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12 September 2017 | Business & Finance

Q& A on banks’ new minimum capital

Q& A on banks’ new minimum capital

Capital requirement is the minimum amount of capital a bank or other financial institution has to hold as required by its financial regulator.

A bank's capital adequacy ratio on the other hand is expressed as a ratio of equity as a percentage of risk-weighted assets.

These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent.

There is a strong consensus among policymakers in favor of higher bank capital requirements especially Tier I capital. The benefit of increased requirements is clear:

  • Having more capital helps banks better absorb adverse shocks and thus reduces the probability of financial distress.
  • More capital would also reduce bank risk-taking incentives and thus improve investment efficiency and overall welfare.
  • A strong banking sector boost economic growth, attracts foreign direct investment and increases business confidence.

The rest of this article is provide answers to questions relating to proposed new minimum capital requirements.

Q1. What constitutes bank capital?
Bank capital in Ghana or shareholders' funds comprises stated capital, income surplus (typically termed retained earnings), statutory reserves and capital reserves (mostly termed revaluation reserves). As shown in the graph below, Banks' minimum paid-up capital grew by 32.2 percent to GH¢4.23 billion in June 2017 compared to the prior due to new bank entry. Shareholders' funds (a combination of banks' paid up capital and reserves) however stood at GH¢11.08 billion as at end-June 2017, representing an annual growth of 18.3 percent, a slight decline from 18.5 percent growth over the same period last year. The Banks and Specialised Deposit-Taking Institutions (SDIs) Act, 2016 (Act 930) section 156 defines the following in relation to a Bank's capital:

  • Minimum paid-up capital includes (a) initial funds required to start-up a bank or specialised deposit-taking institution, and (b) The operational start-up costs as may be prescribed by the Bank of Ghana but excludes expenses incurred in employing capital.
  • Paid-up capital includesminimumcapital,additionalfullypaid-upshares,andthecapitalisationofincomesurplus.
  • Net own funds includes the sum total of share capital that has been paid-up, free reserves but excludes revaluation reserves on property, plant, and equipment, other non­ distributable reserves unless with the approval of the Bank of Ghana, other than the Reserve Fund established under section 34, subject to netting out accumulated losses, goodwill and unwritten off capitalised expenditure including pre-operating expenses and deferred tax

Q2 . Does Bank of Ghana have the right to set a minimum capital of Banks?

Absolutely Yes.
The Banks and Specialised Deposit-Taking Institutions (SDIs) Act, 2016 (Act 930) section 28 subsection 2 specifies that theBankofGhanamayprescribedifferentrequirementsunderthissectionfordifferentclassesofspecialiseddeposit-takinginstitutions.

Section 28(1) of Act 930 states that A bank or specialised deposit-taking institution shall ensure that while in operation, it maintains in the country a minimum paid-up capital, unimpaired by losses including accumulated losses or other adjustments, as may be prescribed by the Bank of Ghana for banks and specialised deposit-taking institutions

The Section 28(3) of Act 930 further stipulates that for the purpose of calculating impairment of paid-up capital, losses shall be set off in the following order:

(a) against income surplus and other distributable reserves excluding revaluation reserves; and

(b) against the Reserve Fund established under section 34 of Act 930.

Q3 . Are Bank required to set additional capital in respect of special risk?

Absolutely Yes.
Section 30 of Act 930 states that the Bank of Ghana may require a bank, specialized deposit­ takinginstitutionorfinancialholdingcompanytomaintainadditionalcapitalthattheBankofGhanaconsidersappropriatetoaddressconcentrationofrisksinthebank,specialized deposit-takinginstitutionorfinancial holding company, or in the financial system.

In addition, section 78 requires Banks to prepare accounts and financial statements in the form and provide details in accordance with a) internationally-accepted accounting standards; and b) rules orstandardsbasedontheBaselCorePrinciplesasprescribedbytheBankofGhana.

The International accounting standard for loan loss reserve effective January 1, 2018 (IFRS 9) requires banks to reserve for their loan loss according to credit risk inherent in the loan portfolio ( expected loss) . Compliance with Basel principles will require Banks to maintain a capital buffer that reflects the level of risk inherent in their asset portfolio (unexpected loses).

