Thursday, March 2, 2017

Preparing for crisis, also for smaller banks!

A version of this article is published in the Jakarta Post on 14 March 2017

The OJK recently announced that it will issue a guideline on internal recovery planning for 12 systemic banks as part of efforts to shield the economy from a major bank failure. A recovery plan sets out the actions that a bank will take to restore its viability in cases of significant deterioration of its financial condition. The OJK rule on this subject - expected to be issue in April 2017 - is a supporting regulation mandated by the 2016 Law on Financial System Crisis Prevention and Mitigation (PPKSK).


The law effectively gives clarity and space to authorities when handling a banking crisis or a threat of it. Nonetheless, despite the better legal protection and clearer protocols, the PPKSK committee will unlikely have a comfortable time when a situation calls for their resolution authorities to be exercised.

To reduce the likelihood that intervention of authorities is called for, a comprehensive recovery plan is necessary: When near-default scenarios happened, what actions would a bank take? Where would it raise capital and liquidity? What businesses would it curtail or sell? How does it test its recovery options and if it sets and monitors early warning signs? What are the triggers to invocate certain recovery actions? How and when would the bank’s management communicate to key stakeholders?

Recovery plan is a special case of contingency plans such as funding contingency plans, business continuity plan, and disaster recovery plan. Recovery plan differs from those plans, as it focuses on severe scenarios when the bank is situated in the near default zone just before the point where resolution tool like bail-in bonds is activated. Bail-in bond is a debt instrument that is converted to equity when capital ratios fall to a certain threshold.

Obviously, to support the recovery planning process, the banks’ directors and top management should deploy dedicated resources. In some countries, banks’ chief executive, main commissioner and controlling shareholder must sign the recovery plan to show their commitment to it.
Hence, the initiative might cause bank executives’ apprehension as many concurrent and related regulations are already at work for example in relation to required submissions of annual business plans, risk based bank rating and stress testing results. After all, Indonesia’s banking sector is widely considered solid with its average capital ratio and profitability of the biggest players being among the highest in the world. If anything, the industry’s priority should be further directed for the handling of non-performing loans, for example.

Being a derivative of the PPKSK Law, recovery planning is indeed a compliance project as the plan will eventually have to be approved by OJK, perhaps after two or three rounds of supervisory revisions. The iterative process is necessary because in their first submission, most banks might not come up with a credible document that is considered by their supervisor as a useful playbook during a crisis.

That being said, according to our observation in other countries (i.e. EU member states), management and shareholder will find the exercise highly beneficial. Recovery planning had drawn together weak parts of their risk management that might currently be ineffective.

For example, we know that stress testing is an important tool to assess vulnerabilities at bank as well as at macro levels. However, its benefit for top management in providing insights and base for concrete actions is often found to be limited, partially due to its complexity and academic aroma. Recovery scenario testing will likely use the same methodology and resources for ordinary stress testing. In banks where integrated stress testing capability is already in place, the recovery plan requirement has not led to additional investment in automation and staffing. But the gain can be significant as stress scenarios in recovery planning have concrete benefits as a basis for improving components of the plan and existing risk management framework.

At any rate, the supervisory authority will likely tell banks to shore up their stress testing practices and integration into their risk management framework when preparing the recovery plan. A particularly helpful approach is for banks to use reverse stress testing as a starting point in recovery planning. This means that a bank will first define a point or magnitude of shocks that would lead to its failure, and then explore plausible scenarios that can cause it. In the process, the bank will not only draw insights about its (hidden) vulnerabilities but also possible measures that could effectively avert a breakdown of its business model.

Because of its considerable virtues, I think smaller banks should also prepare recovery plans - while appropriately taking into account their size, complexity, and nature of business. A lesson from centuries of financial history is that banking crisis is a constant, only its timing is variable. Sometimes, a failure of smaller player, say bank number 13 in the size ranking, can trigger a full-blown crisis. By the same token, an imminent failure of a small player might be considered having a systemic threat that a decision is made in support of a rescue using public funds.

