A Rethink Of Capital Requirements For Asian Banks?

The current financial crisis has placed pressure on banks in the US, Europe and the Asia Pacific region to review the structure of their businesses as well as their compliance with global standards. Bail out packages have been passed by governments in all three regions (albeit to varying degrees) in order to boost financial sustainability. The level of implementation of international financial standards is also coming under review, as governments and market commentators consider whether more stringent regulatory requirements are necessary.

Given the nature of the financial crisis and the risks it has highlighted, one of the key compliance issues to be addressed by regulators and banks is the level of capital reserves that banks should be obliged to keep. This briefing brings into focus this particular element of the suite of regulatory conditions that banks may be required to satisfy in order to weather the present storm. As the briefing acknowledges, banks in the Asia Pacific region may benefit from a privileged position compared to their peers in other parts of the world.

Bail out measures

In the global financial turmoil that began in the second half of 2007, the world has seen the failure of big names in the banking industry, including Bear Sterns and Lehman Brothers. Faced with what commentators have called the worst economic crisis since World War II, governments have acted to save their countries' financial systems, often by acting to save distressed banks. The US government has pledged about US$172bn out of a total US$250bn to a wide variety of banks and financial institutions, such as Goldman Sachs, Citigroup and JPMorgan Chase, including by way of subscription for preference shares¹. The UK government has also announced a capital injection of £37bn into the nation's major banks: £20bn into RBS and £17bn into HBOS and Lloyds TSB upon their successful merger. As a result, the banks will be partially nationalised; the government will have a 60 per cent stake in RBS and a 40 per cent stake in HBOS and Lloyds TSB. In continental Europe, the French government is injecting €10.5bn into the top six banks in the country and ING will receive €10bn from the Dutch state. The governments of other European countries such as Germany, Italy and Spain have also injected money into banks operating in those countries.

Bail out measures have also been announced in a number of countries in the Asia Pacific region, including Japan, Australia, South Korea, China and HK. In China, it is reported that economic stimulus measures worth RMB4,000bn (US$586bn), a sum which represents about 15 per cent of gross domestic product, will be taken over the next two years. As noted in BusinessWeek, the measures will be 25 per cent financed by central government and 75 per cent financed by provincial authorities, corporate investors and bank loans, and they will include massive spending on infrastructure, tax rebates for exporters and increased aid for the rural economy. Despite the broad scope of the measures, they do not appear to encompass the injection of new capital into banks. In Hong Kong, on the other hand, the Hong Kong Monetary Authority (HKMA) has taken steps to ease banks' short term funding pressures and provide assurances to the market about the availability of liquidity. As reported by Hong Kong's Information Services Department, until the end of March 2009 the HKMA will lend money for up to three months to individual licensed banks against collateral of acceptable credit quality and at a lower interest rate compared with the interbank rate. Chief executive Donald Tsang has also announced in his 2008/09 policy address that the HKMA will review and strengthen the supervisory framework for liquidity risk management of authorised institutions and will revise the methodology for calculating capital adequacy ratios in accordance with the latest international guidelines.

Challenges for the banks

The reason for the above bail out measures is of course that national banking systems are facing a number of challenges, of which three are explained in the Economist dated 11 October 2008. The first is one of solvency, as banks are struggling to replenish capital after suffering major losses. The second relates to long-term funding, as banks have not been able to borrow in the longer-term paper markets and have found it difficult to finance the share of their assets not covered by deposits. And third, there is a short-term liquidity problem. Banks have been cut off from their main source of liquidity as short-term money markets have been effectively closed. To address these inter-related issues, which the Economist has labelled a 'three-headed monster', various governments have committed taxpayers' money in order to recapitalise financial institutions. This will certainly improve banks' capital position, which is chiefly indicated by their capital adequacy ratio (CAR) and 'Tier 1' capital ratio, as discussed below.

Capital adequacy ratio and Tier 1 capital ratio requirements

Before 1988, there was no standard definition of capital. As central banks used different definitions of the term, it was difficult to compare the financial position of banks in different countries. In order to provide a level playing field, the concept of capital for regulatory purposes was standardised in the first Basel Capital Accord (Basel I). Basel I was formulated by the Basel Committee on Banking Supervision (the Basel Committee) at the Bank for International Settlements (BIS), an international organisation formed in 1930 to foster international monetary and financial co-operation and to serve as a bank for central banks around the world. Based on deliberations by these central bankers, Basel I provided a set of minimal capital requirements for banks whereby banks' assets are classified according to credit risk. Basel I has been widely adopted by over 100 countries, however it is now seen as outmoded compared to the more comprehensive second accord (Basel II), which was adopted by the Basel Committee in June 2004.

