Risk-based bank capital management in line with Basel-II
Sunday, 5 April 2009
Md. Lutful Kabir
BANKING sector in Bangladesh is passing through a historic moment after declaration of parallel implementation plan of Basel II (BRPD Circular-9 dated 31.12.08) by Bangladesh Bank (BB) -- a parallel run during FY 2009 with the existing capital adequacy framework and full adaptation from 2010. Basel II promotes implementation of more risk-based capital adequacy structure and ultimately revises the operational framework of the banks.
Banks are highly prone to augmenting revenue generation that sometimes persuades to accept lower quality borrowers without considering risk infusion in their credit portfolio. Again, appropriate cost-based pricing is less concentrated due to non-counting of capital allocation cost towards the funding. Loan portfolio is being weighted with fixed risk weight under the existing capital adequacy framework for capital allocation, irrespective of risk factors of the counterparty that leads to inorganic asset or portfolio growth where organic capital growth (i.e. earning retention) doesn't pace in line with the above.
Due to limited capital base of the banks, any drain or non-performing loan (NPL) in the credit portfolio ultimately affects the organic capital growth that causes to erode depositors' fund. Hence, Basel II evolved with a protection framework towards the depositors' fund having an appropriate capital level commensurate with individual bank's risk exposure.
As a matter of fact, BRPD circular 9, to implement the Basel II principles appears in the banking sector to rearrange the business model for capital adequacy. Under the new circular, risk-based capital requirement also widely covered the market risk and operational risk, in addition to the earlier credit risk. Capital requirement is normally perceived to be increased above the previous level of capital adequacy ratio (CAR) for each bank. However, only with appropriate balance sheet management, a bank can manoeuvre the additional capital requirement under the new BRPD circular 9 of Bangladesh Bank. Banks are now required to have prudent approach to managing their different exposures of the balance sheet components for the appropriate capital adequacy level.
The recent BRPD circular also brought forward a few key areas in bank management that ultimately leads to capital adequacy. Bankers need to consider those areas in their future strategic move for proper capital management.
The recent circular commends maintaining the 'Minimum Regulatory Capital' as a prime precondition, in line with the Pillar I principle of Basel II and also recommend for maintenance of a cushion above the required level, considering the historical loss precedents or the expected loss in near term, termed as 'adequate capital' in BB circular, popularly known as 'economic capital' in Basel II framework. It sets individual bank's responsibility in developing an internal capital adequacy assessment process (ICAAP) and setting capital targets that are commensurate with the bank's risk profile and control environment.
So, adequate capital is the amount which is needed to secure the survival of a bank in a worst case scenario that will work as a buffer against heavy shock. It covers the minimum regulatory capital for credit, operation and market risk -- risks which are not captured by minimum regulatory capital and the risk factors external to the bank. It is predicted under the new circular that those banks which are maintaining capital adequacy equal or marginally above the existing requirement of 10 per cent, may face a great challenge in maintaining capital adequacy from 2010 unless they adopt the balance sheet management techniques provided in the new circular to reap the opportunity of reducing the capital requirement through reduction of the total risk exposure of the bank. However, access to primary/secondary market for raising capital base won't be very easy, even it might increase the cost of capital significantly for recurrent increase of share capital base.
Under the recent circular, capital is required to be risk adjusted and extensively covered for each business exposure, in addition to the probable risk the bank may face from operation and market forces. Globally banks are moving fast towards the trading book (generally consists of trading instruments) activities over banking book (generally consists of loan and advances) that are exposed to significant market risk because of its involvement in trading of debt instruments, equities, foreign exchange and commodities.
Realizing the fact, the new circular specified that at least 20 per cent of market risk needs to be supported by Tier-1 capital and introduction of Tier-3 capital (i.e. subordinated debt instrument below five years but above two years of maturity) exclusively for newly considered market risk is an additional mechanism of raising capital for the banks. Issuing of Tier-2 (subordinated debt over five years maturity) and Tier 3 capital components may also develop the capital market in near future with significant number of short term and long term debt instruments issued by banks.
The recent BRPD circular presumes that banks will be more inclined to rearrange the different balance sheet exposures for capital adequacy as well as profitability. Because, permanent expansion needs proportional capital support in the funding ratio of 9: 1 for deposit: capital respectively or in different proportion based on the exposure risk weight.
