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Basel III: Risk, Liquidity, and Capital in the Middle East

With liquidity rapidly tightening and Basel III slowly coming into effect both formally and informally across the GCC, banks in the region are undergoing a significant transformation as they adjust to the capital adequacy, liquidity and risk management techniques outlined in the framework. But questions are being raised about whether the new capital rules will put the brakes on UAE banks’ rapid expansion over the past 5 years.

The Basel III standards on banks’ capital adequacy, stress testing, and market liquidity risks were formulated in 2010 and 2011 by the Basel Committee on Banking Supervision in a bid to minimise structural and system risks of the kind that in large part exacerbated the credit crisis and brought world markets to a standstill in 2008. A continuation of the work completed under Basel I and II, the framework introduces a number of banking system reforms that fall into three broad categories: enhanced minimum capital and liquidity requirements; enhanced supervisory review processes for firm-wide risk management and capital planning; and enhanced risk disclosure and market discipline.

These can be broken down further into six areas. The framework aims to increase the quality, consistency, and transparency of a bank’s capital base to help them better absorb shocks and to mitigate the risk of insolvency; introduces countercyclical buffers to protect banks from periods of capital stress and macroeconomic events; strengthens capital requirements (Common Equity Tier 1 of 4.5%, up from 2%, must be maintained at all times) and management requirements around counterparty risk; limits the amount of leverage banks are allowed to accumulate (banks must maintain a leverage ratio in excess of 3%); introduces new liquidity standards (Liquidity Coverage Ratio, LCR, and Net Stable Funding Ratio, NSFR); and enhances reporting and governance standards.

Basel III has been adopted by most of the internationally active banks in North America and Europe – with a reasonable degree of uniformity, but across the Middle East there are some divergences in how the framework has been interpreted or implemented.

In Qatar for instance, all banks have been required to submit Basel III LCR and NSFR liquidity measures to the Qatar Central Bank (QCB) on a monthly basis since August 2012. Any bank that deviates from the targeted minimum limits of LCR or NSFR is required to provide a reasoned account of their liquidity positions, and provide detailed plans on how they expect to make up any shortages and bring the ratios above the mandated thresholds.

The Central Bank of Oman implemented similar reporting measures around the same time as the QCB, and in January 2015 the LCR requirement begun being phased in. The initial requirement is a minimum of 60% for 2015, with this limit rising 10% each year until January 2019 (the formally agreed target for full implementation), when banks will be required to meet the 100% LCR threshold.

Saudi Arabia has arguably been the most proactive in the region in terms of adoption. The Saudi Arabian Monetary Agency (SAMA) has undertaken a number of noteworthy initiatives designed to strengthen the prudential framework relating to bank capital. SAMA issued the final rule on Basel III risk-based capital in December 2012 to implement the first phase of Basel III (which took effect in January 2013). A number of new rules and policies were also put in place in October and December 2012, particularly on capital requirements for bank exposures to central counterparties (CCPs). Several aspects of SAMA’s framework are more conservative than the Basel framework according to a report penned by the Bank For International Settlements (BIS).

Other central banks have taken to more informal adoption. The UAE has not formally implemented Basel III, but the Central Bank of the UAE has verbally communicated to banks that they must issue Tier 1 capital that is compliant with Basel III rules as early as 2013. The Central Bank of the UAE is currently in discussions with banks in the region on a draft implementation proposal and hopes to announce a phased formal Basel III implementation strategy within the coming weeks.

Shed No Tiers

The implementation of Basel III has implications for some region’s banks, largely – though not exclusively – centred on liquidity, a dominant theme in the region in and of itself given the current economic environment.

“The oil price has impacted liquidity earlier than we had expected, and will put some pressure on capital ratios. The reason being that there will be fewer bank deposits, particularly by the sovereigns, reducing the funding these banks were previously getting – at very favourable rates,” explains Kapil Damani, Head of Capital Products, DCM at BNP Paribas.

“Liquidity in those banks has already begun to tighten, accompanied by higher interest rates and a credit slowdown as well.”

Damani says that when you look at the capital ratios in the region, because the expectation is the price of oil will remain low for some time, there will be less lending within the region and therefore less pressure on the capital ratios because assets are expected to grow by just a small amount.

“Putting numbers to that, in the UAE alone we saw 8% credit growth within the banking system in 2015; the expectation in 2016 is that this will reduce to 5-6% with further downside risk, and accompanied to some extent with an aversion to lending to SMEs. Overall, there is a good chance that will reduce some of the pressure on capital ratios.”

Dr Jarrad Hee, Head of Capital and Portfolio Risk at Emirates NBD says liquidity is not especially significant for the region’s larger banks, which generally hold highly liquid assets and sit well above the capital adequacy and liquidity thresholds prevalent within the region and in other markets.

The UAE’s banking system has average Tier 1 capital adequacy in the region of 17.5%, well above the mandated 12% locally (10% internationally, as mandated in Basel III).

“The challenges are similar to those in other emerging markets, such as systems and talent constraints. The mindset is changing, and has to change, for the more proactive banks,” Hee says.

