The time is right to return to and discuss the Basel Accords pertaining to banking solvency, since the Basel Commission has accepted the Banking Control Commission of Lebanon (BCCL) as a member of the Basel Consultative Group. The article herein tackles the topics currently under discussion and the positions of major countries in this regard, especially the European Union (EU) and the United States.
First, remember that Lebanon is not one of the 27 countries that are members of the Basel Commission. The Commission includes ten European countries: Germany, France, the U.K., Italy, Spain, Switzerland, Sweden, the Netherlands, Belgium, and Luxembourg, and five countries from the Americas: The U.S., Canada, Mexico, Argentina, and Brazil. Moreover, there are five developed countries from Asia/Oceania: Japan, Australia, South Korea, Hong Kong, and Singapore, and six members from emerging and developing economies: China, India, Indonesia, Russia, South Africa, and Turkey. Saudi Arabia is the only Arab member. The combined banking assets of all member countries account for more than 90 percent of the world’s overall banking assets.
Since the Basel Commission is specifically tasked with setting up international banking guidelines, it makes sense that the members are represented by each country’s central bank governor and representatives from their banking regulatory authorities. Most countries in the world, if not all, are actually committed to the Basel standards, even though the guidelines do not have the power for automatic enforcement. The guidelines become effective – in the EU countries for instance – when they are issued as directives by the European Commission and when they are executed by national monetary authorities. National monetary authorities often enjoy sufficient latitude in some applied aspects of these guidelines, without prejudice to the essence of the Basel Accords.
All Basel agreements are founded on a basic principle: Banks must hold a level of equity (capital plus earnings allocated for reserves) commensurate with the loans and credit facilities granted. Concluded in 1988, the first Basel Accord (Basel I) set this ratio at eight percent of the banks’ risk-weighted lending portfolio. Each type of banking risks was assigned a corresponding weight. Starting from 1996, the market risk (foreign exchange and interest rate risks) was also included in the calculation of this ratio. In 2004, the operational risk was added under the Basel II accord. The accord also introduced the concept of the ‘three pillars’. The first pillar specifies the minimum required equity to cover the mentioned risks and to absorb unanticipated losses resulting from crises. The second pillar gave regulatory authorities the leeway to impose additional equity ratios if they consider this appropriate. The third pillar required banks to be transparent in their disclosures to the market. Lebanon has committed to this accord, which was implemented by all banks. As a result, equity of all banks grew from $410 million in 1994 to $9.22 billion in 2008/2010. Their solvency ratios rose from 4.5 percent to 12 percent, for these two periods respectively. The Banking Control Commission of Lebanon (BCCL) has used its prerogatives in the special cases of some banks. Each bank’s annual report and consolidated balance sheets and income statements have finally been disclosed in line with international accounting standards and transparency requirements. The disclosures included sufficient information about doubtful loans and the provisions allocated to them. In a nutshell, Lebanon’s commitment to the Basel Accords and the strengthening of the banks’ capital provided the country with certain immunity and stability. It has also helped the sector a great deal in dealing with international markets.
Citing the 2008/2010 period above has not been done in vain. The global financial crisis in 2008, with its dangerous fallout on major international banks, required state interventions to rescue them. This also prompted the Basel Commission to conceive a new accord called ‘Basel III’ that was concluded in November 2010 as directed by the G20 group of countries. In general, this accord was more stringent and more exhaustive in defining the capitalization prerequisites. Banks were required to gradually increase their Common Equity Tier 1 (CET1) ratio to seven percent by 2019, or the double of its value, which was 3.5 percent. Tier 1 Capital Ratio and Total Capital Ratio (TCR) are required to grow to 8.5 and 10.5 percent respectively by the end of 2019 and to include the so-called additional precautionary requirements and resolution process. The local monetary authorities have required banks to abide by solvency rates that are higher than those recommended by the Basel Commission. They have also shortened the implementation period. Banks had to achieve a CET1 ratio of eight percent, a Tier 1 Capital Ratio of ten percent, and a TCR of 12 percent by the end of 2015. Available data, according to Bilanbanques 2016 (page 43), show that at the end of 2015 effective solvency ratios were as follows: A CET1 ratio of 10.83 percent, a Tier 1 Capital Ratio of 13.72 percent, and a TCR of 15.03 percent.
Going back to the subject of Basel III, it should be noted that it has added two dimensions to the Basel Accords. The first one pertains to liquidity, enabling banks to tackle liquidity gaps for a specific period of time without having to resort to the market or the authorities. The second dimension is the leverage ratio that measures total assets relative to equity, which practically means a harmonization between lending and equity levels. Both dimensions were the product of the global financial crisis. It is well known that banks operating locally are characterized by liquidity ratios that are higher than international requirements, even at the expense of profitability. The leverage of local banks, or the assets to capital ratio, is 11 times which is considered an average figure compared to international levels.
For more than two years, the Basel Commission has been conducting meetings and discussions on request from the G20 group of countries, which are the actual decision makers within the Commission. The demand of the G20 focuses on the necessity of harmonizing the methods of measuring risks among countries without having to amend the solvency rates or other requirements stipulated in Basel III. Despite its apparent simplicity, this approach involves complexities that are intensified by the balance of powers among blocks of countries within the G20 and in the Basel Commission, especially the two largest poles: The U.S. and the EU. The financing structures of these two economies differ radically. The financial market in the U.S. provides more than 70 percent of the country’s financing needs while funding from banks accounts for less than 30 percent. In Europe, financial institutions and banks provide 80 percent of the funding to the economy, with the remaining 20 percent provided by the financial markets. It should be indicated here that the European pattern is dominant in Lebanon.
In brief, the American side at the Basel Commission is proposing the adoption of a Global Standard Approach for a general and total risk measurement, provided that at least 76 percent thereof should be taken from the weighted risks on the basis of which the minimum equity is determined. This means that the U.S. proposal does not take into consideration the necessity of dealing with customers’ solvency. Instead, solvency should be approached globally (loan to value), whereas average values taken from international standards would be associated with each kind of risks.
Conversely, the European side sees the importance of retaining the Basel III methodology, including the internal assessment approach that studies a customer’s solvency and repayment capacity (loan to income). It consequently keeps the capitalization requirements linked to real risks. In the eyes of the Europeans, accepting the U.S. methodology means adding equity that is not justified risk-wise. It is feared that the U.S. methodology will inconvenience customers with additional burdens that can be avoided by adopting the loan-to-income approach. The European Commission has threatened not to turn any new agreement into an executive document if European interests were not taken into account. The U.S.-European divergence was exacerbated with the Trump administration. This is evidenced by the Congressional letter sent to the Federal Reserve Chairperson Janet Yellen, warning her not to abide by any rules of conduct decided in Basel and imposed on U.S. banks.
It is unlikely that any new Basel accord will materialize amid these circumstances, as the involved parties will be satisfied with the existing agreement, namely Basel III. This agreement has been rigorously implemented by Lebanon both in terms of mandatory rates and the implementation period, including the equity of banks and the International Financial Reporting Standard 9 (IFRS 9) requirements. All this comes at a time of deterioration in the level of the State solvency, an escalation in the risks of lending to the economy, worsening of the deficits of foreign trade in goods and services, and of a decline in capital inflows. In such particular circumstances, many people try to score points in public debates by proposing to burden the banks beyond their capacity and without taking these requirements or the financing of the State into account. If it is hard to finance a deficit of $4 billion now, how could funding be secured for a projected annual deficit of nearly $7 billion!