Q4: Please define the following components of shareholders' funds stated capital , retained earnings, Fair value reserve, revaluation reserve, statutory reserve, Credit risk reserve

  • Stated capital : (a) Ordinary Shares – This refers to the total amount of fully paid common shares, including share dividends, for which the corresponding certificates have been issued and (b) Perpetual and Non-cumulative Preferred shares – This refers to the total amount of fully paid perpetual and non-cumulative preferred shares including share dividends, for which the corresponding certificates have been issued.
  • Retained earnings/income surplus: This refers to the undistributed or free portion of the accumulated profits.
  • The fair value reserve refers to the effects from the fair value measurement of available-for-sale financial assets (AFS) after deduction of deferred taxes. These unrealised gains or losses are not recognised in profit or loss until the asset has been sold/matured or impaired.
  • Revaluation (Capital) reserve: This reserve comprises the cumulative net change in the fair value of property and equipment.
  • Statutory reserve represents the cumulative amounts set aside from annual net profit after tax as required by Section 34 of the Banks and Specialised Deposit-Taking Institutions Act, 2016 (ACT 930). When a bank's statutory reserve is less than the amount represented by paid-up capital at the financial year-end, the bank is required to transfer an amount of its net profits after taxes each year to the reserve fund until the deficiency has been eliminated. Thereafter, a minimum annual transfer of 12.5% is required. The proportion of net profits transferred to this reserve ranges from 12.5% to 50% of net profit after tax depending on the ratio of existing statutory reserve fund to paid up capital.

Among many other reasons, the statutory reserve was to help protect depositors' interest and secure some financialviability of the commercial bank itself and the banking industry as a whole. In many instances the statutory reserves have grown to equal or surpass the minimum stated capital of these commercial banks.

  • Credit risk reserve represents the cumulative balance of amounts transferred from/to retained earnings to meet gaps in impairment allowances based on Bank of Ghana's provisioning guidelines and IFRS.
  • Other reserves normally represent actuarial gains and losses on pension obligations and foreign currency differences arising from the translation of the financial statements of foreign operations

Q5: Define core capital of a Bank
Most regulators consider Tier 1 capital of a Bank as key measure of a Bank's capital. Tier 1 capital (i.e. core or primary capital) is the portion of capital which is permanently and freely available to absorb unanticipated losses without the bank being obliged to cease trading, and it is defined to be made up of equity and disclosed reserves.

Basel guidance BCBS June 2011 par 52 defines Common Equity Tier 1 capital (prior to regulatory adjustments) as the sum of the following elements:

  • Common shares issued by the institution that meet the criteria for classification as common shares for regulatory purposes;
  • Surplus (share premium) resulting from the issue of instruments included in Common Equity Tier 1;
  • Retained earnings;
  • Accumulated other comprehensive income and other disclosed reserves;
  • Common shares issued by consolidated subsidiaries of the institution and held by third parties that meet the criteria for inclusion in Common Equity Tier 1 capital.

BoG in its Bank of Ghana Banking Supervision Department (BSD) guide for reporting institutions and its BSD 5 template defines Tier 1 Capital as

  1. Equity- a. Issued and fully paid ordinary shares b. perpetual non-cumulative[1] preference shares
  2. Disclosed reserves- Created or increased by appropriation of after tax retained earnings or surplus; e.g. share premiums, retained profits, general / statutory reserves, etc.

iii. Minority interest which refers to that part of the net result of operations and net assets of the subsidiary attributable to interests, which are not owned, directly or indirectly through subsidiaries of the bank.

BoG guide for reporting institutions states that revaluation surpluses on plant and equipment and other assets that qualify under PPE shall not be considered as capital for capital adequacy ratio computation purposes.

