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Balance between Regulation and Growth - Implementation of Basel III in Asia
Andrew Sheng
President, Fung Global Institute
Advanced Programme for Central Bankers and Regulators on Basel III
17-19, January 2013
The Chinese University of Hong Kong
Institute of Global Economics and Finance
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Financial Reform Landscape remains Complex
Source: E&Y. Financial Regulatory Reform - What it means for bank business models, November 2012.
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Financial Regulatory Reform
• Ensure that tighter standards, such as higher capital and
liquidity requirements, do not choke off the global recovery.
• Support the development of a global mechanism for managing
volatile short-term capital flows, and development of
macroprudential surveillance and regulation at the national and
regional levels.
• Establish an effective regulatory framework for
macroprudential supervision and regulation at the national and
regional levels.
Source: Asian Development Bank Institute, Policy Recommendations to Secure Balanced and Sustainable
Growth in Asia, October 2010.
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Asian Voice and Interests
• There needs to be an Asian voice on financial reform and regulation
rather than allowing the debate on issues to be dominated by a
perceived choice between American and European approaches.
• A “one-size-fits-all” approach is inappropriate due to differences in
financial systems, stages of development and banking industry
practices, and may lead to excessive burdens in areas such as
capital and liquidity adequacy requirements and leverage ratios.
• In addition, there is a risk of spillover effects from developed country
regulatory changes and low-interest-rate policies that lead to
migration of risky financial activities to Asia that could affect regional
financial stability.
• Asian leaders should consider sponsoring their own research on the
impacts of the new regulations on Asian financial institutions and
markets.
Source: Asian Development Bank Institute, Policy Recommendations to Secure Balanced and Sustainable
Growth in Asia, October 2010.
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Key Points
• We need to put the Implementation of Basel III in Asia within the proper context.
• Post-2007 Global Financial Crisis, Basel III is an important standardization of
minimum capital and liquidity standards for global banking.
• This is a NECESSARY, but NOT SUFFICIENT CONDITION for global financial
stability, because Financial Stability Board and national regulators have only just
begun to address SHADOW BANKING, or non-bank financial intermediaries, risk
issues. Although important, banks account for 43.1 percent of global financial
assets as at the end of 2011, whereas stock market capitalization and bond markets
(excluding derivative financial assets) account for more than half of financial sector
risks.
• Hence, to obtain overall financial system stability, we need to look also at real sector
imbalances, monetary and fiscal policies, and interconnectivity and feedback
mechanisms between financial sectors (banks and shadow banks) as a systemic
whole.
• We must never forget that Finance must serve the Real Sector, not the other way
around.
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Key Questions
• What are Basel III’s main impact on (1) banking system and (2)
growth and overall credit?
• While Basel III are Minimum conditions for capital and liquidity,
do the complex calculations on risk weights impair or
disadvantage EME banks?
• Which parts of Basel III should be priority for implementation?
Should we move out of standard risk-based model towards
Internal Risk-Based (IRB) models?
• What areas of structure (shadow banking), financial
infrastructure and other issues should we consider ( Basel III
included as part of package) for financial system stability?
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Contents
• Introduction
• What are the key issues and concerns?
• Role of Asia finance in rebalancing Asia’s Growth
Model
• Conclusion
Appendix: Amendments to the Liquidity Coverage Ratio (LCR)
and the new BCBS Charter; and CRR4
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Introduction Section 1
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Asia finance must be there to serve the real sector
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Asian banks are the primary providers of funding for private sector growth
Asia’s shift towards a domestic and regionally-driven engine of growth would require continuous funding from Asia’s bank-dominated financial system
However, Asia faces funding issue under Basel III rules that would reduce the incentive for banks to lend to trade finance and SMEs, and discourage long-term lending for infrastructure at a time when this is critical for Asia’s sustained growth
While Basel III requirements on higher capital adequacy, enhanced liquidity and an overall leverage cap are commendable, the detailed rules on liquidity and risk-weighting may restrain the funding capacity of Asian banks
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Banking sector has to adjust to unprecedented regulatory change
Source: McKinsey. The Triple Transformation, October 2012.
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Global capital markets business also has to adjust to regulation
Source: McKinsey. The Triple Transformation, October 2012.
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Need for adaptive business models to seize new growth trends
Source: McKinsey, BCG.
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Going to where the new trade corridors are
Source: BCG. The Transaction Banking Advantage, October 2012.
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Revamping payments value chain
Source: BCG. The Transaction Banking Advantage, October 2012.
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Need true banking transformation to improve financial metrics
Source: McKinsey. The Triple Transformation, October 2012.
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Need to reverse declining ROE due to lack of performance improvement and rising capital ratios
Source: McKinsey. The Triple Transformation, October 2012.