While it is true that the state of the banking industry is stronger than ever, that conclusion is often based on average profitability and capital indicators. In an industry where confidence and interconnectivity are prominent, downward surprises can come from any (smaller) bank. There is a considerable advantage of having a banking industry that is strong on average and does not have contagious weakest chains at the same time. The existence of too weak players could unduly prevent the central Bank of Indonesia to apply a countercyclical macroprudential measure because otherwise, banks with weak financials and poor business models cannot keep up. They could also prevent the OJK from imposing greater prudential standards, or allowing a fiercer competition that benefits banking customers, e.g. lower lending rates.

Concern with the weakest links in the banking system is a key reason why all banks, unlike players in other sectors, face so-called minimum requirements for capital and liquidity. This being said, the ‘minimum’ requirements have an inherent problem in that it is sometimes too little and too late. The capital requirement for example is largely calculated from past snapshots such as last quarter’s risk positions.


That is why, with its strong forward-looking orientation, the upcoming OJK's recovery plan regulation will further strengthen Indonesia's banking sector. It can lead to early management and/or supervisory actions to deal with a significant threat of default and, as necessary, can trigger faster consolidation in the industry.



The initiative is so relevant for banks’ risk management that it should be applied to smaller players in the near future as well.

Saturday, July 9, 2016

Regulatory developments in financial risk realms: And what they mean for risk management practices in ASEAN banks

I. Introduction

Previous waves of Basel reforms, particularly with regard to minimum capital requirements (Pillar 1), have arguably had limited impact on banks’ business models in ASEAN. However, this time it’s different. Several of the recently introduced global standards, guidance and consultative papers give a clear indication of their more significant and lasting impact.

One of the key reasons for this impact will be that the recent regulatory standards address areas that are closely linked to real challenges faced by banks in ASEAN, for example with respect to credit risk management and loss provisioning practices. There is also an apparent trend that the Basel Committee is striving to enhance risk sensitivity of so-called standardized capital frameworks which are widely used by ASEAN banks. What’s more, increasing expectations for a rigorous implementation of the Basel requirements by local regulators and banks alike, as well as more demanding disclosures, will have additional ramifications for risk management departments.




We will shed light on four key regulatory pressures in financial risk realms (highlighted in the below figure), namely, LCR (effective generally by end-2015); The Revised Standardized Approach for Credit Risk (Consultative paper, published in December 2015); IFRS 9 (effective as early as January 2018); And IRRBB (effective in 2018, based on end-December 2017 financials).


II. Liquidity risk: Basel Liquidity Coverage Ratio (LCR) 

Given the commercial banking business model largely prevalent in the region, the introduction of the LCR requirement is not expected to result in significant shifts of funding and asset mix. According to our observations, a large majority of banks in the region are also relatively comfortable with meeting the 100% LCR target. However, these banks face the challenge of some local regulators expecting daily LCR reporting by 2017. 

Furthermore, one should bear in mind that the Basel LCR is a standardized approach based on a predefined weighting scheme, which might not represent an accurate liquidity risk profile of banks operating in different national jurisdictions. For example, the Basel LCR assigns a run-off factor of 5% for ‘stable’ retail deposits assuming the existence of an effective deposit insurance scheme that backs such deposits. In reality, the effectiveness of deposit insurance might vary by country, due to different features and strength of national deposit insurance corporations.

Many aspects of sound liquidity risk management is furthermore, by nature, non-quantifiable, for instance in relation to intra-group funding arrangements. After all, a bank must establish an appropriate policy framework to link its risk appetite, stress tests and contingency funding plan. As a good practice, it needs to work with a wider range of stress scenarios to gauge its buffer adequacy and to align its liquidity pricing accordingly. The latter has increasingly drawn the interest of bank executives in this region since liquidity buffer has become rather costly - due to lower interest rate levels - and needs to be charged to units or products that generate such buffer requirement. 
The following diagram depicts linkages of the liquidity risk management themes beyond compliance with the Basel LCR rule, with a central role assigned to internal stress tests.



