Basel II heralds huge banking reforms

Basel is a small, sleepy town in northwestern Switzerland, close to the borders of France and Germany. Basels pretty, medieval architecture and picture-postcard location on the banks of the Rhine make it a popular destination with European tourists.

But that aside, the town and its 160,000 inhabitants appear to have little to distinguish themselves on the world stage.But appearances can be deceiving. Behind Basels humble facade, a team of international bankers is planning a financial revolution that is reverberating around the world Ð including the Middle East.

Basel is home to the Bank for International Settlements (BIS), the elite financial club formed by the worlds central banks. And along the corridors of power at BIS headquarters in Centralbahnplatz, work is nearing completion on the Basel II banking accord.

Without a doubt, Basel II will impact Middle East banks, says Darren Stubing, chief banks analyst at ratings agency Capital Intelligence (CI) in Cyprus. It is a quantum leap in capital standards and will have a big effect on banks in the region going forward.

What is Basel II? Essentially, its the tough new rulebook for international banks. Jean-Claude Trichet, president of the European Central Bank and a driving force behind Basel II, says it will strengthen the stability of the financial system and . . . serve as a source for sustainable growth for the broader economy.

In practical terms, Basel II will impact Middle East banks in a host of ways. It will change how banks lend money - and which countries they lend money to. It will force banks to be more open and transparent about their balance sheets, and it will force them to manage their risks far better. In the process, it will force them to invest millions of dollars in new IT systems and consultancy fees to comply with the new regulations.

Timetables

Strictly speaking, Middle East banks will not have to comply with Basel II. Under the timetable for Basel II, only G-10 banks are expected to adopt Basel II by the end of 2006. (The G-10 is actually 11 countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.

Luxembourg also sits on the Basel Committee on Banking Supervision, which is drafting Basel II.) However, there is little doubt that scores of Arab banks will have to comply with Basel II well before the end of the decade. Initially, Basel II will only apply to G-10 countries, as was the case with the original 1988 Basel accord.

However, history shows that other international banking regulators (mainly central banks) soon adopted the 1988 Basel accord as best practice, and required their domestic banks to comply. Today, more than 100 countries require their banks to comply with Basel I, including many in the Middle East.

Most of these central banks have pledged to adopt Basel II at the earliest opportunity. Definitely we are going to get our banks to comply with Basel II, says Khalid Ateeq, executive director of banking supervision at the Bahrain Monetary Agency (BMA), the countrys central bank.

Maybe not by the beginning of 2007, but by mid-2008 or 2009. Bahrain is the regions banking hub, and the BMA is recognized as the regions strongest regulator, so it is no surprise that the BMA plans to be an early adopter of Basel II. But the BMA is far from a lone voice: all six GCC central banks are working together on Basel II implementation, while many other Middle East central banks are also understood to be keen to comply.

Under pressure

Even if central banks dont force their hands, competitive pressures will. The international banking community is a closely knit circle. Banks borrow from each other all the time Ð particularly from the big institutions in the advanced world. G-10 banks are an important source of liquidity anywhere in the world, says Daniel Hanna, international economist with Standard Chartered bank in Dubai.

If Arab banks dont raise their game and comply with Basel II, they could find themselves left out in the cold by the international lenders on whom they depend. Bahrain International Bank, which was wound up earlier this year, is a salutary lesson in what can happen to an Arab bank if international lenders withdraw credit.
'I think the impact will be felt quicker than many people expect,' says Hanna.

Clearly, then, Arab banks cannot hide from Basel II. This poses a number of questions. What are the pros and cons for Arab banks? Are Arab banks ready? And what does Basel II mean for Gulf companies Ð and to a lesser extent consumers Ð who rely on Gulf banks for funding? First, the pros for Arab banks. Sunder George, deputy chief executive of BankMuscat, says complying with Basel II should make Arab banks more efficient.

The aim of Basel II is to ensure banks have adequate capital to address the underlying risks. The accord would help the Gulf banks by providing an impetus to improved measurement and management of risks.

Capital adequacy is the tool with which it ensures that banks identify, measure and manage risks prudently. Darren Stubing at Capital Intelligence agrees. There are potential efficiency gains. Capital will become very closely tuned to the risk profile of assets. He says that if some Arab banks work towards the most efficient version of Basel II, they could reduce the capital they need by 10-20 percent.

