Emerging BASEL IV: An Opportunity For African Banks?

Introduction
LAGOS, Nigeria, Capital Markets in Africa: Whilst developed countries have been frantically adopting the string of new capital adequacy regulations released by the Basel Committee of Banking Supervision (“BCBS”), since the global financial crisis, the situation across the African continent has been very different. Apart from South Africa, which has been closely aligning with the BCBS developments, the picture on the rest of the continent is very mixed. Some countries on the continent still apply Basel I capital adequacy rules, some have partially adopted BII and some have partially adopted BIII. This trend in new banking capital adequacy regulation adoption is similar in other emerging continents around the world.

In general, developing countries have found the implementation of the BII/BIII rules very challenging – in particular the advanced approaches which rely on internal models for capital measurement. This can be attributed to compliance rules complexity, limited models expertise, lack of historical loss data, underdeveloped credit bureau integration and legal system shortcomings.

Due to the above reasons, developing country regulators have followed a cautious approach, adopting new rules slowly and, in general, only allowing standardized approaches for banks in their jurisdictions. The BII/BII standardized approaches are simple to implement, but lack in risk sensitivity and comparability with capital adequacy ratios of advanced approach banks. Unless a jurisdiction also allows advanced approaches for its banks, it is generally not being considered as being compliant with BII/BIII.

Emerging Basel IV
Apart from the new liquidity requirements, BIII has been targeting add-ons to the minimum capital adequacy ratio through new capital buffer rules (counter cyclical buffer, capital conservation buffer, etc.) However, the base for calculating capital requirements (i.e. risk weighted assets (“RWA”)) was not materially changed with BIII. Since the release of BIII, the BCBS has been conducting a significant overhaul of the RWA measurement rules for all risk types – credit, market, operational, etc. through various consultations and impact studies. Rules on all the amendments are expected to be finalized by the end of 2016 for staggered implementation thereafter, through 2019 by developed countries.

The main aim of the revisions is to promote harmonization of capital requirements across jurisdictions by finding a balance between risk sensitivity, simplicity and comparability. This has been necessitated by the large differences in risk weights across advanced approach banks globally.

The revised standardized approaches
A key feature of BIV is a new set of standardized approaches for operational risk, trading and banking book credit risk and trading and banking book market risk. The aim of the new standardized approaches are to provide capital floors for banks using advanced approaches and to provide improved risk sensitivity and calibration to the current standardized rules. The new standardized approach rules are significantly more comprehensive and risk sensitive than the current BII/BIII ‘broad brush’ standardized rules. Unlike under the BII/III framework, jurisdictions will be considered compliant with the BIV framework if they allow the use of the standardized approaches only.

Although the new rules will be phased in and not implemented in a ‘big bang’ fashion, such as with BII, the amendments constitute such a significant change from the BII/BII approach that commentators now commonly refer to them as BIV, even though the regulators have not officially used this term.

BIV and internal models
BIV is a major departure from the reliance on internal models which was introduced with BII and continued under BIII with more stringent requirements in some areas (e.g. market risk). Under the new regime, the use of internal models for capital adequacy measurement is discontinued for some risks (e.g. operational risk and credit spread risk in the trading book). For other risks, e.g. market risk in the trading book, internal models are partially allowed. However, for all risk types internal model capital measures might be constrained by the equivalent standardized approach calculation, which will provide a minimum capital floor. Advanced approach banks have made significant investments in internal models for capital adequacy measurement and is likely to continue doing so under BIV. However, for standardized approach banks, the cost vs benefit equation of investing in internal models for regulatory capital measurement have been significantly altered. Going forward, there could be less incentives for standardized approach banks to adopt internal model based advanced approaches.

BIV Capital Implications
The BCBS stated aim is not to increase capital requirements overall in the global banking system, but to achieve harmonization and reduced variability of risk weights across jurisdictions. Capital implications of the new rules could differ widely across jurisdictions. This will be due to the different stages of BII/BIII adoption in developing jurisdictions and differences in risk weights of BII/BIII advanced approach banks across developed jurisdictions being observed at present. The latter is one of the reasons for BIV and can be attributed to differences in rules interpretation (e.g. local vs international rating scale adoption) and different stress testing regimes for setting minimum capital floors across developed jurisdictions. Apart from differences in capital adequacy regimes across jurisdictions, the capital implications of the new rules will be influenced by business models, portfolio/product structures and risk mitigation practices which could impact individual banks in the same jurisdiction to a greater or lesser extent.