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Business model transformation – the basis for future growth • Capital markets business is most challenging due to regulatory
pressure, high funding costs, and shrinking revenues.
Source: McKinsey. The Triple Transformation, October 2012.
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The need for a balanced view, with appropriate “fit” for EMEs
1. Basel III was designed to address the causes of the 2007-2009
Financial Crisis in the advanced markets, aimed to resolve the
issue of under-capitalisation and over-leverage in the advanced
wholesale banking model.
2. Current Basel III on risk-taking governance requirements represent
substantial improvement in quality, quantity and comparability of
banks’ risk/reward profile. Asia needs that and supports Basel III.
3. However, there is substantial variation in quality of banks,
supervisors and regulators between more retail-based systems
(e.g., China, Canada, India, Australia) and wholesale systems (US,
UK and some EU countries).
4. Need for clarity on WHAT is National discretion? WHAT fits local
conditions and what is necessary to supplement Basel III
implementation to ensure overall systemic stability.
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Agree that under-capitalisation and illiquidity of internationally-active banks need to be solved
Figure 1. Ratio of Debt to GDP Among Selected Advanced Economics
(In percent, GDP-weighted, 1987=100)
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Do Basel III rules address the priority policy and real sector needs in Asia?
• While Asian banks can meet the current Basel III capital
requirements, it is not clear as Asia grows faster with higher
credit needs, whether there will capital constraints going
forward.
• Asian banks are at different stages of development and Asian
countries have different national imperatives.
• Capacity of Asian banks to implement Basel II/III vary hugely
between banks, especially the smaller and non-internationally
active banks.
• Europe is expected to have the largest shortfall of over €272
billion in meeting Basel III capital requirements, and the US
may have a shortfall of $60 billion.
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Tighter financial conditions resulting in capital shortfalls, in turn worsening the real economy
Source: IIF. “The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework”. September 2011.
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Basel 2.5/III uses Risk Weighting and Models to assess Risks
• Advanced country banks have high sovereign ratings and have
experience in Internal Risk Based (IRB) Models which assign
lower risks, if banks can prove with data.
• Asian banks are less sophisticated and rely on standard
model, and because sovereign credit ratings are lower, and
Asian banks do not have good risk data, they automatically
have higher capital costs relative to European banks (see next
Slide).
• Example:
For top ASEAN banks For top European banks For top American banks
• Basel III’s CET1 =
average of 10.7%
• Basel II’s CT1 = average
of 11.5%
• Basel II’s CT1 average =
10.2% (one bank has an
average of below 7%)
• Basel III’s Tier 1 Common
Ratio average = 8.4%
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Asian banks disadvantaged with the use of sovereign credit rating
• Much more capital needed to support the same amount of
loans or bonds (based on S&P risk weights, ASEAN+3 banks
will need 300% more capital).
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Asian banks have high RWA relative to total assets
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Top banks in Asia
Country Largest Bank Total
Assets ROA
% CAR
(Tier 1 %) CAR
(Total %) Cost to Income
% LTD Ratio
%
Germany Deutsche Bank 2805.29 0.20 12.90 14.50 82.83 68.55
France BNP Paribas 2547.68 0.31 11.60 14.00 NA 121.88
US J.P. Morgan 2265.79 0.84 12.30 15.40 64.70 64.17
US Citibank 1873.88 0.59 13.60 16.99 65.00 71.25
Japan Mitsubishi UFJ 2603.95 0.19 12.31 14.91 NA NA
China ICBC 2476.30 1.35 10.07 13.17 29.91 63.50
Hong Kong HSBC 1333.03 0.28 9.10 14.40 66.20 83.20
Singapore DBS 279.49 0.89 12.90 15.80 43.30 86.40
South Korea Kookmin Bank 238.62 0.80 10.14 13.09 NA 105.00
Malaysia Maybank 135.96 1.08 11.84 15.36 49.60 90.10
Taiwan Bank of Taiwan 135.74 0.09 10.50 11.38 NA 67.61
India ICICI Bank 94.73 1.61 12.70 18.50 42.91 76.10
Thailand Bangkok Bank 68.69 1.30 12.21 15.35 NA 92.60
Indonesia Bank Mandiri 56.66 2.23 14.90 17.20 41.60 74.10
Philippines Banco de Oro 26.84 0.95 10.00 15.80 67.90 66.73
Source: The Asset, Volume 14 Number 11, December 2012.
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Whither Basel III for Asia?
• The US has postponed implementation of capital rules for the year 2013
and delayed implementation of liquidity rules. Pressure to delay the start
date was due to concerns over the complexity of the rules and the cost to
banks at a time of weak global economic growth.
