Basel Accord and Nepalese Banking Industry

Arbind Aryal – The growth of each economy depends on the strength of the financial system. In the context of Nepalese banking industry after the insurgency period of civil war and inaugurations of new provisional constitution in 2062, private sector entrepreneur play a role of Catalyst in developing the financial literacy and awareness by investing and opening bank and finance company to the reach of general public, with the flow of establishing Bank and Financial Institutions (BFIs) economic activities are busted through freely mobilization of capital, further general people get the opportunities to become entrepreneur and investor through primary market. Nepal Rastra Bank (NRB) issue License for the maximum number of BFIs which leads the banking fraudulent activities and crime too, current issue is the mirror of those policies. BFIs invest up to maximum limit in unproductive activities by the cause one property is sale more than 10 times within a year with more than 20% profit margin on each time so the value increased more than 6 times of original value within 1 year which is the main cause to increase NPL & NPA in banking sector.

Regulatory body and management team are always in search of minimizing that risk issuance of guideline and bylaws are the result of the awareness, but are not implemented effectively. There are different types of crime and banking fraudulent activities around the world concerning the size of the economy and level of general thought of the public. Seeing the issue of those activities a committee is formed in 1980s, after the rate of bank failures in the United States was increasing at an appalling rate. This was primarily due to the Savings and Loan (S&L) Crunch and the fact that banks had been lending uncontrollably. As a result, the external debt of a lot of countries had been growing at an unsustainable rate and the probability of major international banks going belly up was terrifyingly high. The banking industry was going through a disorder and was offensively in need of a framework to bring some order within the confusion. To prevent all hell from breaking loose, representatives from central banks and supervisory authorities of 10 countries, known as the Basel Committee on Banking Supervision (BCBS), met in 1987 in Basel, Switzerland to issue guidelines relating to capital and risk management activities of global banking institutions. This was the beginning of the Basel Accords.

Basel I is the first in the series of regulations issued by the BCBS and was enacted in 1988 to improve banking stability. It weighed the capital owned by a bank against the credit risk it faced. Basel I defined the bank capital ratio and set the ball rolling for solvency monitoring and reporting. It focused on:

1. Assets of financial institutions are broadly divided into five risk categories (0%, 10%, 20%, 50% and 100%).
2. Banks that operate internationally are required to have a minimum of 8% capital to risk-weighted assets.

There are many drawbacks of the first initiation towards financial stability and correspondence effects to world’s economy. Further, another revised capital framework was develop to overcome from the counterparty risk for different types of borrower and to support the diversification of the portfolio in June 2004 named Basel II but it was implemented in the years prior to 2008, and was implemented in early 2008 in most major economies.The committee set three pillar:

1. Minimum Capital Requirement or capital adequacy
2. Supervisory Review
3. Market Discipline

The three major components of risk that a BFIs faces: credit risk, operational risk, and market risk. This Committee further redefined the definition of risk-weighted assets and provided guidelines for calculation of minimum regulatory capital ratios dividing the eligible regulatory capital of a bank into tier. The amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. And should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet, the proportion of its assets it must hold in cash or highly-liquid assets.

Supervisory Review focused on a regulatory response to the first pillar, giving regulators better tools to over those previously available. It also provides a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk that Banks can review their risk management system.The Internal Capital Adequacy Assessment Process (ICAAP) is a result of Pillar 2.

The last and final pillar Market Discipline requires disclosures by banks regarding their risk exposures, capital adequacy and the overall risk assessment process. Greater disclosure will increase the discipline in the marketplace, leading to greater financial stability. Basel II was much more comprehensive in its risk definition and provided a really good framework based on the three pillars. However, even this was not perfect. Between 1998 and 2008, the volume of credit default swaps being sold in the industry kept growing exponentially and increased. This led to a complete meltdown of the financial system. The financial crisis of 2008 was a wake-up call for the international financial services industry. It was the real and perfect illustration of how the entire banking industry can go from boom to bust in just a matter of days.

Further, Market discipline focused the responsibility on banks, financial institutions, sovereigns, and other major players in the financial industry to conduct business while considering the risks to their stakeholders. It is a market-based promotion of the transparency and disclosure of the risks associated with a business or entity. It works in concert with regulatory systems to increase the safety and soundness of the market. In the absence of direct government intervention in a free market economy, market discipline provides both internal and external governance mechanisms. Further it refers to the obligation by banks and financial institutions to manage their stakeholders' risk in the course of their day-to-day operations. Banks and other financial institutions assume some level of risk with each loan they disburse. This risk is passed on to other borrowers and clients as well as stockholders.

Banks and financial companies are required to prepare publicly-available financial and operational documentation in order to ensure financial transparency and disclosure of information. In this way, market discipline discourages banks and financial companies from assuming excessive or dangerous levels of risk. Doing so might affect not only their ability to make loans, but also compromise the interests of existing stockholders and clients (checking account holders, depositors, and borrowers). Because Market discipline places constraints on banks and financial companies level of risk because such risk would be reflected in financial statements and may discourage prospective clients and investors.