This capital could then be employed elsewhere, leading to better return on capital employed. The potential gains from improved risk management speak for themselves Ð a lower proportion of non-performing loans.

The potential gains from additional transparency are less immediately apparent for banks. The authors of Basel II say they will be felt indirectly - shareholders and lenders will be more willing to extend finance to transparent banks, and at lower cost. And blue-chip customers will be more willing to place their accounts with transparent banks.

With improved risk measurement tools, banks would increasingly pursue risk adjusted returns and not just absolute returns, says BankMuscats Sunder George. Pricing based on RAROC [Risk Adjusted Return on Capital] will become more prevalent. Hence the organizations that are financially strong and have a desirable risk profile will get better rates from banks and this in turn will improve their competitiveness in the market place.

Ralph Ricks, adviser on regulation and supervision to the BMA, says Pillars 2 and 3 are the ones that banks should watch. I would argue that the biggest impact will come through transparency and risk management. The BMA already employs risk-based regulation, and requires banks to report results every quarter, so for Bahraini banks, Pillars 2 and 3 will hold few surprises.

But in many other Arab jurisdictions, this level of intrusion and openness will come as a culture shock to the banking sector.

The downside

What about the cons? One immediate downside is the cost of implementation. BankMuscats Sunder George says most Gulf banks are adequately capitalized, so they are unlikely to have to raise additional capital to comply with Basel II. However, the costs of complying with new operational and credit risk requirements could be significant - not least in information technology.

There will be quite a lot pressure on banks to upgrade, and that will require investment going forward, says CIs Darren Stubing. Disaster recovery (DR) represents a huge potential cost. John Bentley, Middle East sales director at Hitachi Data Systems (HDS), says the cost of building a back-up facility can be as much as $30 million for a mid-sized bank.

Basel II will require that banks maintain a vast range of backdated data on transactions for up to eight years. The IT storage implications of this are huge. Particularly so when it has to be backed up at a duplicate site several hundred kilometers from a banks head office.

We have definitely seen a significant impact in storage requirements from Basel II, says Bentley. Basel II is saying that you have to record and keep certain types of data. And you have to have disaster recovery, if not double disaster recovery. Some financial institutions have analyzed their requirements going forward and forecast that they will have to double their storage capacity every 18 months.

There is a significant cost implication in that, not just in storage capacity, but how you manage it. Sovereign ratings. The greatest burden will fall to small banks - particularly those in economically weak Arab countries. Sovereign risk will play a significant role in assessing the level of capital that banks have to allocate for an asset.

In simple terms, if they are lending to a bank in a high-risk country, they will have to charge a higher interest rate. That is bad news for banks in Arab countries such as Lebanon and Egypt, each of which has a low sovereign credit rating. For international banks that are active in the Gulf, there are country risks, says Simon Williams, senior economist at the Economist Intelligence Unit (EIU) in London.

If you are a European bank with assets in Saudi Arabia or Bahrain, part of the way you assess that risk is by assessing country risk. Under Basel II, each country will be given a sovereign rating by an approved body such as the EIU, Moodys, Capital Intelligence or Standard & Poors. In the Middle East, certain countries have a higher sovereign rating that others, says Standard Chartered's Hanna.

Lebanon is a lot less creditworthy than the UAE. That will have an impact. Some observers say the combined impact will be a wave of consolidation in the Arab banking sector. Economies of scale mean that larger banks will be able to absorb the IT investment costs more easily than smaller banks. At the same time, larger banks generally face a lower cost of capital than smaller banks.

If Basel II leads to a flight to quality, this trend will be exacerbated. For some smaller Arab banks, the economic rationale of merging may become overwhelming. Indeed, this is reflected in the preparations Arab banks have made for Basel II.

Market sources suggest that while many of the larger banks are making good progress towards preparing for Basel II, it is not on the radar of smaller banks. It is a bit hit and miss, says CIs Stubing. Some banks are quite advanced, while at the other end of the scale, there are others who havent really done much.

