Challenges for BASEL-II Implementation in Bangladesh
Muzaffar Ahmed FCMA, FCS | Thursday, 21 August 2008
THIS article is written in response to the one, written by Mr. Mamun Rashid under the heading Challenges for BASEL-II Implementation in Bangladesh and published in the Financial Express in its issue on August 09, 2008. Mr. Mamun has raised some apprehension and suggested to consider implementation of Basel-II in a go slow process. Since the regulators are working to implement the Basel-II with a given time-frame, I considered it expedient to further clarify some of the issues of the articles in order to avoid confusion among the interested readers on the issue of Basel-II implementation in Bangladesh. My views on the subject are to supplement the article with some of the missing lines that will make the article meaningful and information worthy .
The Bangladesh banking sector has undergone many changes during the last 12 years. The central bank has taken a number of measures during this period to bring improvement in the areas of corporate governance and risk management. Having many odds and limitations of the impact of the above regulatory measures, it can be said that banking sector is the only sector of the economy that is most regulated compared to others. Although some of the regulatory decisions were taken without allowing adequate time and without taking adequate prior preparation, these ultimately yielded positive results in the sector.
Under such the above circumstances, I do believe and agree with some of the apprehensions of Mr. Mamun, as he raised in his article. However, I believe that the time selected by Bangladesh Bank (BB) for going ahead with Basel II implementation with parallel run with effect from January 2009 is right and timely.
In this connection, I like to share the result of a survey conducted by the State Bank of Pakistan in 2005 on the point of implementation of BASEL-II in Pakistan, where most of the banks opted to implement Basel-II as early as possible in order to keep them in line with international requirements and also to derive benefit out of it.
The writer, in his article, viewed that under the Standardized Approach (Simplified approach), the banks are to heavily rely on External Credit Assessment Institutions (ECAI) which are few in number, having poor rating penetration. He also suggested to develop robust External Credit Rating Agencies (ECAIs). While I agree with the writer that under Standardized Approach, the rating agencies, as ECAI, has an important role, but what he meant by Development of Robust Rating Agencies is not clear. On the point of "few", I like to mention that globally the rating agencies does not have any mushroom growth. India, one of the largest economies of the world, has only four rating agencies including foreign rating agency, out of which only one rating agency occupies 75% rating market. Pakistan, Sri Lanka, Malaysia, Indonesia and Taiwan each has a maximum of two rating agencies. The development of rating agency is dependent on capital and money market development. Again, development of rating agency does not means the increased number of rating agencies, rather it mean the capacity and quality of rating agencies.
In this connection, we must remember that the utilization of the services of rating agencies for bank loan under Basel-II is a temporary phenomenon. The banks will ultimately be required to develop their internal rating over a period of five to six years. Basel-II document requires a bank to have at least five years customer data to go for Internal Rating Based Approach (IRB). Up to that period, perhaps, the services of rating agencies will be required by the banking community.
Therefore, expecting more number of rating agencies to come for this very specific period without looking into the basic need of the economy will ultimately lead to a situation like having large number of low quality financial auditors in the economy. Having my long experience with rating and as a member of Best Practice Committee of Association of Credit Rating Agencies in Asia (ACRAA) sponsored by the Asian Development Bank (ADB), I feel that still the Bangladesh economy, at this stage, does not have the capacity to absorb the full services of a single rating agency. A recent research conducted by the ADB to develop the best practice guidelines for rating agencies strongly suggested that a rating agency must have a paid up capital of minimum five million United States Dollar to function properly. Therefore, mushroom growth in rating agency without having market will definitely lead to a very worse situation.
While on the point of utilizing the services of rating agencies by the banking community, the Basel Committee suggested that the regulators must follow a recommended guideline for selecting rating agencies as ECAI. The above requirements are stringent with Default and Transition benchmarks and also trigger benchmark provisions to cancel recognition by the regulator if the above statistics fall below the given benchmarks. In order to comply with the above international benchmarks, rating agencies will have to develop and use the rating system that must be in line with international norms.