Similar to internal assessments that banks must perform under the Pillar 2 and ICAAP (Internal Capital Adequacy Assessment Process) frameworks, internal liquidity adequacy assessment process (ILAAP) has been performed by leading banks over the last several years, especially in the UK and other key European Union member states.

The ILAAP could become an upcoming supervisory target in ASEAN to comply with the Principles for sound liquidity risk management and supervision (BCBS, September 2008) . In Malaysia, for example, banks have been asked by BNM to improve their liquidity & fund transfer pricing mechanism. In Indonesia, bank supervisors have paid extra attention to the quality of liquidity risk stress testing performed by larger institutions in particular. 


Implications
At present, concerns of compliance in relation the Basel LCR largely revolve around operational and reporting issues. These are not to be underestimated given the requirement for daily LCR reporting (in some countries) and the expectations of global and national regulators for high quality and consistent implementation of the LCR standards.

However, the global best practices in risk management and supervision also indicate the importance of ‘Pillar 2’ implementation in the realms of liquidity risk. This means more attention for principle-based liquidity risk management and supervisory review of all relevant component of liquidity risks including banks’ intra-day liquidity & collateral management, liquidity & funds transfer pricing, and stress testing.

Banks must adapt their risk infrastructure to meet both daily LCR reporting requirement as well higher supervisory expectations for sound liquidity risk management.


III. Credit risk: Revised Standardized Approach (Second consultative document, December 2015)

The Basel Committee on Banking Supervision (BCBS) is currently proposing revised standard approaches (SA) for credit, market, and operational risks.

As is well known, the SA is a methodology for calculating minimum risk-based capital requirements and should not be seen as a substitute for prudent risk management by banks. In credit risk areas, when a bank solely opts for the standardized approach, linkage between the bank’s required capital allocation and day-to-day credit risk taking will be minimal.

This revised SA proposal seeks to mitigate this concern by seeking a balance between simplicity and risk sensitivity, and by ensuring that the revised SA constitutes a suitable alternative and complement to the Internal Ratings-Based (IRB) approach. The Basel Committee therefore sees the revised SA for credit risk as a means to reassert its goal to reduce banks’ mechanistic reliance on ratings. 

In order to achieve these objectives, a SA bank should undertake its own due diligence and internal risk management. If the due diligence assessment reflects higher risk characteristics than that implied by the external rating of the exposure, the bank would apply a higher risk weight for the exposure.

Implications
The due diligence requirements mean that “banks should be able to conduct their own assessment of the creditworthiness of, and other risks relating to, the financial instruments to which they are exposed, and satisfy their supervisors of that capability” (BCBS 347, p. 3). 
Consequently, banks should have in place effective internal rating systems, processes and controls to meet good practices, which are normally benchmarked against Basel II rating requirements for banks adopting the IRB approach. Stated differently, an SA bank would need to review and upgrade its rating models and governance even if it does not have a plan to switch to the IRB approach. 


IV. Market risk: Interest rate risk in the banking book

In April 2016, the BCBS issued standards for Interest Rate Risk in the Banking Book (IRRBB) which reflect changes in market and supervisory practices over the last twenty years since the Committee publish Principles for the management and supervision of interest rate risk in 2004. Since the document represents a Basel standard, like the existing capital and liquidity standards, national regulators are expected to adopt it in time. Compared to the 2004 Principles, the IRBBB Standard has the following key enhancements:

a) Greater guidance on IRRBB management processes
The standards explicitly mention the requirement to perform a wide range of stress tests including reverse stress tests. 

Scenarios should be sufficiently wide-ranging to identify gap, basis and option risks. Banks are required to pay attention to concentrations due to possible liquidation problems in stressed markets. 
The behavioural and modelling assumptions made in the context of IRRBB should be conceptually sound, well documented, rigorously tested and aligned with the bank’s business strategy. As part of good practices in this area, banks also need to estimate how administered rates might change in the interest rate scenarios and assess the potential interaction with other risk types, including as to how interest rate shocks affect cash flow profile.

b) Introduction of standardised IRRBB Framework
The BCBS also introduces a standardised IRRBB framework to be applied by banks either if mandated by the supervisor, or if desired by the bank itself. The standardised framework sets out the required steps to measure a bank’s IRRBB exposure. 