The following items are required to be further deducted from tier 1 capital:

  1. Goodwill and other intangible assets.
  2. Current year's unaudited profit or loss.
  3. Revaluation reserves.
  4. Anticipated losses not yet provided for.
  5. Investments in the equity of subsidiaries.
  6. Investments in the equity (capital) of other banks and financial institutions.
  7. Advances of capital nature granted to connected persons.
  8. Unrealised revaluation losses on investments in securities

Q6: What is the components of shareholders' funds that will be considered for the purpose of determining whether a Bank meets the minimum Capital requirement of GHs 400 million?

This will be clarified by Bank of Ghana in their directive. Using past guidance on minimum capital, the minimum capital is defined as stated capital plus retained earnings.

Statutory reserves though it is a shareholder funds, according to section 34 ( 2) and 35 (e ) of Act 930, such funds should

be set aside before distribution of dividends, making it not available for distribution.

Some banks have proposed that the central bank should revisit the requirement for a statutory reserve. Opinions have been expressed that banks be permitted to capitalise statutory reserves, some of which have accumulated huge reserves.

Revaluation reserves are required to be excluded per Act 930.

BoG guide for financial institutions states that the Credit Risk Reserve so created is not available for distribution as dividend and inclusion in the adjusted capital base for purposes of the Capital Adequacy Ratio (CAR) computation.

The fair value reserve for available-for-sale securities normally represent fair value changes on government securities, under IFRS 9 using the business model test some of these securities may qualify as amortized cost leading to the zeroing out of those reserve and also AFS reserves are not considered as part of Tier 1 capital.

Q7: What do you mean that banks use capital and debt to finance their asset portfolios?

When a bank purchases an asset—say provide a loan—it must fund or purchase the loan with something or other. Some of the purchase price is paid with bank capital—money raised by selling shares or earned by doing business—and some is paid with money the bank borrows. Increasing the level of debt financing relative to capital financing increases a bank’s leverage.

So what the regulators are doing here is placing a stricter limit on the relative level of debt that can be used to finance our biggest banks’ assets.

Q8: How does capital absorb losses?
Suppose we have a bank with GHS 100 in assets, which have been financed with GHS 3 of capital and GHS 97 of debt. If the value of the bank’s assets falls by $2, the bank can take the loss by writing down the equity portion. The bank will still be solvent because its assets are worth more than what it borrowed. But if the value of the assets dropped by GHS 4 instead, the bank would now be insolvent.

The key to this is that capital is the amount a bank can afford to lose before its debts exceed its available assets. The capital portion can be written down because a bank’s shareholders have agreed to absorb the losses by having the value of their contribution to a bank’s balance sheet written down. The debt portion cannot be written down because debt is made up of promises to pay bondholders or depositors fixed amounts.

Q9: Won’t banks make fewer loans if higher capital limits are imposed? Is this bad for access to credit?

All things being equal, yes.
A bank that keeps its capital level exactly the same will have to shrink its balance sheet and make fewer loans in the future.

But all things are not equal. Making fewer loans means reducing income. This means shareholders will receive smaller dividends unless the bank dramatically cuts back on other costs. The banks hit by this rule, however, will likely choose to raise more capital—most likely by retaining earnings and reducing dividend payments—in order to be able to continue to grow their income under the new rules.

Q10: So there will be some loans banks won’t make if the capital component is higher?

That’s right. Some loans will have risk-adjusted returns too low to justify the capital required to make them. This means banks may have to review the profitability of their current loan portfolios in the light of the increased capital requirement and also noting non-interest revenue that may be generated from client relationships so as to improve profitability. Ultimately this is a bank strategic decision encompassing target market, client selection and competitive dynamics among others. From a regulator perspective the essence of the increase in minimum capital is to strengthen the capital position of banks and thereby achieve increased confidence in the banking sector.

Q11: What are the benefits of increase in minimum capital of Banks?

There is a strong consensus among policymakers in favor of higher bank capital requirements especially Tier I capital

The benefit of increased requirements is clear:

  • Having more capital helps banks better absorb adverse shocks and thus reduces the probability of financial distress.
  • More capital would also reduce bank risk-taking incentives and thus improve investment efficiency and overall welfare.

A strong banking sector boost economic growth, attracts foreign direct investment and increases business confidence.