• Europe is also re-considering and the Bank of England has expressed
concerns on the complexity of the rules, especially since bank supervision
is returning to the Bank of England.
“Rather than pushing through a flawed Basel III, we need to take the time to
do it right so we do not have to do it over. … Basel III’s implementation has
been postponed, and that offers a real chance to get it right. If we do, we
won’t need Basel IV” – Thomas M. Hoenig, 2012*
As a result, Basel Committee announced agreement on Liquidity Rules with
a delayed phase in period.
* Get Basel III right and avoid Basel IV. http://www.ft.com/intl/cms/s/0/99ece1b0-3fa0-11e2-b2ce-
00144feabdc0.html#axzz2HRMF1qU1
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What are the key issues and
concerns?
Section 2
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Emerging Market banks find it currently easier to meet Basel III requirements
Figure 2. International Comparison of the Financial Liabilities/Assets Ratio
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Asia has its own national banking development agenda and time frame
• The extensiveness of the rules will have tremendous
implications on re-shaping and micro-managing the business
models of banks locally, regionally and worldwide.
• This raises the question of whether national regulators should
be given more discretion to adjust their regulatory and
supervisory guidelines in line with the Basel principles in a
manner that suit their national banking development agenda
and time frame.
• BCBS has now created a small team to look at “simplifying
Basel III”. This is the time to engage BCBS through Asian
regulators which can influence the final outcome, especially
those which are represented either at G20 or FSB/BCBS
levels.
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Implementation of Basel III will have costs on all banks, global or local
Constrained credit
provision by Emerging Market banks
Retrenchment and deleveraging by global
banks
Risk of synchronised slowdown globally if Asian growth also
constrained by limits on credit
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Issue 1: Potential trap of synchronized recession
• If the unintended consequences of implementing Basel III are
to slow Asian growth because of the limited capacity of the
banking system to support the growth of the real economy,
especially for SMEs, trade and infrastructure finance, then the
whole world may be trapped in a policy-induced unintended
synchronized recession.
• Solution: Each Asian country should study what are the credit
needs projected to 2020 and see if addition capital would be
required to meet the new credit needs.
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Issue 2: Risk-weightings biased against Asian banks
• Basel capital rules favour banks that have developed
“advanced risk models” for determining risk-weighted assets
(RWA). Asian banks are some 10 years behind in this respect.
Hence, they will not be able to use efficient conversion factors
even if they are given a transition period up to 2019.
• Solution: Each Asian country will have to develop better data-
bases on credit history in order to re-calculate the risk weights;
this will enable the larger banks to move toward Internal Risk-
Based models with their own risk weights.
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Issue 3: Credit ratings biased against Asian banks
• The Basel III risk-weightings are based on current sovereign
credit ratings.
• Asian economies (and by definition, Asian banks) have lower
credit ratings, even though their sovereign debt has high
foreign exchange backing (up to 50%) and Asian economies
have higher savings and lower fiscal debt.
• Many Asian banks are state-owned, thus the urgency to raise
large capital cushions is not as imperative as the European
case.
• Solution: Asia should consider creating Mutual (owned by
users and industry) not-for-profit Credit Rating Agencies that
can give ratings that are more objectively based. This will
provide competition to current top 3 that have become TBTF.
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Issue 4: Liquidity risk framework not directly relevant to Asian banks
• The Basel liquidity risk framework aims to restrain the balance
sheets of banks which: (1) are highly leveraged; (2) have
significant maturity mismatches; and (3) are funded mainly by
the wholesale markets.
• However, Asian banks generally do not fall within any of these
three categories because they have large deposit bases, the
population has high savings rate, and the fiscal and balance of
payments positions at the national level are much more robust.
Solution: Asian banks should work with central banks to
examine how domestic liquidity can be provided in manner
which would not create a ‘rush for funding’.
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Basel liquidity rules vs. Asian situation
• High loan-to-
deposit ratios
• High leverage
• Flexible exchange rates
• Substantial liquid assets
• Low nominal leverage
With low fiscal debt and high foreign
exchange, limits on loan-to-deposit
ratio, Central Banks can easily
provide liquidity to domestic banks.
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Issue 5: Asia has huge need for infrastructure funding
• The detailed rules on liquidity, risk-weightings and leverage
may constrain the capacity of Asian banks to fund
infrastructure since there is growing maturity mismatch risk.
• Furthermore, Basel III rules also make asset securitization
more expensive.
• The ADB estimates that US$8 trillion will be required to finance
infrastructure, creating massive potential for the development
of Asian municipal and infrastructure bond markets.
• Solution: Develop Asia’s fixed income markets through asset
securitization. This would help to lessen the maturity mismatch
in bank balance sheets [e.g., Cagamas and HKMC].
