Rameswurlall Basant Roi: Evolution of the Basel capital adequacy
requirements
Address by Mr Rameswurlall Basant Roi, Governor of the Bank of Mauritius, at the Seminar on
"Enhancements to the Basel Process: Recent developments relating to Basel II & Basel III",
hosted by AFRITAC South, International Monetary Fund, Africa Training Institute, Ebene, 21
August 2017.
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Ladies and Gentlemen
Thank you Mr Ravi Mohan, Resident Advisor to the IMF's AFRITAC South, for inviting me again to
share my views on this very interesting topic: Capital Adequacy Framework. It's a great feeling to
be in the midst of so many regulators from our continent. I said it's a "great feeling" because of
"fellow feeling". Our contributions as regulators and supervisors of financial institutions to
financial stability are seldom recognized. But we always hit the news headlines when all the sins
of an ailing or a failed financial institution are conveniently heaped on us.
As regulators, we however need to have the unswerving faith in our abilities to regulate and
supervise financial institutions that have become increasingly complex in a world where trillions
of dollars flow across the world in a single day by the simple click of a mouse. True, at times, the
weight of the regulatory and supervisory burden turns out to be exceedingly demanding, so
demanding that it takes a serious toll on us. I am nevertheless truly happy - and very happy
indeed - to be here, this morning, to address the participants of the AFRITAC South Seminar
today on a topic that constitutes the very foundation of a safe and sound financial sector.
To set the backdrop for the sharing of your regulatory and supervisory experience during this
Seminar, I believe it's fitting to go back into history in order to give it a sense of perspective. But
before I do so, let me narrate a short childhood story about myself. In my native village which is in
the southern part of this country, there was only one, what used to be commonly known as,
barber's shop. The barber was a plain and financially lean countryside fellow. My parents used to
send me to that barber's shop for a haircut about once every month in the early 1950s. Once
seated in the chair for a haircut, no person could miss a framed picture of what looked like
smartly dressed businessmen in an office with one of them in a standing position talking to the
rest. A line at the top of the picture read as follows: "For Credit, Come Tomorrow." I was six
years old or thereabout when I had first read it. And I had not then understood what it meant and
why was this colourless picture glued against the wall side by side with a mirror in the full view of
all the barber's clients. As I grew up, I had slowly started to get the gist of this line. Years later, I
had asked a school friend about the barber who was not around anymore. I was told that the
barber had gone out of business because he had given up the idea of, "For Credit, Come
Tomorrow." I had then asked myself the question, "What if the principal business of an enterprise
is not to give haircuts to people but to extend credit out of other people's money?" Once I joined
the Bank of Mauritius as an economist in the mid-1970s, I got a very wide angle view and a
fullscale appreciation of the importance of capital for any enterprise, more specifically for financial
institutions.
Regulators have long realised that capital is the backbone of a bank; it absorbs losses and it can
prevent bank failures. What the capital base of a bank should be is a grand question. The
determination of the right amount of capital has always been a very demanding exercise. Why is
it so? It is primarily because of credit and the risks associated with it. By definition credit is the
disposition of one person to trust another. It is singularly varying.
In the 1950s, the US Federal Reserve used the Analysis of Bank Capital to bring up a formal
evaluation basis for banks' capital adequacy. This approach was dropped in 1970 as it proved
difficult to precisely determine the adequate quantum of bank capital in the face of the growing
complexity of the system. The long period of financial repression, that is, direct control on bank
lending to the private sector and force-feeding banks with government debt instruments had
made the core business of commercial banks safe between the mid-1930s and the early 1970s.
Central banks' function of maintaining financial stability by way of regulation and supervision had
atrophied. Questions were vigorously set as to how monetary policy could be better applied to
forestall booms and busts. The collapse of the Franklin National Bank of New York and the
collapse of the infamous Bankhaus Herstatt in 1974 had turned out to be a clarion call for putting
emphasis on regulation and supervision of banks. The then financial crisis found both central
banks and banks ill-equipped and lacking in respect of skills in risk management. They were both
unprepared for disruptive shocks to financial stability.
For many years, a select group of central bankers used to meet regularly at the Bank for
International Settlements in Basel. Supervisory officials, too, forming part of the central banking
community had joined in to discuss matters of common interest. The Basel Committee on
Banking Regulation and Regulatory Practices eventually took shape. If I understand correctly, it
later came to be known as the Basel Committee on Banking Supervision (BCBS for short). The
concerns for financial stability in the wake of the collapse of the two banks in 1974 I referred to
earlier and the breakdown of the Bretton Woods system that subsequently ushered in a phase of
financial sector liberalisation, including exchange control liberalization worldwide, gave rise to
quite a wide spectrum of risks. If unchecked, they could jeopardise financial stability.
