Basel III: Scope for improving the Guideline

The Bangladesh Bank (BB) issued 'Guidelines on Risk-Based Capital Adequacy (Revised Regulatory Capital Framework for banks in line with Basel III)' vide BRPD circular no. 18 dated December 21, 2014 (hereinafter referred as Guideline for brevity). The final Guideline was preceded by a draft one. The draft was published in the BB's website for comments from the stakeholders. A number of changes have been made in final Guidelines in line with the feedback of the stakeholders. The BB deserves appreciation for this consultative approach.

Gradual implementation of Basel III in Bangladesh has started from January 01, 2015. But when will the full implementation of Basel III start - from the year 2019 or from the year 2020? The BB has provided conflicting information on it.

As per BRPD (Banking Regulation & Policy Department) circular 18 dated December 21, 2014, initiation of full implementation of Basel III in Bangladesh will start from January, 2020. Furthermore, according to reports in different national dailies, the BB Governor expressed his hope to ensure complete implementation of BASEL-III from the first day of 2020. On the contrary, it is mentioned on page v of the Guideline that Basel III capital regulations would be fully implemented as on January 01, 2019. After analysing the available documents, it appears that initiation of implementation of Basel III will, in effect, start from January 01, 2019 in Bangladesh since there is no difference in capital requirements for the years 2019 and 2020 as prescribed in the Guideline.

QUANTITY AND QUALITY OF CAPITAL: In line with Basel III, regulations related to quantity and quality of capital have been revised in the Guideline. A Capital Conservation Buffer (CCB) of 2.5 per cent is to be built up @ 0.625 per cent each year from the beginning of 2016 to 2019. This is in addition to existing Minimum Capital Requirement (MCR) of 10 per cent. Thus, for illustration, total of MCR and CCB requirements will be 10.625 per cent and 12.50 per cent as on January 01, 2016 and January 01, 2019 respectively. There is a difference between CCB and MCR from the legal point of view. If a bank fails to maintain MCR, the BB may impose penalty and restrict operational activities as per section 13 of the Bank Company Act, 1991. However, if CCB is not built up by a bank, there will be restriction in distribution of profit (cash dividend and discretionary bonuses to staff) and the bank will be allowed to carry out banking activities as usual. The severity of restriction on distribution of earnings will depend on level of shortfall. For example, if a bank has no CCB, it has to conserve 100 per cent of its earning while if it has slightly lower than 2.5 per cent of CCB, it has to conserve 40 per cent of earnings and rest 60 per cent can be distributed.

Minimum tier 1 capital requirement has been divided into two parts: Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1). Minimum tier 1 capital requirement has been increased from 5 per cent to 6 per cent, out of which minimum CET1 and AT1 requirements are 4.5 per cent and 1.5 per cent respectively. In Bangladesh, average tier 1 capital ratio presently maintained by banks is around 9.0 per cent. As such, banks should not in be trouble to maintain minimum tier 1 capital.

REVALUATION RESERVE: Definition of capital has been made stringent in the Guideline. In line with Basel III, Tier 3 capital has been eliminated. Revaluation reserve for fixed asset, securities and equities will be gradually eliminated. Elimination of revaluation reserve should draw due attention of the banking community.

Basel II explicitly allowed revaluation reserve. Basel III document, which only contains the areas of amendments of Basel II, does not say anything on elimination of revaluation reserve. So, it can be presumed that Basel III does not eliminate revaluation reserve. This presumption is supported by the fact that the Reserve Bank of India included revaluation reserves as a component of tier 2 capital. Thus, the elimination of revaluation reserve by BB may be considered as a conservative approach to enhance the quality of capital.

The BB has not provided the logic behind elimination of revaluation reserves. One reason may be that the revaluation of asset may not be done in a prudent and objective manner by banks. If so, it should not be considered as a basis for de-recognition of revaluation reserve. The revaluation of asset is subject to a set of regulations including the Bangladesh Accounting Standards, directives issued by the Bangladesh Securities and Exchange Commission (BSEC) and circular of the BB. Instead of de-recognition of revaluation reserve, proper implementation of these regulations should be ensured to confirm objective and fair revaluation of assets. Otherwise, the validity of deduction of eligible collateral value while calculating specific provision will also be under question.