The two Basel accords make use of a bank's CAR, the ratio of a bank's capital base to its exposure to various risks, and a bank's different 'tiers' of capital as classified by reference to the capacity of each tier to absorb losses². Tier 1 (core) capital mainly consists of ordinary shares, irredeemable non-cumulative preference shares and disclosed reserves. Tier 2 capital mainly consists of subordinated debt and hybrid capital instruments. As Tier 1 capital is the 'highest' form of capital, the Tier 1 capital ratio has been called the 'purists' measure' of the cushion protecting against unexpected losses. Under the Basel accords, banks' benchmark Tier 1 capital ratio is 8 per cent. However, the Wall Street Journal has reported that according to UK analysts banks need to raise their Tier 1 capital ratio to 9-10 per cent in order to create an adequate buffer against future losses. The Economist has noted that a number of European banks, including RBS and Crédit Agricole, have recently raised their Tier 1 capital targets in preparation for a harsher economic climate and more stringent requirements by regulators.

In recognition that capital adequacy and Tier 1 capital requirements cannot be considered in isolation, Basel II incorporates the following three more holistic 'pillars'.

• Pillar I comprises a set of rules for calculating the CAR and Tier 1 capital ratio, taking into account operational, credit and market risks. A minimum CAR of 8 per cent is prescribed under Basel I and II, as mentioned above, however there is no minimum requirement for the Tier 1 capital ratio.

• Pillar II prescribes sound internal processes for the assessment of capital adequacy and risks that are not covered under Pillar I. When assessing capital adequacy, financial institutions are required to consider their position in the business cycle. They can hence prepare for a downturn by building up higher levels of capital in good times. There is also a supervisory review process.

• Pillar III provides for enhanced market transparency and discipline, supplementing the supervisory effort that forms part of Pillar II. Pillar III relates primarily to the disclosure of risk profiles, capital adequacy and risk management.

Basel II improves on its predecessor by taking account of a wider range of risks and differentiating between the risks presented by different borrowers. Moreover, Basel II offers scope for flexible application, as it allows banks to implement it in a manner suited to the degree of complexity in their operations. There are three levels of compliance with Basel II: a standardised approach and two internal ratings-based (IRB) approaches, foundation and advanced. Furthermore, Basel II comprises more risk-sensitive capital requirements and provides incentives for better risk management and a more effective supervisory framework. For all of these reasons, Basel II has been well-received. According to a 2006 survey by the Financial Stability Institute, about 100 countries planned to apply Basel II within a few years of its introduction. In the European Union, member states implemented the standardised approach in 2007 before moving on to the more advanced IRB approaches in January 2008. The US is planning to implement the advanced approaches in mid-2009. In the Asia Pacific region, Basel II has been adopted to varying extents. In addition to the countries listed in the table below, other Asian countries that introduced Basel II during 2007 and 2008 include the Philippines, India, South Korea, Malaysia, Thailand and China.

Implementation of Basel II in some Asia Pacific countries³

In Hong Kong, the policy framework developed by the HKMA largely comprises the advanced approach to Basel II. Hong Kong's early adoption of such a framework will hopefully help it to cope as well as possible with the financial crisis. Indeed, the HKMA framework already provides the further and more urgent international recommendations that are now being made in other jurisdictions in order to improve the resilience of banking systems and to strengthen capital and liquidity requirements and risk management practices. In China, the China Banking Regulatory Commission (CBRC) issued guidance on the implementation of Basel II on 28 February 2007, followed by further guidelines on 18 September 2008 concerning monitoring requirements and technical specifications (eg in relation to capital measurements, risk disclosure requirements, internal rating systems, specialised credit ratings, management of credit risks and operational risk requirements). Large Chinese commercial banks with overseas branches or many offshore businesses are required to comply with Basel II from as early as the end of 2010, although with possible postponement until 2013. Other commercial banks, including branches of foreign banks in China, may implement the current Chinese capital supervision provisions and obtain approval for compliance with Basel II from the end of 2011.

According to the Measures for Management of Capital Adequacy Ratios of Commercial Banks, which have been in place since 1 March 2004 (and amended on 3 July 2007), the CAR of commercial banks in China should be at least 8 per cent and the Tier 1 capital ratio should be at least 4 per cent. It is reported in the 21st Century Economic Report and the National Business Daily that: (i) in September this year, the CBRC raised the minimum CAR of small and medium sized listed commercial banks to 10 per cent and the minimum Tier 1 capital ratio to 5 per cent; and (ii) next year, it is expected that a CAR of at least 12 per cent and Tier 1 capital ratio of at least 6 per cent will be required for such banks. These increased capital ratio requirements may have been made in response to the financial crisis. However, according to the First Financial Daily and the China Securities Journal, an official at the CBRC has stated that the new requirements constitute guidance rather than compulsory requirements. It nevertheless appears that the CBRC can require individual banks to conform to specific standards, as the 21st Century Economic Report states that an employee at Everbright Bank China has confirmed that the CBRC required the bank to maintain a CAR of above 9 per cent from the end of 2008.

As the above discussion shows, important steps towards full implementation of Basel II are occurring in the Asia Pacific region. Overall, it appears that the application in the Asia Pacific region of the standards set out in Basel II is keeping pace with that in the US and Europe – although enforcement may possibly be lacking. However, a different picture emerges in respect of recapitalisation efforts.

