15.1 per cent: Average Tier 1 ratio of Saudi Arabia’s banks at the end of June 2011
15.6 per cent: Egypt’s Commercial International Bank’s capital adequacy ratio
Middle Eastern banks had little reason to be perturbed by the advent of the Basel II regulations, devised in 2004 by the Basel Committee of Banking Supervision.
In the pre-Basel II world, regional financial institutions adopted an evolutionary approach to risk management, gradually upgrading liquidity and capital ratios where necessary and relying on their conservative approaches to risk to see them through any unexpected crises.
Despite a generally high level of preparedness, Basel II nonetheless represented a structural change to the way banks operate, introducing a series of targets requiring them to adopt a more risk-sensitive framework for the assessment of regulatory capital.
Gulf banks in particular appeared ready and willing for the new regime, with the majority of GCC financial institutions boasting capital adequacy ratios higher than the statutory 8 per cent minimum. This was not just a matter of jumping through hoops to satisfy the Swiss-based authors. The self-same prudent risk strategies had helped the vast majority of regional banks to survive the global financial crisis more or less intact, when it hit in 2008.
“Capital adequacy levels as a whole in the Saudi banking system are quite comfortable in absolute terms”
Robert Eid, Arab National Bank
Kuwait was the first Arab country out of the blocks, implementing the new capital adequacy accord by the end of 2005, ahead of the 2006 target date. Bahrain was not far behind. Indeed, few Gulf states’ banking systems encountered any serious problems adjusting to Basel II in the following couple of years. The average capital adequacy ratio is now above 15 per cent for every GCC banking system.
Regional regulators set the bar high from the outset. The UAE Central Bank’s minimum Tier 1 capital ratio, for example, is 8 per cent, with a total capital requirement of 12 per cent – four percentage points above the Basel minimum.
The UAE’s banks have taken their lead from the top. By the end of 2010, the average capital adequacy and Tier 1 ratios were an impressive 20.3 per cent and 16.1 per cent respectively.
“In terms of capital adequacy, banks are well positioned to meet Basel III requirements and this is more or less the same across the GCC,” says Christos Theofilou, an analyst at ratings agency Moody’s Investors Service.
“However, in terms of liquidity and funding they are not as uniform. For example, in Bahrain, the wholesale banking system is dependent on wholesale funding rather than deposits, as is the case with most banks in the Gulf, which may make it more of a challenge to meet the Basel III liquidity ratios.”
A second driver behind the Gulf states’ support for prudent risk strategies was the emergence of significant debts associated with two troubled conglomerates in Saudi Arabia in 2009, the Saad Group and AH Algosaibi & Brothers.
This prompted banks to take measures to gradually reduce excessive concentrations in their loan books.
“During the period after the financial crisis, banks put far more emphasis on consolidation and managing their existing portfolio, rather than growing their loan book,” says Theofilou.
With judicious support from the Saudi Arabian Monetary Agency, the central bank, Saudi banks have used the Pillar 2 requirements of Basel II to strengthen risk management practices and reinforce their loss absorption capacity.
Galvanised by their exposure to the debts incurred by the Saad and Algosaibi empires, Saudi banks have focused strongly on improving risk management in the past couple of years. Saudi banks’ capitalisation levels, with an average Tier 1 ratio of 15.1 per cent at the end of June 2011, are up on the 13.3 per cent seen at the end of 2008, and provide an adequate buffer against future losses linked to corporate problem loans.
Of the Saudi banks rated by Moody’s, the lowest capitalised bank is Sabb, which still boasted a comfortable Tier 1 capital of 11.7 per cent at the end of September 2011.
“Liquidity is also not an issue for Saudi banks,” notes Theofilou. “They have a lot of deposits funding their businesses and have a lot of liquid assets as well. On aggregate, for our 10 rated Saudi banks, liquid assets to total assets were about 38 per cent at the end of September, while loans to deposits were around 74 per cent.”
The quality of capital is equally robust, with Saudi banks’ Tier 1 equity consisting primarily of common equity with no use of any hybrid instruments – the source of much of the woes in the Western banking system in 2007-08.
Riyadh-based Arab National Bank (ANB), which enjoyed a total capital ratio of 17.5 per cent at the end of June with a Tier 1 capital ratio of 14.5 per cent, is another bank that has benefited from a conservative strategy.
“Capital adequacy levels as a whole in the Saudi banking system are quite comfortable in absolute terms and certainly in relative terms compared to others in the area,” says ANB chief executive and managing director Robert Eid. “That’s not to say that we won’t have to keep a close eye going forward on these factors.”
Banks in the Middle East and North Africa (Mena) states caught in the crossfire of the Arab uprisings may struggle more to maintain capital and liquidity buffers. Concerns have been expressed over Egypt’s banking sector, with Moody’s downgrading the five rated Egyptian banks by one notch each in early November.
