Khaled mahmud raihan

the bangladesh bank (bb) introduced risk-based capital adequacy (rbca) framework
for banks from 2009 in line with the basel-ii. After one-year parallel run with the
basel-i, the basel-ii has fully come into force from january 2010 as a regulatory
compliance. Under the rbca framework, the bb is entrusted with the task of
ensuring that the banks accurately assess all the risks they are exposed to and
maintain the required capital in commensurate with their risk profile. Just after the
implementation of basel-ii, the capital adequacy ratio (car) of all banks were
reduced, on an average, by 3 per cent to 3.50 per cent due to increased capital
requirement for credit risk as well as newly-introduced market and operational
risks. Since most of the banks were marginally capitalised as a consequence of
overnight change in capital requirement, the bb allowed some breathing time to the
banks and implemented the minimum capital requirement (mcr) (popularly known
as 'pillar-1') in three phases; where the mcr was fixed at 8 per cent up to june 30,
2010 (phase-1), 9 per cent up to june 30, 2011(phase-2) and 10 per cent onward
(phase-3).

Initially most of the banks were mainly concentrated on maintaining the mcr
without going through greater detail of the philosophy of risk-based capital
adequacy framework under the basel-ii. Banks' primary focus was on 'capital
management', that is, enhancing the capital base to support business growth. As a
consequence, most of the banks went for rights offer, issued subordinated debt to
augment tier-1 and tier-2 capital. However, with the passage of time, banks started
moving towards 'asset management', that is, managing asset portfolio with the aim
of reducing the risk-weighted assets (rwa) to support regular capital growth. Credit
rating of the counter-parties of the banks by the external credit assessment
institutes (ecais) is being used as a tool for 'asset management'. This paradigm shift
was mainly driven by the fact that capital is the costliest source of fund and the
management of the banks started believing that capital enhancement is not the
ultimate solution to support business growth since it overburdens the banks to
maintain certain level of return on equity. Again the idea of 'capital management'
does not support risk management philosophy since the banks have now turned
into 'risk intermediary' from traditional 'financial intermediary'.
During the three years of basel-ii regime, most of the banks complied with
minimum car excepting state-owned commercial banks (scbs) during june and
december 2010 when those banks in general, marginally fell short of requirements.
Foreign commercial banks (fcbs) were always at the comfort zone due to their
business nature and adequate capital buffer against their business size. However,
the private commercial banks (pcbs), on an average, were at marginal position
although average car of pcbs stood at around 11.50 per cent as on december 31,
2011.

Now, the question comes whether this additional buffer of capital is sufficient for
the banks. At this stage, should the banks be complacent with the existing level of
car? The answer, by all reasoning stands at 'no'. From industry point of view, all
pcbs are not at the same comfort zone; some of the banks are still at marginal
position where a minor shock can reduce the car at below the regulatory
requirement. In addition, the regular credit growth might warrant addition capital.
More importantly, the existing capital level of the banks is only to cover the mcr
under pillar-1 risks (credit, market and operational risks). The bb is in the process
of implementing pillar-2, that is, supervisory review process (srp) under which the
banks should have a process for assessing overall capital adequacy in relation to
their risk profile and a strategy for maintaining their capital at an adequate level.
Adequate capital means mcr plus some additional capital for all other risks which
are not captured during calculation of rwa for mcr.

The srp teams of all the banks, in the mean time, submitted the process document
through internal capital adequacy assessment process (icaap). The supervisory
review evaluation process team (srep team) of bb has started dialogue with the srp
teams for evaluation of the banks' icaap. Against the above backdrop of
implementation of pillar-2, additional capital will be required against residual risk,
credit concentration risk, interest rate risk (banking book), liquidity risk, reputation
risk, strategic risks etc. These additional risks will attract, on an average, 2 per cent
-- 2.5 per cent additional capital requirement.