According to the new circular, the same amount of the capital can be provisioned for different business exposures based on the risk weight of the exposures e.g. Tk. 10 can be provisioned as regulatory capital for an exposure of Tk. 500 (equivalent to 20 per cent risk weight assets), Tk. 200 (equivalent to 50 per cent risk weight assets), Tk.100 (equivalent to 100 per cent risk-weight assets), Tk. 80 (equivalent to 125 per cent risk-weight assets), Tk. 67 (equivalent to 150 per cent risk-weight assets). It reveals that the balance sheet expansion of a bank will be highly dependent on the present risks exposed by its different balance sheet claims and only then the available capital may be utilized to support the prospective business without raising capital. This is the high time for the banks to assess whether its existing capital supports the existing risk exposure or falls short of requirement; else, credit expansion may be hindered if it faces challenge in maintaining capital.
The recent circular has great effect on loan pricing and ultimate profitability determination approach of the bank. It recommends that each loan or exposure is required to be priced to assess its profitability or in selection of investment option from the alternatives. Involvement of capital is considered as the prime factor in loan pricing because different exposures demand different capital requirement as according to its risk exposures. Hence, the new circular introduced the concept of risk adjusted return on capital (RAROC), economic profit (known as 'economic value added') in measuring the profitability of the exposures or selecting the investment option.
An exposure may be profitable considering the spread under the existing practice, while in the 'economic value added' concept, it may face loss because of only considering the cost of the regulatory capital in funding. Again, economic profit may vary for the same amount of exposures due to the difference in regulatory capital requirement based on the risk of those exposures.
On one side, the recent circular widely covered three major risk areas viz. credit risk, market risk and operational risk for minimum regulatory capital; and on the other side, it also specified an allocation procedure of regulatory capital among the major risk areas. It stated that at least 20 per cent of market risk needs to be supported by Tier-1 capital; eligible Tier-2 and Tier-3 capital must be equal or less than of Tier 1 capital; capital adequacy ratio (CAR) must be 10 per cent of RWA with core capital i.e. T1=5 per cent of RWA (risk weighted assets); Tier 3 capital is limited up to 250 per cent of Tier 1 after meeting credit risk capital requirement; subordinated debt shall be limited to 30 per cent of Tier 1 capital in calculating the regulatory capital; 50 per cent of the asset or securities revaluation reserve shall be eligible as Tier 2 capital. It reveals that not all capital components will qualify in calculating the regulatory capital and concentrating on any component will not be prudent (like right issue of shares) rather make it rational in respect of the bank.
Banks are required to be farsighted to support market risk mainly through issuing short-term debt instruments (treated as Tier-3 capital), and also issuing the long-term debt instruments like perpetual bond (treated as Tier-2 Capital) to support capital requirement against newly incorporated operational risk. Presently, bankers are adapted to calculate the required capital after taking the exposures, whereas, the BRPD circular commends taking exposures after allocating capital against the exposures. Hence, in preparing budget or forecasting the business growth, the bank initially needs to allocate eligible capital for current business and then, allocate the balance of eligible capital for business expansion.
Although higher capital requirement is perceived under the recent capital adequacy circular, the circular itself inherently encourages different mitigating approaches to reap; even a bank can reduce its regulatory capital requirement than its present level albeit maintaining higher asset portfolio. The most widely discussed areas, inter alia. include portfolio rationing, use of credit risk transfer (CRT) techniques, exploring the credit risk mitigation (CRM) tools, pursuing the good corporate clients and public sector entities to be rated by external credit assessment institutes (ECAI).
According to the existing capital adequacy circular in line with the Basel I, all private sector corporate lending enjoys 100 per cent risk weight; however, in the new BRPD circular, private sector financing has been differentiated in house finance (50 per cent risk weight), small and medium enterprises (SME) (75 per cent risk weight), retail financing, consumer lending (75 per cent risk weight), venture financing (150 per cent risk weight) and the balance exposures in corporate financing (20 per cent to 150 per cent risk weight). Presently all public sector exposures are enjoying 20 per cent risk weight, however, according to the new circular, different risk weights (20 per cent to 150 per cent) have been introduced.
