Investors and financial intermediaries will face a tough task in meeting the slew of new regulations sweeping the financial markets in the year ahead – with some new rules likely to conflict with each other as policy-makers have struggled to meet the aggressive timeframe to implement financial reform following the advent of the global financial crisis in 2007/2008. There is also a strong likelihood that meeting the reform timetable will be impossible in a number of Asian jurisdictions.
But Marc Saidenberg, senior vice-president of the bank supervision group at the Federal Reserve Bank of New York, used his keynote presentation at the Asia Risk Congress held at the Four Seasons hotel in Hong Kong on October 25 to reinforce the importance of the new Basel III capital and liquidity rules being introduced around the world. He pointed out that regulators are keen to reduce spillover from the financial system to the real economy during time of distress and this has resulted in the need to increase the capacity of banks to take losses.
Saidenberg said that until the latest round of regulatory reform, policy-makers and supervisors had failed to determine the ‘right level’ of capital at a micro level. He reminded delegates that Basel I, introduced in 1988, was aimed at increasing capital; its successor, Basel II, was aimed at making the rules more risk-based but to keep capital levels flat.
By contrast, Saidenberg said there was a “huge set of analyses” done to assess the appropriate amounts of capital for Basel III. “At no point until recently has someone asked what the right level of capital is for the capital conservation buffer, as well as the surcharge and counter-cyclical buffer, and tried to identify the theory behind each of those which is not easily observed,” he said.
The new framework also consists of a methodology to identify systemically important institutions and requires them to hold higher capital ratios. This additional cost takes into account the “externalities” associated with the failure of systemically interconnected financial institutions. “The goal of this is to internalise those externalities,” Saidenberg said, adding his views do not necessarily reflect those of the New York Fed.
While China shares the common goal of following internationally agreed financial reforms promoted by global economic forums and standard-setting bodies such as the Financial Stability Board and the Basel Committee on Banking Supervision, these reforms are only applicable partially for China and emerging markets. That’s because they represent efforts by developed nations to tackle post-crisis problems accelerated by their light-touch regulatory approach, said Luo Ping, director-general of the China Banking Regulatory Commission (CBRC), during his keynote address.
Luo said China and other emerging markets should focus their domestic priorities on building a strong baseline of banking supervision while they are adopting international standards such as Basel II and Basel III. He added that what has traditionally set Chinese banking regulators apart from their western counterparts is that Chinese regulators have always believed in the merits of straight financial supervision and rejected the idea of “dramatic deregulation” and liberalisation of financial markets. This focus on supervisory fundamentals has enabled China’s financial institutions to avoid some of the problems that plagued US financial services firms during the financial crisis of 2007–2008.
“While adopting international standards we need to keep a right balance between strengthening supervision and promoting innovation. [China and emerging markets] should not follow the same cycle of deregulation and re-regulation [in a supervisory approach like a] pendulum swing,” said Luo.
In May, the CBRC announced new regulatory standards for the country’s banking sector, including new capital and liquidity principles under Basel III. In August, the regulator consulted financial firms on various potential methodologies for calculating the banks’ regulatory capital adequacy ratio. Luo said the CBRC will likely finalise the proposed methodology on capital management in a “few weeks’ time”. The CBRC is asking banks to adopt both Basel II and III requirements starting in 2013. Luo added that Chinese banks have traditionally had simpler balance sheets than their western counterparts and their level of non-performing loans has been low in recent years, giving them a higher capacity to withstand more stringent requirements.
Turning to the subject of the supervision of systemically important financial institutions (Sifis), Luo said the global financial crisis showed that the main contributors to “too big to fail” problems were the interconnectedness and complexity of individual firms, and that the latter poses enormous challenges to supervisory oversight. The CBRC has identified some local Sifis in China, and they will be subject to an additional 1% charge on their capital adequacy ratio, he said.
Meanwhile, end-users and clearing members of central counterparty (CCP) clearing houses will need to devise collateral strategies that ensure they can source eligible assets at a time when the introduction of new international capital rules under Basel III – along with the lack of interoperability across CCPs – will make those assets scarce, according to panellists debating the use of CCPs in the region.
