Banks may have to raise their capital once Basel IV norms come into effect

Steve Punch, director-head of financial risk management, KPMG and Emilio Pera, partner-head of financial services, KPMG, talk about the impact of the latest capitalisation rules, set to be launched in the near future

Interview

Steve Punch, director-head of financial risk management, KPMG and Emilio Pera, partner-head of financial services,

Over the years, the banking regulators in Oman have made significant changes in rules to comply with Basel norms, so what more is expected now?

Pera: The Basel III framework has evolved since its inception, specifically following the global financial crisis in 2008, and has been rolled out across the world over the last four    to five years. Liquidity measures have become a key part of the banking framework. Further regulatory enhancements can be expected as the market continues to develop. Some financial pundits refer to these enhancements as Basel IV, although no official information on the matter has been released.

What we have seen on a global scale is that developed markets, such as those within the G20, have implemented Basel norms whilst regulators in some emerging markets have adopted these in a piecemeal fashion, with local sensitivities taken into consideration. In recent years, we have witnessed the acceleration of the regulatory agenda in Oman and also across the GCC that is aimed at integrating several new Basel initiatives into the Central Bank of Oman’s rulebooks.

Punch: If we consider the Basel III standards, these are focused on a tighter and additional capital definition, and introduced two new liquidity metrics. Since then, the Basel Committee has been busy drafting numerous new standards, including a redefinition of the requirements for credit, market and operational risks. This is expected to provide greater risk sensitivity when it comes to how banks are required to manage risk, especially credit risk. Some industry followers, including KPMG, have termed these new requirements as “Basel IV”.

The standardised approaches and calibrations for Pillar 1 risks are expected to change. This is important and relevant for banks in countries, such as Oman, where CBO requires banks to calculate regulatory capital using the Basel-standardized approach. It is expected that risk-weighted assets (RWA) for retail customers and financial institutions (FI) exposures will rise, thereby requiring banks to hold more regulatory capital against those exposures.

Does this mean if implemented, these new norms could result in increasing borrower-interest rates in Oman?

Punch: The business rule of thumb is that higher risk usually renders increased interest rates. Basically the new Basel IV-standardised approach will require banks to review their retail and other portfolios to identify higher risk riskier customers. If the context becomes more risk-sensitive, we believe that this may ultimately cause the interest rates for some customers to rise. Banks will also be required to collect specific customer information on a more regular basis. For instance, previously on retail segments there were only two type of risk weights: 35 per cent for anything that is backed by mortgages, and 75 per cent for unsecured loans, the regulatory retail portfolio. Under Basel IV this is expected to change completely.

The proposed Basel amendments to the standardised approach for credit risk require banks to look at loan-to-value (LTV) ratio to calculate risk weights. So if you have low LTV, you will most likely pay low interest and vice-versa which makes sense as previously, all mortgages were put in the same bucket.

For different asset classes, various other methods are being proposed.

Wouldn’t rising interest rates put additional pressure on already stressed assets as most banks are struggling with the rise in stressed loans, particularly due to lower crude oil prices?

Pera: Extending credit to customers and subsequently improving their liquidity, is one of the key drivers of economic growth in a country. It is therefore very important to maintain a balance between extending credit and at the same time effectively managing the credit risk portfolio of banks within the regulatory requirements established by the regulator. Establishing a good understanding between the regulator, the banking sector and the government is very important as I believe the banking sector is one of the engines of growth of any economy, but only within a sound financial system.

When could we see Basel IV norms coming into effect and what stage are they in now?

Punch: Actually it is going to happen sooner than we think. The first draft of Basel IV norms was released in December 2014. The second draft was brought in December 2015, and we expect that they are going to release the final draft in the first quarter of next year, or soon after. The implementation timing is not clear yet, but it could be by the end of 2018.

Pera: I would like to add that not all countries are currently on an equal level when it comes to the implementation of Basel regulations. Some are still at Basel II levels, whereas others have already, or are in the process of, implementing the Basel III framework. There are certain structural limitations in local economies, and this can explain why a number of countries take a phased approach when implementing some of these norms.

What type of challenges will banks face in implementing these requirements in future?

Punch: A main challenge for banks and regulators will be the additional data requirements. This is because banks will have to report their regulatory capital ratios on a monthly basis to the central bank, and obviously things like loan values, valuations and serviceability will change over time. Under current regulations, banks only collect information for individual borrowers at the beginning of a loan.

Banks will have many more risk-weight categories than just the 35 per cent and 75 per cent currently available.

Pera: Skill shortages will be one of the key areas that will need to be addressed in future. And this is applicable in cases of Basel prudential regulatory and accounting changes. The new norms will require more specialised banking professionals.

Punch: My view is that the CBO should consider conducting an impact assessment study now as we know that other regulators outside the GCC region have already begun assessing the impact on capital adequacy ratios. In response to the 1st draft, the Quantitative Impact Study undertaken by the Basel Committee estimated that banks might have to increase their capital base by 50-70 per cent. A significant portion of this was driven by proposed amendments to the corporate space but this has now been withdrawn. In the second draft, the requirement seemed to indicate a 25-30 per cent increase. So we can infer that banks in Oman may need to increase their capital by around similar amounts once these new regulations become official. 

The most likely scenario is that banks may have to implement this Basel IV by the end of 2018 or in the fourth quarter of 2018. Since there will be a significant funding requirement, banks may need to plan well in advance and avoid operating below the minimum capital requirements set by CBO. It is worth noting that the Tier I capital requirement in Oman is one of the highest in the GCC. An impact assessment required by the regulators will determine the capital implications and allow the CBO and the banks to better determine their additional capital needs.

Banks may have to raise their capital once Basel IV norms come into effect
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