November 24, 2014

If Embraced Properly, Basel III Presents Long-Term Opportunities for Middle East Banks and Regulators, Says Strategy& Study

Basel III requirements will act as a catalyst to upgrade capabilities and improve risk-return profile of Middle East banks

As sample of 25 of the most important banks in the region are expected to experience an average capital shortfall of around 25 percent of total regulatory capital required by 2019

The new regulations will force regional banks to take a closer look at their capital allocation and deploy their capital more strategically

Basel III will push banks to have a fundamental rethink on capital and risk, allowing them to generate sustainable growth strategies in the long term

Basel III regulations present an opportunity for Middle East banks and regulators to embrace new rules and improve the sector’s asset quality and risk-return profiles, according to a study by management consultancy Strategy&, formerly Booz & Company.

The Strategy& study, which analyses the ability of a sample of 22 banks in the Gulf Cooperation Council (GCC) and the Levant to meet BASEL III capital requirements, outlines the long-term opportunities for the banking sector and identifies potential roadblocks in the process of full compliance with Basel III requirements, starting by capital shortfall.

Complying with Basel III regulations should encourage Middle East banks to take a more calculated and strategic approach to decisions about businesses, asset choices, and growth, while allocating capital toward opportunities that fit the bank’s actual risk and return profiles. At the same time, this could have the potential to strengthen investor and client confidence in Middle East banks and lead to profitable and well-managed growth in the financial services sector going forward.

“For forward-looking banks, the Basel III requirements can be much more than a technical burden and a drag on growth and profitability. Rather, financial institutions should consider the new rules as a catalyst to upgrade their capabilities, as well as a clear call for thoughtful, balanced and better articulation of their risk-return profile and strategic choices. The new regulation, once implemented across the region, should benefit the regional banking system not just during times of financial crisis or market dislocation, but for decades to come,” says Jihad K. Khalil, Senior Associate with Strategy&.   

The new regulations will force regional banks to take a closer look at their capital allocation and deploy their capital more strategically. However, it is expected to slow down some banks’ rapid expansion abroad.  

The study shows that the sample of 22 of the largest players in the Middle East banking sector will experience an average capital shortfall of around 25 percent of total regulatory capital required by 2019 as per Basel III rules, assuming current growth rates.

The study encourages bank executives to develop a clear understanding of the new requirements that cover six areas of reform, to be able to support the compliance with Basel III regulations. These areas are: (1) definition of capital; (2) countercyclical buffers, (3) enhanced risk coverage; (4) new leverage ratio; (5) new liquidity standards; and (6) other general risk guidelines.

Among these areas, the new liquidity standards have received the lion’s share of attention, because they are new to the Basel guidelines. These requirements place greater emphasis on banks to hold high-quality liquid assets such as government debt. The Middle East debt markets may not consistently be deep enough to provide that sort of liquidity, the study suggests.

According to the study, one of the biggest challenges for the Middle East banks is redefining capital requirements. Under Basel III rules, the minimum capital adequacy ratio (CAR) is expected to fall anywhere in the range of 15 to 18 percent, with (regional) Systematically Important Financial Institutions (SIFIs) expected to be required to comply with the high end of that range. The higher requirements, combined with more stringent definitions of capital, mean that banks will need to raise substantially more capital if they want to continue on their current growth trajectory; otherwise, some tough decisions about key growth areas will need to be made.

Middle East banks will need to address the new capital requirements by 2019. But without making any changes to the way they do business today, some are expected to find themselves with capital adequacy ratios shortfalls sinking down to -10.4 percent of Basel III minimums. Certain fast-growing players in Qatar, Kuwait, and the Levant may be the hardest hit, as any continued growth in assets requires accompanying growth in Tier 1 capital to meet new standards. By contrast, countries that have witnessed relatively slower growth in recent years, including Bahrain, Saudi Arabia, and the United Arab Emirates (UAE), may face less difficulty meeting or even exceeding required CARs if they continue along the same cautious trajectory. However, if they want to choose to ramp up on their regional and international expansion plans, their capital requirements will shoot up considerably in order for them to meet the Basel III requirements. Whichever the case, it will be imperative for all GCC and Levant players to carefully rethink their business and asset mix, with an eye on strategic capital requirements.

“Banks can avoid potential issues and ease the path into Basel III compliance by engaging early and often with regulators. Working through central banks, banks should ask their regulators to run a quantitative impact study to assess the impact of Basel III on their overall local market. With this information in hand, regulators can then consider tailoring regulations to the unique needs of the local banking sector,” says Dr. Daniel Diemers, Partner at Strategy&.   

To support banks through this transition and to instil a new mind-set regarding risk and regulatory compliance, Strategy& suggests a top down approach covering four dimensions - (1) governance and oversight, (2)  core risk processes and models, (3) human capital and  (4) risk and management information systems.

Without a fundamental rethinking of their approaches to capital and risk, banks may fall potentially short of Basel III requirements, the study says. However, rather than feeling restricted by the new regulations, banks could view Basel III as an opportunity to deploy their capital more strategically. By doing so, they will make the hard choices that will allow them to generate sustainable growth for years to come.