Basel III refers to the latest capital and liquidity standards prescribed by the Bank for International Settlements (BIS). Bangladesh has entered into the Basel III regime effective from January 01, 2015. Bangladesh Bank (BB) amended its capital standard which was based on Basel II and circulated new regulatory capital and liquidity guidelines in line with Basel III of BIS. The new capital and liquidity standards have great implications for banks. Let us focus the guideline of the BB and identify the challenges ahead for the banks of Bangladesh.
The discussion may be started from original Basel III accord of the BIS, which is the base of the BB's guideline. Basel III was introduced in 2010 with the intention of gradual implementation starting from January 01, 2013 and full implementation starting from January 01, 2019. Basel II guideline, the previous version of capital standard, was felt inadequate to maintain financial stability during global financial crisis started in 2007. The financial instability took a heavy toll and led to economic crisis in various countries. Basel III guideline has been formulated to improve shock resilience capacity of the banks to
prevent recurrence of such financial and
economic crisis.
Basel III has identified the reasons of bank failure in recent crisis. The main reasons of the crisis, as identified in the Basel III document, are use of excessive leverage, gradual erosion of level and quality of capital base, insufficient liquidity buffer, pro-cyclicality and excessive interconnectedness among systematically important institutions. Let us have a look at how these factors have contributed to the financial crisis and what are the measures suggested by Basel III to defuse the threats.
SHADOW BANKING: Excessive leverage i.e. use of non-equity fund has played major role in both initiation and deepening of the crisis. The initiation of the crisis was in shadow banking system of the USA. The shadow banking system is a set of institutions that carry out functions very similar to those of traditional banks but that are less regulated. They are kept less regulated because they do not receive deposit from the public. How do they provide bank-like services without accepting deposit? Let us explain it with a simplified example.
Suppose that an investor availed margin loan from a broker to purchase a security. The security is kept pledged to the broker against the margin loan. The broker can use the pledged security to enter into a repo (repurchase agreement) transaction with a pension fund which have excess fund to invest for a short period. The pension fund can deposit the excess fund in a bank but the return of such short-term deposit is not attractive. So, pension fund searches for alternative profitable avenues for investment with equal importance on safety of the fund. If it enters into repo transaction with the broker, it will be able to invest its short-term fund more profitably that is secured by repo security. In this case, the pension fund is called repo lender, the broker is called repo borrower and the security of the repo transaction is called collateral. Thus, a bank-like transaction is made in the shadow banking system and leverage is created.
The shadow banking system created excessive leverage by entering into a huge number of such contracts in the period prior to the financial crisis. The asset size of shadow banking system in the USA was even higher than the formal banking system at that period. Mortgage Backed Securities (MBS) were popularly used as repo collateral in these transactions. MBS are created by pooling mortgage loans and selling them as security. The sale of mortgage loan increases the availability of fund for extending further loan. The demand of MBS as repo collateral in pre-crisis period caused more securitisation of mortgage loans and the loanable fund for house purchasers increased markedly. The availability of loan increased the home prices excessively.
In 2007, the overpriced housing market started to decline in the US. Consequently, the price of the mortgage-backed securities started to fall due to fear of increase of default by the home owners (borrowers). As a result, the repo lenders started to refuse to lend money against such securities. The securities had to be forcedly sold out to pay the repo lenders money. The sale pressure of the securities further reduced the price of the same and the loop continued to worsen the scenario day by day. Â
Like the shadow banks, the formal banks also accumulated excessive leverage in their balance sheet while maintaining necessary risk-based capital ratio. The de-leveraging process and the price slump in the shadow banking system greatly affected these banks. They were compelled to reduce their leverage in a forced manner that caused huge losses, reduced capital ratio and contracted the availability of the credit in the economy.
It is apparent that the excessive leverage of the banks contributed to the crisis. Even the banks maintained necessary risk-based capital ratio. It means that capital ratio alone is not sufficient to protect the stability of financial sector. As such, Basel III introduces a simple, transparent, non-risk-based regulatory Leverage Ratio to constrain leverage in the banking sector and supplement risk-based capital ratio as a safeguard against model risk. The leverage ratio is calculated by dividing tier 1 capital with total exposure.
SUBSTANDARD QUALITY AND INADEQUACY OF CAPITAL: Another reason of failure of banks to withstand the shock of financial crisis was substandard quality and inadequacy of capital. The capital of the banks lacked good proportion of high quality capital like common share and retained earnings in the pre-crisis period. Short-term subordinated debt was used as tier-3 capital which did not have the strength to provide support during the prolonged crisis. Rather these debts matured within a short period of time and banks faced extra pressure to redeem the debts. At the onset of crisis, the banks made large distributions of capital in the form of cash dividend, share buy-back and generous compensation with the market signaling that they are sufficiently strong, which actually weakened the position of the banks.
To increase the quality and quantity of the capital base of the banks, Basel III has introduced the following measures:
i) Tier 1 capital has been divided into two parts: Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1). Minimum Tier 1 capital requirement has been set at 6 per cent out of which CET1 is 4.5 per cent and AT1 is 1.5 per cent. However, minimum capital requirement has been kept unchanged from Basel II.
ii) The definition of capital has been made stringent. Tier 3 capital has been eliminated.
iii) A buffer CET1 capital named Capital Conservation Buffer has been proposed @ 2.5 per cent in addition to the minimum capital requirement. Restriction has been put in distribution of profit (cash dividend and discretionary bonuses to staff) until the buffer is developed. Â
iv) In addition, the banks are required to deduct goodwill and other intangible assets, deferred tax asset, shortfall in provision, defined benefit pension fund assets and liabilities, investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10 per cent of bank's capital, investment in own share, gain on sale related to securitisation transactions etc. from their capital.
