With input from Abdourabbih Abdouss, head of enterprise risk management architecture and analytics, risk management, Mashreq Bank

When asked what would make the biggest improvement to the financial risks facing construction contractors in the UAE, more than one quarter of respondents to the construction industry survey called for new regulations to make the cashing-in of performance bonds conditional on third-party certification or arbitration. Many called for greater commitment and increased industry partnerships.

Assessing risk

Banks assess the creditworthiness of obligors in the contracting industry on the basis of a combination of financial information and qualitative factors including the governance structure and the industry outlook. The outcome of this assessment is reflected in the credit risk rating of the borrower.

Because of the bespoke nature of construction projects and the diverse and fragmented construction client base, providing finance to construction contractors is highly complex and requires expert, first-hand judgement from businesses.

As part of the ongoing monitoring of clients’ creditworthiness, Mashreq Bank has deployed a dedicated team of engineers who work to understand project progress and provide critical input to the banks’ credit risk managers and risk rating models. The ultimate objective of having a risk rating model in place is to generate a score, which translates into a likelihood of default of that borrower. The higher the likelihood of default, the higher is the amount of capital retained by the bank to cover the risk of exposure. However, capital carries a cost which reflects shareholder’s expected return on capital .

Rigid international financial regulations since the global financial crisis in 2008 require banks to maintain higher levels of core capital, increasing the cost of capital allocated to financing activities. This translates into higher pricing for the relationship between a bank and contractor.

But the pricing can vary from bank to bank, depending on how each bank scores its borrower. Different banks can have varied approaches to the same customer, impacting the capital pricing charged to the borrower. Regulations ensure regional banks follow a standardised approach from a capital adequacy perspective, but the likelihood of default still remains subjective to a bank’s risk modelling.

About one third of GCC institutions use off-the-shelf risk rating models typically designed around major western markets such as the US. These models can be significantly disconnected from the reality of the regional and local markets. With new regulations such as the International Financial Reporting Standard (IFRS) 9, scrutiny on many regional banks has increased and some of these banks might find that their model fails the validation test and will have to redevelop these off-the-shelf models.

Not all banks follow this approach. Mashreq Bank is one of the few banks in GCC that has tailored risk models since 2005. This has allowed Mashreq to collect credit risk data and perform multiple model validation cycles.

Exposure that a bank holds on its books refers to three elements in terms of pricing—cost of funds, cost of capital and expected loss.

Most credit exposures in the contracting industry are non-funded in nature—for instance guarantees and performance bonds—and attract capital charge. For an institution to minimise capital charge, it should work on the collaterals. There are many different kinds of collateral, but a central bank will usually recognise tangible collaterals such as cash, deposits, shares and bonds.

Basel III

Following the debilitating effects of the 2007-08 financial crisis on banks globally, the Basel Committee on Banking Supervision built on Basel I and Basel II guidelines as part of the continuous effort to enhance and tighten the banking regulatory framework. Basel III seeks to equip banks to deal with financial shocks and improvise their financial stability by strengthening regulation, risk management, transparency and capital requirements. It focuses on increasing bank liquidity and decreasing bank leverage in order to improve the quality of a bank’s capital ratios and the standards for short-term (Liquidity Coverage Ratio) and long-term funding (Net Stable Funding Ratio).

Bank’s capital is divided into Tier 1 and Tier 2 capital. Tier 1 capital is the core capital consisting of shareholder’s equity and retained earnings. Tier 2 capital is supplementary capital and mainly consists of revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves and undisclosed reserves. The new accord, Basel III, creates additional challenges for the banking industry as banks are now required to maintain a higher quality of Tier 1 capital, consisting of more equity Tier 1 capital (CET1) and additional Tier 1 capital (AT1). Mashreq is well capitalised and hardly has any Tier 2 capital.

The new Basel III reforms also lay out the basis for liquidity requirements. The Liquidity Coverage Ratio (LCR) is the total amount of high-quality liquid assets compared with net cash outflows. The introduction of the LCR will necessitate banks to hold significantly more liquid, low-yielding assets, which will negatively impact the profitability of the bank. The Net Stable Funding Ratio (NSFR) would incentivise the banks to reduce their dependence on short-term funding and improve stability of the funding mix.

IFRS 9

Until 2017, banks only considered impairments that occurred as a result of a customer default. Effective 2018, IFRS 9 requires banks to switch from an ‘incurred loss’ model to an ‘expected loss’ model. Under the concept of IFRS 9, expected credit losses are used for calculating impairment allowance for the bank. Future expectations are taken into account and larger impairments can be provisioned earlier on. The change in the impairment allowance is reported in profit and loss.

Impairment is recognised under one of the three stages under IFRS 9. When an asset is acquired, the asset is recognised as Stage 1 and the impairment allowance is measured as the present value of credit losses from default events projected over the next 12 months.

If the asset quality deteriorates ie, there is a significant increase in credit risk, it gets recognised as Stage 2. The impairment allowance is then measured as the present value of all credit losses projected for the instrument over its entire life.

Stage 3 is where the financial asset is credit impaired. If the creditworthiness of the customer improves, the allowance can once again be recognised to that of Stage 1 following a cooling period of at least a year. However, varying regulations in the region can translate into different pricing and lending periods for the same customer. Macroeconomic conditions and industry outlook also play a key role in estimating impairment allowance.

Open-ended guarantees present a special case for most banks in the Middle East. Should such an asset be classified as Stage 2, the impairment allowance would rise significantly in the absence of a fixed maturity date. The legal committee of the UAE Banks Federation (UBF) is now looking into and drafting the terms of such guarantees, but it requires input from government entities who are the primary users of open-ended guarantees.

Impact on lending

A combination of increased capital requirements and stringent liquidity requirements under Basel III will mean an increased cost of borrowing for a contractor. Since banks will have to retain capital to meet the standard requirements, lesser capital will be available for project finance.

The magnitude of impact on a bank depends on its capital structure, and further development of the regulation may carry greater uncertainty for the banks on their pricing.

Looking forward

Banks need to have consistency when it comes to using risk models in the region. In the absence of a common framework, there will be an arbitrage between banks. Collecting credit default data to predict situations such as likelihood of default can help minimise such differences.

The construction industry should work very closely with the banking regulators, to avoid a situation where the nation is the best at upholding regulations, but at the same time there is run-off of business from the country. There is an interesting trade-off between complying with the regulation, and at the same time maintaining certain economic stability and being profitable for investors. The business should be involved in refining the regulations.

The UBF is a not-for-profit organisation representing 50-member banks operating in the country. It can influence or negotiate the way the regulation is applied, to make sure the banking system is stable. If the industry tries to voice its problems to the UBF, these may ensure that their concerns are used when applying regulations to a particular economy. A transparent relationship between the industry and UBF is a critical channel that should be pursued.

Abdourabbih Abdouss is the head of enterprise risk management architecture and analytics, risk management at Mashreq Bank

This article is extracted from a report produced by MEED and Mashreq entitled Regulating Construction: Adapting to New Standards. Click here to download the report

To know more about the MEED Mashreq Partnership, get in touch with us at MEEDMashreqPartnership@meed.com or find more info on www.meedmashreqconstructionhub.com