Sunday, April 10, 2011

Relevance and insights of Basel III for Asian banks: The case of Indonesia

Indonesian banks will be among those in Asia entering phase three of global banking reform more easily due to inherent conservatism since the 1998 Asian crisis, says the central bank (The Jakarta Post)

Thanks to ample capitalization, earning power and liquidity, Indonesia's banking sector and its supervisor have valid reasons to be confident for meeting the Basel III standards relatively easily. At least if the compliance challenge is compared to banks in the Eurozone.

But the risk is that one is becoming complacent on a failure to fully understand how consequential the reform (in its fullness) can be. According to the Basel Committee, Basel III is build from Basel II and its adoption should be seen in light of continued improvement of banking system’s infrastructure and incentives in a.o. governance practices, compensation and the moral hazard associated with systemic financial institutions.

The implications of Basel III will be felt sooner than later as the pressure and expectation by the market, general public and regulators grow in significance much earlier than the implementation phase-in from 2015 onwards. In the Netherlands for instance, the central bank has required banks to prepare a migration plan to Basel III and subject them to periodical reporting for monitoring purposes already in 2011.
See for implementation of Basel III in the Netherlands here; For the Central and Eastern European (CEE) region, see the IFCR site here.

Besides its relevance, there are also elements of Basel III that introduce some useful (if not new) insights for policy makers in Indonesia and maybe elsewhere. I will touch upon some of those elements here for further discussion.

Capital adequacy standards
From a sample of the 2010 annual reports of banks listed in the Jakarta Stock Exchange, it is clear that the Indonesian banks are well capitalized according to the Basel III norms, in terms of size and quality of equity base.

Bear in mind however, Indonesia's banks are still to calculate and report the capital adequacy ratios (CAR) according to the Basel II framework. Just in February 2011, Bank Indonesia issued the final rule about the Basel II’s Standardized Approach for credit risk entering into force on 1 January 2012. This highlights the distance Indonesia's banks and supervisor have to travel to get to Basel III environment.

Furthermore, it is less clear how adequate the capital base would be if all the risks are captured in Pillar 1 calculation and Pillar 2 processes in line with the revised Basel II guidelines. On the back of currently high credit growth, capital adequacy can become an issue, if incentives are not given to banks to retain more earnings in the book, which brings us to the next essential insight from the new capital adequacy framework.

Capital Buffers
Basel III contains proposals for a capital conservation buffer and a countercyclical buffer, that is, the build up of buffers in good times that can be drawn down in periods of stress. Under the capital conservation buffer, when a bank’s capital levels move closer to minimum requirements, the bank will be imposed a constraint on its discretionary distributions such as dividend payments and bonuses.

Compared to recent developments in the US and Europe, Indonesia's dividend and bonus policy issues are presently not on the table. This missing agenda is less likely to manifest under Basel III, particularly when there are excesses in payments of dividends and bonuses in a way reminiscent of the situations before the 2008 global financial crisis.

The second kind of buffer will be imposed when, in the view of national authorities, there is an excess aggregate credit growth (e.g. actual credit/GDO ratio > the trend of credit/GDP ratio).

The countercyclical capital buffer guideline provides a relevant insight for gauging a recent central bank initiative. From 1 March 2011, Indonesian banks will face higher reserve requirements as a penalty, if their loan-to-deposit (LDR) ratio falls outside the range between 78% and 100%. Since the average LDR of the sector and the LDRs of the biggest banks such as Mandiri and BCA are currently below the range, aggregate credit growth in 2011 and beyond can easily come out higher than about 25% recorded last year.

I believe the authority should refrain from using such prudential rule to stimulate credit growth. It is very easy for an individual institution to be tempted into a reckless lending spree given this incentive. While Indonesia’s credit-to-GDP ratio is relatively low, periods of excess aggregate credit growth are found to be associated with the build-up of banking crisis risk. Therefore, Basel III proposes the countercyclical buffer, among others, to deal with an excessive asset growth (i.e. too high credit multiplier).

Stating the insight differently: When operating under the Basel III regime, it will be quite unlikely that Bank Indonesia introduces such regulation that would spur lending and yet at the same time may be required under the Basel III guidelines to impose a countercyclical capital buffer as credit growth is far exceeding nominal GDP growth.

Liquidity standards
The Basel III minimum liquidity standards are comprised of the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The LCR ratio is designed to make banks more resilient to potential short-term disruptions in obtaining funding by requiring banks to have sufficient high-quality liquid assets. The NSFR is designed to address longer-term structural liquidity mismatches. Taken together, this liquidity framework covers asset-liability sides of the balance sheet and provides incentives for banks to use stable sources of funding.

Given the banks' low loan-to-deposit ratio, high holding of IDR government bonds and reliance on deposit funding, Indonesian banks and regulators are understandably not concerned about their ability to deal with the Basel III requirements. But the liquidity framework implications are potentially more significant than it may appear at first glance.

For example, while demandable deposits (e.g. current accounts and savings) are recognized as stable funding source, time deposits with residual maturity of greater than 30 days markedly have higher weight (i.e. higher stable funding value) in the calculation of total stable funding source.

All else equal, banks are compelled to accumulate more time deposits.
Let's look at a sample of the 2010 annual reports of small and big Indonesian banks focusing on their retail funding structure:

a. Most big banks or banks with strong franchise value show low time deposits as % of total retail deposits (average < 15%).
As comparison, the ratios are higher in countries where central banks impose higher reserve requirements on demand deposits and savings deposit (re: Financial statements of Brazilian and Turkish banks). For a general overview on the use of reserve requirements as a policy instrument see Montoro and Moreno (2011);
b. Smaller banks have higher percentage of time deposits, but average remaining maturity is often less than 30 days and will thus be treated less favorably under Basel III;
c. Time deposits rate (in Indonesia) is notably much higher than savings rate.

The fact that cheaper sorts of retail deposits account for the lion share of the total funding explains, in my view, why net interest incomes of the Indonesian banks, especially the bigger ones, are very high compared to other countries.

As a consequence, Basel III implementation will directly and indirectly raises funding costs and compress profitability as banks will need to increase longer term, more expensive, funding sources, or increase the share of low yielding high-quality assets.

The Basel III liquidity framework also introduces several monitoring metrics that supervisors will employ to assess the liquidity risk of a bank, most notably in regard to concentration of funding and the LCR by currency. An LCR by currency for example will likely lead Indonesia’s banks to cover their foreign currency customer deposits by holding low yielding USD-denominated high-quality bonds. Furthermore, concentration of funding by product types, currencies, maturity etc. will be part of monitoring tools and disclosure requirements.

Beyond the Basel III context, see an increasingly popular paper by Shin (2010), which emphasizes vulnerabilities of banks from the reliance on unstable short-term funding and short-term foreign currency liabilities.

Concluding remarks
A number of observers tends to think that the overall regulatory reform led by the Basel Committee is made in response to the financial crisis that has little relevance to Indonesian banks with business mix primarily in basic banking without much complex derivatives activities. See for a critique on effectiveness of Basel III in Asia, Milne (2010).

The Basel III accord, however, encapsulates both macro and micro prudential policy frameworks. It has relevance on capital and liquidity risk management as well on incentives and related regulations in the banking sector. Eventual implementation of Basel III will raise the costs of banking as well as change the Indonesian banking business model and financial market more significantly than initially thought.

While actual implementation dates may seem to be on the distant future, understanding its insights will raise current public awareness of the perils of excessive credit growth and fragility of bank liabilities. Especially when the economy is in the middle of an upturn, Basel III is an opportunity for the regulator to shore up its policy instruments and should be embraced earlier than later.

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