Again, on the point of writer's apprehension that the banking community will be dependent on few rating agencies, I would like to mention here that rating is not mandatory under Basel-II, nor it is made mandatory by any country either. The banks are allowed to entertain non-rated clients also. However the existing risk weight of 100% for non- rated clients may be dealt with in two ways:
1)The banks may be allowed to give risk weight at the rate of 150% to non-rated clients, with main objective to encourage the clients to get themselves rated over a period of time after improving the performance, governance and disclosures to get good rating as well as to get the advantage of lower interest rates. India has adopted the above practice to improve the ultimate corporate health of the economy. The corporate businesses will compete with each other to improve performance and to have good ratings;
2)The banks may be given option to get a percentage of their portfolio to be rated indiscriminately. (Discretion may lead the banks to get the rating of only good clients to have low capital while keeping the bad clients out of rating net, which will lead the bank to have more risk in the portfolio compared to the required 100% risk weight)
On the point of time of Implementation, I disagree with the writer for going slow on Basel-II Implementation. I personally feel that the time is now ripe to adopt BASEL -II by replacing the old BASEL-I which was implemented in Bangladesh in 1996 without considering even its major amendment of adopting Market Risk in that year. We must remember that the scenario of banking sector and risk profile of banks has significantly changed during the last couple of years. Banks are no longer a lender and mostly a service provider with substantial risks against each service/ product. Although there is a paradigm shift in the banking sector with the entry of private banks which are generally more careful of loan handling compared to the nationalised commercial banks (NCBs) or state-owned still the number of non-performing loans is in increasing trend even in the private sector banks. The above is the cumulative result of many factors. The banks are in serious competition for market share. The branch managers of each bank are operating with targets and therefore, hungry for clients. As the quality of the auditing is poor and bankers do not have any mechanism to identify the real financials required by them for evaluation, they are to rely on many figures which are misleading to reflect true ability and willingness of a borrower. In addition, most of the banking officials are unable to review the clients professionally with the fear of loosing them. The international banks, with large capital base and franchise value are in an advantageous position to have good clients at a low interest rate. In this scenario, a client rating will be of much help for the banks to know the clients from independent report of rating agencies. The clients will also try to improve rating. It is noteworthy here that many good banking clients are still not aware of requirements of banks and rating agencies although they can comply with them with some extra efforts. Rating will definitely help them. Therefore, Basel-II implementation will have a positive impact on the banking sector. It will definitely assist the banks to understand real risk and it curbs their non-performing loan (NPL) ratio in the long run.
In this connection, I like to share my experience in the mandatory rating of the insurance sector. When the Chief Controller of Insurance issued the Circular of mandatory rating of the insurance companies, almost all the insurance companies wanted that they must be given time to prepare themselves for rating and insisted for the same for many months. But Dr. Mahfuzul Haq, the then Chief Controller of Insurance remained strict on his circular and time-frame. The above ultimately brought all insurance companies (except two government-owned companies) under regulatory framework of rating. After the mandatory rating, it has been observed that while the good rated companies have been trying to further improve their position, the bad rated companies are asking for the surveillance rating to incorporate the latest developments in the surveillance report. The banks are now more interested in the rating report representing claim paying ability of the companies before assigning policies instead of higher discount in premium. The above is a positive development of the sector after mandatory rating. I believe banking sector will be substantially benefited from the rating services.
What will happen, if Basel-II implementation is delayed? The reply was given by an Indian professional who categorized, inter alia, that the foreign banks operating in India will be benefited immensely. Its dominance with huge capital base and franchise value will continue to have the good clients at low interest rate keeping the bad borrowers with the local banks who do not bargain on interest rate and they want loan at whatever interest rate.
Implementation of BASEL-II will bring significant opportunities for banks. The banks will try to diversify products to get capital relief, small and medium enterprises along with house loan financing will get financing priority. The banks will behave intelligently to shift the priority of financing by remodeling its balance sheet which will bring significant and desirable change in the banking operation.
Before I conclude I like to share my views that BASEL-II implementation will more rationalize the capital adequacy than raising additional requirement.
The risk mitigating factors such as securities/ collaterals hitherto not taken into account in Basel-I will be taken into consideration under BASEL-II which will reduce the capital requirement. For good clients, who are in the rating zone of A and above, bank will get significant capital relief as the bank will not be required to have capital with 100% risk weight.
The above capital relief may be utilized against additional capital required for operational risk. If the Bangladesh Bank keeps the unrated portfolio at 100% which is now in place, the intelligent bankers may even operate at lesser capital compared to Basel-I. The BB has assigned the Basel-II implementation task to a separate Cell which has been operating seriously and by this time they have acquired knowledge and acumen on Basel-II regulations.
