'Bad banks' vulnerable under Basel 2, warn bankers

At a luncheon held at Hong Kong''s Foreign Correspondents Club, two senior bankers gave their views on how Basel 2 will affect Asia''s banks.

The new Basel Capital accord -- popularly known as Basel 2 -- has already made many bankers in Asia concerned about how they will manage their risk when it is implemented in 2004. A lot of the initial reaction to the proposals has been negative; banks will go out of business, costs of implementing complicated risk-management technology will be prohibitive. Those are just two of the concerns.

However, the news is not all bad, according to two senior bankers who attended a panel discussion on the accord earlier this week at Hong Kong's Foreign Correspondents Club. While accepting that the new proposals will present the region's banks with some tough challenges, both Simon Topping, executive director for banking policy at the Hong Kong Monetary Authority (HKMA), and Paul Sheehan, vice-president of Asian Bank research at Lehman Brothers, suggest the changes Basel 2 will enforce will ultimately be positive for the region.

Topping is not alone in arguing that 1988's rules, as stipulated by the Basel Committee on Banking Supervision and which require banks to hold 8% of their assets as capital, have long ceased to be relevant to banks over a decade later.

"The existing accord is being used less and less by banks; it is just a mechanistic calculation that produces a required amount of capital," says Topping. "It's not about how banks allocate capital to a business because it does not differentiate between different types of risk. The new accord is trying to be more risk sensitive.

"Instead of just saying that you must provide a certain amount of capital for all corporates or mortgages, it says 'let us have a look at the quality of particular loans and allocate different amounts of capital according to that quality'," Topping continues. "The incentive in this accord is not to hold more capital but for banks to manage their risk more sensitively."

Nonetheless, there are problems with how the proposals, as they currently stand, would work in reality -- which Topping acknowledges. "There has been a lot of criticism because from a lot of banks in Hong Kong because it does require them to hold more capital but this is a temporary teething problem and everyone understands that.

"There are also another couple of problems where the calibration needs to be adjusted," suggests Topping. "One is for operational risk where at the moment the accord largely covers the risk of losses due to counter party default: credit losses. Under the new accord, they are trying to cover operational risk losses which are losses caused by faults in the system and people. As things stand, this could knock between 2% to 3% off an Asian bank's capital ratio, which is significant. That is something that we do not feel appropriate because Asian banks historically have not suffered large losses through operational risk."

Perhaps the main area in which Topping feels larger banks, at least those in Hong Kong, can benefit is that Basel 2 will allow banks to implement an internal-ratings based approach on how they allocate capital, using credit risk models and their own experience.

"This is a big step forward but we only expect a handful of banks in Hong Kong to use this method initially," he says. "The advantage of this approach is that banks will be able to break down their 'performing' books into at least six categories. They will not just be able to say whether a loan is performing or not, they'll be able to say what kind of risk it is, how much they want to allocate to different types of risk and monitor that risk. We believe all the banks in Hong Kong of significant size should use this technique as part of their risk management."

Sheehan believes Basel 2 will be beneficial to the regional economy, but not necessarily to the region's banks. "Despite the upheaval, I'm willing to say this is unambiguously positive for Asian economies," he states boldly. "It is going to do a number of things that are going to help us along here, such as enforce some of the structural changes we have wanted to make in coming out of what was really a systemically-caused crisis.

"Firstly, it will force banks to improve risk management and measurement and, largely, the problems have been with the latter," Sheehan adds. "Regardless of what you think about some of the bankers in different countries, by and large they have a common temperament and that is that they are fairly risk averse and conservative, even in all the countries where the banks have gone bankrupt. The problem is that they haven't been given the tools to properly measure their risk."

Sheehan believes this situation will be addressed by the new accord. "Basel 2, by forcing banks to look at their exposures, by forcing them to at least consider whether they should develop an internal ratings approach and by certainly integrating the 1994 Market Risk Accord with the underlying credit risk accord, is going to bring us to a much higher level in terms of risk measurement, and thus allow boards of directors to set their risk appetite from a standpoint of more information rather than less."

Because banks will have to be more circumspect in their activities, particularly with their lending, this is going to have an upside for the region's capital markets. "Some of the large corporate lending is going to move off a bank's balance sheet, where it has always been a somewhat questionable activity," argues Sheehan. "What that will help do, and you can see this already, is develop more liquid capital markets as the lending moves into fixed income instruments. I think it is quite telling that even in places such as Thailand and Indonesia, which are considered to be extremely distressed at this point and where banks are not looking to take large corporate exposure, you do see the domestic fixed income markets flowering and beginning to become more liquid."

Nevertheless, some Asian banks will struggle to put the new accord in place. "We will see the overall level of capital for banks rise; the accord is not intended for all banks to raise their levels of capital, but a disproportionate number of the markets where you will see additional capital needed are in Asia. We have to recognize that it will be a negative for those banks still trying to get back on their feet after the crisis," remarks Sheehan, echoing Topping's earlier comments.

"Most worrying is the possibility that some of the Asian markets are going to be entirely shut out of the global banking system because they will not be able to put up the expenditures or put up the capital to comply with the new accord," he continues. "When we think of some of the small Asian markets and the bad times they have had, it is imperative that banks be able to spread their risk out over a larger and more diverse base. To that extent, some would be confined to their domestic markets and not be able to hedge outside. This would permanently impair their ability to earn a good return on capital and probably mean that they would be vulnerable to regional or global banks coming in and taking their business."

Basel 2 is probably going to result in a real case of survival of the fittest among Asian banks, although that might not be such a bad thing, according to Sheehan. "In terms of specific winners and losers, I can see most of the benefits going to a few banks, which is probably as it should be given that Asia has far too many banks," he argues. "The good banks are the largest international banks such as HSBC, Standard Chartered, DBS, as well as the major Japanese banks. As for the laggards, Basel 2 is bad news for bad banks. Their inter-bank risk weightings will move from the automatic 20% up to as high as 150%, which will effectively price them out of this market. I would say specifically that all of the Thai banks are vulnerable, most of the Philippine banks, all of the Indonesian banks and even some of the South Korean banks."

In this new era for banking, a changing of mindset is going to be crucial if a bank is to be successful, Sheehan concludes: "Being large will not be enough to save you, you will have to get smart."

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