The standardised framework aims to better capture IRRBB compared to the 2004 Principles, and therefore implementing it can enhance IRRBB management capability of banks, especially in entities that have not established more sophisticated internal measurement systems (IMS).

c) Tight outlier test
A bank is identified as an ‘outlier bank’ if it would experience a loss of economic value in excess of 15% of its Tier 1 capital under a set of prescribed interest rate shock scenarios. Such a bank would be subject to further supervisory review and/or should be expected to hold additional regulatory capital. The outlier criteria has thus been tightened compared to the 20% threshold included in the 2004 Principles. 

d) Enhanced disclosure requirements
Another notable feature of the IRRBB standards is that banks must disclose the level of ΔEVE (ie. economic value sensitivity) and ΔNII (ie. interest earning sensitivity) under a set of prescribed interest rate scenarios. Banks should also disclose the average and longest repricing maturity assigned to non-maturity deposits (NMDs).

ΔEVE should be computed with the assumption of a run-off balance sheet, where existing banking book positions amortize and are not replaced by any new business. ΔNII should be calculated assuming a constant balance sheet, where maturing or repricing asset cash flows are replaced by new cash flows with identical features with regard to the amount, repricing period and spread components.
For internal management purposes, banks are encouraged to model earnings under dynamic balance sheet approaches by incorporating future business expectations, adjusted for the relevant scenario in a consistent manner.

The disclosure requirements for NMD imply that banks must be able determine the duration, in particular, of their current account and saving accounts (CASA) using a best practice methodology. Bank Supevisor will expect that formal policies are in place in order to assess the model risk that corresponds to the (validation of) IRRBB measurement, including in the areas of behavioural modelling of various products with optionality risks.

In contrast to the 2004 Principles, banks are now expected to articulate the IRRBB Risk Appetite in terms of risk to both economic value and earnings, including the implementation of policy limits that aim at maintaining IRRBB exposures consistent with their risk appetite. This requirement has operational implications especially for banks that currently deploy (static) earnings measures as the only tool to measure the IRRBB.
The following chart visualizes key elements and processes included in the Basel IRRBB standards:






Implications
The enhanced Pillar 2 framework included in the new IRRBB standards is an important driver for banks in the region to invest in the upgrade of its balance sheet management and automate its data inputs as much as possible in order to reduce administrative errors. 
Compared to the 2004 Principles, the standardized IRRBB framework has been updated to enhance risk capture, and can be used as a benchmark for internal models. By the same token, for those banks that are still to establish an IRRBB internal measurement system (IMS), the standard provides a clear direction as to how banks can improve their methodologies, governance and disclosures.

V. Expected credit loss: IFRS 9 and BCBS guidance

Major financial institutions in ASEAN are currently busy implementing the new requirements resulting from the introduction of International Financial Reporting Standard 9 (IFRS 9).
IFRS 9 is expected to materially influence banks’ financial statements, with impairment calculations the most affected. The expected credit loss (ECL) calculations rely on a forward-looking assessment, rather than an incurred loss calculation. IFRS 9 requires banks to plan for possible credit losses far earlier rather than after a customer has defaulted. As a result, the ECL is linked to a broader risk management and regulatory context as it will have an impact on overall balance sheet management and capital adequacy assessment.  It also goes beyond a pure accountancy calculation with an impact for numerous stakeholders in the bank, including risk, treasury, and business units.
The BCBS recently published “Guidance on credit risk and accounting for expected credit losses” (BCBS 350, December 2015) to set out supervisory expectations on sound credit risk practices associated with the implementation and ongoing application of ECL accounting frameworks. 
It highlights a number of areas of judgements that give rise to greater need for improved governance, where that judgement is applied. As an example, banks need to address the definition used to determine significant increase of credit risk since origination. Depending on where the line is drawn, expected credit loss will be measured as 12 month or lifetime, leading to a different provision.
Therefore, the guidance has emphasised the importance of high-quality, robust and consistent implementation of applicable ECL accounting frameworks, both within and across all jurisdictions (eg. BCBS 350/p.3). For instance, the Basel Committee considers that practical expedients are intended mainly for entities outside the banking industry.
Other big challenges in implementing the ECL framework are to define and prepare the right input data and to implement a feasible technical solution capable of dealing with the new complexity. Good practices we observe in the industry is that banks are planning to develop the ECL models by leveraging available accounting and risk management data while ensuring a consistent implementation with regards to reconcilability with regulatory reporting. 
Banks with advanced approach for credit risk can build ECL models upon their existing internal credit risk models, which are already used to perform capital allocation and stress testing. In order to determine point-in-time risk parameters (probability of default [PD], loss given default [LGD], exposure at default [EAD], etc.) required to calculate the ECL, the banks should incorporate forward-looking information and macroeconomic factors. 