I believe that the regulators will be able to maintain the time-table and will continuously improve when the implementation will start. We must note that the apprehension raised by Mr Mamun all part of development. None can expect that we first develop ourselves and start, rather start and development always goes together. Therefore, I believe that Basel-II implementation time-frame is right for the country and any delay will go against the economy.
The writer is the President and
CEO of CRISL
The Bangladesh banking sector has undergone many changes during the last 12 years. The central bank has taken a number of measures during this period to bring improvement in the areas of corporate governance and risk management. Having many odds and limitations of the impact of the above regulatory measures, it can be said that banking sector is the only sector of the economy that is most regulated compared to others. Although some of the regulatory decisions were taken without allowing adequate time and without taking adequate prior preparation, these ultimately yielded positive results in the sector.
Under such the above circumstances, I do believe and agree with some of the apprehensions of Mr. Mamun, as he raised in his article. However, I believe that the time selected by Bangladesh Bank (BB) for going ahead with Basel II implementation with parallel run with effect from January 2009 is right and timely.
In this connection, I like to share the result of a survey conducted by the State Bank of Pakistan in 2005 on the point of implementation of BASEL-II in Pakistan, where most of the banks opted to implement Basel-II as early as possible in order to keep them in line with international requirements and also to derive benefit out of it.
The writer, in his article, viewed that under the Standardized Approach (Simplified approach), the banks are to heavily rely on External Credit Assessment Institutions (ECAI) which are few in number, having poor rating penetration. He also suggested to develop robust External Credit Rating Agencies (ECAIs). While I agree with the writer that under Standardized Approach, the rating agencies, as ECAI, has an important role, but what he meant by Development of Robust Rating Agencies is not clear. On the point of "few", I like to mention that globally the rating agencies does not have any mushroom growth. India, one of the largest economies of the world, has only four rating agencies including foreign rating agency, out of which only one rating agency occupies 75% rating market. Pakistan, Sri Lanka, Malaysia, Indonesia and Taiwan each has a maximum of two rating agencies. The development of rating agency is dependent on capital and money market development. Again, development of rating agency does not means the increased number of rating agencies, rather it mean the capacity and quality of rating agencies.
In this connection, we must remember that the utilization of the services of rating agencies for bank loan under Basel-II is a temporary phenomenon. The banks will ultimately be required to develop their internal rating over a period of five to six years. Basel-II document requires a bank to have at least five years customer data to go for Internal Rating Based Approach (IRB). Up to that period, perhaps, the services of rating agencies will be required by the banking community.
Therefore, expecting more number of rating agencies to come for this very specific period without looking into the basic need of the economy will ultimately lead to a situation like having large number of low quality financial auditors in the economy. Having my long experience with rating and as a member of Best Practice Committee of Association of Credit Rating Agencies in Asia (ACRAA) sponsored by the Asian Development Bank (ADB), I feel that still the Bangladesh economy, at this stage, does not have the capacity to absorb the full services of a single rating agency. A recent research conducted by the ADB to develop the best practice guidelines for rating agencies strongly suggested that a rating agency must have a paid up capital of minimum five million United States Dollar to function properly. Therefore, mushroom growth in rating agency without having market will definitely lead to a very worse situation.
While on the point of utilizing the services of rating agencies by the banking community, the Basel Committee suggested that the regulators must follow a recommended guideline for selecting rating agencies as ECAI. The above requirements are stringent with Default and Transition benchmarks and also trigger benchmark provisions to cancel recognition by the regulator if the above statistics fall below the given benchmarks. In order to comply with the above international benchmarks, rating agencies will have to develop and use the rating system that must be in line with international norms.
