Repositioning the Region:- The Role of the Financial Services Industry

1. Repositioning the Region:- The Role of the Financial Services Industry Rewiring the Region’s Financial Industry Architecture Implications of Basel III on the Operating Performance of Indigenous Banks

2. 1. Pre 2007 Banking Crisis • Commercial banks had implemented or just began to implement Basel II “three pillars” concept • Minimum capital requirements (addressed risk) • Credit risk • Operational risk, and • Market risk • Supervisory review - Pillar 2 deals with the regulatory response to Pillar 1, giving regulators much improved “tools” - in particular it provided a framework for dealing with all the other risks a bank may face such as systematic; pension; concentration; strategic; reputation; liquidity; and legal risks • Market discipline - sought to promote greater stability in the financial system

3. 2. What is Basel III? • Comprehensive reform of global banking regulations • Substantially strengthen bank capital requirements • Basel III is all about Capital – capital is the amount of high quality assets that a bank must hold to cushion against losses. - banks must hold more capital - higher quality capital, and - more “liquid” capital

4. 2. What is Basel III? • More capital - bigger cushions mean that banks won’t be as vulnerable to losses during times of economic turmoil • Better capital - main focus for higher quality assets such as common equity (the purest form of capital) • More liquidity - where liquidity is the ability to turn assets into cash. Banks must have enough high quality liquid assets to cover cash outflows over a 30 day stress period. • Buffers and additional capital requirements for systematically relevant institutions.

5. 2. What is Basel III? • The new capital requirements are % of risk weighted assets. • Under Basel III banks will need 4.5% of common equity under times of stress, and 7.0% during good times. • The next highest form of capital "Tier 1," adds another 1.5% of capital, and adding "Tier 2," results in another 2.0%. • In total, banks will now need: • 8.0% capital in times of stress • 10.5% capital in normal times • Up to 13% capital when the economy is hot • Definitions of Tier 1 and Tier 2 capital are still being tweaked

6. 2. What is Basel III?

7. 3. How is Basel III different from Basel II? • Capital ratios: • Core Tier 1: Basel II - 2% and Basel III - 4.5% • Tier 1: Basel II - 4% and Basel III - 6% • Capital conservation buffer • Basel II - None and Basel III - 2.5% so total common equity = 7% • Counter cyclical buffer • Basel II - None and Basel III - 0 to 2.5% • Additional capital requirements for systematically relevant financial institutions • Basel II - None and Basel III - still being finalized

8. 3. How is Basel III different from Basel II? • Internal Controls • Basel II focused on banks internal models to determine bank capitalization • The risk inputs were very subjective • Basel III standardizes capital and liquidity definitions • Liquidity coverage ratio - promotes banks short term reliance to potential liquidity disruptions • Net stable funding ratio - seeks to address mismatches between the maturity of a bank’s assets and that of its liabilities • Leverage ratio of 3% - will be tested from Jan. 1 2013 to Jan. 1 2017

9. 4. Why is Basel III Important? The recent financial crisis proved: • Capital levels that large international banks operated with were insufficient, and • Caribbean banks, including indigenous banks, have almost always met the regulatory capital ratio requirements • Capital lacked quality Basel III would result in: • Tightened definition of common equity • Limitation of what qualifies as Tier 1 capital • Market discipline through new disclosure requirements • Identification of inter-linkages and common exposures among all financial institutions • Systematic capital surcharge for systematically important financial institutions

10. 5. Impact of Basel III for commercial banks? • Ideal or Blue Sky World • Fewer bank failures, fewer taxpayer bailouts - banks hold more and better quality capital to withstand future shocks • Stronger banking system in the long run • Greater confidence in the stability of the financial system once implementation commences • Longer implementation period: • Would aid the current fledging recovery worldwide • Allow banks to adapt by retaining earnings, issuing equity • Profits rise as bad loans decline • Bank share prices improve as they engage in acquisitions