As a consequence, strong simulation functionalities are imperative for a more sophisticated financial institution to keep expected credit losses at an appropriate level.

Implications
IFRS 9 will result in significant revision of existing models for impairment calculations and require banks to manage additional data requirements to meet regulatory expectations for a robust implementation.
For a bank that has not developed internal credit rating systems according to Basel II requirements, the introduction of the ECL accounting framework is a catalyst to dedicate resources to develop its rating data, models and systems while strengthening the link between accounting, treasury and risk management functions.

VI. Concluding remarks

Banks can strike a better balance among liquidity, solvency and profitability by understanding how one risk affects another. As illustrated in the following diagram, the themes offered above are closely related, with implications that different management functions face a higher degree of interdependency. 
To comply with the proposed SA for credit risk, banks must improve their due diligence capabilities, which are fundamentally represented by a sound risk rating system.  As accounting is moving from an incurred loss model to an expected loss model, banks must find a way to incorporate macroeconomic predictions into their ECL calculations. In this new world of risk management, each risk model and stress test that a bank develops should hence factor in the same assumptions about the future and be applied bank- wide during the internal capital and liquidity adequacy assessment processes.


“This time is different” 
Most of the first series of regulatory accords were borne out of the lessons from the 2008/2009 financial crisis in the US and Eurozone, and often deemed irrelevant for the banking environment in this part of the world. 
However, the above noted regulatory developments would likely have more meaningful impacts this time around, and they potentially have more linkages with actual challenges of commercial banking in ASEAN. The additional risk sensitivity infused into the (proposed) standardized approaches will close the gap with how managers measure and manage risk in their business. Finally, the regulatory push for better disclosures will lead to increasing needs for automated risk management systems and high-quality data.
Banks should take inspiration from the new regulatory developments and use them to drive positive change.





Monday, April 21, 2014

Reviving systemic liquidity risk awareness

In this banking reform series, we shed further light on systemic liquidity risks arising from reliance on demandable retail deposits, known as current and saving accounts (CASA).

Indonesian banks are fiercely competing for market share in CASA. Overall, they are quite successful too as shown below by the rising trend of CASA since 2008/2009.


                                Source: BI banking statistics

Savers appear to accept a poor return of barely 2% (average). Compare it to current rates of inflation (6% – 8%), or consumer loan of 13% per annum (at least) .

Remarkably, banks can hoard their excess cash in the central bank’s overnight deposit facility (FASBI) to get 5.75%. The graph below shows a considerable 3% of spread  between FASBI and saving yield since the expansion of the deposit insurance coverage at end-2008.



                                     Source: BI banking statistics

Combined with the rising CASA share, the repressed saving interest rates and the profitable access to FASBI have enabled Indonesian banks to have a high-risk adjusted return on deposit taking business. 

Is there a free lunch here?
Perhaps for the banks, but not for the nation. The public/government will have to foot the lunch bill when medium-size or larger banks collapse due to an aggressive maturity transformation. This is because insurance fees accumulated so far by the deposit insurance corporation (LPS) would not be sufficient to cope with a loss of more than LPS' free capital of around 30 – 40 trillion Indonesian rupiah (IDR).