The Asia Pacific region: a different picture

Compared with the US and Europe, the extent of recapitalisation efforts in the Asia Pacific region is not yet fully clear. Concerns have been expressed regarding the balance sheet strengths of Asian banks and the stance of local regulators in respect of Tier 1 capital ratios, with some market commentators asking whether Asian governments should require Tier 1 capital ratios to be kept at a certain level as part of their bail out and economic stimulus packages. As reported in the Financial Times, however, the average Tier 1 capital ratio and CAR of banks in the Asia Pacific region stood at 10.16 per cent and 13.19 per cent respectively in 2007. These ratios are considerably higher than those of the banks' American and European counterparts. In fact, it is reported that the ratios currently remain at a reasonable level in most countries in the Asia Pacific region despite some slight declines due to more stringent calculations under the Basel II framework. As a result, Alistair Scarff, head of Asia Pacific financial institutions research at Merrill Lynch, has reportedly stated that 'The financial health of Asian banks is very different to that of a decade ago. From my vantage point, no bank in Asia faces having to recapitalise to shore up their balance sheet at this stage.' The answer to the above question concerning Tier 1 capital ratios therefore seems to be that currently there is no pressing need to impose a minimum requirement on Asian banks. In other words, the existing Basel I and Basel II commitments, where implemented and imposed on banks in Asia, may be sufficient for the time being.

One explanation for the different situation in Asia compared with the US and Europe is that Asian banks may not face all the same problems as their American and European peers. For instance, while the extent of global exposure to sub-prime lending remains unclear, it appears that Asian banks may be less exposed than US and European banks. Whatever the cause of recent losses, however, the Financial Times has reported that of the US$500bn written off by banks in January to August 2008, write-offs by Asian financial institutions accounted for only about 5 per cent whereas the 23 banks in the world with the most asset write-downs and credit losses are all North American and European. In fact, not only have Asian banks managed to avoid large write-downs during the current climate, they have also accumulated profits. In the second half of 2007, amid the US sub-prime crisis, the aggregate net profit of the 300 largest banks in the Asia Pacific region increased by 37.5 per cent. The Financial Times has indicated that these impressive results may be attributed to improvements in various aspects of the banks' business after the 1997-98 Asian financial crisis, as well as improved creditworthiness due to banks' requirements for better asset quality, enhanced risk management, concerted regulatory efforts and strong growth in core businesses supported by solid economic growth.

Outlook

George Soros recently espoused his theory before the US House of Representatives' Committee on Oversight and Government Reform, that markets do not tend towards equilibrium but are instead inherently stricken with a defect he calls 'reflexivity'. This defect is due to distorted views of market participants and biased market conditions, which tend to reinforce trends and create bubbles such as the recent housing bubble. Soros argues that regulation is necessary to prevent the natural creation of such bubbles. He notes that bubbles cannot be controlled purely by monetary means, therefore additional tools must be used such as variable margin requirements and minimal capital requirements to control the amount of leverage that market participants may employ. Soros's perspective provides persuasive support for the idea that further financial regulation is a necessary component of a never-ending search for an optimum market equilibrium.

If one accepts Soros's argument that it is time for the pendulum to swing back from relative financial deregulation toward greater regulatory oversight, then one is likely to agree that banks should be a key target of such increased oversight. This briefing paper has discussed banks' capital reserves, which constitute a key indicator of financial condition and thus cannot escape the regulatory gaze. In the present circumstances, it seems wise to promote full implementation of the existing international standards regarding banks' capital position. Further capital requirements in addition to Basel I and Basel II may also be necessary, and will no doubt be introduced in due course. As Michel Tilmant, the chief executive and chairman of ING, is reported by the New York Times to have said, 'market conditions have changed dramatically in recent weeks and have led to an internationally recognised belief that going forward, in this market environment, capital requirements for financial institutions should be higher.'

While regulatory action in respect of banks appears more critical to some countries' financial systems than to others, it seems likely that concerted global efforts that are swiftly applied would be beneficial to all. So far banks in the Asia Pacific region may not have been hurt as badly as those in other regions by credit losses in the current downturn, possibly because of the quality of their assets. Nevertheless, looking ahead, it would seem prudent for banks in this region to strive to maintain the strongest possible capital position. Regulators may assist by requiring effective implementation of Pillar II of the Basel II regime, which adds a layer of supervisory judgment to the more rule-based Pillar I. Effective supervisory judgment is likely to play a particularly key role as an alarm bell to signal potential problems. As Mr David Carse states in his review of the HKMA's policy framework on banking stability, 'The broad thrust of the international supervisory initiatives is, in a sense, a return to basics – focussing on strengthening capital and liquidity requirements and risk management practices.'

Footnotes

1 Source of these and other data in this paragraph: the Financial Times.

2 There is also Tier 3 capital under Basel II. 'At the discretion of their national authority, banks may also use a third tier of capital (Tier 3), consisting of short-term subordinated debt ... for the sole purpose of meeting a proportion of the capital requirements for market risks.' Annex 1a, Basel II – comprehensive version.

3 Source: Banking on More Capital, Finance and Development (a quarterly magazine of the IMF), and the website of Financial Supervisory Commission (Taiwan), available at www.fscey.gov.tw.

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