A BIZARRE PROBLEM: Elimination of revaluation reserve will cause another bizarre problem. The increase of price of securities will not enhance the capital of the bank, but the capital requirement for these securities will increase. So, if the price of the securities increases, the risk becomes lower but the capital requirement becomes higher. The BB should allow partial recognition of revaluation reserves for equity and securities to compensate the increase of capital requirement under market risk.

Revaluation of fixed asset has been used by a number of banks to enhance their tier 2 capital. If revaluation reserve is eliminated, these banks will face greater challenges to meet their capital requirement.   

The banks are required to deduct a number of items from capital. The list of such items includes 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 etc.  The impact of the deduction of these items will vary from banks to banks. However, it can be assumed that the deduction for these items will be quite large for a large number of banks.

Deductions of goodwill and other intangible assets, deferred tax asset and shortfall in provision are not new. These were also subject to deduction in previous guideline in line with Basel II. As a new item, defined benefit pension fund liabilities may appear as a sizeable amount, especially for the aged banks which did not properly assess the liability earlier in line with BAS 19. The BB has allowed amortisation of such expenditure over five years from the beginning of 2015. This deductible item should get the highest attention of the bankers.

Another important deduction is investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10 per cent of bank's capital. This amount may also be sizeable one, especially for the banks having high stock market exposure with concentration of holdings in shares and securities of financial institutions. The BB has allowed phase-in of deductions of such items, which means that 100 per cent deduction will not be made from beginning of 2015. In 2015, 20 per cent of such amount will be deducted, which will incrementally reach 100 per cent in 2019. Such deduction can be managed relatively easily by banks by reducing exposure to the financial sector.

Investment of bank in its own shares may cause deduction of capital for some banks. Though the purchase of own share (treasury stock) is not allowed as per section 58 of the Companies Act, 1994, a bank may hold shares of mutual fund and the mutual fund may hold the share of the same bank. Such holding through mutual funds is also subject to deduction from capital.

LEVERAGE RATIO: The leverage ratio is not supposed to be a tough requirement for the banks of Bangladesh. Our financial sector has never indulged in derivative products. So, maintaining 3.0 per cent leverage ratio as per the Guideline should be easy for the banks.

The Guideline admits that Basel III promotes countercyclical buffer for protecting the banking sector from periods of excess credit growth but it has given no indication whether countercyclical buffer will be applicable for banks in Bangladesh or not. The Guideline is also silent regarding any special capital requirement for systemically important bank, if any.

The Guideline requires higher capital requirement for claims that are past due for '60 days and more', which was earlier required for past due for '90 days or more' in the previous guideline. This is not a requirement of Basel III. The BB did not provide any explanation in favour of such a shift to stringent regulation. However, this will increase capital requirement of banks to some extent.

The BB has introduced Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) as minimum standards for liquidity in line with Basel III. Earlier, the BB obtained data on these ratios from banks for quantitative impact study. Though BIS has followed graduated approach in implementation of LCR to avoid any material disruption, the BB made it fully obligatory from September, 2015 without any phase-in period. It is a matter of observation whether banks can succeed in fulfilling the liquidity requirements immediately. The BB has issued 'Guidance Note on Liquidity Coverage Ratio (LCR) & Net Stable Funding Ratio (NSFR)' vide DOS circular no. 1 dated 1 January 2015 in order to facilitate reporting process. Though LCR and NSFR are applicable from September, 2015 as per the Guideline, DOS circular states that these will be applicable from January, 2015. So, there is conflicting information in DOS circular. Banks are advised in the DOS circular to develop methodology to determine their own 'run-off factors' and 'weight factors' for future use, which are useful for calculating LCR and NSFR.  

ANOMALIES: There are a few anomalies in the Guideline. We believe that these are inadvertent mistakes. On page 10 of the Guideline, tier 1 capital requirement has been mentioned as 7.0 per cent, which should be 6 per cent. In sl. m of Table 9: Risk Weights for Balance Sheet Exposure, 'gross of specific provision' has been mentioned in lieu of 'net of specific provision'.

The scope of market disclosure under pillar 3 has been increased. Disclosures on Leverage Ratio, Liquidity Ratio and Remuneration are newly added to the Guideline. Disclosures on remuneration require special attention of the banks.

