Malaysia bank CROs slam Basel capital floor proposal

Basel Committee proposal incentivises risk taking, creates less sensitive risk measurement and disincentivises good risk management

John Lee: flaws in the floors

Regulation to introduce a capital floor will encourage banks to take on riskier customers, and water down adherence to sound risk management, according to three chief risk officers (CROs) at major Malaysian banks.

The Basel Committee on Banking Supervision issued a proposal in December 2014 for minimum capital levels to apply to risk-weighted assets (RWAs) using a revised standardised approach to bank capital in order to limit the variability of RWAs across the industry. But the measures were not welcomed by CROs speaking on a panel discussion at Asean Risk on May 14.

"At the end of this conversation your bank will be making less money, holding more capital, have less dividends and [have] potentially less pay for all of you so this is an important topic," said David Thomas, group CRO at CIMB Bank who added that credit risk represents 65–75% of all banks' capital in Malaysia making this area the biggest focus for risk managers.

All three banks on the panel use an internal ratings-based approach to model capital requirements. This means they will be among the top tier of banks most affected by the current proposal, which nullifies the usefulness of an internal model that assesses risk in a granular way.

The Basel Committee has been silent on the level of the floor but Risk.net reported that at above 75% some banks would stop using internal models.

The drive for consistency is flawed in the first place. By setting a floor it creates different incentive in the system

John Lee, CRO at Maybank, said that while the basis for a capital floor – variability in treatment of capital by banks for the same credits – is clear, it would create perverse incentives.

"The drive for consistency is flawed in the first place. By setting a floor it creates different incentive in the system. For a credit with a risk weight of 50% and a less good credit with a risk weight of 80%, if the floor is set at 70% what will a bank do? I will not lend to the guy with lower risk as I move from 50% to 60–70% so I'd rather lend to the higher risk guy and get slightly better margins," said Lee.

Participants also questioned the efficiency of allocating significantly more capital to assets that were proven to be very low risk. Thomas at CIMB took the example of a Singapore bank's mortgage book, which is "almost risk free" as defaults are extremely low.

"Singapore banks' [mortgage portfolios] on average have a risk weight of between 6–14% and if they set a floor that would move from 38–45%, the capital requirement increase significantly and ramifications longer term are that the capital cost needs to be passed on to someone as banks can't absorb that. Is that an efficient use of capital?" he asked.

Maybank's Lee said that the existing leverage ratio framework within Basel III also provided a "natural floor" at 3% and Lee suggested that with regulators in the US and Switzerland looking at a higher measure, 4% and 5% respectively, this could be a better approach.

A study by the Institute of International Finance showed that a leverage ratio of 3% provided an average risk weight floor of around 30% with a 4% ratio roughly causing a 40% floor.

Lee also suggested that regulators could use the Pillar II framework on bank capital to tweak banks on a case-by-case basis rather than using a uniform measure.

"Instead of setting a floor if regulators are uncomfortable with individual banks' modelling capabilities or internal data then one idea would be to make it a Pillar 2 issue. In Pillar 2 there is already a model risk component to ask banks to add on extra capital," said Lee.

Patrick Ho, chief risk officer at RHB Bank, said banks also already "build in conservatism" to their probability of default numbers and suggested banks will find it harder to find investors in future.

"From a business shareholder's perspective is it worthwhile investing in banks any more given they need so much capital for returns? From a regulator perspective one can never compare one bank to another as portfolios are not homogenous," he said.

The panellists also said the Basel floor proposal was contrary to the idea that banks with better risk management should receive a competitive advantage.

"Banks are not public utilities, banks compete and those that can manage risk effectively and minimise defaults should be rewarded so by creating a floor you are incentivising certain banks to underperform as the last 25% doesn't matter as you are floored. You should be incentivising banks to enhance their risk management skills," Thomas said.

Lee at Maybank would instead go ahead with a compromise approach of using varied floors according to the riskiness of different portfolios.

"Based on my interactions with the Basel Committee it will probably be implemented [in its current form] and the concession they might give is that instead of applying floors across the board we look at different portfolios so with the mortgage portfolio having low risk weights we assign a certain floor," he said.