How to save capital under capital rationing: against the above backdrop of
increased capital requirement, the banks need to save capital through capital
rationing process for their expected business growth. Since major portion of the
rwa (around 90 per cent) emanate from credit risks, banks will have to rearrange
both balance sheet and off balance exposures in terms of business segments. Credit
exposures are categorised as public sector entities (pses), banks and non-banking
financial institution (nbfis), corporate, retail portfolio, small enterprises, consumer
finance etc. Banks need to have the policy of capital rationing in each business
segment considering their risk weights. While pses, banks and nbfis and corporate
exposures carry variable risk weight (depending on the credit rating of the counter-
parties by ecais), others carry fixed risk weight. Capital rationing should be started
with a sound capital allocation process. Capital requirements against operational
and market risks are usually centrally controlled while capital allocation against
credit risk is to be based on business line-wise, sector-wise and, more importantly,
branch-wise.

Branch banking and capital rationing system: considering the growing importance
of branch banking, branches of the banks are not isolated from the intricacy of the
basel-ii. The basel-ii is no longer confined to reporting of car to the bb rather it is a
complete risk management tool. As such branch management has a significant role
to play as major risks of a bank come from the branches in the form of credit risk.
Under capital rationing system, the head office is required to allocate certain level
of capital to each branch based on which the branches are to extend their credit
portfolio keeping in mind the target level of business growth and profit.

Basel-iii: challenges ahead: the World Bank, the international monetary fund (imf)
and the basel committee on banking supervision (bcbr) have suggested stress tests
for use in the assessment of capital adequacy. In line with the above, the bb
introduced rigorous process of stress testing to reveal the magnitude of change of
car at different shock level. These tests help in managing risks of a bank to ensure
optimum allocation of capital across its risk profile. The bcbr has already
developed and approved basel-iii of the international regulatory framework for
banks. The framework ensures resilient banking system with greater liquidity
buffer, capital of higher quality, and more accurate measurement of risks. Although
the bb is yet to give its road map to implement basel-iii, it has positive intention to
implement the same in the near future. Upon implementation of basel-iii, capital
conservation buffer @2.5 per cent of rwa will be imposed which will enhance the
capital requirement to a great extent.
In view of the upcoming challenges, bankers should be very proactive in their
action keeping themselves updated about the latest development in the field of risk
management. Top management of the bank should have foresightedness in capital
allocation process so that profitability can be maximised with an optimum capital
structure. Liquidity management will also get the priority because persistence of
liquidity problem affects solvency of a bank and can create panic in the industry.

Misconception: credit rating and credit rating agencies have been playing an
important role in car maintenance of banks. As such a clear understanding of the
role of rating agencies and the impact of rating on both car as well as risk
management at branch level in customer selection are crucial. The concept of
credit rating is comparatively new in bangladesh although crisl, the architect of
rating concept and rating profession in the country, has celebrated its decade of
rating operation this year. The rating industry got the momentum and became
familiar in the financial and corporate arena after the implementation of basel-ii.
During the last one year, in addition to spreading the scope of rating, some
misconceptions have developed not only among the market participants and users
of ratings but also among the regulators. Regulators have given license to eight
rating agencies in bangladesh against five rating agencies in india, two rating
agencies each in pakistan, malaysia and singapore without having any reasonable
ground and appropriate market study.

Due to abnormal increase in supply side, rating industry started polluting with
unhealthy competition in terms of 'price cut' and 'rating shopping'. Since the rating
market is highly 'fee sensitive', the new players are offering very low price to get
an entry into the market as well as to cover their operating costs. Bankers, the
prime users of counter-party credit rating under basel-ii regime, are also allured by
desired rating (target rating) for capital adequacy support. However, bankers
should be aware that rating is not merely a tool for capital adequacy requirement
rather it is completely a risk management tool.

Rating is an opinion which should truly reflect the fundamentals of a company. A

justified rating will guide a banker while the opposite would misguide him. If a
banker relies on a rating (an inflated rating) that does not reflect the fundamentals
and extend credit based on that rating, it is primarily the bank which will suffer for
any loss; not the credit rating company. Bankers as well as the counter-parties
should not also be allured by low fee structure because by offering lower fees,
these rating agencies are likely to compromise with the quality due to obvious
reasons. A credit rating report should ideally cover all the risks associated with the
entity or the enterprise. The users of ratings should not only look into rating itself
but also see whether the credit rating reports produced to them justify the ratings.
This will probably make the difference because at the end of the day only one thing
that survives is the 'quality'!!