Thai SMEs at risk from Basel III CVA charge – Bank of Thailand profile

The impact on the real economy and on SMEs of regulatory reforms such as Basel III and OTC derivatives rules, says Somboon Chitphentom of the Bank of Thailand

Somboon Chitphentom

Banks in Thailand have successfully implemented Basel III capital requirements starting from January 1, 2013. Local and foreign banks in Thailand must maintain the capital adequacy ratio of at least 8.5%, which is unchanged from the current requirement. Tier I capital must be at least 6%, including minimum 4.5% of common equity.

However, the implementation of the Basel III credit valuation adjustment (CVA) risk capital charge is still under consideration, says Somboon Chitphentom, senior director of prudential policy at the Bank of Thailand. The bank issued a consultation paper on CVA in April 2012 to investigate its merit following concern that it would not be appropriate for the domestic banking sector.

"After reviewing feedback from the industry and assessing capital impacts from the quantitative impact study, which used the Bank for International Settlements' QIS reporting template, we found that the new capital charge may lead to higher costs for over-the-counter derivatives transactions, and would likely impact businesses especially SMEs [small and medium-sized enterprises], which use derivatives mainly as their hedging instruments," says Chitphentom.

Alternatives to reduce the capital charge are limited since there is no credit default swap market in Thailand and no central counterparty (CCP) is currently able to clear Thai baht instruments.

Chitphentom says an in-depth impact analysis is crucial in developing prudential policies to better capture counterparty credit risk while not harming the real economy. This is particularly relevant when foreign exchange movements are highly volatile and hedging instruments become more essential. Chitphentom believes implementation of the CVA risk capital charge should be considered together with the capital requirement for bank exposures to CCPs and other tools such as margin requirements for non-centrally cleared derivatives.

Thai banks will be able to meet the liquidity requirements without much adjustment

"If there is a concern that the postponement of the CVA implementation in Thailand would induce banks to underestimate the counterparty credit risk, I would emphasise again that the OTC derivatives market in Thailand is relatively small compared with the loan market, and thus the counterparty credit risk is not a large component of bank risks. At this point, in my view, CVA could be implemented in the future but is not a top priority," says Chitphentom.

In response to the international push for central clearing of OTC derivatives and reporting data to trade repositories, the Bank of Thailand has set up a task force comprising both supervisors and market players including the Bank, the Thai Securities and Exchange Commission, the Office of Insurance Commission, and the Stock Exchange of Thailand together with commercial banks, to study the feasibility of setting up domestic CCP and trade repository services.

Chitphentom says low volumes on the Thai OTC derivatives market do not justify requiring these instruments to be centrally cleared.

"The Thai market is relatively small and most OTC derivatives are used for hedging purposes, by both end-users and banks themselves. Secondly, the most actively traded products are interest rate swap and foreign exchange derivatives, which usually are exempted from mandatory central clearing by most regulators," he says.

"Furthermore, counterparty credit risk in OTC derivatives is not a major component of Thai banks' risk. Counterparty credit risk-weighted assets of OTC derivatives account for less than 5% of total credit risk-weighted assets as of end-December 2012. Therefore, there is no immediate need for a CCP but if the market environment changes, setting up a domestic CCP for OTC derivatives in Thailand could be reconsidered," he adds.

As for the implementation of Basel III liquidity requirements, Chitphentom says that it will, in general, likely impact bank lending to the private sector.

"Thai banks will be able to meet the liquidity requirements without much adjustment, if and when we require them to do so because our banks' funding sources are largely via retail deposits, and if there are any adjustments needed there are plenty of high-quality liquid assets available in the market to support the increased demand for HQLA."

He adds: "The main challenge is that the cost of complying with the liquidity coverage ratio would likely translate into higher costs of funds and be passed on to the real sector, affecting both accessibility and price of loans to the private sector, particularly SMEs. The impact would be more acute for any bank-based economies and could hamper economic growth, particularly when considering the combined impacts of various regulatory reforms."