Frankie Phua, Managing Director, Head Group Risk Management at UOB, explores the Basel updated, the final changes and gives guidance on the regulatory requirements Frankie is also speaking on the regulatory reforms at RiskMinds Asia, in Singapore this October.
Against the backdrop of the avalanche of post-crisis Basel regulations that have been issued over the last few years, will the finalisation of the Basel III Post-Crisis Reforms (aka. “Basel IV” by industry) in December 2017 mark the end of regulatory uncertainty for financial institutions?
The journey to finalising “Basel IV”
Issued on December 2010, the Basel III framework is notably the anchor of the Basel Committee’s response to the global financial crisis, with the goal of promoting a more resilient banking sector through strengthened global capital and liquidity rules. The changes revolve around 5 broad principles:
- Higher minimum capital requirements
- Improved quality, consistency and transparency of regulatory capital
- Improved risk capture, including but not limited to fundamental review of trading book, credit valuation adjustment (CVA) capital charge
- Introduction of capital buffers with a macro-prudential focus
- Expansion of risk metrics to include leverage and liquidity requirements
The Basel III framework was heading in the right direction; increased banks’ capital levels and improved risk coverage while maintaining overall risk sensitivity. This is until the Basel Committee published a consultation paper on Reducing Variation in Credit Risk-Weighted Assets – Constraints on the Use of Internal Model Approaches (i.e. “Basel IV”) in March 2016. The distinctive feature of the revisions introduced is to reduce risk weights variability for harmonising capital computation, purportedly to restore the lost faith of stakeholders in the reported capital ratios in the recent crisis.
While it is a grandiose plan to reform the financial markets, the consultation paper was plagued with criticism and wide-spread concerns, ranging from the restrictive application of internal models, skyrocketed credit conversion factors for off-balance sheet exposures, to the worrying capital output flooring of 90%. After nearly two decades since the Basel II framework has successfully transformed the financial markets to increase risk sophistication, the consultation paper brings back reminisce of where we first began our journey, Basel I.
Fortunately, common sense has prevailed and the final set of “Basel IV” reform measures has largely preserved risk sensitivity and coherence, but not losing sight on its objective of strengthening the post-crisis banking sector. These are witnessed by the following changes in the finalisation of the “Basel IV” framework from the initial consultation paper:
- Attenuate the narrow application of internal models for credit risk for bank, large corporate and specialised lending asset classes
- Scaled-back increase in credit conversion factors for commitments
- Phase-in approach for imposing output floor of 72.5%
Looking at the Broader Economy
Beyond financial stability, it is imperative to assess how the cost of regulation can potentially affect financial intermediation and the impact on the broader economy.
Firstly, the revised standardised approach has lowered the risk weight for unrated corporate SME from 100% to 85%, encouraging lending to a segment that plays an important role in boosting economy, especially in the post-crisis period. Notwithstanding that, banks are likely to increase its demand for financial collaterals and guarantees in tandem, to meet credit risk mitigation eligibility under the revised standardised approach that is more limited than the IRB approach.
In a post-crisis era, it is undeniable that the Basel Committee set out with the right intention to implement rigorous capital measures to prevent the recurrence of another financial meltdown.
Secondly, the upward revision to input floors and other limits on the model estimation for banks would make trade finance financing that typically rely on banker’s guarantees more costly, adversely affecting international trade. Similarly, this same effect may be felt in the specialised lending asset class, where infrastructure and development projects are largely financed by the banking sector.
Thirdly, under the revised standardised approach where risk weights for residential mortgage is dependent on loan-to-value (LTV), the current risk weight of 35% would only apply to exposures with LTV of less than 80% in the new framework. The cliff-effect introduced for exposures with LTV of more than 80% may help in curbing the excessive exuberance in property markets, particularly in Asia.
Closer to home, it is expected that the capital impact of the Basel III framework on Asian banks – and consequently the broader economy – are likely to be benign given the healthy capital ratios and light degree of reliance on internal models.
In a post-crisis era, it is undeniable that the Basel Committee set out with the right intention to implement rigorous capital measures to prevent the recurrence of another financial meltdown. However, we have to recognise the delicate balance between imposing high capital requirements to improve banks’ resilience against losses and the need for banks to be reasonably profitable in order to sustain a banking system and support economy growth. Over-bearing capital requirements on banks can have its backlash.
The industry is also coming to terms with the over reliance on risk models, which have become increasingly complicated to the extent of being over-engineered. Ultimately, risk management is not a physical science like physics, but more of an art requiring expert judgement. We should recognise that all models have limitations and are constrained by the many assumptions we use. Common sense and business sense should always prevail, rather than hiding behind the false comfort of complicated models to prove our points. Otherwise, it is the tail wagging the dog.