The Basel II Capital Accord, the set of rules issued by the Bank for International Settlements (BIS) in 1999 to establish new regulations for banks world-wide, aims to encourage the development of better risk management by banks. Additionally it aims to add momentum to consolidation in the banking sector, change the shape of the credit curve through credit related differentiation in risk weightings, and strengthen incentives for banks and corporate borrowers to maintain and improve their own credit quality.
Although most large Western banks regard the Basle II Capital Accord compliance targets as simply an “officialization” of their practices over the last decade, Lebanese banks are yet ill-prepared to meet them. They are not alone in their anguish, as most Asian, African and emerging market banks, as well as some smaller US and European banks, consider the forthcoming regulations to be impossible to meet, and are contemplating an increasingly uncertain future.
Such anxiety is easily understood, as there are still several factors that are inhibiting the development of risk management cultures and processes. Indeed, Lebanese banks still have a weaker connection between risk management and corporate strategy than their Western peers, there is a lower level of risk management review at the board level, as well as a weaker link between management performance and risk management effectiveness. They also lack the appropriate historical data to develop and support their internal models. The culture – whereby a banker’s performance is determined by his ability to raise deposits and generate revenues – is clearly insufficient and cannot be developed quickly enough to embody credit risk consciousness. Some banks in Lebanon do not realize that one miscalculation of credit, market or operational risk can have dire consequences on already limited capital.
The Basel II Accord requires banks to generate a healthy and recurrent return out of a carefully planned risk portfolio. The difficult environment provided by the Lebanese economy has affected their ability for efficient diversification. They all offer the same traditional services and have not shown imagination in activity and product diversification. Moreover, loan data collection, which constitutes an imperative part of Basel II’s directives (very useful for calculating probabilities of default, exposure at default, etc.), has always been the weakest aspect of most Lebanese banks. Some of the larger banks have only recently started to build up a data warehouse, whereas Basel II requires banks to have a minimum of five years’ data in order to be able to develop an internal rating system.
The gathering of qualitative data assumes greater importance in Lebanon than in Europe for example. Financial accounts do not necessarily show the real picture and Lebanese banks have to show extra care in gathering non-financial data that could at some point prove to be instrumental in the lending decision. Lebanese banks also present some weaknesses in terms of credit analysis capabilities. Indeed, credit analysis methodologies are seldom developed, and risk mitigation techniques remain basic. For example, most banks have not yet developed advanced skills such as transferring risk by way of securitization, (although to be fair, the legal environment in that context has not been developed as yet), seeking new risk mitigating skills by using collateral that is not correlated to the loan itself, and creating liquidity in the credit market.
With Basel II, Lebanese banks will no longer be able to follow the safe but undifferentiated strategy of accepting a given level of market pricing, holding all assets underwritten and not differentiating their risk portfolio sufficiently. They will have to run their business and develop their lending according to economic considerations and view shareholder value as a key driver, rather than just abiding by regulatory standards. Banks in Lebanon will also have to learn to live with capital volatility, update their risk models to take into account extreme economic conditions such as those that now prevail in the country, and strive for improved data for their risk management systems.
Failure to develop these capabilities could result in credit crunches, as banks would choose to stop lending if risk models provide inaccurate assessments, creating as a result a real economic crisis that would impact negatively on small and medium size enterprises and individual borrowers. A credit crunch is the last thing a fragile Lebanese economy needs at the moment, and the banks carry a heavy responsibility. There must be a will to transform the Lebanese banking sector into a sophisticated lending machine, rather than just a deposit bank-system, with the sole purpose of financing the government through treasury bond subscriptions.
Certain medium and small-sized banks could be faced with no alternative but to withdraw from certain activities, such as corporate lending, which they cannot develop according to Basel II guidelines, due to a lack of resources. The shunning of some commercial or investment banking activities could be harmful to the domestic economy, which is already in dire need of financing diversification. Moreover, the contraction in the activities of a certain number of banks could lead to a frenzy of bank sales and mergers. Indeed, around 40 banks are not expected to be able to implement the Basel II guidelines, and will be hurrying up to sell their franchise, to larger domestic, regional or international banks. Such a clogging up of merger and acquisition activity could lead to significantly depressed prices for the sellers, and could in turn harm depositors’ confidence in the banking sector.
As for banks willing to implement the Basel II Accord and hence be competitive on a global, or at least a regional basis, they will inevitably need to increase their capital at one stage. Although current capitalization levels for the larger banks appear more than comfortable at the moment – with capital adequacy ratios exceeding the 20% mark – the application of Basel II rules as they appear today is likely to reduce such ratios to levels below 8%, which is the current regulatory minimum for banks world-wide. (Banque du Liban currently imposes a minimum capital adequacy ratio of 12%). This possible outcome would force banks to seek additional capital, which can normally be obtained through the capital markets. However, the local equity market is illiquid, there is no appetite from retail investors for domestic shares, and the trend for emerging market share offerings has been dead and buried for a very long time. On the other hand, domestic banks could increase their capital through organic growth, although this requires time and the maintenance of profitability at current levels, or they could have existing shareholders or new strategic investors inject fresh capital.
In any case, there is no turning back now. Basel II is expected to be imposed by the beginning of 2007 – for banks in G10 countries – and Lebanese banks will have no choice but to either take the challenge of Western peer pressure and be compliant with the guidelines – or become smaller niche players. Embracing the challenge of Basel II can only be beneficial to Lebanese banks, and could ultimately prove to be a major factor towards a potentially significant economic recovery.
Nicolas Photiades is managing director of Orion Financial Solutions. He is an advisor to the Lebanese banking sector on securitization and structured financing.
BASEL II EXPLAINED
Under the accord, a new set of risk ratings for borrowers determine the capital a bank needs to approve loans
The Basel II Capital Accord is a set of new capital rules for banks worldwide. The idea is that the riskier the loan portfolio or assets, the more capital a bank needs to hold. Basel I established minimum capital requirements for lending based on a definition of regulatory capital, and a measure of risk exposure and rules specifying the level of capital in relation to those risks. Under Basel II, the definitions of regulatory capital and the level of capital (8%) in relation to risk exposures are unchanged. The main changes relate to the measures of risk exposure, and within this, the focus on credit risk exposure, on which the proposed risk weightings are based. Measurements for market and operational risk are still being discussed.
Basel II gives a great deal of importance to credit ratings, which will determine the risk weighting on an asset and hence the amount of capital needed. For example, if a borrower is rated B (below investment grade) internally or externally, then it will have a risk weighting of 150%, but if it was rated AA, then the risk weighting would be 20%. Of course, all risk exposures have to be classified into categories, with each one subject to specific risk inputs, weights and minimum requirements. Under Basel I, the risk weightings had less differentiation and were divided into only four categories (0%, 20%, 50% and 100%). Under Basel II there is a multitude of risk weightings, which are determined by external ratings or a bank’s internal rating system.
Example: Under Basel I, a corporate borrower would obtain a risk weighting of 100%, regardless of its rating. If this corporate borrower took a loan of US$10 million, then the bank would have to set aside US$800,000 of capital (100% x 8% = 8%, ® 8% x US$10 million = US$800,000).
Under Basel II, the risk weighting on the same corporate borrower would depend on its rating. If the bank has an internal rating system, and rates this corporate A, then the risk weighting would be 50%. Therefore, a US$10 million exposure on this borrower would require capital of US$400,000 (50% x 8% = 4%, ® 4% x US$10 million = US$400,000).