01 01. 2013
Basel III and Asia
The Basel Committee for Banking Supervision developed Basel III to further strengthen the resiliency of the international banking system. Much of the tightened standards were in reaction to the Global Financial Crisis (GFC) of 2008, a crisis that started in the Western economies and illuminated weaknesses specifically in many Western banks. In contrast, during the GFC, both the Asian economies and Asian banks fared comparatively well, with not a single major Asian bank requiring rescue by the state.
Basel III has been embraced by regulators globally, with implementation to start on January 1, 2013, with several provisions, such as the counter-cyclical buffer and Globally Systemically Important Institutions (G-SIB) add-on, being gradually phased in over time. However, it is likely several major jurisdictions will not in fact commence Basel III on that date. The United States banking regulators announced in November that due to the large volume of industry comments and consultations, implementation is indefinitely delayed. The Financial Stability Board, when assessing regulatory progress in implementing Basel III, noted that given delays in issuing final Basel III regulations, it was likely that only six of the twenty-eight identified G-SIBs would be subject to Basel III as of January 1. More recently, press sources indicate the desire by some EU officials to also delay commencement of Basel III.
Roll-out of Basel III and the response of international banks to new capital standards, can have a major impact on Asia. International banks fund a substantial portion of the credit needs of Asian borrowers; any withdrawal or cut-back of international bank lending in Asia can cause a shortfall of credit availability that would adversely impact regional economic growth. Given these continued uncertainties over the timing of global implementation, and particularly the impact on foreign bank lending in Asia, Asian regulators should also tailor implementation of Basel III to the specific needs of their countries. Such tailoring may focus upon the timing of implementation as well as the need for any supplemental capital buffers, rather than on changes to any core provisions of Basel III. Also, tailoring should reflect that banks in Asia are generally in stronger financial positions than their peers in the West, giving Asian regulators more leeway in implementing Basel III. In Asia banks also play a more important role in economic growth, given the greater reliance of Asian economies on bank financing versus capital markets financing.
Our focus throughout is on Asia ex-Japan, because the economic and regulatory considerations of Japan are different from the rest of Asia.
Asian Banks are financially strong now
The drivers of bank collapses during the 2008 GFC have commonly been identified as those banks having some combination of excessive retention of risks of structured products, insufficient capital buffers, and inadequate liquidity to survive a crisis of confidence. Large Asian banks do not suffer these problems. Structured asset-backed securities are not well developed in Asian markets, and so Asian banks have little such holdings. Asian banks are amply capitalized relative to Western banks.
To compare banks across regions, we selected a few banks from each of the Asian markets under consideration—typically the three largest—and several of the largest European and Australian banks. Figure 1 shows that Asian banks consistently have higher ratios of RWA/Total assets, so they have much smaller risks of understating their true RWAs by misestimating risks, as was found in some of the Western banks that failed. Note that US banks were excluded due to the absence of Pillar 3 reports that would enable apples-to-apples comparison to the European and Asian banks.
Figure 2 shows a similar finding when looking at the ratio of total on- and offbalance sheet commitments relative to Tier 1 capital. The lower ratios found in Asia suggest Asian banks are less likely to run into problems of suddenly needing to fund offbalance sheet commitments, again as happened to some banks during the GFC.
Looking at the Tier 1 capital adequacy ratios in Figure 3, we see that Asian banks have similar Tier 1 ratios as Western banks. Hence, all three measures indicate that Asian banks’ balance sheets are as well or better capitalized than typical large western banks.
Asian banks also fare well in terms of overall liquidity. Due to the high savings rates and more limited development of money market funds in most Asian markets, Asian banks have comfortable assets-deposits ratios, which is a rough measure of the adequacy of banks liquidity and which is shown in Figure 4.
These comparisons show that generally Asian banks are in sound financial shape, and typically stronger than most European banks. Compared to those in the West, Asian banks seem to pose less near-term systemic risk, and so arguably there is lesser imperative to impose the new Basel III standards in haste, especially given concerns, as outlined in the next section, that continued deleveraging by Western banks will constrain bank lending and hence economic growth in Asia, and also in face of the continuing uncertainty and debate on the pace of Basel III implementation in the West.