Why are savers accepting such a low yield? This is quite a puzzle, isn't it?
I think weak interest rate competition in CASA has played a role. In the case of time deposits, interest rate competition is more prevalent since (better endowed) clients are more price-elastic and better served. By contrast, small saving accounts holders pay less attention to saving interest rates; do not shop around for better deals, or would find accounts switching to other banks rather onerous. The different behaviour and treatment of saving and time deposit accounts holders could weaken the upward mobility of median-income households, and eventually cast doubt on the integrity of financial inclusion programs.

Another possible explanation is that savers accept the low returns since their saving is safe under the LPS' insurance coverage. 

Historically, however, confidence of retail depositors has never been really tested since the establishment of LPS in 2005. In my view, key shortcomings of LPS’ deposit insurance scheme need to be repaired in order to make it credible (i.e. low repudiation risks) and effective (e.g. shorter pay-out period, clarity of coverage terms, etc).

One of next articles in the banking reform series will revisit the distortionary features of the current scheme at greater length. For the moment, the following quote would suffice to underscore some criteria for a better deposit insurance arrangement:

...an “effective deposit insurance scheme” refers to a scheme (i) that guarantees that it has the ability to make prompt payouts, (ii) for which the coverage is clearly defined and (iii) of which public awareness is high. The deposit insurer in an effective deposit insurance scheme has formal legal powers to fulfill its mandate and is operationally independent, transparent and accountable… “ (paragraph 76 of the BIS’ LCR text).

Underpricing of systemic liquidity risk

The increasing popularity of CASA implies rising systemic liquidity risks. Should confidence in the banking sector fall apart, banks with larger demandable deposit balance would suffer most from sudden withdrawals. 

The existence of (generous) deposit insurance relaxes a pivotal risk management challenge in banking and help to create banks to become risk immune. Negative externalities (spillovers) will worsen when bank executives increasingly believe that the deposit insurance generates smaller odds for fatal deposit outflows during financial distress. 

It is not coincidental that the Indonesian CASA boom started in 2008/2009 when the deposit insurance coverage was raised from IDR 100 million to IDR 2 billion. With a more limited deposit guarantee scheme, I think banks would have sufficient incentives to acquire time deposits (TD).

The rising CASA reflects an underpricing of systemic liquidity risk. It means that systemic-risk costs do not get internalized by individual banks since they lack impetus to contain the externalities and associated market failure.

Policy prescriptions

What is unique about a bank is that, when it fails, it drags down the rest of the financial sector and the broader economy. Therefore, even a very small bank was rescued in 2008 in order to prevent bank runs despite the existence of a generous deposit guarantee scheme (the world’s highest in per capita terms).

In economic theory, regulation is called for where there is negative externality or market failure. Recent regulatory initiatives like the Basel III accords focus on the market failure of systemic (liquidity) risks as well as enhancement of banks'risk management quality.

Implementing international standards such as Basel III could give Indonesian bank regulators opportunity to fix such a market failure. Having said this, however, more than a mere implementation of Basel III is needed.

First, the liquidity framework should be implemented properly. It means that regulators should embrace qualitative parts of the standards advocating e.g. sound risk management governance, implementation of funds transfer pricing and continual improvement of stress tests. It also means that outflow assumptions for retail deposits in the calculation of the liquidity ratios (i.e. LCD & NSFR) should be significantly higher than percentages applied in developed countries with established safety network institutions. The higher outflows assumption will raise banks' liquidity buffer requirements.

In particular, application of higher outflow (i.e. around 25%, instead of Basel III’s 5% - 10%) would make Basel III accords even more relevant for banks in Indonesia and in other emerging countries.

Second, Bank Indonesia should increase minimum reserve requirements on CASA in order to arrest the externalities from accumulation of short-term retail fundings. Simultaneously, it also needs to decrease reliance on central bank’s standing deposit facility - hence lower FASBI rate! - in favor of more active open market operations (OMO) to siphon off excess domestic liquidity. The OMO would involve using central bank or government debt papers in repo (in case of liquidity injection) and reverse repo (liquidity absorption) transactions. 