Again, on the point of writer's apprehension that the banking community will be dependent on few rating agencies, I would like to mention here that rating is not mandatory under Basel-II, nor it is made mandatory by any country either. The banks are allowed to entertain non-rated clients also. However the existing risk weight of 100% for non- rated clients may be dealt with in two ways:
1)The banks may be allowed to give risk weight at the rate of 150% to non-rated clients, with main objective to encourage the clients to get themselves rated over a period of time after improving the performance, governance and disclosures to get good rating as well as to get the advantage of lower interest rates. India has adopted the above practice to improve the ultimate corporate health of the economy. The corporate businesses will compete with each other to improve performance and to have good ratings;
2)The banks may be given option to get a percentage of their portfolio to be rated indiscriminately. (Discretion may lead the banks to get the rating of only good clients to have low capital while keeping the bad clients out of rating net, which will lead the bank to have more risk in the portfolio compared to the required 100% risk weight)
On the point of time of Implementation, I disagree with the writer for going slow on Basel-II Implementation. I personally feel that the time is now ripe to adopt BASEL -II by replacing the old BASEL-I which was implemented in Bangladesh in 1996 without considering even its major amendment of adopting Market Risk in that year. We must remember that the scenario of banking sector and risk profile of banks has significantly changed during the last couple of years. Banks are no longer a lender and mostly a service provider with substantial risks against each service/ product. Although there is a paradigm shift in the banking sector with the entry of private banks which are generally more careful of loan handling compared to the nationalised commercial banks (NCBs) or state-owned still the number of non-performing loans is in increasing trend even in the private sector banks. The above is the cumulative result of many factors. The banks are in serious competition for market share. The branch managers of each bank are operating with targets and therefore, hungry for clients. As the quality of the auditing is poor and bankers do not have any mechanism to identify the real financials required by them for evaluation, they are to rely on many figures which are misleading to reflect true ability and willingness of a borrower. In addition, most of the banking officials are unable to review the clients professionally with the fear of loosing them. The international banks, with large capital base and franchise value are in an advantageous position to have good clients at a low interest rate. In this scenario, a client rating will be of much help for the banks to know the clients from independent report of rating agencies. The clients will also try to improve rating. It is noteworthy here that many good banking clients are still not aware of requirements of banks and rating agencies although they can comply with them with some extra efforts. Rating will definitely help them. Therefore, Basel-II implementation will have a positive impact on the banking sector. It will definitely assist the banks to understand real risk and it curbs their non-performing loan (NPL) ratio in the long run.
In this connection, I like to share my experience in the mandatory rating of the insurance sector. When the Chief Controller of Insurance issued the Circular of mandatory rating of the insurance companies, almost all the insurance companies wanted that they must be given time to prepare themselves for rating and insisted for the same for many months. But Dr. Mahfuzul Haq, the then Chief Controller of Insurance remained strict on his circular and time-frame. The above ultimately brought all insurance companies (except two government-owned companies) under regulatory framework of rating. After the mandatory rating, it has been observed that while the good rated companies have been trying to further improve their position, the bad rated companies are asking for the surveillance rating to incorporate the latest developments in the surveillance report. The banks are now more interested in the rating report representing claim paying ability of the companies before assigning policies instead of higher discount in premium. The above is a positive development of the sector after mandatory rating. I believe banking sector will be substantially benefited from the rating services.
What will happen, if Basel-II implementation is delayed? The reply was given by an Indian professional who categorized, inter alia, that the foreign banks operating in India will be benefited immensely. Its dominance with huge capital base and franchise value will continue to have the good clients at low interest rate keeping the bad borrowers with the local banks who do not bargain on interest rate and they want loan at whatever interest rate.
Implementation of BASEL-II will bring significant opportunities for banks. The banks will try to diversify products to get capital relief, small and medium enterprises along with house loan financing will get financing priority. The banks will behave intelligently to shift the priority of financing by remodeling its balance sheet which will bring significant and desirable change in the banking operation.
Before I conclude I like to share my views that BASEL-II implementation will more rationalize the capital adequacy than raising additional requirement.
The risk mitigating factors such as securities/ collaterals hitherto not taken into account in Basel-I will be taken into consideration under BASEL-II which will reduce the capital requirement. For good clients, who are in the rating zone of A and above, bank will get significant capital relief as the bank will not be required to have capital with 100% risk weight.
The above capital relief may be utilized against additional capital required for operational risk. If the Bangladesh Bank keeps the unrated portfolio at 100% which is now in place, the intelligent bankers may even operate at lesser capital compared to Basel-I. The BB has assigned the Basel-II implementation task to a separate Cell which has been operating seriously and by this time they have acquired knowledge and acumen on Basel-II regulations.
I believe that the regulators will be able to maintain the time-table and will continuously improve when the implementation will start. We must note that the apprehension raised by Mr Mamun all part of development. None can expect that we first develop ourselves and start, rather start and development always goes together. Therefore, I believe that Basel-II implementation time-frame is right for the country and any delay will go against the economy.
The writer is the President and
CEO of CRISL