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Large interest in infrastructure financing
• Asia is at the early stages of securitized debt markets.
• China also needs mortgage securitization to reduce maturity
mismatch, particularly through bond market.
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Issue 6: Trade finance is Asia’s lifeblood
• Trade finance business is forecast to grow at 9% annually to 60% of
all global trade by 2020, with one leg in Asia.
• Solution: Central banks should incentivise banks to promote trade
finance and consider establishing a “Trade window” for real market
transactions.
Trade finance underpins 30–40% of the lending SMEs received. It forms the most relevant part of working capital financing
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How to ringfence trade finance in times of crisis
• Central bank could offer low-cost liquidity to commercial banks,
against “ringfenced” portfolios of trade assets.
• Public entity could purchase trade and hold trade assets
directly.
• Public entity could “guarantee” specific trade obligations, to
support a liquid market in trade assets.
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Basel III’s impact on trade
BAFT-IFSA: Basel III may raise trade finance
costs by 18-40%
Demand for trade finance rising rapidly
* BAFT-IFSA, Basel III-Impact on Trade, Tod Burwell, November 2011, Washington, D.C.
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Issue 7: Asia’s SME development drive and job creation
• Asia is at the cusp of an SME development drive to promote job
creation, innovation and market competition. SMEs rely heavily on
trade finance and short-term bank credit, they account for 80-90% of
job creation to address employment and equity challenges.
• Both European Commission and UK recognize that lending to
SMEs, though carrying higher credit risks, have large social benefits
in terms of growth and employment generation.
• The net effect of higher risk-weights on SMEs and higher costs and
lesser credit to SMEs may generate exactly the economic slowdown
that creates higher risk for the banking system.
• Hence, policymakers have to weigh the positive spillover effects of
SME health vs protecting banks against credit risk.
• Solution: Policy-makers should work alongside private sources of
equity to meet SME financing needs.
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Lending to small enterprises still lower than medium and large enterprises
Figure 3. Growth Rate of Outstanding Loans Extended to Large Enterprises, Medium
Enterprises, and Small Enterprises
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Access to finance is a major problem for SMEs
• A ECB survey shows that access to finance is perceived as the
second most pressing problem for SMEs, after their order
book.*
• Accordingly, the European Banking Authority (EBA) is
examining a proposal by the European Parliament to adjust the
risk-weights for lending to SMEs, and an increase in the
threshold of EUR2 million for the Standardised Approach and
EUR5 million for the Internal Ratings-Based (IRB) Approach.
* European Central Bank, Survey on the Access to Finance of SMEs in Euro Area, April 2012.
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We are in a self-fulfilling vicious cycle
SME have high
risks
We do not lend to SMEs
SMEs will not be able to grow
Economy will slow
down
Risk-weighting increases
risk
We have to distinguish the positive externalities of SMEs, trade finance, infrastructure, which creates jobs and future growth, from the negative externalities of fast trading, high leverage, things that will destroy the economy systemically
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Issue 8: Implementation cost on banking operations
• Lastly, the implementation of complex Basel III rules will result in
Asian banks incurring disproportionately large costs.
• Asian banks are still in the process of implementing Basel I and II
(and 2.5); and yet they are now burdened by Basel III.
• Asian banks’ expertise and experience are scarce.
–Whether scarcity management and regulatory resources should be
focused on developing a banking system that supports and fits
Asian realities, rather than “one-size-fits-all” rules designed for
implementation by advanced countries.
• Global banks have the capacity to absorb these costs but not the
smaller national banks in Asia, which are at different stages of
development.
• Solution: Asian banks should review their business models that can
help generate new revenues to help fund these costs.
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Non-Bank Assets (NBFI or shadow banking) more than Bank Assets
• Regulatory arbitrage from banks to shadow banks more than bank
assets.
• Contagion can occur between banks and shadow banking. Risk are
not just in banks.
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Basel Rules are not law and do not have legal force
• Whilst national regulators need to use Basel III as standards,
the total national requirements and law are still paramount.
Source: BIS. Group of Governors and Heads of Supervision endorses revised liquidity standard for banks http://www.bis.org/speeches/sp130106.htm
“3. Legal Status. The BCBS does not possess any formal supranational authority. Its decisions do not have legal force. Rather, the BCBS relies on its members' commitments, as described in Section 5, to achieve its mandate.” - New Basel Committee on Banking Supervision (BCBS) Charter, January 2013
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Role of Asia finance in
rebalancing Asia’s Growth Model
Section 3
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What do we mean by “Rebalancing”?
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National rebalancing must address mismatches and gaps
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Impact of rebalancing on non-reserve currency countries