CAPITAL STANDARD FOR ISLAMIC BANKS: There is one important issue: capital standard for Islamic banks. Previous capital guideline of the BB (as per Basel II) contained a separate section for Islamic banks. Considering the uniqueness of Islamic banking, such a separate rule was justified. The section was formulated in line with IFSB 2, a customised capital standard for Islamic financial institutes in line with Basel II. However, the section has not been updated in latest Guideline of the BB in line with IFSB 15, a customised version of Basel III for Islamic financial institutions. Being a full member of IFSB, the BB set out the objective of 'reviewing existing regulatory and supervisory practices of Islamic banks in light of international standards drawn up by IFSB' in its Strategic Plan (2010-2014) as a near term priority. It would have been appropriate to review the capital standard for Islamic banks in line with IFSB 15. Furthermore, the existing rule is incomplete and has become ineffectual in the absence of implementation by the BB. The BB does not enforce this separate provision of Guideline for Islamic banks. Rather the same standard of conventional banks is applied to Islamic banks. This writer had an opportunity to ask a top official of the BB for not enforcing the separate capital standard of Islamic banks. He replied that the implementation required revision of present financial reporting framework of 'Guidelines for Islamic Banking'. We have no information whether the BB has taken any initiative for upgrading the guidelines. If the answer is negative, it is high time that the BB took proper steps to review and update the supervisory guidelines for Islamic banks.  

THE CHALLENGES: There are some challenges that banks are likely to face during the implementation of Basel III:

i) Capital requirement of the banks will increase owing to capital conservation buffer (CCB). In case of failure to maintain CCB, there will be restriction in distribution of profit in the form of cash dividend and discretionary bonuses to staff.

ii) Elimination of revaluation reserve will reduce the capital positions of some banks,

iii) Defined benefit pension fund liabilities may appear as sizeable one, especially for the aged banks which did not properly assess the liability earlier in line with BAS 19. This item should get the highest importance of the bankers,

iv) Deduction of investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10 per cent of bank's capital will reduce the capital position of some banks. Such deduction can be managed relatively easily by reducing exposure to financial sector,

v) Investment of bank in its own shares through mutual funds is also subject to deduction from capital. Banks shall have to look through holdings of mutual fund securities to deduct exposures to own shares,

vi) Higher capital requirement for claims that are past due for '60 days and more' instead of '90 days or more' will increase capital requirement of banks to some extent,

vii) Banks have to develop methodology to determine their own 'run-off factors' and 'weight factors' for calculating LCR and NSFR, and

viii) Disclosures on leverage ratio, liquidity ratio and remuneration are newly added to the Guideline. Disclosures on remuneration require special attention of the banks.

SUGGESTIONS: The Bangladesh Bank has done a good job. The efforts to formulate a comprehensive capital and liquidity standard are laudable. However, there always remains a scope for further improvement. Here are some suggestions to the BB for further improvement of the Guideline:

i) The BB should clarify when the full implementation of Basel III will start - from 2019 or from 2020?

ii) Instead of elimination of revaluation reserve for fixed assets, proper implementation of regulations on revaluation of assets should be ensured to confirm objective and fair valuation,

iii) The BB may allow partial recognition of revaluation reserves for equity and securities to compensate the increase of capital requirement under market risk,

iv) The BB should clarify when liquidity standards will be applicable - from September 2015 or from January 2015,

v) The BB may follow graduated approach of implementation of LCR and NSFR to avoid any material disruption, if likely,

vi) The BB may clarify its roadmap on countercyclical buffer and special capital requirement for systemically important bank, if any,

vii) Higher capital requirement should be imposed for past due for '90 days and more' instead of '60 days or more' in line with Basel framework,

viii) The errors on page 10 (mentioning tier 1 capital requirement as 7.0 per cent instead of 6.0 per cent) and in sl. m of Table 9: Risk Weights for Balance Sheet Exposure (mentioning 'gross of specific provision' in lieu of 'net of specific provision') should be rectified, and

ix) Capital and liquidity standards for Islamic banks should be updated and implemented in line with IFSB 15 to reflect the risk exposure of Islamic banks.

The writer is a Chartered

Financial Analyst (CFA).

[email protected]