by Vikram Narayan, CEO & Country Manager, Experian Services India Private Ltd
In the aftermath of the 2008 financial crisis, there was general consensus that the global financial system needed reform. When the Basel Committee on Banking Supervision (BCBS) published its regulatory recommendations in 2009, the impact was felt far and wide. The Basel III framework has been called a “regulatory tsunami" by José Maria Roldan, Chairman of the Basel Committee Standards Implementation Group. Banks would be forced to change the way they had been doing business for decades, and the outlook was uncertain. They would not only have to have more capital on hand in the event of financial disruptions, but the composition of that capital also would have to be retooled to ensure resilience even under particularly adverse economic conditions. Following are the areas that would be impacted under the Basel III framework.
Better Quality Capital: The area most impacted will be Tier 1 core capital, i.e. common equity
Increased Capital Requirements: The minimum requirement for common equity will be increased to 4.5 percent, and Basel also will provide for an additional capital conservation buffer set at 2.5 percent.
Additional liquidity requirements: One of the primary causes of the financial crisis in 2007 to 2010 was a sudden lack of liquidity in the banking system.
Major impact on profitability: Analysts expect that new minimum capital requirements; revised capital compositions; and enhanced liquidity requirements will hamper profitability, return on equity (ROE), and growth.
How will banks react to Basel III?
Clearly, Basel III represents a seismic shift in financial regulations. According to industry experts, financial organisations are expected to react in several different ways to help mitigate the impact of the many new requirements they face.
According to industry analysts, many of their reactions will be strategic initiatives, involving migrating their organisation’s models to new business models that will be less affected by the new requirements and more profitable. For example, a retail banking group might decide to sell one if its non-core investment banking units to reduce capital charges. An organisation might adjust its product mix and pricing, terms and conditions to optimise risk-weighted assets (RWA) and capital usage. These can include disposal of assets such as selling non-core operations, divesting from specific businesses (e.g., investment banking), pulling out from one or more geographical markets, restructurings and other operational initiatives, and capital management programmes.
Using Analytics to optimize RWA
Many banks are employing a top-down approach to strategies that help offset the negative impact on profitability of the new regulatory environment. However, an alternative, bottom-up approach can be very effective at optimising RWA. By focusing on improving and optimising their credit strategies, banks can achieve significant benefits in terms of value creation — and create more value out of their existing portfolios.
Business and regulatory drivers are a fact of life for banks. They must balance business and regulations at both a strategic level and an operational level. At the operational level, these business drivers are translated into specific credit strategies. Organisations can accept or reject customers; apply pricing, limits, and other terms and conditions; and cut costs to meet their objectives. Optimising credit strategies simply means making the best decisions — adjusting factors such as acceptance criteria, collateral, pricing, limit setting and loan amount.
A well-designed decision optimisation framework can provide a roadmap to developing a sound credit strategy.
Analytical models and tools can help organisations not only address compliance issues such as Basel III, but also transform those regulatory requirements into a compelling competitive advantage. Applying a bottom-up approach to optimising credit strategies is not only possible, but also highly effective in offsetting the negative impact of Basel III regulations. By improving their credit strategy, banks also can apply a powerful approach to RWA optimisation.
This approach to RWA optimisation also helps ensure that day-to-day credit decisions are always consistent with the bank’s risk appetite and capital allocation plan. Banks also can take advantage of their credit strategy optimisation environment to provide input into their capital budgeting process.
The optimisation framework is a powerful tool that can improve efficiency and profitability of organisations not only in the area of credit strategies and decisions, but also throughout several other areas of their business. These may include optimizing marketing offers to existing and prospective customers, optimising the actions to be performed on customers in collections or maximising the performance of pay/no-pay decisions in a credit card portfolio. In these and other business areas, the increase of performance that can be achieved when applying the optimisation framework is usually outstanding.