Despite these benefits, some players in the banking industry has adamantly pushed back the effort to increase capital requirements, arguing that an increase in the bank capital requirement could adversely affect bank lending and leads to lower economic growth.

Q12. What are the Implications if a Bank fails to meet the minimum capital by December 31, 2018

A Bank that does not have capital up to ¢400 million as at December 31, 2016 will be considered as an undercapitalized Bank. An undercapitalized Bank may lose it license in the following sequence of events:

  1. First attempt/action: The undercapitalized Bank will be required tosubmit capital restoration plans within 45 days to BoG’s requesting it.
  1. The Bank has 180 days from submission to conclude the capital and liquidity restoration process – Section 105(2b) of Act 930
  2. BoG will further imposes restriction on growth of assets or liabilities, in other words the Bank may not be able to lend or accept deposit from the public ( Section 105 (5a)(5b)(5c) of Act 930
  1. If the problem persists after the first attempt BoG will provide a 90 day window for a new plan and a further 180 days to correct – Section 106 (1a) (1b)
  2. Third, where the initial 2 attempts fail, BoG will place the institution into official administration – Sections 107-122 of Act 930
  3. Lastly, section 123 of Act 930 provides BoG the right to revoke the license of the Bank when BoG believe the Bank will be insolvent within 60 days.

Q 13: State of readiness of the industry: What is the current status of Banks in Ghana relating to the propose capital of ¢400 million

I have assessed banks' current ability to comply with the 2018 minimum capital requirements under the hypothesis that banks would consider capitalising their income surplus as reported at 31 December 2018. I have also considered the withholding tax implications of this route to achieving the minimum capital required. Under Ghana Tax laws, a transfer from income surplus to stated capital attracts a withholding tax of 8% [2] .

On the basis of the information disclosed in the June 30, 2017 and December 31, 2016 financial statements of banks we determined that banks in green (GCB, Barclays Bank of Ghana Ltd. and Zenith Bank Ghana Limited) are the only banks that might not require additional capital to meet the minimum capital requirements for 2018.

As shown in the table below, the industry would potentially need to raise GH¢8.6 billion (in absence of financial

statements available for National Investment Bank Ltd, OmniBank Ghana Limited, the Beige Bank Limited, the

Construction Bank (Gh.) Limited, GHL Bank Limited and ARB Apex Bank Ltd, I assumed each of them will need GHS 400

million) by 31 December 2018 (ignoring IFRS 9 impacts, profits for 2017, and potential consolidations).

This is estimated to be about 78% of June 2017 total shareholder's funds of GH¢11 billion per the July 2017 Banking sector report 10.

This estimate excludes potential impact of new accounting requirement (IFRS 9) which its capital impact is GHS 283 million

(see Q & A 14 below)

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Q14 : I understand there is a new accounting standard that will require Banks to recognize loan loss reserves faster than before and such accounting standard is effective January 1 , 2018, tell us a little bit about the accounting standard and its impact on current levels of loan loss reserves, proposed capital requirements and capital adequacy

The new accounting standard that will require faster level of loan loss reserve starting January 1, 2018 is called IFRS 9 Financial Instruments. IFRS 9 will require banks to show their losses earlier than in the past. Overall, the losses themselves do not change in total over the life of the loans; only the timing of their recording by the bank will be different. The new approach is seen as more timely and it reflects the underlying economics more closely since expected future losses are already priced in the interest rate charged on the loans.

Before IFRS 9, accounting rules forced banks to “wait” for a loss event before recording a loss against a loan asset. This was the case even when banks expected that a percentage of their loans would not be paid back in full. When the downturn came they had to catch up by recording significantly larger losses all at once. The result was the heavy criticism of banks during the financial crisis for providing “too little too late”.

After long discussions it was agreed that this was not helpful; losses should be booked when they are expected as well as when they actually occur. Accounting rules have been changed (in the US under the Current Expected Credit Loss (CECL) model and under IFRS 9 in the rest of the world) to anticipate losses from the day the loan is granted: this is what accountants mean by moving from an “incurred loss model” (which needs an event to occur before a loss is recorded) to an “expected loss model”.