Figure 1: RWA / Total Assets
Figure 2: Ratio of Total Assets+Commitments+Guarantees to Tier 1 Capital
Figure 3: Tier 1 Capital Adequacy Ratio
Figure 4: Ratio of Total Assets to Customer Deposits
Bank lending and financing is needed for continued growth in Asia
The Global Financial Crisis clearly demonstrated that banking crises can precipitate economic crises, and so systemic risk in banking needs to be well-contained through effective prudential regulation and oversight. But as many regulations impose costs on the industry, potentially reducing the supply of credit (via minimum capital requirements and some banks’ desire to deleverage to meet those requirements), or increasing cost of such credit (by raising margins to provide the financial returns required by shareholders for supplying equity to banks), regulators must seek the right balance between systemic risk reduction and the availability of credit to the economy.
This is particularly critical in Asia – over the past several years, the demand for credit and loan growth in Asia has remained healthy, generally growing several percentage points faster than nominal GDP, as shown in Figure 5. Due to less liquid local capital markets, Asian corporates tend to rely much more on bank lending than corporates in Western economies, as illustrated in Figure 6. With the emergence of Asia as the main engine driving the global economy, any reduction in the growth of the supply of bank credit to Asian corporates would have consequences on growth in Asia as well as the rest of the world.
After the GFC, continental European banks, in particular, have been forced to de-leverage their balance sheets. As part of this effort, those banks have reduced their loan exposures across international markets, particularly in developing markets such as Asia, as shown in Figure 7. This is significant, as continental European banks have played a major role, particularly in trade finance and long term project and infrastructure finance in Asia for many years, and therefore this could lead to shortfalls in credit supply in some of the areas most critical for Asia’s development.
To date, the UK banks have picked up much of the slack created by the withdrawing banks, as shown in Figure 8. However, this involved a doubling of their balance sheets over a short period of time, something which is unlikely to be maintained over the next 5 years. Given the increased earnings and capital pressures on the two leading UK-based banks active across Asia currently, there is substantial risk that going forward the UK banks will stop increasing their market share of Asian credit. Other foreign banks face similar likelihoods of reducing their Asian market share due to earnings and capital pressures in their core markets. If this occurs, then there is significant risk that Asia will not have sufficient bank credit to fund its forecasted growth, without either significant external capital raising, or increasing the current levels of leverage, which would also increase the systemic risk to their banking systems.
To better understand this potential problem, we have developed high-level projections of loan growth needs across Asia. Please refer to Appendix A for more details on our assumption and data sources. Linking these loan projections to bank capital requirements and local banks retained earnings, we can assess the extent to which local banks have sufficient capital to support the balance sheet growth commensurate with forecasted GDP growth. Where projected retained earnings are insufficient, additional capital could be obtained by some mix of reducing dividend payouts from historical norms and new equity issuance. To the extent that those two sources are inadequate, then either the Asia’s bond markets must take up the slack, or some of the forecasted loan demand cannot be met.
These projections indicate that given current economic forecasts, plus the impact of Basel III, not directly on Asian banks, but indirectly through the impact on global banks, by 2017 Asian banks will need to generate USD250 BN of additional capital through some combination of lowering their payout ratios and new external capital as illustrated in Figure 9. The largest capital gaps are in India and Hong Kong as shown in Figure 10. The large capital shortfall predicted in India is due to the high double digit GDP and loan growth forecasts for India (14─15%), while the Indian banks on average do not have sufficiently high ROEs (projected at 13.9% after the increased capital due to Basel III) to generate enough retained earnings for the projected loan growth. The projections for Hong Kong are driven by very different factors. Hong Kong banks have healthy ROEs, but a large proportion of Hong Kong loans are funded by Western banks, so the assumption that Western banks will stop growing in Asia creates a very large funding gap.
To get an understanding of how challenging it may be to raise the additional required capital in each country, we also look at the forecasted capital gap in 2017 as compared to current bank capital in each country as of 2011, which is shown in Figure 11. Hong Kong and India have the largest percentage gaps, followed by the Philippines. To the extent that this reflects the greater challenges of raising so much new capital in each country, then these nations face perhaps higher risk of slower economic growth due to insufficient bank lending.