Central clearing of OTC derivatives will become mandatory in G-20 countries, which includes Australia, China, India, Indonesia, Japan and South Korea, at the end of 2012. Other jurisdictions, such as Hong Kong, have also committed to mandatory OTC clearing, and CCP clearing is relevant to any financial institution that needs to follow Basel III as the use of a qualifying CCP attracts a low risk weighting of 2% that would be applied to exposure-at-default, a parameter for calculating capital ratios.
Darren Measures, executive director and head of risk for Asia-Pacific at JP Morgan, says he expects a lot of collateral upgrade trades will arise soon in the region. This will occur as Tier I capital is increasingly strained under Basel III, likely putting a squeeze on high-quality collateral. “Is there enough liquidity out there to service that collateral upgrade requirement?” Measures asked delegates.
Karim Chabane, director of collateral management for regional securities finance at Citi, said that before an institution decides to do a collateral upgrade trade it should first have a clear vision about what it has got in its collateral pool. “Fragmentation is not just [an issue] facing [clients choosing their] CCP; it is also an issue of where your collateral is sitting. Typically you would hold US Treasuries in the US and German Bunds in Germany, so getting this consolidation is already a first step,” said Chabane.
Some speakers also believe the fledgling offshore renminbi bond market in Hong Kong – whose instruments are dubbed ‘dim sum’ bonds – is being held back by a lack of longer-tenor issuance. At the moment, the market is focused on maturities of three to five years, which means few Hong Kong blue-chip companies are tempted to tap the 158 billion yuan ($24.7 billion) outstanding bond market.
Part of the reason for lower long-term issuance is the lack of effective hedging options available to public and private companies, according to Francis Ho, group treasurer of CLP Holdings, one of the two power companies serving the city of 7 million inhabitants. Ho noted that potential issuers can only find liquidity in three- to five-year tenor derivatives for hedging dim sum bonds, also known as CNH bonds, which are denominated in deliverable offshore renminbi.
However, China’s capital account liberalisation policies are also a significant source of risk for potential issuers and investors. Hing Tang, managing director of the quantitative strategy business unit of BOCI-Prudential Asset Management, said he is sceptical about whether investors and issuers would be keen on longer-tenor dim sum bonds as uncertainty still hangs over China’s progress in opening its capital account to allow easier repatriation of renminbi proceeds raised offshore back to mainland China.
Chief risk officers at three leading European insurers believe there is still an unlevel playing field in Asia for risk-based capital (RBC) structures, leading to difficulties for their firms in competing in some product areas with local and international insurers operating in the region.
“It’s hard to argue that it doesn’t make sense to base your capital on the amount of risk you take,” said Mark Stamper, regional risk officer at Axa Asia. “The European insurance market is leading the way; it’s not easy though, we are struggling to implement it... [it’s] not simple to assess how much risk you take.”
Axa is only implementing Solvency II – a risk-based capital rule for European insurers being introduced in 2014 – in Hong Kong at present. But Stamper said Axa is already running into difficulties on the product side competing with other major insurers. Major non-European insurers include the likes of AIA.
Another panellist explained that the move to risk-based capital has forced insurers to rethink portfolios on the asset and liability side. “Those companies that are already embarking on Solvency II have started thinking about the consequences whereas some competitors have not, which leads to an uneven playing field in the short run but in the long run other companies will realise the value and voluntarily do it,” said Sigurd Volk, regional chief risk officer at Allianz Insurance Management Asia-Pacific.
Doug Caldwell, chief risk officer at ING Asia-Pacific, believes European insurers are competing well despite the challenges. “In Asia it’s not a consistent playing field so it will create pockets... but all firms here [on the panel] have been working on Solvency II principles for the last three to five years and have been competing in Asia reasonably well so it’s not impossible,” Caldwell said.
During another CRO panel debate, panellists said the rise of the chief risk officer role in the Asia-Pacific region may result in more conflict between increasingly powerful risk heads and company chief financial officers (CFOs).
The creation of CROs, who typically report directly to the chief executive and/or chairman, became more popular following the global financial crisis of 2008 when risk management and risk quantification became viewed as critical components to ensure the future wellbeing of financial institutions and corporations. As a result, the quantification of risk started to feed into management decisions and risk management was no longer viewed merely as a compliance exercise.