The expected loss model in IFRS 9 is complex and it requires banks to look into the future and to estimate the range of possible economic scenarios that might occur. Banks will have to decide what they think is going to happen to their customers and when. Although this will be done on a portfolio rather than individual borrowing level, they have to consider different circumstances, wider economic events and extreme conditions. This may sound onerous but anticipating future losses in this way will promote more prudent (i.e. later) recording of profits on the loans.

It is helpful to understand that the estimate of losses at any point in time is just that, an estimate. It is also worth noting that unforeseen future events cannot, by definition, be factored into these calculations, so economic shocks can still cause significant and sudden additional losses. This is one of the reasons banks have to hold substantial buffers of capital to absorb such losses if they arise and this is tested regularly by prudential regulators.

The overall impact of IFRS 9 will be that banks will report their losses sooner, but these are not new losses. They have been reflected in the lending decisions and only the timing of their recognition is affected.

While this treatment is more prudent, there are some real challenges. Measurement is highly subjective because it relies on an estimate. This element of forecasting will potentially lead to volatile results. When recession is predicted losses will accelerate, even if current economic circumstances are benign. Comparison between banks will be difficult since their view of the future could be radically different. Analysts looking at bank financial statements may find this problematic.

The international accounting standard (IASB) field work on the impact assessment of the new accounting standard indicates that allowances could increase as follows:

  • Between 30% and 250% for mortgage portfolios
  • Between 25% and 60% for non-mortgage portfolios

The European Banking Authority (EBA) Impact assessment is a30% increase in current loan loss reserve. Also, A Deloitte survey shows approximately 50 percent more allowance as compared to the current levels of provisioning.

An increase in balance sheet allowances under IFRS 9 can result in a material reduction in shareholders' equity.

If balance sheet allowances increase by >40%then core Tier-1 capital ratios for many banks would be materially affected. All else equal, this assumes that the impact from accounting transition flows directly to regulatory capital.

Q15 : I understand there is a new accounting standard that requires Banks loan loss reserves to be recognized faster than before and such accounting standard is effective January 1 , 2018, should Banks consider that in their Capital planning for December 31, 2018.

Absolutely Yes, In addition to the new accounting standard, Banks should stress scenarios of economic and credit performance from now till end of December 31, 2018 to enable them plan for the capital required.

Q16: what are some of the business and strategic implications Banks should consider in relation to the new approach to recognize loan reserve under IFRS 9

To help banks get ahead, I have identified strategic actions in five areas: portfolio strategy, commercial policies, credit management, deal origination, and people management.

  1. Adjusting portfolio strategy to prevent an increase in P&L volatility

IFRS 9 will make some products and business lines structurally less profitable, depending on the economic sector, the duration of a transaction, the guarantees supporting it, and the ratings of the counterparty. These changes mean that banks will need to review their portfolio strategy at a much more granular level than they do today.

Economic sector. The forward-looking nature of credit provision under IFRS 9 means that banks will need to reconsider their allocation of lending to economic sectors with greater sensitivity to the economic cycle.

Transaction duration. The more distant the redemption, the higher the probability that the counterparty will default. Under IFRS 9, stage 2 impairments are based on lifetime ECL—the expected credit losses resulting from all possible default events over the expected life of the financial instrument—and will therefore require higher loan-loss provisions.

Collateral. Unsecured exposures will be hit harder under the new standard. Collateral guarantees will help mitigate the increase in provisions for loss given default under IFRS 9, particularly for exposures migrating to stage 2.

Counterparty ratings. IFRS 9 imposes heavier average provision “penalties” on exposure to higher-risk clients, so counterparty ratings will have a direct impact on profitability. Industry observers expect provisioning for higher-risk performing clients to rise sharply once the new framework is in place.

