The banking world was rocked in early 2000 when the Basel II Capital Accord came out with its first draft. This accord emanated from the Bank for International Settlements (BIS), which is an international organization whose aim is to promote international monetary and financial cooperation, discussions and policy analysis, and acts as a bank for central banks worldwide.
Back in 1988, the BIS created the Basel Committee for capital adequacy for banks worldwide. This first Basel I accord stipulated that different risk weightings had to be applied to the different bank asset classes, and that these risk weightings determined the amount of capital needed by banks to cover the risk on their assets. However, Basel I only broadly covered three types of loans with an undiversified and incongruous risk weighting scale (0%, 20% and 100% for OECD – Organization for Economic Co-operation Development – governments, OECD banks, and everything else respectively). The capital adequacy ratio or the equity to risk weighted assets ratio had to reach a minimum of 8% for all banks worldwide.
The Basel II accord put an end to the over-simplistic Basel I and established new rules for banks. Under Basel II, risk weightings are highly diversified and depend uniquely on mostly credit risk. Basel II is asking all banks to base their risk weightings on credit ratings, whether these are provided by specialized rating agencies or an internal rating system developed by the banks themselves. The minimum regulatory capital adequacy ratio remains at 8%, but is arrived at using exponentially more sophisticated risk assessment methods.
Step in right direction
For many, the Basel II accord is seen as a significant step in the right direction, as it forces banks to improve radically their risk management practices. It also forces banks to realize the importance of “economic” capital, which is the capital needed given the underlying risk level on the asset side. This new accord also puts more responsibility on the national supervisor; in Lebanon’s case the banking Control Commission (BCC), as it faces the task of developing sufficient and suitable resources to meet the demands of the accord.
No matter how revolutionary this new accord is on bank capital, it is creating havoc among most of the world commercial banks. Indeed, most banks on the planet are not ready and are ill-equipped to meet the Basel II conditions, and realize that once Basel II regulations are implemented, their capital adequacy will look weak and insufficient. The difference between the Basel I and Basel II accords are so significant that all the work established by banks on the basis of Basel I from 1988 till today will appear obsolete. Risk management systems and risk models will have to be significantly updated at a very high financial cost, while entire business philosophies and strategies will have to be completely re-thought.
For large international banks, Basel II is not really a problem, as they have been developing a work ethic and a risk management system that is similar to what has been laid out by the Basel II accord. It is no surprise in any case to find that most members of the Basel Committee responsible for coming up with the Basel II accord are all former bankers employed by these large multinational institutions. By laying out the new principles, the Basel Committee is in a way forcing more level playing fields in international banking and indirectly creating a situation whereby the weaker banks, which are unable to adapt to the new system will have to either raise their game or disappear altogether, pushed out by competition.
The Basel II accord is due to be implemented in developed economies (mainly G8 countries) in January 2007, while all other countries will be given more time to adopt the new rules. In Lebanon, the BCC has set the date of implementation for sometime in 2008. Given the current state of the Lebanese banking system in terms of risk management and credit risk assessment capabilities, the date set by the BCC for the implementation of these tough rules and regulations might be considered tight. Most, but not all, Lebanese banks, have struggled to understand the concept of Basel II for the last few years, despite massive communications efforts by the central bank and the Association of Lebanese Banks. Most have not yet started to build a data warehouse (five years worth of qualitative and quantitative information), as required by Basel II, and wouldn’t have the capacity to analyze such data even if it existed.
Before implementing the Basel II accord, Lebanese banks need to recognize that risk management must be embodied in the core strategy and culture of the bank, and that there should be a need to adopt an integrated approach to managing risk throughout the institution. They will have to come to terms with the idea that economic capital and shareholder value are the essential key drivers, and not just regulatory capital.