The first Basel standard, Basel I, also known as the Basel Accords, was a product of the Cooke
Committee, after Peter Cooke from the Bank of England who chaired the Basel Committee for
more than a decade. The Cooke Committee Report was agreed in 1988, a response to the
collapse of the Franklin National Bank and of the Bankhaus Herstatt in 1974 and to other
considerations. Basel I had set a minimum capital requirement for internationally active banks.
The minimum ratio of regulatory capital to total risk-weighted assets was set at 8 per cent of
which the 'core capital', a restrictive definition of eligible capital labelled as Tier I capital, stood at
4 per cent. It was designed to be implemented by the members of the BCBS by 1992, only four
years after it was agreed. Basel I was amended in 1996 to take into account market risks in
banks' trading books, whereby an additional capital charge was introduced to cover market risk.
Although Basel I was meant for implementation by members of the BCBS, many non-member
countries with internationally active banks also started implementing the Basel standards.
Basel I had weaknesses. It did not differentiate enough the risks associated with individual loans,
thus providing banks with opportunities for regulatory arbitrage. Basel I, overlooking operational
risk, focused on credit and market risk only. These deficiencies demanded an improvement in
the Basel standards. After years of intense debates and negotiations, Basel II was finally agreed
in 2004. While leaving some basic parameters of Basel I unchanged, Basel II aimed at ensuring
that the regulatory capital reflected actual risks banks were taking. In other words, Basel II
dramatically altered the system for risk-weighting of assets. It, of course, goes to say that Basel II
moved away from compliance- based supervision to a more complex risk-based supervision.
Basel II thus assigned a pivotal role to the players, that is, banks and external credit rating
agencies, in the workings of risk assessment. Banks were allowed, under the foundation Internal
Ratings-Based approach, to use their own models for risk assessment by using metrics set by
the supervisors.
I am sure most of you here must be aware that Basel II requirements were more elastic and
institution-specific. They brought on the scene a risk management regime whereby banks could
opt for either the standardised approach with its fine-grained risk categories linked to external
credit ratings or the internal ratings approach where sophisticated mathematical models could be
used. The years following the implementation of the Basel II Accord saw a surge in the reliance
on various models by large international banks.
The 2008 financial crisis revealed weaknesses in Basel II. The risk-sensitivity of Basel II capital
requirements were questioned as they were found to have exacerbated pro-cyclicality with
deepened likelihood of crisis. The need to effectively address risks associated with securitization,
counterparty credit exposure arising out of derivatives and securities financing was palpably felt.
Basel III was thus agreed between 2010 and 2014; it seeks to increase the quantum and quality
of banks' capital beside introducing liquidity standards and macro-prudential measures for
preventing the build-up of systemic risk.
With a view to giving a broad perspective of what is required of regulators in today's world, let me
give you a broad brush stroke of what Basel II and III are made of. Basel II, whose focus was
mainly on refining the risk sensitivity of assets, encompasses the following:
1. Standardised Approach to credit risk;
2. Foundation Internal Ratings-Based approach to credit risk;
3. Advanced Internal Ratings-Based approach to credit risk;
4. Basic Indicator approach to operational risk;
5. Standardized Approach to operational risk;
6. Advanced Measurement approach to operational risk;
7. Standardized Measurement method for market risk;
8. Internal models approach to market risk;
9. Pillar 2 which is the Supervisory Review Process, and
10. Pillar III which is market discipline.
Basel III has enhanced the capital framework and introduced stringent liquidity standards along
with a macroprudential flavour. The innovative elements of Basel III are:
1. Upgraded quality of capital;
2. Capital conservation buffer;
3. Countercyclical capital buffer;
4. Leverage ratio;
5. Liquidity Coverage Ratio;
6. Net Stable Funding Ratio;
7. Risk coverage - counterparty credit risk;
8. Capital surcharge on Global Systemically Important Banks;
9. Capital surcharge on Domestic Systemically Important Banks; and,
10. Total Loss Absorbency Capital (TLAC).
The foregoing gives a full view of what are expected of regulators in the standard-setting
countries as well as in the standard-taking countries. It's a formidable task for all of us. The
majority of the world's regulators are 'standard-takers' as far as international banking standards
are concerned. They have no say in the standard-setting exercise and have no formal obligation
to adhere to the standards. Yet many countries falling outside the BCBS are implementing them.
