Basel-III: Challenges and opportunities

As part of the graduation process of capital adequacy standard, the Basel

Committee on Banking Supervision (BCBS) released the global regulatory
framework on Basel-III capital accord in December 2010 in view of strengthening
global capital and liquidity rules with the goal of promoting a more resilient banking
sector. The objective of the reforms was to improve the banking sector's ability to
absorb shocks arising from financial and economic stress thus reducing the risk of
spillover from the financial sector to the real economy. In line with the above,
Bangladesh Bank (BB) instructed the scheduled commercial banks to implement the
Basel-III capital accord with a roadmap after detailed quantitative impact studies on
the banking sector. In continuation of the same, BB recently issued "Guidelines on
Risk Based Capital Adequacy (Revised Regulatory Framework for banks in line with
Basel-III)" which replaced the previous circulars in this regard. The major areas of
the graduation process are summarised below:

MAJOR CHANGES IN BASEL-III: Basel-III is not an isolated guideline rather it is the

latest refinement of Basel capital adequacy standard. The major changes are
described below:
1. Strengthening capital framework: The latest capital accord focuses on raising
both quality and quantity of regulatory capital and enhances the risk coverage of
the capital framework. Consequently, the Tier-1 Capital (renamed as 'going-concern'
capital) has been framed under two components, Common Equity Tier-1 (CET1)
Capital and Additional Tier-1 Capital where the first component will be comprised of
common shares and retained earnings while the later will be comprised of
instruments that are subordinated, have fully discretionary noncumulative dividends
or coupons and have neither a maturity date nor an incentive to redeem. In
addition, Tier-2 Capital (renamed as 'gone-concern' capital) will be harmonised with
100 per cent deduction of revaluation reserve for fixed assets, securities and equity
securities from Tier-2 capital under a transitional arrangement (20 per cent in 2015
followed by 40 per cent in 2016, 60 per cent in 2017, 80 per cent in 2018 and 100
per cent in 2019).

2. Enhancing risk coverage and addressing systematic risk and interconnectedness:

In view of enhancing risk coverage, the reform package includes additional capital
charge for Credit Value Adjustment (CVA) risk which captures risk of mark to market
losses due to deterioration in the credit worthiness of a counterparty in addition to
default risk of counterparty. Basel Committee also suggests that systematically
important banks should have loss-absorbing capacity beyond the minimum
standard due to their interconnectedness in the economic system. As such they
have developed a proposal on a methodology comprising both quantitative and
qualitative indicators to assess the systematic importance of financial institutions at
global and domestic level.
3. Capital conservation buffer and phase in arrangement of minimum capital
requirement: The new directive prescribes the banks to maintain Capital
Conservation Buffer (CCB) @2.5 per cent, comprised of CET1, of Risk Weighted
Assets (RWA) in order to address pro-cyclical (any economic quantity that is
positively correlated with the overall state of the economy) and counter-cyclical
(any economic quantity that is negatively correlated with the overall state of the
economy) dynamics. However, the additional buffer to be gradually developed. The
transitional arrangement for enhancing capital base is shown in the following table:
Banks will not be allowed to distribute dividend (either cash or stock form) in case of
capital level falls below the prescribed level. If CET1 capital falls below the required
level, the banks will be required to conserve a certain per cent of earnings in the
subsequent financial year. However, if a bank fulfills minimum capital requirement
but fails to fulfill the requirement of conservation buffer, the bank may distribute
stock dividend subject to approval of Bangladesh Bank.
4. Leverage and liquidity standards: In order to address the excessive leverage in
the banking system, Basel-III directive has incorporated a simple, transparent and
non-risk based regulatory Leverage Ratio (LR=Tier-1 Capital/Total Exposure). The LR
to be maintained at least @3 per cent and to be reported on quarterly basis.
However, LR will be migrated to Pillar-1 in 2018. The new directive has further
strengthened its liquidity framework by developing two minimum standards for
funding liquidity. In order to promote short term resilience of a bank's liquidity risk
profile by ensuring that it has sufficient high quality liquid resources to survive an
acute stress scenario lasting for one month, Liquidity Coverage Ratio (LCR=Total
High Liquid Assets/Total Net Cash Outflow) has been introduced. Again, Net Stable
Funding Ratio (NSFR=Available Amount of Stable Funding/Required Amount Stable
Funding) has been introduced to promote resilience over a longer term horizon. The
threshold limit for LCR has been fixed at ?100 per cent while the same is >100 per
cent for NSFR.
CHALLENGES AND OPPORTUNITIES: Keeping in view of the above changes, the

following implications might be observed in the banking industry:

1. New directive has emphasised on increasing quality capital (particularly, Tier-1
Capital). However, it might not adversely affect the banking industry as Tier-1
capital contributes the lion's share of eligible capital. Financial Stability Report (FSR)
(2013) of Bangladesh Bank revealed that Tier-1 capital ratio was 9.0 per cent of
RWA at YE (year ended) 2013 which is sufficient enough to address additional
capital buffer.
2. Minimum total capital plus capital conservation buffer will have to be reached at
12.50 per cent of RWA by 2019. Average Capital Adequacy Ratio (CAR) of the
banking industry was 11.50 per cent (CAR of Private Commercial Banks was 12.52
per cent) at YE 2013 which reduced to 10.68 per cent (CAR of Private Commercial
Banks was 12.05 per cent) at June end 2014. Again, as revaluation reserves will
gradually be deducted from Tier-2 capital, there might create a vacuum in eligible
capital base. The cumulative effects might put pressure on fulfilling capital
requirement. The banks will either have to raise the capital base or efficiently
manage the asset portfolio to reduce the RWA in line with organic capital growth. All
this will require a long-term capital planning for the banks.
3. Under Basel-II directive subordinated debt was limited to 30 per cent of Tier-1
capital. New directive does not give any restriction on raising subordinated debt
although Tier-2 Capital can be admitted maximum up to 4.0 per cent of total RWA or
88.89 per cent of CET1 whichever is higher. This will allow the banks to further
extend capital base through issuing subordinated debt. Moreover, subordinated
debt of perpetual nature (like Mudaraba Perpetual Bond of IBBL) will qualify for
additional Tier-1 Capital under the new directive.

4. In terms of maintaining leverage ratio, it has been observed from the FSR (2013)
that, excluding specialised banks, the banking industry is at comfort zone with 4.57
per cent leverage for state-owned commercial banks followed by 7.75 per cent for
private commercial banks (excluding Islamic), 7.89 per cent Islamic banks and
27.70 per cent for foreign banks as against minimum requirement of 3.0 per cent
under the new directive.
5. As systematically important banks might require capital in addition to minimum
requirement (upon regulatory approval), these institutions might be under
regulatory focus and will act as the driving force in the financial system.

Despite many challenges, it is quite evident that the Basel-III framework will
definitely make the banks more risk-resilient and shock-absorbent than ever before.
However, mere reporting and compliance are very insignificant part of the whole
thing. Real benefit can only be achieved if the inherent philosophy is well
understood and implemented by the practitioners.
The views expressed in the article are the author's own and not necessarily of the
organisation he represents. The author, a member of ACCA, is an Assistant Vice
President of Islami
Bank Bangladesh Ltd.
kmraihan@islamibankbd.com