Even then, Egyptian banks have been focusing on good housekeeping. The country’s largest private-sector lender, Commercial International Bank (CIB), with a 15.6 per cent capital adequacy ratio, looks in better shape than much of the competition. In the first half of 2011, CIB decreased its exposure to government treasury bills and increased its interbank lending to foreign banks, making it less vulnerable to domestic banking-system credit risks, says Moody’s.
Although Lebanon’s banks remain highly exposed to the country’s sovereign debt, the cental bank Banque du Liban has played a pivotal role in ensuring that strong risk management is embedded in Beirut’s banking culture. At the end of 2010, Moody’s rated Lebanese banks’ aggregate Tier 1 and total capital adequacy at 12.9 per cent and 13.7 per cent respectively, while their aggregate total equity-to-total assets ratio was 8.5 per cent, compared with 7.5 per cent at the end of 2009.
One of the challenges imposed by Basel II is applying the conditions in a context where many companies do not have credit ratings. But this is where Lebanon has an in-built advantage.
“The Lebanese banking sector is highly regulated,” says Joe Sarrouh, adviser to the chairman of Lebanon’s Fransabank. “We need an investment grade to issue paper. And most of our banks are still run by their owners, so the conservatism is there as well.”
Not that Lebanese banks can rest on their laurels. Moody’s warns in an early December research note on the country’s banking system that Lebanese risk-weighted assets are understated, as low-rated local-currency denominated government securities and central bank certificates of deposit carry a 0 per cent risk weight.
Adapting to Basel III, the next stage in the process, presents an ongoing challenge for Mena banks, with the more onerous requirements dictating the pace of reform for the rest of the decade. Basel III is the progeny of the global financial crisis, devised in response to the glaring flaws that emerged in the world banking system after 2007. It raises the bar higher, strengthening bank capital requirements and introducing new regulatory requirements on bank liquidity and bank leverage, partly in order to address concerns that Basel II might have contributed to the crisis by allowing banks to understate risk and hold too little capital against unexpected losses.
There are concerns that Basel III could ultimately entail negative consequences for banks, with the setting of new standards for the quality and quantity of capital and the insistence on tighter liquidity coverage ratios threatening to undermine risk taking and reduce lending.
“We need a clear definition of what will go into the solvency calculations and … the differing weightings”
Joe Sarrouh, Fransabank
Regional bank chiefs are sanguine about this threat. “Basel III is a process in the making and we will certainly have to keep a close eye on the stipulations going forward, but I wouldn’t say it will affect our strategy in a material way,” says ANB’s Eid. “With a few exceptions, Saudi banks have Tier 1 capital that is whiter than white and we don’t have the problem structures that prevail elsewhere – the hybrid instruments that are now coming under closer scrutiny.”
This point is backed up by US ratings agency Standard & Poor’s (S&P), which highlights the limited use of hybrid capital instruments in the Gulf and the common equity component of capital that is already significantly higher than the Basel III standards. Furthermore, S&P does not anticipate any meaningful changes in either the overall lending appetite or lending pricing as a result of the Basel III capital requirements.
Such concerns may apply more to banks active in mature markets like Europe, which could struggle to raise capital without affecting the bottom line. In the GCC, capital is sufficiently high for this not to be a major problem.
This does not mean that migrating to Basel III will prove a seamless process for Mena banks. Much work needs to be done to define the methodology and definition formula for the new solvency ratios, says Fransabank’s Sarrouh. “We need a clear definition of what will go into the solvency calculations and what are the differing weightings. There should be common understanding between the regulator and the implementor on what we are talking about. We have to speak the same language,” he says.
Bankers warn that Basel III should not throw the baby out with the bath water, creating collateral economic damage as lenders adapt to more stringent capital and liquidity standards.
“One has to be careful that the pendulum doesn’t swing too far one way or the other,” says ANB’s Eid. “We’re moving towards an era of tighter and pervasive regulation, a much more prescriptive landscape. A significant part of this is warranted, but at the same time we mustn’t go overboard.”
From Basel II to Basel III
The revised Capital Accord (Basel II), also known as the International Convergence of Capital Measurement and Capital Standards, was published in June 2004 by the Swiss-based Basel Committee on Banking Supervision. It comprises three pillars:
- Pillar 1: Defines the minimum capital requirement for the main components of risk: credit; operational; and market risk
- Pillar 2 Addresses banks’ internal processes for assessing capital adequacy in relation to risk, introducing the supervisory review process for assessing internal capital adequacy
- Pillar 3 Focuses on enhanced disclosure, covering risk and capital management
The Basel III revised capital rules are aimed at raising the level and quality of capital in banks
- Tier 1 capital levels to rise from 2 per cent to 4.5 per cent
A capital conservation buffer of 2.5 per cent, compared with existing level of 2 per cent
- Tier 2 capital becomes contingent, loss absorbing capital
The new liquidity rules introduce short term (30 days) Liquidity Coverage Ratio (LCR) and a long-term (1 year) Net Stable Funding Ratio (NSFR). The monitoring period for these ratios starts in 2012 whereas the implementation will be in a phased manner starting in 2015 and 2018