Figure 11: Forecast Tier 1 capital shortage in 2017 as percentage of 2011 level
Other potential unanticipated effects of Basel III
While the analysis above has focused on the potential effects of Basel III with regards to bank capital and credit supply, it also noteworthy that even as we have seen Asian banks being liquid and well-funded at the moment, an industry-wide reallocation away from illiquid bank loans into more liquid securities triggered by the Basel III requirements for liquid assets, and the ongoing global tightness in funding liquidity, especially for cross border transactions, could further exacerbate the credit supply issues we have noted here, putting the growth trajectory in Asia further at risk.
In addition to these macro-level effects of Basel III, we foresee potential micro level effects in terms of the allocation of the supply of credit amongst the different Asian countries, and the economic sectors within each economy.
Trade finance may be significantly affected by Basel III through the imposition of the Asset Value Correlation (AVC) multiplier for exposures to large financial institutions. The AVC multiplier was introduced in Basel III in recognition that the tight linkages between financial institutions, especially through derivative credit risk exposures, was one of the triggers for the Global Financial Crisis. However, many financial institutions in Asia have significant credit exposures to other financial institutions, not through derivatives, but through trade finance.
As a result of the AVC multiplier, trade finance exposures where the counterparty is a financial institution would see an increase in regulatory capital requirements of between 32─36%, in addition to any increase due to the higher levels of regulatory capital ratios required under Basel III, which may lead banks to allocate capital to other operations instead of trade finance. The higher capital requirements would also imply that the pricing of trade finance credit would need to increase by 10─30 bps – as trade finance margins are at a cyclical low at this point in time due to weak demand, this is likely to be absorbed by the banks, again encouraging the reallocation of capital away from trade finance. At the extreme, given the lower margins in trade finance, which in Asia historically has post provision operating margins of between 0 bps in markets like Taiwan and 250 bps in markets like Indonesia, absorption of these increased costs may lead banks to exit certain markets such as Taiwan, Korea and to a certain extent, even Singapore and Hong Kong, where the margins are relatively lower.
SME lending is a particular concern for market participants globally. SMEs are especially reliant upon bank financing as they have very limited access to capital markets debt financing. While the anticipated impact of Basel III in terms of capital requirements for SMEs does not disadvantage SME lending relative to the existing rules specifically, the combination of the potential fall in the supply of credit, and the reallocation of capital away from the areas of higher capital consumption may result in an overall reduction in the supply of credit to this critical sector. On an inter-country level, this may further disadvantage markets, such as Taiwan and India, where the margins on SME financing have been weaker historically.
Project finance, especially in infrastructure financing for roads, railways, power plants, water and sanitation facilities, has been identified as by the Asian Development Bank as a critical factor driving growth in Asia. Out of the identified US$8 TN required in infrastructure investment over 2010─2020 in Asia7, there already is a current shortfall in financing, with the largest need relative to supply of infrastructure project financing being in India, where our projections have shown the largest capital gap exists. A tighter supply of credit in Asia as a result of the implementation of Basel III will certainly have further deleterious impact on the current situation. Furthermore, the long term and lumpy cashflows associated with project finance often requires the use of interest rate swaps to enable the borrowers to hedge their interest rate repayment risk – under the Basel III rules for Credit Valuation Adjustments (CVA), the provision of such by the lending banks would also be affected, potentially leading to further sub-optimal provision of solutions for infrastructure financing.
What can Asian regulators do?
This paper shows that Asian banks are generally well-capitalised with stable funding. However, the residual impact of the GFC on Western banks may hurt Asian economic growth through a reduction of Western bank lending that cannot be fully offset by domestic banks. In additional, several provisions of Basel III may hurt Asian lending in ways that are not commensurate with the risk of that sector, such as trade finance.
Fortunately, because each country faces different levels of preparedness and macroeconomic economic contexts, Basel allows national regulators discretion in several areas. Given uncertainty over the adequacy of future bank lending in some Asian countries, as well as potentially excessive risk weighting of low-risk sectors such as short-term trade finance, we think Asian regulators should consider exercising this discretion in:
- Timing of roll-out. As some Western regulators are delaying implementation of Basel III beyond January 1st, Asian regulators may also wish to use additional time to study the potential impact of Basel on loan growth rates and pricing of credit. We understand even with the regulatory community is already some thinking about simplifying Basel and developing Basel 3.5. As most Asian regulators have already specified January 1, 2013 as the commencement date, timing could be adjusted by specifying the new capital standards as a ‘parallel run’ for now prior to full implementation.