For the moment, the situation is such that there is a lack of comprehensive and reliable default and recovery data, back-testing results are non existent, and few banks are capable of using internal ratings models under the IRB method. Moreover, there are still several more factors that are inhibiting the development of robust risk management cultures and processes: Lebanese banks have a weaker connection between risk management and corporate strategy than their Western peers, there is a lower level of risk management review at board level, as well as a weaker link between management performance and risk management effectiveness. While a majority of markets are putting in significant efforts to develop internal risk management models, most banks in Lebanon still lack the appropriate historical data to develop and support their own internal models, the development of which is of vital importance to the banking sector as well as to the economy as a whole. These models will have to assess default rates, and more importantly recovery levels, as it is usually during a downturn, similar to what Lebanon is going through today that banks have to realize their assets. Although Gulf money is swamping Lebanon for the moment and the disposal of property collateral for bad loans can be done more easily, it remains that recovery levels will always fall below what the banks have always assumed. Basel II should therefore force local banks to develop a performing risk management model that would assess default and recovery rates more realistically.
A badly developed risk model could considerably underestimate a bank’s need for capital when calculated in the economic cycle and could even lead banks to decide to stop lending as long as their risk models are inadequate. Indeed, if incorrect assumptions are built into credit models, credit crunches could result, as banks would be feeling uncomfortable lending to the private sector. In fact, it’s like a fighter plane going to battle without a modern radar. This plane would be blind and would rather choose to withdraw from a potentially losing battle. A credit crunch is similar in the sense that banks may choose to stop lending for fear of embarking on potentially significant levels of bad loans. Such scenario would be disastrous for the economy and would most probably see a substantial number of companies going bust for a lack of liquidity and funding. In other words, a lack of organization on an internal level for banks in order to tackle risk properly, could lead to an implosion of the economy. The danger for the country’s economy collapsing would not be the government’s inability to repay foreign debt, but the banks’ incapacity to assess risk.
Although such a scenario has a small probability of ever occurring, it should nevertheless be taken very seriously by both the banks and the national regulator/supervisor. The latter has already circulated detailed questionnaires on Basel II to all banks, in an effort to check the status of each bank as regards to their ability to implement these new demanding guidelines. The response from some banks, particularly the smaller ones has reflected a recurring ignorance of the matter as well as some degree of panic. When first issued, the Basel II regulations were widely considered to be a weapon of mass destruction to the smaller and emerging market banks worldwide. The accord placed emerging markets banks (including Lebanese banks) at a disadvantage as compared to multinational banks, especially those which are present in their domestic market. It also added further momentum to the consolidation pressure faced by smaller banks which lack the resources to develop sophisticated internal rating and other risk models. For most small banks the choice will be simple: either reinforce capital and become niche players, or sell, before it’s too late, to larger banks, which have the resources to implement Basel II regulations.
If the Basel II regulations are to be applied to the balance sheet of Lebanese banks today, then the capital adequacy ratio, as defined by the BIS, would drop well below the 12% minimum regulatory level set up by the central bank. At the moment, the average capitalization ratio for the Lebanese banking system stands at around 21%, which appears too high given the risk environment. However, if Basel II conditions are applied, given the approximate probabilities of default, the ratio would drop sharply to around 5% (in some cases, well below that level), reflecting a high level of risk on the asset side.
This future inadequacy in capitalization should make the banks more aware of the urgent need to increase capital, using various means, with a particular focus on IPOs (initial public offerings) and listings on the BSE. A listing would diversify the shareholder base, force the listing bank to maintain transparency and market discipline (in strict accordance to Basel II’s Pillar III), and would allow for quick subsequent capital increases whenever they are needed. A large number of banks seeking a listing on the BSE over the next two years would boost the local bourse significantly, as the number of stocks would increase and local and international investors would be offered a greater stock diversity. The secondary market would also be enhanced in terms of liquidity and any potential bubble would be prevented, or at least postponed to a later date, as the arrival of the new banking stocks would offer continuity in terms of investment opportunities.
However, banks should be aware that capital increases would have to take place starting today and on a gradual basis. If Basel II rules are implemented in 2008 and banks are not prepared on the capital side, a massive traffic jam of banks seeking a listing, all at the same time, may then occur. No market in the world can take a large number of simultaneous IPOs from companies in the same sector. Such a situation would be catastrophic for the BSE, the banks and the Lebanese economy. Let us hope these warnings are heeded.