Under an agreement between central bank governors and top financial supervisors from 27 countries and territories, the Basel III rules announced in September require banks over the next nine years to boost the capital they hold to offset risk-bearing assets.
Peter Lam, KPMG director, risk and compliance services, said banks should comfortably meet the requirements, although they would incur costs in implementing and maintaining the new system. "Under the new regulations, we could see higher capital charges which could reduce industry profitability as a whole if profitability is measured in return on equity," Lam said.
Speaking at the "Basel III: New Rules for Bankers" seminar co-organised by Classified Post and Kornerstone, Lam said the new framework was initiated in response to the credit crunch, which caused several international banks to collapse and others to rely on government support.
"The Basel III accord is not a solution in itself, but acts as an engine that can help set in place processes for dealing with different types of risk," he said. "In the past, banks had been concentrating on meeting compliance and building up risk management capacity without thinking too much about how to drive the processes."
He said the new rules were designed to make the world's banking industry more transparent and safer. The revamped regulations should reduce banks' incentive to take excessive risks, lower the likelihood and severity of future crises and enable banks to withstand - without government financial intervention - the type of stresses associated with the financial crisis.
Politicians and concern groups have been calling for regulations to ensure banks have enough liquidity or cash-like assets to tide them through difficult periods. Blaming the global credit crisis partly on risky trading by banks, G-20 leaders have also been urging regulators to work on tougher bank capital rules.
Lam told seminar participants that under the Basel III framework, banks would be required to gradually increase between 2013 and 2019 the capital they hold to offset risk-bearing assets to 10 per cent of total assets. From 2013, tier-one capital requirement will rise from 4 per cent to 4.5 per cent.
"Banks will not be able to raise the capital overnight and change capital structure. The Basel III framework involves a great deal of fundamental impact to banks' capital position so the long transition period is generally received with relief by the banking industry," Lam said.
The transition period would also ensure the sector could meet the higher capital standards through retained earnings and fund-raising activities, even as they keep lending.
Lam said failure to maintain capital ratio above the buffer could result in restrictions on the payment of dividends, share buybacks and bonuses.
In addition to capital standards, Basel III includes a range of reforms agreed earlier this year to reduce risk-taking by banks, and how banks treat tax assets on their books.
Other amendments include strengthening counterparty credit risk, capital buffers, expected loss provisioning, reviewing leverage ratio and property valuation of systemic risk. Lam said losses through counterparty credit risk were a major contributing factor highlighted during the financial crisis. Under the Basel III framework, counterparty credit risk is part of a stress-testing requirement.
"Modifications added to the existing Basel accord will not solve everything, but they should provide good fundamental building blocks to promote sound risk management in banks to help dampen the next financial crisis if one should occur in the future," Lam said.
He added that to comply with Basel III, banks would need to invest in risk-reporting systems, better IT infrastructure and human resources to improve risk management. Lam said banks should strengthen the preparation of a capital plan, usually based on a firm's growth forecasts.
Stress testing a matter of urgency
Stress testing has become a fundamental part of the banking industry.
Speaking at the "Basel III: New Rules for Bankers" seminar, co-organised by Classified Post and Kornerstone, Peter Lam, KPMG director, risk and compliance services, told participants that stress testing was a major component of the new framework.
"In different formats, banks have been using stress-testing analysis for years. However, stress testing as referred to under the new Basel III framework requires a more quantitative approach and methods where assumptions can be evaluated," Lam said.
For example, stress testing could be linked to changes in a bank's activities if China's economic environment deteriorated or a sovereign debt crisis occurred. "There is no one-size-fits-all type of stress test and each bank will have its own exposure to different stress parameters," he said.
Banks could examine the impact of events in all the major macroeconomic variables over the past 10 to 20 years and the likelihood of similar events happening again. Stress testing could also include choosing costly and rare scenarios and then putting them to a valuation model that would look at cost and damage to reputation, he added.
To be effective, scenarios needed to be re-run and re-evaluated on a regular basis to accommodate both changes in a particular bank's asset mix and in future expectations, Lam said. Senior management must also be involved, as they should have a clear picture of the scope of the entire business.
Although the Basel III framework is being phased in, Lam said banks should put comprehensive stress-testing systems in place as soon as possible. "Regulators, stakeholders and shareholders will be expecting the banks they are involved with to implement stress-testing practices as soon as they can," he said.