Romanian lenders touch Basel III

Regulators have been stepping up their efforts to get a grip on the banking sector and prevent a new financial collapse of the likes of the 2007-2008 one, and Basel III standards were enshrined two years ago in a bid to increase risk mitigation and fill the regulation gaps. New rules focusing on the capital and funding of lenders will kick in next year, making the overall system safer, although lending to the real economy could be restricted, warn specialists.

By Ovidiu Posirca

In 2010 the Basel Committee on Banking Supervision issued the Basel III rules text, with revamped regulations on bank capital adequacy and liquidity, which has been endorsed by the G20 countries.

Nout Wellink, chairman of the committee, described the new framework as a “landmark achievement” that will secure financial stability and reduce the frequency and severity of future banking crises.

Understanding the new Basel

The implementation of the directive on the capital agreement Basel III will be phased in from January 2013 for the European banking system and the process should be concluded by January 2019. The requirements will be introduced in the EU through the Capital Requirements Directive (CRD) 4, which applies to all EU member states.

The European Commission has so far presented a draft directive, which governs access to deposit-taking activities, and a regulation establishing prudential requirements, while further implementation measures at national level are expected, said Costin Teodorovici, partner at law firm Bulboaca & Asociatii.

“Basel III establishes tougher capital standards through more restrictive capital definitions, higher risk-weighted assets (RWA), additional capital buffers, and higher requirements for minimum capital ratios. As a consequence the reforms will fundamentally impact profitability (measured as return on equity) and require the transformation of the business models of many banks,” said Paul Facer, partner, assurance services, financial services industry group leader, at the professional services firm PwC Romania.

The Basel Committee uses the RWA to determine the minimum capital requirements of a bank. This streamlines the inclusion of the off-balance sheet exposures and makes it easier to compare banks in different regions.

The capital target ratios, know as core Tier 1, will reach 7 percent under the new regulation. This represents the funding that a bank must have to cover the risks it takes in numerous activities such as lending or trading. The broader requirement for all Tier 1 capital is set at 8.5 percent, which includes an additional noncore Tier 1 capital of 1.5 percent.

The minimum common equity will be hiked from 2 percent to 4.5 percent of RWA at all time, explained Teodorovici. At the same time, a capital conservation buffer is being introduced, which is set to reach 2.5 percent in 2019. This additional safety mechanism has to be met with common equity.

“The quality of capital is expected to increase by eliminating certain items, such as minority stakes exceeding a certain level or deferred tax payments, and banks will be required to observe longer term liquidity ratios,” said Teodorovici.

He added that new standards provide the tools to counter systemic risks such as leverage ratios. Regulators will be able to cool down high lending rates during growth periods by imposing an additional anti-cyclic buffer of up to 2.5 percent of the RWA.

“When the capital ratio goes down, the buffer capital is used to cover losses, and the agreements require banks to maintain a significant share of the obtained revenue to restore this capital and impose restrictions on the distribution of dividends, the purchase of your own shares and the payment of discretionary bonuses,” said Cristian Bogaru, partner at law firm BWSP Hammond Bogaru & Associates.

Another provision sets the leverage limit at 3 percent, meaning that a bank’s total assets – including on- and off-balance sheet assets – should not be more than 33 times bank capital, according to Angela Manolache, director advisory, at professional services firm KPMG.

“As part of the liquidity reform, two new liquidity ratios will be introduced, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), which will require banks to hold significantly more liquid, low-yielding assets and to change their funding profile, with an increased demand for longer-term funding,” said Manolache.

Gauging Basel III’s impact on Romania

The Romanian Banking Association (ARB) has set up a commission on Basel III to implement it, make propositions and seek clarifications.

The capital agreement is very restrictive on risk-taking by banks, which may significantly reduce lending to SMEs, according to Radu Gratian Ghetea, president of the Directorate Council at ARB, and president of CEC Bank.

He stated that ARB, along with other European Banking Associations and banking groups, has lobbied the European Parliament and European Commission to change the proposed regulations.