This shift in structural profitability suggests that banks should, where possible, steer their commercial focus to sectors that are more resilient through the economic cycle. This will reduce the likelihood of stage 1 exposures migrating to stage 2 and thereby increasing P&L volatility. Higher-risk clients should be evaluated with greater care, and banks could introduce a plafond (credit limit) or other measures to restrict the origination of products most likely to be vulnerable to stage 2 migration, such as longer-duration retail mortgages and longer-term uncollateralized facilities, including structured-finance and project-finance deals.

Banks could also consider developing asset-light “originate to distribute” business models for products and sectors at higher risk of stage 2 migration. By originating these products for distribution to third-party institutional investors, banks could reduce their need for balance-sheet capacity for risk-weighted assets and funding, and avoid the large increase in provisions they would otherwise have to make for stage 2 migration. Pursuing such a strategy would involve developing an analytical platform that can calculate fair-value market pricing for each corporate loan and enable banks instantly to capture opportunities for asset distribution in the market.

  1. Revising commercial policies as product economics and profitability change

IFRS 9 will reduce profitability margins, especially for medium- and long-term exposures, because of the capital consumption induced by higher provisioning levels for stage 2. In particular, exposures with low-rated clients and poor guarantees will require higher provisions for stage 2 migration. For loans longer than ten years, provisions for lifetime expected credit losses may be up to 15 to 20 times higher than stage 1 provisions, which are based on expected loss over 12 months. To offset this negative impact on their profitability, banks can adjust their commercial strategies by making changes in pricing or product characteristics:

Pricing. When possible, banks should contractually reach agreement with clients on a pricing grid that includes covenants based on indicators that forecast the probability of migration to stage 2, such as the client's balance-sheet ratio and liquidity index. If a covenant is breached, the rate would increase—for example, by 10 to 20 basis points to compensate for the extra cost of stage 2 for exposures between five and ten years, and by 25 to 35 basis points for exposures longer than ten years. If flexible pricing is not possible, the expected additional cost of a stage 2 migration should be accounted for up front in pricing. This cost should be weighted by the expected time spent in stage 2: for example, 3 to 5 basis points on average for exposures with a maturity of five to ten years, and 5 to 10 basis points for those longer than ten years.

Product characteristics. Banks could adjust maturity, repayment schedule, pre-amortization period, loan-to-value, and break clauses to reduce the impact of IFRS 9 on their profitability. In particular, they should aim to reduce their maturity and amortization profile by providing incentives to relationship managers and clients to shift to shorter-term products, and by introducing new products or options that allow early redemption or rescheduling.

  1. Reforming credit-management practices to prevent exposures from deteriorating

Under IFRS 9, the behavior of each credit facility after origination is an important source of P&L volatility regardless of whether the exposure eventually becomes nonperforming. Banks therefore need to enhance performance monitoring across their portfolio and dramatically increase the scope of active credit management to prevent credit deterioration and reduce stage 2 inflows. Different approaches can be used to do that, including an early-warning system or a rating advisory service.

Forward-looking early-warning systems allow banks to intercept positions at risk of migrating to stage 2. This system would extend the scope of credit monitoring and shift responsibility for it from the credit department to the commercial network. “Significant deterioration” will be measured on a facility rather than a counterparty level under IFRS 9, so virtually every facility will need to be monitored to preempt the emergence of objective signs of deterioration, such as 30 days past due. Monitoring facility data and ensuring that information about guarantees is complete and up to date will be vital in preventing the expensive consequences of migrations to stage 2.

The commercial network should be fully involved in a structured process through which risk management flags any facility approaching migration and identifies the likely reason: for instance, a deterioration in a debtor's short-term liquidity or a problem with data quality. An algorithm—or a credit officer—then assigns possible remediation and mitigation actions, such as opening a short-term facility to solve a liquidity issue or updating balance-sheet indicators to improve data quality. Finally, the relationship manager sees the flagged position and proposed remedial actions on the system and contacts the client to discuss a set of strategies. These might include helping the client improve its credit rating through business or technical measures like those just mentioned, taking steps to increase the level of guarantees to reduce stage 2 provisioning, and adjusting timing and cash flows in the financing mix to the assets being financed so that long-term maturities are used only when necessary.