Insufficient liquidity buffer is the third point of our discussion regarding the reasons of financial crisis. The banks excessively relied on short-term low-cost funding to create long-term assets. They also failed to maintain high-quality long-term assets to stand out the stressed condition. During the crisis, they faced much difficulty to meet the liquidity needs, which necessitated intervention from the central bank. The crisis revealed that supervisory standard on liquidity is of equal importance as capital to maintain stability of the financial sector. Accordingly, Basel III introduced liquidity standard as a complement to the capital standard.
LIQUIDITY COVERAGE RATIO (LCR) AND NET STABLE FUNDING RATIO (NSFR): Basel III developed two minimum standards for liquidity which supplement the BIS's 'Principles for Sound Liquidity Risk Management and Supervision' published in 2008. These are Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The objective of LCR is to promote short-term resilience of a bank's liquidity risk profile by ensuring that it has sufficient high-quality liquid asset to survive a significant stress scenario lasting for one month. The objective of the NSFR is to promote resilience over a time horizon of one year by requiring banks to fund the activities with more stable sources of funding.
Now, let us focus how pro-cyclicality deepened the crisis. Pro-cyclicality favours the banking system at the buoyant period but adversely hit at the time of crisis. When the economy runs well, banks' capital rises from higher profit and lower provision requirement. The amount of risk weighted asset becomes low as the borrowers earn favourable rating owing to optimistic economic outlook. As a result, banks can earn high credit growth supported by good capital ratio. As the economic scenario reverses, the banks' capital undergoes pressure from lower profitability coupled with increase of provision requirement. Risk weighted asset rises owing to lower rating by borrower. Consequently, banks capital ratio decreases, which compels them to reduce the lending activities. The resultant credit crunch adversely affects the economy and lengthens the crisis.
To address pro-cyclicality, Basel III suggested countercyclical buffer. This buffer varies from 0-2.5 per cent at the discretion of national supervisory authority. The buffer is to be built up at the time of high credit growth that may signal a build-up of system-wide risk and is withdrawn when such threat disappears. The other measure of the Basel Committee to address pro-cyclicality is to promote forward-looking provisioning by jointly working with the International Accounting Standard Board (IASB). As an outcome, the IASB has released complete IFRS 9 replacing IAS 39 last year to be effective from January 1, 2018. IFRS 9 contains forward-looking 'expected loss' impairment model for classification instead of 'incurred loss' approach of IAS 39.
COMPLEX TRANSACTIONS: Excessive interconnectedness among financial institutions also made the financial crisis so severe. Financial institutions were engaged in an array of complex transactions, which rapidly transmitted the crisis from one institution to another. To limit the interconnectedness among financial institutions, Basel III suggested a number of measures. These measures include: i) the bank's capital will be deducted for investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10 per cent of bank's capital, ii) Use of central counterparties has been encouraged in the over-the-counter derivatives, iii) Higher capital requirement has been imposed for derivative products and iv) capital surcharge has been made applicable for systemically important banks.
THE CASE OF ISLAMIC BANKS: Before we proceed to a discussion on the BB's guideline, we need to give attention to one issue: how Basel III is applicable for Islamic banks. It is important because the BB's capital
guidelines contain a separate section for Islamic banks.
The Islamic financial system has some uniqueness that should be properly addressed while formulating capital guidelines for Islamic financial institutions. Leverage, which played a major role in recent financial crisis, cannot be created excessively in this system. Islamic financial products should be linked with real economic activities like trading, production etc. These products cannot be based on another financial contract since Shariah restricts trading of debt and undue speculation. Besides, most parts of the fund collected by Islamic institutions are based on risk-sharing principle, which is equity in nature. Thus the leverage in Islamic financial system should remain limited and the system is not likely to trigger financial crisis similar to the recent one. Nevertheless, the Islamic financial institutions are subject to financial losses, may be to lesser extent than their conventional counterparts, from any crisis originated elsewhere in the global financial system.
At the same time, since the Islamic financial products are asset-based, they often carry market risk (probability of loss from reduction in market price) to some greater extent. They also have some other unique risks like displaced commercial risk (commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by mudaraba depositors).
Capital adequacy standard for Islamic financial institutions should address their uniqueness. At the same time, the standard should converge with international best practices like Basel framework, where applicable, as Islamic financial institutions are also part of the global financial sector. In view of the above, the Islamic Financial Services Board (IFSB), an international standard setting organisation for Islamic financial institutions participated by around 200 members including the BB, adapted and modified the Basel frameworks and issued several standards for Islamic financial institutions. IFSB-15 is the latest standard of IFSB on minimum capital requirement in line with Basel III which was issued in December 2013 and effective from January 1, 2015. IFSB also has liquidity guidelines (Guideline for LCR has been finalised and guideline for NSFR is under preparation).
One of the distinctive features of IFSB capital standard is that it elaborates the capital requirement both risk-wise and contract-wise. It discusses capital requirement for credit, market and operational risks. Besides, it identifies how financial assets based on musharaka, mudaraba, ijara, istisna,salam, murabaha, qard etc. involve the risks at different stages of these contacts. Another distinctive feature is that Risk Weighted Asset (RWA) funded by profit-sharing deposit accounts is excluded from total RWA after making some adjustments for displaced commercial risk. Additionally, since the Shariah-compliant financial products are asset-based, the pledged assets are allowed for credit risk mitigation- the method of reducing risk weighted asset by deducting collateral.
The writer is a Chartered Financial Analyst (CFA).
 anu.iba.34@gmail.com