“From capital adequacy to capital optimization (1st of 2 parts)” by Christian G. Lauron (March 19, 2012)

SUITS THE C-SUITE By Christian G. Lauron
Business World (03/19/2012)

(First of two parts)

In our January 2012 column entitled “Governance: The return to scenario planning,” we wrote: “… Boards must now discuss the pressing need to transform the agenda from resilience to accelerated performance, by examining strategic planning and aligning strategy, business and operations in a period of high uncertainty….”

The uncertainty is starting to settle down, at least for global financial regulatory reforms, as details are rapidly taking shape in capital, liquidity (including asset-liability management or ALM) and governance. The emerging view is that proactive supervisory engagement, with a deliberate approach in identifying the strategic and business implications of the regulatory reforms, provide an edge to the more agile organizations. In this article, we will give a summary of the capital reforms and provide our views on what is the likely medium-term management agenda.

GLOBAL GUIDELINES AND LOCAL DEVELOPMENTS

The following are the key points of Basel III and the corresponding initiatives (to date) of the Monetary Board (MB) and the Bangko Sentral ng Pilipinas (BSP):

• Minimum capital requirements. The minimum level for total capital will remain at 10% of risk-weighted assets (RWA) — higher than the 8% prescribed under international guidelines — but the proportion of Tier 1 capital is being increased. Under the BSP framework, the Common Equity Tier 1 (CET1) and total Tier 1 capital will be set at a minimum of 6% and 7.5%, respectively, which are higher than the 4.5% and 6% floor required by Basel III.

• Non-allowable capital. Under Basel III, the capital eligibility of certain hybrid capital instruments with redemption features will be gradually phased out from 2013 to 2021. However, this staggered implementation will not apply to Philippine banks, since the MB mandated the full adoption of the capital adequacy standards by January 2014. Further, the tiering of capital has been greatly simplified: “loss-absorbing” is now the main, if not the sole, criterion for inclusion in qualifying capital.

• Regulatory capital adjustments. Basel III requires the deduction from CET1 of items such as goodwill, deferred tax assets, intangibles, certain holdings in other unconsolidated financial institutions, defined benefit pension fund assets, treasury shares, and shortfalls in provisions compared to expected losses (locally called unbooked valuation reserves). It is important to note that BSP Circular 538 (Risk-Based Capital Adequacy Framework) issued in 2007 already requires the deduction of these items from Tier 1 capital when determining a bank’s capital adequacy ratio (CAR). This means that from that time and until the advent of Basel III, Philippine banks have been required to maintain not only higher minimum CAR but also relatively more compact Tier 1 capital compared with international requirements.

• New capital buffers. Basel III introduces two capital buffers. A capital conservation buffer of 2.5% of CET1, which will be added to the minimum CET1 level, is required to be built by banks in “good times” to be drawn upon in “bad times.” Banks unable to meet the capital conservation buffer will be subject to capital distribution constraints. The country-specific countercyclical buffer will be applied to overheating markets, and this buffer varies from between 0% and 2.5% of CET1. BSP is studying both buffers.

• Market and counterparty credit risk adjustments. For market risk, Basel III guidelines took effect in 2011 on new stressed Value-at-Risk (VaR), incremental risk capital charges, comprehensive risk capital charges for certain correlation trading portfolios, and additional securitization requirements. Counterparty risk guidelines will “go live” in 2013 for effective expected positive exposure (EEPE) with stressed parameters, new credit valuation adjustment (CVA) charge, new minimum capital charges for wrong-way risk (WWR), higher asset value correlation multipliers for large financial institutions, new standards for the capitalization of exposures to central counterparties (CCPs), higher quantitative and qualitative requirements for collateralized transactions, and higher operational requirements (backtesting, stress testing and model validation).

• Leverage ratio. Introduced as a supplementary measure, the leverage ratio is a minimum percentage of Tier 1 to gross on- and off-balance sheet assets. Data will be collected by supervisors during an observation period using total capital and CET1, and the disclosure will start in 2015. Basel III is setting a minimum Tier 1 leverage ratio of 3% during the observation phase.

• Systematically important financial institutions (SIFIs). Basel III provides an indicator-based measurement approach that can be supplemented with supervisory judgment in determining the additional CET1 requirement of 1% to 3.5% for organizations classified as SIFIs.

The BSP has announced that the draft capital adequacy guidelines will be released to banks for consultation within the first quarter of 2012 and for finalization within the year. This will enable banks to conduct a one-year parallel run in time for the full adoption of the revised capital adequacy standards in 2014. These capital adequacy standards will be applied along with other regulatory initiatives, including stress testing and the internal capital adequacy assessment process (ICAAP).

MANAGEMENT ‘THINKING MODELS’

It is important to understand the evolution of thinking models in the management levels of Philippine banks to gauge the medium-term strategic and business implications of the capital reforms.

In 2005, Fair Value Thinking came into the picture with the full adoption of International Financial Reporting Standards (IFRS). A hybrid economic view was introduced in financial reporting with the calculation requirements on fair value and use of time value of money, the redefinition of operating performance to a more balance sheet- and flow-based capital measure (now called comprehensive income), and the disclosure of risk and capital management.

In 2007, Bottom-Up Risk View was introduced when the foundations of Basel II were implemented, covering the key banking risks — market, credit and operational. This was followed in 2008 with the “Top-Down Risk View” to provide a strategic dimension to a bank’s risks. In 2009, with the introduction of ICAAP, an ‘Integrative View’evolved, which involves the following:

• Linking of the “Bottom-Up” and “Top-Down Risk” Views through Enterprise Risk Management (ERM);

• Linking ERM to corporate and capital planning through the ICAAP (see August 2, 2010 C-Suite article, “The challenge of ICAAP”); and,

• Application of integrated stress testing (see July 26, 2010 C-Suite article, “Stress testing as a governance tool).

From 2009 to 2011, the thrust of the banks’ ICAAP and stress testing exercises included rigorous assessment of capital adequacy, understanding and distillation of emerging risks (particularly systemic and transmission risks) on the bank’s balance sheets and capital, and exploration of convergence between existing risk and capital measures (e.g., CAR, economic capital, risk-adjusted performance measure) to financial measures (e.g., earnings before interest and taxes, free cash flow, economic value added).

In next week’s article, we will explore a highly effective enabling process for capital optimization called strategic forecasting.

Christian G. Lauron is a partner of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.