But when it comes to liquidity not all banks are impacted equally. If a bank uses its cash to lend to a somewhat obscure borrower, then the risk weighting requirement will increase immediately, so the liquidity positions of the banks is important but it doesn’t necessarily impact their capital levels or capital ratios. The capital ratios of the banks will be determined by the nature and quality of the assets of that bank, the quality of the loan book, the risk weightings assigned and therefore the amount of capital they have issued.

Some experts argue that Islamic banks may be at a disadvantage relative to their peers, in part because of the liquidity of these assets.

“For Islamic banks the challenge isn’t really capital but the availability of high-quality liquid assets. Many of the Islamic banks in the region have trouble finding these because they can’t buy conventional bonds, and in many cases it is extremely difficult to find high quality, highly liquid, Sharia-compliant assets. It is a huge problem in the GCC,” says Andrew Cunningham, Founder and Director of Darien Analytics, a financial regulation and corporate governance advisory.

Damani agrees to an extent, though he also says the liquidity crunch felt in the UAE and across the GCC region is dampening the appetite of local investors, many of which tend to pour money into Islamic paper, thus amplifying the impact on Islamic finance institutions in the region. This is despite the narrower spreads these instruments typically see (about 20bps) when compared to conventional instruments.

“A large component of the capital issued in standard sukuk format was soaked up at very attractive levels by local investors. With the low oil prices, I think we are expecting much lower regional demand than we’ve seen in the past, which will impact Islamic banks more than those which rely primarily on conventional issuance structures.”

Reducing And Measuring Risk

When it comes to liquidity and the link to systemic risk, few elements of Basel III are as important as the net stable funding ratio (NSFR), which requires banks to maintain a stable funding profile in relation to their assets and off-balance sheet activities.

The NSFR is intended to limit banks’ overreliance on wholesale short-term funding, encourage better assessment of funding risks across all of a bank’s on and off-balance sheet items – and is an important metric used to mitigate the impact liquidity and potential balance sheet strains incur on a broader systemic level.

“NSFR is extremely important because within the current context of the strains on liquidity in the region, NSFR becomes a very helpful ratio for isolating any big mismatches in funding that banks may resort to,” says Abhijit Choudhury, Chief Risk Officer at National Bank of Abu Dhabi.

“The other elements in play here, which could become even more significant for the Basel III discussion going forward, is the extent to which extra capital buffers will be required by systemically important financial institutions (SIFIs or G-Sibs) in the region, which also relates to how risk weighted assets (RWA) are measured by institutions,” Choudhury said.

Calculating the additional capital that will be required is accomplished through a process defined by the Basel Financial Stability Board (FSB) known as TLAC – total loss absorption capacity. According to the final minimum TLAC threshold released by the FSB in November 2015, from 1 January 2019, the minimum TLAC requirement for G-Sibs will be at least 16% of the resolution group’s risk-weighted assets (RWA's), increasing to 18% from 1 January 2022.

But with different banks under multiple jurisdictions being subject to a variety of capital requirement rules – based on the degree to which their regulators adopt the Basel III framework – there is a risk some institutions will benefit from more generous capital buffer requirements than others.

“Basically, if you are a big bank on a syndicated deal with five lenders based in different jurisdictions, each with different capital requirements, and you are competing with these institutions for deals, some banks could be placed at a disadvantage from the outset,” said one financial analyst based in Qatar, one of the countries in the region to have formally adopted Basel III rules.

The way RWA is determined is also at issue here. Basel has three approaches to measuring RWA:  standardised approach; Foundation Internal Ratings Based (F-IRB) approach – which is based largely on a bank’s internal models; and an Advanced Internal Ratings Based (A-IRB) approach, introduced under Basel II.

Increasingly regulators around the world are moving away from allowing banks to use their own internal models (F-IRB), arguing instead that there needs to be a level playing field throughout the world where you have a broadly standardised capital floor imposed.

Most major international banks are operating on the A-IRB approach, so they are measuring their capital in a way that is more closely aligned with a measure of economic capital that a bank has actually consumed, as opposed to regulatory capital. Most banks based in countries within the GCC that haven’t formally adopted Basel III still operate on the F-IRB approach to measuring RWA.

Changing the way credit risk is measured is also a critical element at issue with Basel III. The standardised approach (SA) prescribes the use of external credit ratings to determine risk weights for certain exposures, but a new approach – which is being considered by Basel as this issue goes to press - is gaining momentum. Known as an adjusted standardised approach, its central aim is to reduce the “mechanistic reliance” on credit rating agencies and offer a more nuanced, robust way of measuring credit risk, but without relying too strongly on internal models that have in the past been linked to wide variations in risk perception internally within banks.

“The reality is CRAs have a tendency to treat certain players and sectors more aggressively than others; a new approach to expressing risk is necessary in some contexts and could help mitigate some of the risks that aren’t fully expressed by CRAs – or that are expressed perhaps more aggressively than may be warranted,” the analyst said.

The biggest difference between the more recent deals and earlier hybrid Tier 1 issuance from the likes of ADIB and DIB is the inclusion of the principle of loss absorption and point of non-viability language.