Basel III is an extension of the existing Basel II Framework, which provide an opportunity for a fundamental restructuring of the approaches to risk and regulation in the financial sector and introduces new capital and liquidity standards to strengthen the regulation, supervision, and risk management of the whole of the banking and finance sector. It introduced much tighter capital requirements than Basel I and Basel II. One of the most evident problems with Basel II was that it didn’t solve the irresponsible lending activities of banking institutions. 

Therefore the presence of global capital framework and new capital buffers require financial institutions to hold more capital and higher quality of capital than under current Basel II rules. The new leverage ratio introduces a no risk-based measure to supplement the risk-based minimum capital requirements. The new liquidity ratios ensure that adequate funding is maintained in case there are other strict banking crises. According to the BCBS, the Basel III proposals have two main objectives:

• To strengthen global capital and liquidity regulations with the goal of promoting a more sustainable banking sector.
• To improve the banking sector’s ability to absorb shocks arising from financial and economic stress, which would reduce the risk of a spillover from the financial sector to the real economy.

To achieve these objectives, the Basel III proposals are broken down into three parts on the basis of the main areas they address:

• Capital reform (including quality and quantity of capital, complete risk coverage, leverage ratio and the introduction of capital conservation buffers, and a counter-cyclical capital buffer).
• Liquidity reform (short-term and long-term ratios).
• Other elements relating to general improvements to the stability of the financial system.

Each area of proposed changes has a separate consultation, debate, and implementation stage. As a result, compared with the implementation of the Basel II, this enhanced level of dynamism, complexity, and interdependency within the global regulatory circumstances will likely to add significant challenge to the implementation of Basel III. Being the better tools to minimize the banking risk it may impact differently based on the level of economic stability, growth level and understanding of the stake holder. Basel III regulatory framework requires banks to maintain the capital adequacy ratio at 8 percent but in the context of Nepal NRB has gone a step forward and already set it at 10 percent. While Basel III requires banks to make a provision of buffer capital by 2.5 percent in 2019 starting from 2016, but the central bank has already asked banks here to maintain a buffer capital of 1 percent starting from the last fiscal year. As per the draft regulation on implementation of Basel III in Nepal, the central bank will increase the buffer capital to 2.5 percent in 2019. It plans to raise the total capital adequacy ratio to 12.5 percent in the next five years while Basel III has proposed maintaining it at 10.5 percent by that time. Nepali banks are not yet exposed to complex financial instruments like derivatives and securitized assets. The global standard has prescribed higher risk weights to such exposure. For this reason, the risk exposure of Nepali banks is unlikely to be affected much by the measures prescribed by Basel III. “However, this will ensure good coverage in the future when the scope of Nepal’s banking industry expands to such instruments and exposure,” it stated. The main impact in general and Nepalese economic are:

Impact on banks:

Weaker banks crammed out (the weaker banks will likely to find it more difficult to raise the required capital and deposit so-called funding and lending) in competitive market. Change in demand from short-term to long-term funding will significantly impact on profitability and ROE.

Impact on the financial system:

Reduced risk of a systemic banking crisis, Reduced lending capacity, reduced investor desire for bank debt and equity.

• Increased quality of capital
• Increased quantity of capital
• Reduced leverage through introduction of backstop leverage ratio
• Increased short-term liquidity coverage
• Increased stable long-term balance sheet funding
• Strengthening risk capture, notably counterparty risk.

 

Impact on economy:

The magnitude of the short-term economic impact of Basel III is subjected to many uncertain factors. Basel III is expected to generate substantial benefits by reducing the frequency and intensity of banking crisis. To comprehend the new regulations, the cost of increasing capital ratios may lead banks to raise their lending rates and reduce lending.

Impact on general public:

The effect of Basel III on the costs of lending with the combination of (a) increased capital requirements, particularly in the common equity element of Tier 1 capital and capital buffers and (b) minimum liquidity requirements are likely to reduce the return on equity for banks. It is unclear how different banks will address the situation but the options include reduction of rates on retail deposits; reduced staff compensation; and increased margins on products. New facilities will factor the capital costs into margin where the market will bear it. However, for existing facilities, if banks are not able to recover their consequential increased costs from their borrowers, their internal rates of return will be reduced. This started under Basel II but there will be a significant shift in Basel III as it is progressively introduced and as countercyclical buffers and liquidity requirements are set and re-set over the life of a loan.

In this respect, the typical increased costs are ambiguous as to whether such a change in circumstances gives the right to an indemnity not resist that the framework legislation remains unaltered. There are many complicated and far-reaching issues arising from Basel III. But there is not any other option or weapon for Nepalese bank to compete with global banking competition, implementation of BASEL III will be safer, but more expensive, with extensive consequence throughout the economy. However, stakeholder needs to resume the increased costs clause to make sure that both the lender and borrowers know how it will work in the new regime.