Middle East banks may face major challenges from Basel III

by  — 25 January 2015

 The Basel III standards on banks’ capital adequacy, stress testing, and market liquidity risks were formulated in 2010-11 by the Basel Committee on Banking Supervision specifically to prevent the type of Western banking crisis that erupted in 2007-08, and led to the global financial crisis, happening again. However, its tangential effects on banks in the [...]

 The Basel III standards on banks’ capital adequacy, stress testing, and market liquidity risks were formulated in 2010-11 by the Basel Committee on Banking Supervision specifically to prevent the type of Western banking crisis that erupted in 2007-08, and led to the global financial crisis, happening again. However, its tangential effects on banks in the Middle East will also be profound in the run-up to the final implementation of the standards on March 31,  2019.

“For forward-looking banks, the Basel III requirements can be much more than an administrative burden and a drag on growth and profitability; rather, financial institutions should consider the new rules as a catalyst to upgrade their capabilities and as a call for thoughtful, balanced improvements of their risk-return profile,” Daniel Diemers, partner with global management consultancy Strategy&, in Dubai, told The Edge. He added: “This will benefit the region not just during times of financial crisis or market dislocation, but for decades to come.”

The most publicised part of Basel III has broadly been its primary goal of increasing the level, quality, and global consistency of regulatory capital, and to standardise the corollary requisite deductions and adjustments. According to the standard, each bank’s Tier 1 capital should enable it to absorb losses while remaining a going concern and, in this context, it categorises Tier 2 capital as a ‘gone concern’ reserve to protect creditors in the event of an insolvency, and abolishes Tier 3 capital altogether. It also states that Tier 1 capital should predominantly comprise common equity and retained earnings, with a tighter definition of common equity Tier 1. In practical terms, says Diemers, for Middle East banks, these requirements place greater emphasis on them holding high-quality liquid assets (HQLA), such as government debt. Currently, the Middle East debt markets are not consistently deep enough to provide that sort of liquidity – although this may change before 2019 – and, although the region’s central banks have never failed to step in to provide liquidity during times of stress, counterparties (especially foreign) may become far less tolerant of banks that rely on implicit support rather than real balance-sheet liquidity.

With that said, specifically for Islamic banks in the region, Mohamed Damak, global head of Islamic Finance for global ratings agency Standard & Poor’s, in Paris told The Edge, the revision of the capital definitions are unlikely to have a major impact on their quality of capital, as most of their capital already comprises common equity. “The recourse to Tier 2 capital instruments – primarily subordinated sukuk issuance – has been limited over the past 10 years. Tier 3 capital instruments are nonexistent,” he said, “and over this period, Islamic banks have issued USD86.1 billion (QAR313.4 billion) of sukuk in total, USD6.2 billion (QAR22.6 billion) of which comprised Tier 2 instruments issued mainly by banks in Saudi Arabia, Malaysia, and Turkey.” It may well be, he adds, that the HQLA issue for the region’s banks as a whole may be at least partly addressed by central banks, the International Islamic Liquidity Management Corporates (IILM), and the Islamic Development Bank (IDB).

This follows the lead of the Central Bank of Malaysia, which in recent years has tackled the HQLA problem by becoming the largest issuer of short-term sukuk that have provided Malaysian Islamic banks with much needed liquidity management instruments. “Basel III implementation may encourage highly-rated sovereigns and corporates to list their sukuk on developed and liquid markets to make them eligible for HQLA inclusion,” he concluded.

It is not just the quality of capital, though, that underpins Basel III, but also the quantity, with the new standards calling for a bank’s minimum capital to assets ratio (CAR) expected to be in the 15 to 18 percent range, with systemically important financial institutions (SIFIs) to be at the very top end of that band. Although the impact of this ratio on Middle East banks is likely to be less significant than on their United States or European counterparts, said Strategy&’s Diemers, the higher requirements, combined with more stringent definitions of capital, mean that they will need to raise substantially more capital if they want to continue on their current growth trajectory, or make some tough decisions about where they want to grow and where they can rein in growth.

In this context, the firm’s analysis of 22 banks in the Gulf Cooperation Council (GCC) and the Levant (Jordan and Lebanon) found that by 2019, Middle East banks that do not address the new capital requirements will find themselves with capital adequacy ratios ranging from shortfalls of -10.4 percent to excesses of +10.5 percent of Basel III minimums. “Fast-growing players in Qatar, Kuwait, and the Levant will be the hardest hit, as any growth in assets requires accompanying growth in Tier 1 capital to meet new standards,” Diemers told The Edge. “By contrast, countries that have witnessed relatively slower growth in recent years – including Bahrain, Saudi Arabia, and the United Arab Emirates – will have little difficulty meeting or even exceeding required CAR if they continue along that trajectory.” Even in this latter respect, he says that, the new capital requirements will hinder their growth if they want to ramp up regional and international expansion, and consequently they too would need to rethink their business and asset mix with an eye to strategic capital requirements.

 

 

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