Typically, under BII/BIII the aggregate capital requirement under the advanced approaches could be around 30% less than the equivalent risk profile standardized requirement. Under BIV, the revised standardized approach floors could increase the capital requirement for low risk portfolios (e.g. investment grade corporates and residential mortgages) compared to internal rating model outputs. In general, one can expect the BIV capital implications for advanced approach banks to be more negative than for standardized approach banks in developed jurisdictions.

Capital implications of BIV for African banks will be a function of many factors, such as extent of capital adequacy reform, business models of banks and risk profiles of banks. Some African countries have set the minimum capital adequacy ratio at a large margin above the BCBS minimum requirement to compensate for the reduced risk sensitivity of the current standardized approaches. To avoid double counting, scope might exist in these jurisdictions to bring their minimum capital adequacy ratios in line with the BCBS requirements, when adopting the more risk sensitive BIV standardized approaches.

Compliance complexity
The Basel IV standardized approaches have much more granular calculation rules than the existing BII/BIII standardized approaches and will be more complex to implement. However, compared to the advanced approaches, it will be a relatively painless implementation that does not rely extensively on loss data availability, risk modelling expertise, re-training of bank staff to use model outputs in decisions, process changes, etc. Migration from the current BII/BIII to the BIV standardized approach should be achievable within 6-12 months for a large African bank compared to the multi-year transformation efforts typically associated with migrating from standardized to advanced approaches.

BIV and capital markets
Compared to the current BII/BIII standardized approaches for measuring market and credit risk capital requirements for banks’ capital market activities, the new BIV standardized approaches are much more precise and risk sensitive in this area. Under the new standardized rules, banks will receive capital benefits for implementing counterparty pre-settlement collateral management risk mitigation practices (netting, margining, etc.). Counterparty capital requirements for trades cleared through central counterparties (exchanges) will also attract significantly less capital requirements than bi-laterally cleared OTC trades. This could provide incentives for African countries to adopt BIV and expedite implementation of derivatives exchanges.

BIV benefits for African banks
Basel IV offers a very attractive alternative for African banks and Regulators who have been contemplating adopting the BII/BIII advanced approaches or for those still on BI. Through the standardized floors, BIV could reduce the competitive advantage that advanced approach banks might have had in developing markets through their internal models capability. It could level the playing field
as subsidiaries of advance approach foreign controlled banks might not be able to hold substantially less capital for the same risk than a standardized approach local bank.

The increased risk sensitivity of the BIV standardized approaches and enhanced disclosure will increase credibility in the capital adequacy measures produced by these approaches. Comparability with capital ratio components of advanced approach banks in developed markets will further aid in understanding of risk profiles and capital adequacy position of African banks, once BIV has been adopted globally. This could lead to increased confidence in the banking systems of many African countries. For the above reasons, one can expect that rating agencies and multi-lateral agencies are likely to place pressure on developing country jurisdictions to be early adopters of BIV.

Conclusion
Whilst new capital adequacy releases have typically posed threats to African banks and regulators, as it raised the compliance hurdle and increased the gap with developed jurisdictions, BIV offers a welcome change. It could provide a low cost opportunity for jurisdictions across the continent to expedite bank capital adequacy reform and align with the latest global capital adequacy standard. This could lead to increased confidence in their banking systems as the BCBS BIV aims of increased risk sensitivity, capital adequacy comparability and calculation simplicity are being realized. Regulators across the continent should therefore take a pro-active approach to BIV by initiating industry impact studies, performing cost and benefit analysis for BIV adoption and design roadmaps for implementation.

By Andre Blaauw, Associate Director, PWC South Africa

This article was featured in the INTO AFRICA October edition, which focused on the Banking Sector in Africa and is titled Banking in Africa: The current status.