Lately, both the private and public sectors are enjoying both fixed or variable risk weight than in the early single risk weight fit for all exposures of that sector. Other than the fixed risk weight, the variable risk weight will be determined according to the rating assigned by recognized ECAIs against each exposure; although BB stated unrated corporate exposure equivalent to 125 per cent risk weight and public sector to 50 per cent risk weight. As a consequence, bankers will be more inclined to harvest the opportunity of reducing capital requirement through rationing its portfolio among the sectors based on the risk weight of those sectors. For example, bankers may increase their exposures in SME and house finance due to its lower risk weight for capital relief. It also suggests that bank can avail capital relief through pursuing, especially the good corporate clients to be rated because it may reduce regulatory capital requirement even by five times against the usual requirement. The bank may also pursue the clients for their revolving exposures to be rated, because performance record of the revolving exposures are better than the term loan, thus presumed to be rated good.
The bank may also reduce the capital requirement through adopting the credit risk transfer (CRT) mechanisms. Globally the most widely used mechanisms include loan sale, loan syndication, securitization and use of credit derivative (yet to be introduced in the country). Use of CRT techniques is also a source of fee-based income for the bank.
Another beauty of the circular is credit risk mitigation (CRM) technique for managing capital adequacy. The CRM techniques suggest using financial collateral and guarantee against the exposures for capital relief. Banks may seek the specified financial collateral like cash, fixed deposit receipts (FDR), debt instrument, equities against the exposures or avail guarantee rated by any ECAI higher than the borrower's rating for credit risk mitigation.
Overall, though the recent circular is primarily supposed to increase the capital requirement for each bank, some banks may cut capital requirements drastically even by 50 per cent. This is not a matter to be panicked about; rather, it is a subject of management; because by introducing the internal capital adequacy assessment process (ICAAP), the bank can assess the capital requirement as well as adopt the option specified in the circular to reduce the capital requirement. Most of the Indian and Pakistani banks successfully maintained the capital adequacy after Basel II implementation.
The author is Assistant Vice President and Head of Corporate Ratings of Credit Rating Information and Services Limited (CRISL) and may be contacted at kabir@crislbd.org
BANKING sector in Bangladesh is passing through a historic moment after declaration of parallel implementation plan of Basel II (BRPD Circular-9 dated 31.12.08) by Bangladesh Bank (BB) -- a parallel run during FY 2009 with the existing capital adequacy framework and full adaptation from 2010. Basel II promotes implementation of more risk-based capital adequacy structure and ultimately revises the operational framework of the banks.
Banks are highly prone to augmenting revenue generation that sometimes persuades to accept lower quality borrowers without considering risk infusion in their credit portfolio. Again, appropriate cost-based pricing is less concentrated due to non-counting of capital allocation cost towards the funding. Loan portfolio is being weighted with fixed risk weight under the existing capital adequacy framework for capital allocation, irrespective of risk factors of the counterparty that leads to inorganic asset or portfolio growth where organic capital growth (i.e. earning retention) doesn't pace in line with the above.
Due to limited capital base of the banks, any drain or non-performing loan (NPL) in the credit portfolio ultimately affects the organic capital growth that causes to erode depositors' fund. Hence, Basel II evolved with a protection framework towards the depositors' fund having an appropriate capital level commensurate with individual bank's risk exposure.
As a matter of fact, BRPD circular 9, to implement the Basel II principles appears in the banking sector to rearrange the business model for capital adequacy. Under the new circular, risk-based capital requirement also widely covered the market risk and operational risk, in addition to the earlier credit risk. Capital requirement is normally perceived to be increased above the previous level of capital adequacy ratio (CAR) for each bank. However, only with appropriate balance sheet management, a bank can manoeuvre the additional capital requirement under the new BRPD circular 9 of Bangladesh Bank. Banks are now required to have prudent approach to managing their different exposures of the balance sheet components for the appropriate capital adequacy level.
The recent BRPD circular also brought forward a few key areas in bank management that ultimately leads to capital adequacy. Bankers need to consider those areas in their future strategic move for proper capital management.