“In the scenario of a relatively difficult international climate, the adapting of banking-financial groups to the solvency requests of Basel III could lead, on the medium term, to a reduction of exposures,” warned Ghetea. “The increase of the capital factor will effectively reduce the lending capacity for the real economy.”

The Romanian banking system comprises 42 credit institutions, out of which nine are subsidiaries of foreign banks. Foreign capital institutions control 81.2 percent of the total net assets, which amounted to RON 370 billion (over EUR 80 billion) this June, according to central bank data. The main foreign lenders that operate locally originate from Greece, Austria and the Netherlands.

The direct impact of new regulations on the capital positions of Romanian banks is expected to be limited, as most local lenders are well capitalized, according to Manolache at KPMG.

The average capital adequacy for the Romanian banking system reached 14.7 percent in June, according to central bank data. With most of the capital base made of common equity Tier 1, the new Basel standards may have little impact. The aim is to curb hybrid capital instruments. The leverage ratio stood at 8.4 percent in the same period. This is higher than the 3 percent stipulated under Basel III, although off-balance sheet assets are not currently included in this ratio, according to Manolache.

Teodorovici of Bulboaca & Asociatii commented that Romania, like other emerging financial markets, has a less complex structure, so certain requirements may have a limited effect.

“The regulators’ intent with Basel III is a future of more capital, more liquidity and lower risk. As a result it is likely that banks, including those in Romania, will face an environment with lower returns on capital and slower growth,” stated Facer of PwC.

The measures that credit institutions could take to ease the impact of Basel III involve the adjustment of the business model and the restructuring of balance sheets, according to Bogaru.

Banks will have to carefully manage the implementation of new rules, while striving to maintain market share.

“If the transition period is short, banks may prefer to reduce lending to increase their level of capital, changing the asset structure,” said Bogaru. He added that a gradual implementation would give banks time to capitalize their profits or issue shares.

The Basel III package is generally expected to have a negative impact on the lending volume, especially in the case of SMEs, and Romania is not likely to be an exception, according to Teodorovici.

Assessing regulation costs

With a new reform package in the pipeline, banks may have to reconsider their business models and find new growth areas.

The ARB president warned the new capital requirements are “restrictive” and could reduce lenders’ interest in financing SMEs, while putting profit in the banking industry under pressure.

“These reforms will also require banks to undertake significant process and system changes to achieve upgrades in the areas of stress testing, counterparty risk and capital management infrastructure,” said Facer of PwC.

Bogaru said the Basel capital requirements will mostly affect small financial institutions and the cost of loans could rise slightly.

“The banking system in Romania is small by international standards. Then, the costs with Basel III are on one hand fixed costs that have to be borne by any bank, and on the other hand the variable ones, which are connected to the size of the bank,” Mihai Bogza, president of the Administration Board at Bancpost, told BR.

“The fixed cost part is burdensome for banks; it is one part of the regulation cost, which banks have to bear, making banking activity in Romania more expensive than in other countries. It creates a competitive disadvantage not only for banks, but for their clients as well.”

He warned that this also eats into bank profits as only some of the costs can be transferred to clients.

Investors may become less attracted by bank debt or equity given that ROE (return on equity) and profitability are likely to decrease, while dividends may be reduced, further driving M&A activity, according to Manolache at KPMG.

Fitch Ratings estimates the 29 global systemically important financial institutions (G-SIFI), which have a combined USD 47 trillion in assets, may need to raise USD 566 billion in common equity to meet new capital standards. This is a 23 percent increase against their aggregate common equity of USD 2.5 trillion.

Furthermore, these banks’ median ROE will fall from about 11 percent to approximately 8 to 9 percent. Fitch states this may reduce the banks’ ability to attract capital, but will strengthen capitalization and lower risk premiums, which is good for investors.

The European banking system is set to enter into a new stage marked by a constant race for new capital and less room for risky tricks, say players.

Banks are required to raise EUR 114 billion in fresh capital, based on the stress tests of the European Banking Authority (EBA). Additional capital requirements will kick in during the transition to Basel III and lenders will need to close a capital gap of another EUR 200 billion by 2015, according to a McKinsey report. European banks will need to raise about EUR 1.1 trillion before 2021, when Basel III is fully enforced.

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