11. 5. Impact of Basel III for commercial banks? • Worse Case or Grey Sky World • Regulatory authorities can underestimate the riskiness of sovereign debt on banks balance sheet • Reduction in credit • Decreased availability and increased borrowing cost • Fewer borrowers have access to funding • Significantly more onerous conditions • Higher unemployment • Banks not meeting the ratio requirements cannot pay out dividends, bonuses, share buybacks • Raise investor concerns over dividends

12. 5. Impact of Basel III for commercial banks? • Worse Case or Grey Sky World 4. Banks may have to come up sizeable amounts of: • New equity • Retained earnings, or • Dispose of assets to meet the new capital ratios 5. Restrict lending for exports in economies where export credit is financed by banks but guaranteed by governments • Basel III doesn’t take into account the importance of export credit guarantees • Competitiveness of systems with export guarantees might collapse • Can result in governments removing private banks from the equation

13. 6. Would Basel III implications differ for indigenous banks? • Basel III’s requirement that banks measure the riskiness of a loan by looking mainly at customers’ credit histories would make it difficult for many customers/companies to get access to funds • Basel III modified definition of capital makes it more consistent and transparent, thus it will bring more discipline in the regional financial services sector by virtue of them having to meet common platforms • Indigenous banks based in islands where the savings rate is low may be pushed to tap offshore debt markets thereby making their margins vulnerable to overseas markets • Derivatives activities are not very large in the region and especially in the case of indigenous banks they are seldom used

14. 6. Would Basel III implications differ for indigenous banks? 5. Small government bond markets regionally would struggle to cover the capital shortfall caused by the Basel III • Caribbean banks capital ratios are at least the same as the Basel III minimum capital ratio, but the quality of these capital ratios are not as strong as defined under Basel III - hence the tighter definition of capital would mean that banks will have to take money out of the system • Lock up liquidity • Reduce investment • Can tighten lending • Increase M&A’s

15. 6. Would Basel III implications differ for indigenous banks? • Indigenous banks may increase their lending to foreign sovereigns to realize the margins of zero-risk-weight status • Leverage ratio is not appropriate for the regional financial system since credit is extended through banks rather than through the securities markets • Leverage ratio favors the American system where banks securitize their mortgage holdings and move them off the balance sheet • Some foreign “subsidiaries” may have to satisfy parent mandate of satisfying Basel III

16. 7. Can regional banks mitigate Basel III impacts? • Banking authorities can impose: • Shorter or longer transition periods depending on their assessment of how long it will take for their banks to realize compliance • Higher capital ratios • “Adequate flexibility” implementation • Indigenous banks may want to comply: • For bragging rights • To maintain access to international funding sources • Cause they are prudent to do so • They are currently in compliance and wish to continue to do so • Ensure 100% accountability by staff for their actions/inactions • Master their jurisdictions

17. 8. Basel III implications for bank risk management? • Banks enterprise-wide risk management meets system-wide risks • System-wide focus addresses problems related to interconnectedness and the perception that some banks are simply too big to fail • The build up of buffers in good times that can be drawn down in periods of stress • Constraints on discretionary payments - dividends, bonuses, share buybacks

18. 8. Basel III implications for bank risk management? 2. National authorities ability to curb excess aggregate credit growth • “Gone concern” contingent capital contractual terms of capital instruments will allow them at the option of the banking authorities to be written off or converted to common shares, and • “Going concern” contingent capital contingent capital in the capital framework, currently under review, seeks to decrease the probability of banks or the banking system as a whole reaching the point of non-viability

19. 8. Basel III implications for bank risk management? 3. VAR based capital regime not equipped for the recent crisis • Value at Risk (VAR) based capital regime has a 10 day liquidity horizon that was not designed for the massive illiquid credit exposures that large international banks had built up • Banks warehoused highly illiquid, structured credit assets in the trading book for which there were no markets; were impossible to value when liquidity broke down; and for which too little capital was held to protect against risks