The recent circular commends maintaining the 'Minimum Regulatory Capital' as a prime precondition, in line with the Pillar I principle of Basel II and also recommend for maintenance of a cushion above the required level, considering the historical loss precedents or the expected loss in near term, termed as 'adequate capital' in BB circular, popularly known as 'economic capital' in Basel II framework. It sets individual bank's responsibility in developing an internal capital adequacy assessment process (ICAAP) and setting capital targets that are commensurate with the bank's risk profile and control environment.
So, adequate capital is the amount which is needed to secure the survival of a bank in a worst case scenario that will work as a buffer against heavy shock. It covers the minimum regulatory capital for credit, operation and market risk -- risks which are not captured by minimum regulatory capital and the risk factors external to the bank. It is predicted under the new circular that those banks which are maintaining capital adequacy equal or marginally above the existing requirement of 10 per cent, may face a great challenge in maintaining capital adequacy from 2010 unless they adopt the balance sheet management techniques provided in the new circular to reap the opportunity of reducing the capital requirement through reduction of the total risk exposure of the bank. However, access to primary/secondary market for raising capital base won't be very easy, even it might increase the cost of capital significantly for recurrent increase of share capital base.
Under the recent circular, capital is required to be risk adjusted and extensively covered for each business exposure, in addition to the probable risk the bank may face from operation and market forces. Globally banks are moving fast towards the trading book (generally consists of trading instruments) activities over banking book (generally consists of loan and advances) that are exposed to significant market risk because of its involvement in trading of debt instruments, equities, foreign exchange and commodities.
Realizing the fact, the new circular specified that at least 20 per cent of market risk needs to be supported by Tier-1 capital and introduction of Tier-3 capital (i.e. subordinated debt instrument below five years but above two years of maturity) exclusively for newly considered market risk is an additional mechanism of raising capital for the banks. Issuing of Tier-2 (subordinated debt over five years maturity) and Tier 3 capital components may also develop the capital market in near future with significant number of short term and long term debt instruments issued by banks.
The recent BRPD circular presumes that banks will be more inclined to rearrange the different balance sheet exposures for capital adequacy as well as profitability. Because, permanent expansion needs proportional capital support in the funding ratio of 9: 1 for deposit: capital respectively or in different proportion based on the exposure risk weight.
According to the new circular, the same amount of the capital can be provisioned for different business exposures based on the risk weight of the exposures e.g. Tk. 10 can be provisioned as regulatory capital for an exposure of Tk. 500 (equivalent to 20 per cent risk weight assets), Tk. 200 (equivalent to 50 per cent risk weight assets), Tk.100 (equivalent to 100 per cent risk-weight assets), Tk. 80 (equivalent to 125 per cent risk-weight assets), Tk. 67 (equivalent to 150 per cent risk-weight assets). It reveals that the balance sheet expansion of a bank will be highly dependent on the present risks exposed by its different balance sheet claims and only then the available capital may be utilized to support the prospective business without raising capital. This is the high time for the banks to assess whether its existing capital supports the existing risk exposure or falls short of requirement; else, credit expansion may be hindered if it faces challenge in maintaining capital.
The recent circular has great effect on loan pricing and ultimate profitability determination approach of the bank. It recommends that each loan or exposure is required to be priced to assess its profitability or in selection of investment option from the alternatives. Involvement of capital is considered as the prime factor in loan pricing because different exposures demand different capital requirement as according to its risk exposures. Hence, the new circular introduced the concept of risk adjusted return on capital (RAROC), economic profit (known as 'economic value added') in measuring the profitability of the exposures or selecting the investment option.
An exposure may be profitable considering the spread under the existing practice, while in the 'economic value added' concept, it may face loss because of only considering the cost of the regulatory capital in funding. Again, economic profit may vary for the same amount of exposures due to the difference in regulatory capital requirement based on the risk of those exposures.
On one side, the recent circular widely covered three major risk areas viz. credit risk, market risk and operational risk for minimum regulatory capital; and on the other side, it also specified an allocation procedure of regulatory capital among the major risk areas. It stated that at least 20 per cent of market risk needs to be supported by Tier-1 capital; eligible Tier-2 and Tier-3 capital must be equal or less than of Tier 1 capital; capital adequacy ratio (CAR) must be 10 per cent of RWA with core capital i.e. T1=5 per cent of RWA (risk weighted assets); Tier 3 capital is limited up to 250 per cent of Tier 1 after meeting credit risk capital requirement; subordinated debt shall be limited to 30 per cent of Tier 1 capital in calculating the regulatory capital; 50 per cent of the asset or securities revaluation reserve shall be eligible as Tier 2 capital. It reveals that not all capital components will qualify in calculating the regulatory capital and concentrating on any component will not be prudent (like right issue of shares) rather make it rational in respect of the bank.