Regulators in developing countries face enormous implementation challenges not only because
of the complexity of the standards and the recalibration needed to reflect local contexts before
they can be fully implemented but also because of gaps in financial market infrastructure and the
lack of sophistication of the financial markets. Where these are missing, one could only expect
low levels of implementation.
We have a bank-centric financial system in Mauritius. Of the 21 banks operating in our
jurisdiction, 12 are foreign international banks. Two of our locally-owned banks have gone
international. We therefore find it obligatory to adhere to the principles established by the
standard setters of the BCBS. Basel I Accord was adopted in our jurisdiction way back in 1993.
The Capital Adequacy Ratio initially set at 8 per cent was raised to 10 per cent in 1998. Basel II
became operational in Mauritius as from March 2008 on a one-year parallel run with Basel I and
was fully implemented as from March 2009. Of the three options for the measurement of credit
risk, Mauritius elected to go by the Standardised Approach. Foreign banks were, however, given
the latitude to compute their ratios using the more advanced approach for reporting to their head
office. Pillar I, Pillar II and Pillar III were adopted in a phased approach. This allowed banks the
necessary timeframe to align their risk management framework with the requirements of Basel II.
To keep pace with international norms, Mauritius adopted Basel III in relation to its capital
framework as from 2014. The capital framework included the conservation buffer of 2.5 per cent
which is graduated for full implementation by 2020 when banks will need to maintain a ratio of
12.5 per cent. This does not represent a challenge for our banking industry as they are already
maintaining a ratio averaging 17.8 per cent. With regards to the liquidity requirements under
Basel III, the Bank of Mauritius has revised its Guideline on Liquidity requirements to incorporate
Liquidity Coverage Ratio in line with the Basel III standards. By October this year, the Guideline is
expected to become effective.
The two large and locally-owned banks which account for over 60 per cent of the domestic
market and a few of the foreign banks are considered systemically important. The Bank of
Mauritius has come up with a Guideline for Dealing with Domestic Systemically Important Banks.
They are required to maintain a capital surcharge ranging from 1.0 to 2.5 per cent as from 2016,
in addition to the capital adequacy ratio and the capital conservation buffer.
Even with the implementation of Basel III, the question remains: are good quality and quantity of
capital sufficient to avert systemic shocks? Regulators and supervisors are pretty well aware
that they are not. Basel III sets down the minimum standards. However, rules alone, no matter
how well written and how consistently implemented, will not be enough to maintain the financial
health and stability of the banking system. Poor risk management, interlinkages and common
exposures can still give shocks to the financial system. For example, a bank's capital ratios can
be rendered meaningless or highly misleading if they are based on inaccurate assessment of
asset quality, off-balance sheet exposures and contingent liabilities. A bank may be reporting high
capital ratios when in fact it may be insolvent due to poor asset quality and inadequate provision
for losses. Furthermore, stringent capital requirements may be of little use if the corporate
governance system of banks are deficient. Capital merely acts as a cushion against losses and
can never be a substitute for poorly managed organisations. On-going vigilance in respect of
corporate governance of banks as another over-arching priority in the supervision of banks is
critically important.
Micro-level supervision, thus, effectively supplements the largely macro-prudential nature of the
Basel III capital adequacy framework. Behavioural changes in banks, including change in culture,
should top-up risk management practices for the effectiveness of any capital adequacy
framework.
Let me take leave of you with a final thought: do never forget the story about the barber that dates
back to the years before the 1970s. His business had collapsed not because of the variety of
risks stemming from the rapid pace of technological progress (Schumpeter's creative
destruction) but because of the risk associated with misplaced trust. The world has since
changed cinematically and dramatically. In the decades before the 1960s, the life of tools,
equipment and machines for production of goods and services lasted for 25 to 30 years. The
cycle of obsolescence was so long that the risks of enterprises going bust because of
technological progress were lower than they are today. Lending institutions faced lesser risks in
those days. With digital technology, the cycle of obsolescence has accelerated. Just imagine the
average lifespan of a phone app is a mere 30 days. We do not have enough time to master
anything in today's world before it is displaced. The risks of enterprises and along with them
lending institutions going bust are indeed unprecedentedly heightened. It's very difficult for any
lender to appropriately assess risks arising out of digital advancement - and more so for any
regulator. Lending institutions indisputably need much stronger capital buffers than in the past in
order to meet the challenges of the unknowns.
With this final thought, may I wish you all the very best in your pursuit to know more about
how best to implement the Basel standards of regulation of banks. The regulatory and
supervisory community in Africa faces enormous challenges. I fervently hope that by the end of
this Seminar you will have learned from each other quite some ways and means of improving
your approach to regulation and supervision of financial institutions.
Thank you.