- Phasing in of standards. Another option is to consider modifying the timing of the phase-in. Minimum Tier 1 capital levels will rise from 4.5% in 2013 to 6% in 2015 while the common equity capital ratio will rise from 3.5% in 2013 to 7% in 2019. If there are substantial concerns over adequacy of bank financing in the near term, the 6% floor might be postponed for a short period until those concerns have abated.
- Calibration of discretionary standards. Some parameters, such as the countercyclical capital buffer add-on, are defined as subject to regulatory discretion, precisely because they are hard to parameterize across all markets. As Asian regulators establish these parameters, they can incorporate thinking on the economic cycle and competitive context, including the extent to which access to credit may be becoming more scarce. In addition, as many Asian regulators have availed of other tools to constrain potential bubbles particularly in real estate (e.g., through changes in stamp duty, minimum LTV ratios, capital gains taxes), which are arguably more specific and effective than capital level measures, the need to add any countercyclical buffer would seem less than in most Western markets, where regulators have typically not intervened with such market-specific actions.
- Tailoring of selected parameters for local markets. In some Asian markets, the impact on specific market segments, such as trade finance or SME lending, may be substantial. Where such impacts seem excessive, the regulator may wish to fine-tune the Basel parameters for those segments. For instance, the AVC impact on trade finance bank counterparties may be refined to better reflect the risks that might arise specifically from short-term trade finance deals. One approach would be to develop AVC parameters specifically for trade finance—rather than generically for all bank counterparty exposures—that would in turn reflect the lower risks of short-term trade finance. We also understand that some Western countries are considering adjusting downward the capital requirements for the SME segment, given the national importance of that segment for economic growth and employment. This may also be considered in Asia. Similarly, exemption of derivative transactions with non-financial end-users from the CVA charge would both lead to lower hedging costs for corporates as well as greater provision of long term financing by the banks to these corporates.
- Setting overall capital targets. Many Asian regulators have set minimum capital standards above the Basel standard. As each bank then needs to maintain additional capital substantially above the minimum to ensure that it will remain comfortably above even during a major recession, this generally imposes even greater costs on the regulated banks. While some excess over Basel minimums can be justified by the higher risk volatility in local Asian markets, the excess should be finely calibrated to actual incremental risks.
Basel III is a strong step forward in the global efforts to minimize banking systemic risk. However well intentioned, these rules work best when they are harmonized across different jurisdictions, implemented concurrently, and where the potential unintended effects of the regulations are considered. Given the many uncertainties regarding additional changes to the framework in Basel 3.5, possible delays in implementing Basel III in some Western markets, the likely need for alignment between the relatively new accounting standards of IFRS and Basel, the uncertainty over adequacy of future bank capital in Asia, as well as over the global economic recovery, Asian regulators should well consider some of the above actions.
Appendix A: Base case model assumption
The key assumptions underlying our base case model and projections are:
- Asian economies will grow over the next five years through to 2017 at the rates for nominal GDP growth forecast by the IMF.
- Asian loans in each country will grow at the same rate as that country’s forecast nominal GDP growth.
- In a given Asian country within our sample, where Continental European banks have reduced their total loan exposures over the past 4 years since the GFC, they would continue to do so at the same rate. The choice of restricting ourselves to projection the loan growth rates over the past four years (2008 – 2011) are to avoid including the pre-GFC period where loan growth was more robust globally.
- In a given Asian country, where Continental European banks have increased their loans over the past 4 years since the GFC, they would only keep their loan book flat going forward. This reflects expectations of further bank deleveraging as Basel III kicks in.
- For UK banks, their growth in each country would be capped at half of the forecast loan growth in that country.
- Imposing Basel III’s higher capital requirements will lead to a drop in ROE of 20%, which in turn reduces banks’ ability to internally generate capital while maintaining a particular dividend payout ratio. The 20% assumption is the same as made by Standard Chartered Bank in their report, “Basel III triggers metamorphosis of Asian corporate funding,” November 8, 2012. Standard Chartered references two other studies that suggest 20% is a reasonable parameter: a Fitch study that estimated the impact on large Asian banks as 20% decline, and a McKinsey study that estimated the impact on European banks as a 30% decline This assumption effectively assumes that banks will not be able to pass along the higher costs of capital through to borrowers. We assume this impact occurs immediately as of 2013.