SA Banks must start preparing for pervasive, significant and some costly, reforms to the global banking regime
The June G20 Summit in Toronto confirmed that the regulatory reform agenda for the banking sector remains firmly on track, now entering a critical stage as a large number of international standards and requirements will be finalised during the second half of 2010. The reforms which have been commonly called ‘Basel III’ will affect the capital base and liquidity requirements of banks, and introduce a leverage ratio as well as enhancements to risk management requirements.
“These reforms will touch the fundamental economics of many financial market activities as well as key systems and business and risk management processes” says Johannes Grosskopf, Industry Leader for the Banking and Capital Markets group at PricewaterhouseCoopers in Johannesburg at a breakfast in Sandton.
Grosskopf says that South African banks and regulators have always been at the vanguard of the reform implementation, and he would think they will continue so through this reform. “While it may be tempting for them to wait for all the answers, the impact of the changes will be pervasive. Successful implementation for both banks and the financial system as a whole will depend on a thorough understanding of these requirements and their effect on the bank’s business model, and on quality change management.”
One area of reform is that of capital base and credit risk capital. “Corporate/institutional banking businesses will require more capital as a result of increased counterparty credit risk for derivatives, repos and securities financing” says Monika Mars, Director at PricewaterhouseCoopers’ Financial Services Advisory practice in Amsterdam specialising in Basel regulatory framework and guest speaker at the breakfast. Mars says banks may also need to raise more capital to absorb increased deductions for the adjustments to provisioning - while the significant issue regarding the deduction of minority interest from capital has been mitigated by the recent announcement by the Basel Committee on Banking Supervision (BCBS). We will additionally see increased capital charges arising from market risk stressed Value at Risk (VaR), specific VaR for trading positions, and securitisation exposures from the market risk capital reform package issued in July 2009.
Whilst these reforms collectively are expected to significantly increase banks’ capital requirements, South African banks are better placed than many of their international banking counterparts to absorb these increases, thanks to their conservative capital levels and the composition of their capital.
On the issue of liquidity, proposed changes will strengthen the liquidity risk management framework, and introduce quantitative standards for funding liquidity. Liquidity coverage ratio tests and a one year structural Net Stable Funding Ratio (NSFR) have been proposed, and the definition of ‘liquids’ has been widened beyond sovereign and semi-sovereign bonds. “These recommendations point to the strong intent of regulators to use liquidity requirements to push banks away from business models that are perceived as generating a cost to society and the public purse” says Mars.
Many analysts believe that the closed nature of the South African economy ensured that South African banks were significantly sheltered from the liquidity crisis. The question that South African banks, and indeed banks in countries such as Canada and Australia, have raised is whether the framework is appropriate for them as they were not at the origin of the crisis. Although some relief has been granted to all the banks in the recent announcement made by the BCBS whereby some of the liquidity requirements have been softened and postponed till 1 January 2018, the recommendations will continue to have a significant impact on the banks.
In its current form the new liquidity ratios present significant challenges to the banks. Grosskopf believes the banking industry, together with all stakeholders, will have to evaluate the changes and assess how best to respond. Failing a joint effort, this could restrict lending volumes, or reduce asset maturities, in order to balance their NSFR which could have a knock-on effect on economic growth.
The introduction of the leverage ratio is aimed at providing a non-risk based measure to supplement the risk based capital requirements. Mars says the leverage ratio could further increase the amount of equity across all operations of banks to support existing levels of asset base. This will particularly impact on institutions with large secured lending books (for example mortgages or repos). Mars added the recent announcement of the BCBS does provide some welcomed relief by postponing implementation and proposing a lower ratio than originally feared.
Enhancements to Risk Management requirements include full accountability from the board and senior management for setting and monitoring a comprehensive risk tolerance and implementing a fully embedded risk culture. Mars says risk management structures will have to consider how individually immaterial risks may combine to create material losses. “This means further enhancement of the stress testing framework and tools, to become more dynamic and integrated across risk classes. It will also lead to increased focus on the risk control units and the duties of the Chief Risk Officer.”
Grosskopf concludes that although many of the reforms may be phased in over time as global economic conditions remain challenging, SA banks must prepare for the changes. “A successful response requires a clear understanding of the proposed changes in the context of the whole organisation. SA banks must now start considering what will be required from international changes, and the South African Reserve Bank, to ensure they are well positioned to withstand the tidal wave of imminent regulatory reforms.”