A study by the Financial Stability Institute published in July 2004 surveyed responses of banks from seven Middle East countries on Basel II implementation. It revealed that only 13 percent of banking assets of locally incorporated banks will move to Basel II by 2006.

However, that figure improves significantly, to 89 percent, for the period 2007-09. So much for the banks. What does Basel II mean for the companies that borrow from them? And the Middle East economy as a whole? Essentially, banks are likely to become more conservative in their lending. Basel II will mean it is more expensive for them to lend to risky companies in risky countries.

So a flight to quality blue chips in stable economies seems all but inevitable. Already banks tend to discriminate in terms of creditworthiness. They are happier lending to established companies than to a startup without any track record, says Standard Chartereds Hanna. [Basel II] could encourage a concentration on more creditworthy names than we are already seeing.

Sunder George of BankMuscat says Basel II will sweep away the cost lending practices of the past, in which many Middle East banks have lent to corporate clients on the basis of personal and family relationships, not credit quality. Name-based lending that is currently prevalent in the region is clearly on its way out.

The need to objectively measure risks will compel banks to insist on transparency from borrowers and to disclose their financial position. Tighter bank lending practices could force Arab companies to seek alternative sources of finance, fueling a growth in stock market listings, bonds and Islamic financing instruments.

Paying up

Borrowers in low-rated countries such as Lebanon and Egypt face potentially the greatest difficulties, thanks to the new emphasis on sovereign risk under Basel II.

Under Basel II, a Lebanese bank will almost certainly have to pay a higher interest rate to borrow from overseas banks. That will be passed on to their domestic customers, which will mean the overall cost of borrowing will rise, says Standard Chartereds Daniel Hanna.

Economic models tell us that higher domestic interest rates mean lower domestic investment and weaker economic growth. Under Basel II, there is a risk that the rich will get richer, while the poor get poorer. Hanna says his greatest fear is that Basel II will be pro-cyclical.

'What I worry about is that it will encourage banks to lend more during the good times, and to cut back during the bad times. Capital requirements will depend to a great extent on credit ratings. Credit ratings tend to improve during the booms in a business cycle and deteriorate during the slowdowns and recessions. As a result, lending can be expected to increase during upswings and fall during downswings.'

In essence, when capital requirements increase in a downturn, banks will reduce lending, which in turn will result in more defaults, and hence worsen the recession. This is particularly worrying for a region that is already pro-cyclical. (The US Federal Reserve tends to lower interest rates when oil prices are high - as is the case today - and vice versa.)However, not everyone agrees that Basel II will have profound implications for lending practices.

Ralph Ricks, an adviser to the BMA, says that the likely impact of the new capital adequacy requirements (Pillar 1) under Basel II can easily be overblown. Some people have suggested that Basel II could impact adversely on bank lending to emerging markets. But a series of studies suggest otherwise. Three pillars. People tend to get obsessed about Pillar 1, Ricks says.

The presumption is that regulatory capital requirements are the determining factor in bank placement of credit. But in most banking systems, banks hold more capital than the minimum requirement of the regulator, because of their own internal requirements or through pressure from ratings agencies.

Ricks argues that the capital requirements of Basel II largely reflect the good practices that most banks already use. In effect, regulation is catching up with banks on this issue, rather than taking a lead. If banks currently arent placing credit according to risk, they are not going to be staying in business very long. Ricks also argues that Basel IIs emphasis on operational risk isnt anything new.

Rather, it is simply formalizing existing guidelines. The risk manager of one of the Gulfs leading banks confirmed that for tier-one regional institutions, most of the requirements of Basel II are already best practice. We have been working to these standards for some time now, and I think the same is broadly true of the major banks in the region.

However, he admits this is not always the case for institutions outside the premier league of Arab banking. Back in Basel, the architects of the new accords are assuring bankers across the world - including the Arab world - that Basel II is a friend, not a foe.

Not everyone shares this view. Some observers believe the regional impact will be huge - almost a big bang for the Arab banking sector. Others argue that the staggered implementation - in terms of timing and sophistication - will mean it is a quiet revolution rather than a bloody revolution.

One thing that everyone agrees on is this: Basel II is coming to the Arab banking world, like it or not, and the time to prepare is now.