Lower FASBI rate (or equivalently, wider standing facilities corridor) as well as more active deployments of reserve requirement and OMO tools will create a more conducive environment for money market developments, thereby enhancing monetary transmission, market discipline and liquidity.


Capital markets development would also get a boost from the above initiatives. Greater liquidity buffer and corresponding increase of IDR government bonds held by domestic banks will lead to moderation of foreign investors holdings. As per Dec 2013, foreign holdings account for  32.54% of total rupiah government bonds, higher compared to countries selected below (perhaps highest in the region). 

The recent experience has shown that decline in foreign ownerships - partially due to uncertainties concerning the US Federal Reserve’s tapering to its asset purchase program - has contributed to domestic liquidity squeeze. 

In short, greater holdings of the IDR government bonds by Indonesian banks - due to Basel III requirement and, perhaps, reduced attractiveness of the FASBI - could raise the resilience of the government bond yields and local currency.



Concluding remarks

I believe banking reforms in liquidity risk policies are necessary not only for reducing negative externalities but also for stimulating long-term saving; revamping competition; improving income distribution, monetary policy and financial markets depth.

Proper adoption of global regulatory initiatives would likely result in either higher saving interest rates, or a greater share of time deposit in total funding. In either case, banks' cost of funds will inch up, but the quality of liquidity risk management at firm and macro levels will rise up to the global standards.

Sunday, December 22, 2013

Will Indonesia's new capital standards make an impact?

A few days ago, BI issued a new capital framework that will be effective as of 1 January 2014! The coming rule is a transposition from Basel III and aims to raise Indonesian banks’ quantity and quality of capital.

We have to appreciate the efforts to roll out the rule in time..

The introduction of the capital rule appears to be a non-event, however, since it has a couple of omissions or implementation choices that weaken the impacts of reforms intended by the capital accord i.e.: (a) to improve individual bank’s resilience and (b) to address systemic risks and procyclical amplification of these risks over time.

Most items omitted are understandable due to their limited relevance for the Indonesian banks e.g. the counterparty credit risk framework to capture derivative related exposures. Another omission regarding avoidance or reliance on external rating, however, might need to be taken on board next time.

The implementation choice to include interim profit without requiring appropriate review or verification procedures, and without deducting foreseeable pay-outs might be a missed opportunity to raise the quality of capital. Allowing banks to include surplus balance of the asset revaluation as additional tier one capital can also be improved by imposing haircuts or other conditions for example in term of saleability, say, within six months.

If the banking sector is so ready to adopt Basel III as often announced before, why not implement the good practice right away?

It means that when one was anticipating no compliance problem with the new capital standards, reference was made to the high average capital adequacy ratio in the industry (now between 17% - 18%). The reality is that solvency ratio of several banks stands far below the average and a more demanding capital regime might kill those banks without capital raising ability.

                                            Source: BI, Kajian Stabilitas Keuangan No. 21, September 2013

Given that larger banks are known to be capitalized around average, most vulnerable banks would be small in size, I would infer.

Therefore, it is remarkable that in the new capital rule, the capital conservation (cc) buffer provision will not apply to smaller banks (i.e. category “1” and “2”).

According to Basel III, the cc buffer ensures that banks, small and big, build up capital buffers outside periods of stress, which can be drawn down as losses are incurred. The framework imposes constraints on earning distributions on dividends and bonuses when banks’ capital levels fall within the cc buffer range. In my view, the cc buffer is also valuable to prevent pay-outs in the face of a debt overhang or at an early stage of crisis.

While all of the above-mentioned omissions and choices of implementation would not be characterized as material deviation, exempting smaller banks is inconsistent with the global standards.

That said, more important than the compliance issue is the need for better supervision on smaller banks, particularly those with a weak business model.
Regulatory forbearance is not the method to make them sustainable and healthy contributors to diversity and competition in the banking sector.

Conclusion
So how will the coming capital rule make a tangible impact for the whole banking sector? The answer is, it would unfortunately enhance neither quantity & quality of capital nor risk governance - at least until 2016 when some buffer requirements will start to be phased in.