By a rating advisory service, banks could advise clients on ways to maintain good credit quality, provide solutions to help them obtain better terms on new facilities, and reduce their liability to migrate to stage 2. Banks could offer a fee-based service using a rating simulation tool that enables credit officers and relationship managers to propose how clients could improve their rating or prevent it from worsening. The tool would need to include a macroeconomic outlook and scenarios to forecast how different economic sectors might evolve; a list of actions for improving or maintaining the client's rating in situations such as a drop in revenues, declining profitability, or liquidity issues; and a simulation engine to assess how ratings may evolve and what the impact of various actions could be. Over time, the bank could build up a library of proven strategies applicable to a range of client situations.

  1. Rethinking deal origination to reflect changes in risk appetite

IFRS 9 will prompt banks to reconsider their appetite for credit risk and their overall risk appetite framework (RAF), and to introduce mechanisms to discourage credit origination for clients, sectors, and durations that appear too risky and expensive in light of the new standard.

For example, if banks consider global project finance to be subject to volatile cyclical behavior, they may decide to limit new business development in such deals. To react quickly and effectively to any issues that arise, they should also adjust the limits for project finance in their RAF, review their credit strategy to ensure that new origination in this area is confined to subsegments that remain attractive, and create a framework for delegated authority to ensure that their credit decisions are consistent with their overall strategy for this asset class.

  1. Providing new training and incentives to personnel to strengthen the commercial network

As banks are forced to provide for fully performing loans that migrate to stage 2, their commercial network will need to take on new responsibilities.

In particular, relationship managers will assume a pivotal role, becoming responsible for monitoring loans at risk of deterioration and proposing mitigation actions to prevent stage 2 migration, as noted above. However, most relationship managers have sales and marketing backgrounds, and though they typically originate loans, they do not actively manage them thereafter. As a result, they will need to be trained in new skills such as financial restructuring, workout, and capital management to help them deal with troubled assets effectively.

In addition to introducing training programs to build these capabilities, banks should review their incentive systems to ensure that relationship managers (RMs) are held accountable for any deterioration in credit facilities in their portfolio. The RMs should be evaluated and compensated on an appropriate risk-adjusted profitability metric, such as return on risk-weighted assets, return on risk-adjusted capital, or economic value added, with clear accountability for how well stage 2 costs are managed.

Q17: What are some of the sound capital planning tactics banks should adopt now

The Basel Committee on Banking Supervision (BCBS) publication 277 called A Sound Capital Planning Process: Fundamental Elements provides four fundamental components of a sound capital planning process: (a) Internal control and governance (b) Capital policy and risk capture (c) Forward-looking view (d) Management framework for preserving capital

The Basel Committee views capital planning as a necessary complement to a robust regulatory framework. Sound capital planning is critical for determining the prudent amount, type and composition of capital that is consistent with a longer-term strategy of being able to pursue business objectives, while also withstanding a stressful event. More broadly, the provision of better capital planning practices furthers the Basel Committee's objective of consistently implementing the Basel III framework as a means of maintaining the resilience of the global financial system.

  • Internal control and governance

It is important that a capital planning process reflects the input of different experts from across a bank, including but not limited to staff from business, risk, finance and treasury departments. There should be a strong link between the capital planning, budgeting and strategic planning processes within a bank. Collectively, these experts provide a view of the bank's current strategy, the risks associated with that strategy and an assessment of how those risks contribute to capital needs as measured by internal and regulatory standards. Otherwise, banks may run the risk of developing capital plans that do not.

As a general matter, both senior management and the board of directors4 are involved in the capital planning process.5 Sound practice typically involves a management committee or similar body that works under the auspices of a bank's board of directors and guides and reviews efforts related to capital planning. Typically, the board of directors sets forth the principles that underpin the capital planning process. Those principles may include the forward strategy for the bank, an expression of risk appetite and a perspective on striking the right balance between reinvesting capital in the bank's operations and providing returns to shareholders. Banks with stronger governance of the capital planning process require the board of directors or one or more committees thereof to review and approve capital plans at least annually. Those same bodies are also required to consider the outcome of the capital planning process when appraising business developments and strategy. The analysis captured in a capital plan informs the capital actions contemplated by the board of directors including, for example, whether to reconfirm or change a common stock dividend or common stock repurchase plan and/or issue regulatory capital instruments. In cases where this decision-making has been delegated to one or more committees of a board of directors, approval of the capital plan typically falls within the remit of the board's risk committee.