Banks are required to be farsighted to support market risk mainly through issuing short-term debt instruments (treated as Tier-3 capital), and also issuing the long-term debt instruments like perpetual bond (treated as Tier-2 Capital) to support capital requirement against newly incorporated operational risk. Presently, bankers are adapted to calculate the required capital after taking the exposures, whereas, the BRPD circular commends taking exposures after allocating capital against the exposures. Hence, in preparing budget or forecasting the business growth, the bank initially needs to allocate eligible capital for current business and then, allocate the balance of eligible capital for business expansion.
Although higher capital requirement is perceived under the recent capital adequacy circular, the circular itself inherently encourages different mitigating approaches to reap; even a bank can reduce its regulatory capital requirement than its present level albeit maintaining higher asset portfolio. The most widely discussed areas, inter alia. include portfolio rationing, use of credit risk transfer (CRT) techniques, exploring the credit risk mitigation (CRM) tools, pursuing the good corporate clients and public sector entities to be rated by external credit assessment institutes (ECAI).
According to the existing capital adequacy circular in line with the Basel I, all private sector corporate lending enjoys 100 per cent risk weight; however, in the new BRPD circular, private sector financing has been differentiated in house finance (50 per cent risk weight), small and medium enterprises (SME) (75 per cent risk weight), retail financing, consumer lending (75 per cent risk weight), venture financing (150 per cent risk weight) and the balance exposures in corporate financing (20 per cent to 150 per cent risk weight). Presently all public sector exposures are enjoying 20 per cent risk weight, however, according to the new circular, different risk weights (20 per cent to 150 per cent) have been introduced.
Lately, both the private and public sectors are enjoying both fixed or variable risk weight than in the early single risk weight fit for all exposures of that sector. Other than the fixed risk weight, the variable risk weight will be determined according to the rating assigned by recognized ECAIs against each exposure; although BB stated unrated corporate exposure equivalent to 125 per cent risk weight and public sector to 50 per cent risk weight. As a consequence, bankers will be more inclined to harvest the opportunity of reducing capital requirement through rationing its portfolio among the sectors based on the risk weight of those sectors. For example, bankers may increase their exposures in SME and house finance due to its lower risk weight for capital relief. It also suggests that bank can avail capital relief through pursuing, especially the good corporate clients to be rated because it may reduce regulatory capital requirement even by five times against the usual requirement. The bank may also pursue the clients for their revolving exposures to be rated, because performance record of the revolving exposures are better than the term loan, thus presumed to be rated good.
The bank may also reduce the capital requirement through adopting the credit risk transfer (CRT) mechanisms. Globally the most widely used mechanisms include loan sale, loan syndication, securitization and use of credit derivative (yet to be introduced in the country). Use of CRT techniques is also a source of fee-based income for the bank.
Another beauty of the circular is credit risk mitigation (CRM) technique for managing capital adequacy. The CRM techniques suggest using financial collateral and guarantee against the exposures for capital relief. Banks may seek the specified financial collateral like cash, fixed deposit receipts (FDR), debt instrument, equities against the exposures or avail guarantee rated by any ECAI higher than the borrower's rating for credit risk mitigation.
Overall, though the recent circular is primarily supposed to increase the capital requirement for each bank, some banks may cut capital requirements drastically even by 50 per cent. This is not a matter to be panicked about; rather, it is a subject of management; because by introducing the internal capital adequacy assessment process (ICAAP), the bank can assess the capital requirement as well as adopt the option specified in the circular to reduce the capital requirement. Most of the Indian and Pakistani banks successfully maintained the capital adequacy after Basel II implementation.
The author is Assistant Vice President and Head of Corporate Ratings of Credit Rating Information and Services Limited (CRISL) and may be contacted at kabir@crislbd.org