevails between liquidity and profitability. 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 expected profit for banks, rather it may adversely affect profitability, trade-off between liquidity and profitability is one of the major challenges for banks. Henceforth, role of the treasury division should not be limited to merely maintaining of SLR and lending to NBFI, as they have to apply more tools to manage their fund efficiently by preparing active portfolio to trade off between liquidity and profitability. The bank itself has to shift its focus from lending business to financial service businesses. Recently, we have seen that banks are diverting to mobile financial services, agent banking etc. which are nothing but to adopt itself to financial service-providing approach.
Capital and profitability are complexly related to each other. Capital can be enhanced in two forms (a) internal i.e. retaining earnings in different forms and (b) external i.e. issuing bonds, injecting money by shareholders in the form of right issues. Between these two, the first one is preferred by the stakeholders. If a bank wishes to expand funded business by Tk 100.00, they will have to increase capital by Tk.8-9, which requires return of at least Tk.1.00 to satisfy the shareholders. Banks have to earn Tk.2.08 profit before tax to distribute dividend of Tk.1.00 [(2.08 - 40 per cent Corporate Tax) - 20 per cent Statutory Reserve]. Considering the factor of provision, the gross profit should be higher as operating cost of banks ranges between 35 per cent and 50 per cent of their gross income.
Stiff competition prevailing in the industry is consistently pushing down the NIM sharply, while operating cost due to inflation and compliance is gradually going up. Besides, new banks have also joined the rally to have their slice through surviving. If we sum up, then it may be said that banks should have to earn more to expand its business. But how they can earn more without enhancing business is the challenge. Yes, this is the challenge to navigate the business plan towards profit target both in short and long-term.
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 capacity. According to the guidelines of Basel III, banks fail to meet the capital requirement (Min.10 per cent + CCB 2.5 per cent) 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 would make them disgruntled and consequently, it may drag down the stock price. Under these circumstances, it will not be easy for banks to raise capital through new issue or right issue.
In this backdrop, there is no other way but to enhance efficiency to survive. Efficiency is not merely a term that would be used rather it must be ensured in terms of asset liability management and banking operation towards profitability by following risk-based approach. The only tool that can really help banks in synchronising profitability along with the Basel regime is risk management. It is inevitable that better risk management ensures better asset quality, less provision, better returns and consequently hefty retained earnings. Now the question is how banks can ensure better risk management.
For efficient risk management, there is hardly any alternative to following top-to- down approach starting from the Board of Directors or owners who are the ultimate beneficiaries of the banks. For this, the Board has to have the mindset that they will even sacrifice short-term gain and tolerate trifling business losses for long-term comfort with their institution and for obvious reason, they have to treat the bank as an institution rather than simply a money-making machine. The more efficient their approach regarding risk management will be the more sustainable institution it will be. Risk management is a job that cannot make everybody happy since it has to raise the red flag well ahead of any anticipated or foreseeable disarray. The Bangladesh Bank must be thanked for its effort for timely publishing Risk Management Guidelines for banking and non-banking financial institutions. Hence, it is the high time to allocate resources and skilled manpower for developing and implementing risk-managing tools in the banking industry of Bangladesh.
The writers are associated with Risk Management Division and Research & Planning Division of the Mercantile Bank Limited. Views shared are those of the authors and do not necessarily reflect the official position
 of the bank they
are associated with.
[email protected]
[email protected]