  • Capital policy and risk capture

An important input to a capital policy is an expression of risk tolerance by management and the board of directors. A risk tolerance statement is approved by the board of directors and renewed annually. It directly informs the bank's business strategy and capital management, including, for example, through the establishment of return targets, risk limits and incentive compensation frameworks at the group and business unit levels. As a general matter, the credibility of a bank's capital planning can be questioned if the process does not adequately reflect material risks, some of which may be difficult to quantify. Banks routinely quantify and hold capital against those risks that are specified in the minimum requirements or Pillar 1 of the Basel II/III regimes. Those risks include credit, counterparty, market and operational risk. Banks with better practices have a comprehensive process in place to regularly and systematically identify, and understand the limitations of, their risk quantification and measurement methods.6 In addition, banks seek to capture in their capital plans those risks for which an explicit regulatory capital treatment is not present, such as, but not limited to, positions that result in concentrated exposures to a type of counterparty or industry, reputational risk and strategic risk. It is also important to establish clear links between capital and liquidity monitoring, considerations that banks did not feature as prominently in past evaluations of capital adequacy.

  • Forward-looking view

Another key element of a sound capital planning process is stress testing or scenario analyses. These techniques are often used to obtain a forward view on the sufficiency of a bank's capital base. As noted in the“Principles for sound stress testing practices and supervision” issued by the Basel Committee in May 2009, an effective capital planning process requires a bank both to assess the risks to which it is exposed and to consider the potential impact on earnings and capital from an assumed economic downturn. In other words, stress testing needs to be an integral component of the capital planning process. Indeed, stress testing and scenario analyses provide a view as to how the bank's capitalisation could be jeopardised if there were a dramatic bank-specific or economic change. Absent such a component, a bank's capital plan would be highly vulnerable, and thus any actions pursuant to it may not adequately insulate the bank against future adverse developments. Stress testing or scenario analyses are quantitatively based, incorporate all relevant risks to the bank and conservatively capture and account for changes in key risk factors across all portfolios and businesses under appropriately severe forward-looking scenarios. In addition, sound practice is evidenced in the repeatability of stress testing and the capability of performing ad hoc scenarios outside the normal stress testing procedures.

For the purpose of capital planning, financial institutions estimate the impact of at least a baseline and a downturn scenario that incorporate a combination of economic, market and bank-specific indicators. The impact of a scenario reflects estimated changes to a bank's revenue, loss, balance sheet, exposure measures and risk-weighted assets. Of the banks observed, leading practice involved exploring the impact of scenarios that captured plausible, severe market-wide and idiosyncratic events that could negatively impact the bank. The Basel Committee's Principles for sound stress testing practices and supervision discusses various techniques that could be used to develop a robust stress test.

  • Management framework for preserving capital

For a capital planning process to be meaningful, a bank's senior management and directors should rely on it to provide them with views of the degree to which a bank's business strategy and capital position may be vulnerable to unexpected changes in conditions. Sound practice entails senior management and the board of directors ensuring that the capital policy and associated monitoring and escalation protocols remain relevant alongside an appropriate risk reporting and stress testing framework. In addition, they are responsible for prioritising and quantifying the capital actions available to them to cushion against unexpected events. In practice, those actions include reductions in or cessation of common stock dividends, equity raises and/or balance sheet reductions. This last set of potential actions could, for instance, include the disposition of capital markets inventory, monetising business units or reducing credit origination. It is critical that management teams assess the feasibility of the proposed contingent actions under stress, including potential benefits and long-term costs, and have a high degree of confidence that such actions can be executed as described. Otherwise, they should not be captured in a bank's capital plan.

Author: Emmanuel Akrong (Credit Consultant)
Email: [email protected]