Dubai: Even as the UAE’s banking sector is preparing to fully comply with the Basel III Capital requirements by 2019, there is a new set of rules on capitalisation levels on the horizon that will have significant impact on the way in which banks will be required to maintain capital and liquidity levels in the UAE.
Analysts expect the new capital rules under what is known as Basel IV will be a significant enhancement to Basel III rules. “The difference will be largely quantitative with banks requiring to comply with commonly accepted standards in deciding risk weighting of assets rather than using internal models,” said Steve Punch, Director Financial Risk Management, KPMG Lower Gulf.
The key capital ratio is a banks’ equity divided by their Risk-Weighted Assets (RWA). “Banks are generally given several options to calculate RWA, but this is not allowed in the UAE where only one option for each risk type exists,” said Punch.
Many banks, especially European banks, may face significant regulatory capital impacts under the so-called Basel IV reforms proposed by the Basel Committee on Banking Supervision (BCBS). The current state of the suggested changes include reworking the approach to RWA and possibly internal ratings, as well as set regulatory capital floors. The proposed changes compliment the Basel III capital and liquidity changes by introducing revised standardised methods for calculating RWA for the 3 main risks banks face, credit risk, operational risk and market risk.
In many countries, banks are given several options to calculate regulatory capital. One of these options allows the use of internal credit models and generally results in a much lower calculation of regulatory capital compared to the standardised approach option. “The revised standardised themes will have a significant effect not only for UAE banks, but also on banks in other markets and more advanced banks due to a limit on the maximum benefit they can obtain between using internal model estimates to calculate RWA, and the revised standardised approaches” says Punch. “Overall the RWA’s across different asset classes is higher, except for corporate exposures”.
According to analysts, if banks do nothing to mitigate the impact of the evolving capital rules, these will require European banks alone to set aside hundreds of billions of dollars in additional capital, while reducing the banking sector’s return on equity. “The impact will be felt by banking sectors across the world including the GCC and the UAE banking sectors and the banks need to prepare for the new rules,” said Punch.
Focus on denominator
Basel III primarily focused on the numerator of the minimum required regulatory capital ratio. It covered increases in both the quality and quantity of banks’ capital, including a higher minimum capital requirements resulting from increased Tier 1 and additional capital buffers such as the conservation buffer, counter-cyclical buffer and a buffer on systemically important banks.
“Under Basel IV the focus is on the denominator of the capital ratio. That is the calculation of the credit, market and operational risk exposures of a bank using either standardised or internal model based approaches. Current standardised model is widely seen as outdated and internal models are already being “de-emphasised” by the Basel Committee,” said Punch.
There is general agreement among regulators that variations across banks in risk exposure weightings based on their internal models do not always seem to reflect the difference in the underlying risks.
As part of setting new standards in risk weightings, the Basel Committee has already finalised revised frameworks for counterparty credit risk, market risks and interest rate risk in the bank balance sheets.
Going forward new sets of rules are expected on increased leverage ratio on systemically important banks and capital treatment of simple and high quality securitizations. The new set of regulations are also likely to include capital-related regulatory initiatives such as enhanced stress-testing and the development of new set of macro-prudential norms that could further enhance risk weighting of assets on banks’ books.
The proposed Basel IV rules likely to come into force from 2019 have come with their own set of concerns for the banking industry across the world. Banks are primarily concerned about higher capital requirements based on common standards would increase their cost of funding, reduce return on equity and constrain their ability to lend, ultimately impacting their margins.
Bankers say, the sector is already under massive regulatory pressure and bringing in revised standardised risk weighting (of assets) against the use of internal models will discourage them from taking a risk-sensitive approach to managing exposures.