A key provision within Tier 1 instruments mandated under Basel III, the point of non-viability loss absorption language basically means the moment a regulator decides that a bank is not viable, that Tier 1 instrument can be written off in full and permanently, meaning investors essentially lose their entire investment.

Basel III permits the point of non-viability requirement to be affected, either contractually within the conditions of the actual bond or by way of statute. Europe have done it by way of statute, so all Tier 1 instruments will automatically include this point of non-viability loss absorption provision. GCC countries do include point of non-viability provisions within the terms and conditions of the bonds themselves, but there is no such statutory implementation of it – it is instead written in as a contingent obligation, which is itself something that continues to be debated in the region.

“The GCC region is rather unique because there are no taxes and lots of these banks are actually state owned in any case. So the whole point of non-viability, and whether this is a feature that is relevant for the region as a means of managing systemic risk, has always been debated since the start of the market in 2012,” Damani says. “Nevertheless, if the UAE regulator determines this is something that is needed for Basel III’s implementation, the bonds issued since 2015 should have that contingent feature and could activate. It is an interesting way of dealing with regulatory uncertainty.”

Generally speaking there are still some broad differences between the implementation of Basel III in Europe and the GCC, despite increasing harmonisation.

In Europe for instance, all Tier 1 instruments – whether accounted for as debt or equities – must contain a high trigger loss absorption mechanism, namely a provision whereby if you breach a certain percentage of your common equity Tier 1 capital ratio, the issuance automatically converts to equity, whereas Basel III technically only requires such a feature to be included in Tier 1 instruments that are debt accounted, explains Jonathan Fried, a partner with Linklaters, which advised on first Basel III-compliant additional Tier 1 capital issuance in Saudi Arabia and on the first Basel III-compliant additional Tier 1 capital sukuk issuance in Qatar.

“Most of the Tier 1 issuances in the region, whether issued as conventional bonds or sukuk, are accounted for as equity, whereas in Europe that would mean they would need to include a high trigger principal loss absorption mechanism; in the GCC it does not,” Fried said.

Issuances Ahead?

The GCC region has seen a number of Basel III-compliant capital issuances in recent years. The first deal to attempt Basel III compliance in the GCC was the Abu Dhabi Islamic Bank’s (ADIB) US$1bn Tier 1 sukuk issuance at the end of 2012. That was followed four months later by Dubai Islamic Bank’s (DIB’s) US$1bn Tier 1 sukuk launched in March 2013. Kuwait's Burgan Bank issued US$500mn in Basel-III compliant Tier 1 securities in 2014. There were also a number of US$500mn Tier 1 issuances by Al-Hilal Bank, most recently in January of last year, and a follow-up US$1bn Tier 1 sukuk issuance by DIB again in January 2015. These were followed by a number of domestic issuances out of Qatar and Saudi Arabia.

Arqaam Capital, the specialist emerging and frontier markets investment bank, expects GCC banks to issue up to US$43bn of Basel III compliant debt (US$17bn of additional Tier 1 bonds and US$26bn Tier 2) by 2019 in order to improve the quantity and quality of their capital base. These instruments will include more robust loss absorption features than their predecessors.

Overall there is roughly US$12bn of outstanding Basel-compliant securities in the region, and the expectation is that as new Basel III-compliant securities are issued older ones will have to be decommissioned, which could kick off a much lengthy process that could end up putting more pressure on some of the region’s banks.

“Basel II instruments that are outstanding will be phased out soon. It could take a few years for them to become efficient from a capital point of view,” says Jaap Meijer, Head of Research at Arqaam Capital. “They will be replaced, but we also expect a pretty significant issuance of additional Tier 1 and 2 instruments over time as we are working towards a total loss absorption capacity being increased.”

Still, that doesn’t mean many banks will rush to issue Basel III compliant instruments anytime soon, particularly given the relative increases in the cost of capital in the region.

“For senior bonds, we haven’t seen any loss absorption features being introduced despite constraints on positive growth. There is certainly a lot of room for additional Tier 1 instruments, but I think banks will be vigorously exploring possibilities to enhance the senior bond market, either through Medium Term Notes (MTNs), to increase liquidity levels and to diversify their funding base instead.”

“Senior bonds are a much cheaper option to boost your liquidity as a bank, so I wouldn’t expect Basel III Tier 1 to be a reasonable alternative,” he adds.

As the UAE and other GCC countries look to formally implement the Basel III framework, questions still remain on the extent of banks’ preparedness. Most are fairly well capitalised – indeed according to some, well over the optimal level – yet, as concerns surrounding liquidity and the ability of GCC states to support their own banking systems begin to swell, attention is increasingly being placed on the elements of the framework that could to an extent disadvantage some players in the medium term. With many critical elements of the framework still evolving or being decided by both the Basel Committee on Banking Supervision and regulators, only time will tell what the true impact of these rules will have in the region.

“There is no question these rules are a step in the right direction. But the extent to which these rules are implemented in a way that doesn’t automatically disadvantage you relative to your peers will be crucial,” Choudhury says.

Middle East Macro Policy & Government Global

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