There have been many regulatory reforms in the wake of 2007-2008 financial crises in the US and Europe. Notable among them is Basel III, arguably most significant to financial institutions glob=ally. To explain why it has come into existence, we need to identify the drawbacks of Basel II and its evolution over time.
Basel I (1988) was categorised as a "one-size-fits-all" approach, while Basel II (2004) offered improved risk-sensitivity but unfortunately created procyclicality in the financial system. In addition, the definition and composition of regulatory capital in Basel II were not reviewed to improve the loss absorption quality of capital instruments. Despite Basel II's risk sensitivity, the requirement for sufficient loss-buffering capital to safeguard against systemic risk, and macro-prudential policy focusing on the interactions between financial institutions, markets, infrastructure and wider economy, were missing. Furthermore, there was no explicit regulation on leverage, as Basel II assumed that its risk-based capital requirement would automatically mitigate the risk of excessive leverage. It turned out that the recent crisis in US and Europe was a consequence of excessively leveraged banks, which clearly showed that the assumption was flawed. Another missing piece was a quantitative standard on liquidity risk, as witnessed in the crisis, when almost every bank suffered solvency issues as they failed to maintain sufficient liquidity buffers.
In an attempt to correct these flaws, Basel III (2010) was formed. Its enhancements on Basel II come primarily in four areas 1) augmentation in the level and quality of capital; 2) introduction of liquidity standards; 3) tools to address excessive leverage and systemic risk; and 4) better and more comprehensive disclosures.
Turning to the more important issue of the impact of Basel III implementation on the Thai banking industry, there are several things of which we should be aware. The most frequently asked question here is, what is the additional capital level that banks in Thailand need in order to conform to Basel III? The immediate burden on Thai banks in terms of minimum capital requirement should be lower than imagined, judging from the high current level of capital. That level stands at around 16 per cent on average, and most of it is of high quality. Therefore, the Thai banking industry has already met the minimum capital requirement of Basel III. Having said that, banks are welcome to reserve more capital than their current levels so as to boost their business prudence and to accommodate the increasing demand for loans in the future. In the longer term, the expanding economic growth will naturally lead to more credit demand which will mean that banks would have been required to raise additional capital even in the absence of Basel III.
How about the cost-and-benefit analysis of Basel III?
Various papers have emphasised the negative consequences of Basel III, but very few have factored its benefits into their analysis. To get a complete picture, one must consider both the costs and the benefits of having banks fund more of their assets with more loss-absorbing capital required by Basel III. The benefits come because a larger buffer of truly loss-absorbing capital reduces the chance of runs on banks and financial crises, which always result in substantial economic losses (international and historical figures suggest that a crisis leads to a 10-per-cent drop in GDP approximately) which eventually become a fiscal burden on taxpayers. On the other hand, the offset to such benefits comes in the form of potential higher costs of inter-mediation through banks, and such costs would be reflected in higher interest rates charged to bank borrowers. Therefore, it is a cost-and-benefit-analysis exercise, or how much we are willing to sacrifice short-term growth for long-term sustainable growth prospects. To justify this, empirical research by BIS and Bank of England economists shows that even if Basel III imposes some extra costs in the short-run, it will secure medium- to long-term growth prospects and stability.
How will Basel III impact the profitability of Thai banks or their business/incentive structure?
As we know, Basel III demands higher and better quality of capital, resulting in higher cost of equity and, thus, lower return on equity (ROE) for banks. However, the ROE of the Thai banking system for the last five years has been consistently above 8 per cent. Theoretically, a lower ROE implies that shareholders take less risk or are more careful in business. In practices, the more interesting question is whether banks will bear the increased costs of capital themselves or pass it to their depositors and borrowers (in order to maintain their high ROE). I believe that there is some room for banks to bear a part if not all of this cost given the excellent performance of Thai banks recently (reported profit of Bt135,000 million for Q1-Q3).
As in other businesses, to compete successfully and sustainably in the longer run, banks need to build their business around core competencies and competitive edges such as scales, operational risk management, skills, geographical reach and customer relationships.
Let me conclude by answering one final question; Does Thailand need Basel III? Some people argue that Basel III would be redundant for the Thai banking system as it would have remained sound through the crisis with or without Basel III, while banks in advanced economies went bust. I personally hold a different view. The importance of Basel III for us is that Thailand is a small and open country and has to integrate with the rest of the world. This is proven by the increasing trend of cross-border business. Unexplainable regulatory deviations from global standards will hurt us both by way of perception and also in actual practice. The perception of a lower-standard regulation will put Thai banks at a global competitive disadvantage (for example, higher funding costs). Meanwhile, the international linkage will need more tightened risk management systems and a sufficient buffer to withstand any external shocks.
The remaining issue is the implementation timeframe for Basel III. The Bank of Thailand plans to implement Basel III in phases starting from 2013 onwards. As discussed earlier, Thai banks are now healthy in terms of capital level and profitability and therefore capable of meeting capital requirements in the next few years. There is no better time to fasten your belt than when you are in good shape. Even though some countries have not been able to meet the planned start date, a number will be ready to begin introducing the new capital requirements as planned on January 1, 2013 - for example, Australia, Canada, China, Hong Kong, India, Japan, and Singapore. Last but not least, there have been some concerns over the liquidity and leverage requirements on long-term funding cost, particularly infrastructure loans and on trade finance business, respectively. However, some details of liquidity requirements are still to be finalised and leverage requirements will not be in effect until 2018, so their impact assessment is still at the preliminary stage. These issues will need to be carefully considered before any commitment is made.
(Views expressed are the author's own.)
Dr Sakkapop Panyanukul is a member of the Financial Institutions Policy Group, Bank of Thailand.
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Article source: http://www.thethailandlinks.com/2012/12/28/basel-iii-and-its-impact-on-thai-banking/
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