Basel III and its implications for the world banking system

Financial institutions around the globe watched closely on the G20 Seoul Summit.

The Summit agenda included discussions on vital global banking regulations, known as Basel III, which will shape significant future decisions regarding, among other items, how much money banks will need to set aside to help avoid another global financial crisis.

The amount banks require for this purpose impacts not only the security of the financial system in a crisis, but the growth outlook for banks around the world.

Although some important decisions about Basel III are being deferred to future G20 meetings, the Seoul Summit provided a significant next step in setting the direction of the industry two years after the crisis.

In the interim, the challenge for banks is to chart a course that rewards both shareholders and customers while avoiding not only unacceptable levels of risk but business practices that perpetuate the kind of boom-and-bust cycle seen all too often in recent years. Banks and regulators, after all, share a vital common interest in protecting the world’s financial system.

The stakes set in the ground regarding capital, liquidity and timelines for adherence have given a shape of Basel III, offering banks some important “signposts” and direction. While the directions currently remain incomplete, it is our view that it is advantageous for banks to progress the main elements of Basel III now – instead of waiting for the ink to dry on the final reforms sometime in the future. Those institutions which can move ahead rapidly will be in a better position to devote leadership attention and the resources needed to focus on customers, competitors and profitability as opposed to internally focused regulatory metrics and ratios.

So what should banks do?

Banks must accelerate the process of integrating their risk and finance functions. The chief financial officer and the chief risk officer must work from a single set of information, and must share an understanding of the inter-relationships among credit, market and operational risk and the impacts on capital and profitability. Enterprise risk management must become a reality rather than a stated objective. Risk must be seen as a growth and profitability-enhancing capability, not as a back-office or compliance-centric function. There are significant opportunities to continue to optimize the current capital positions, particularly as the cost of capital continues to increase.

Banks must improve their overall data management. Under Basel III, banks would need to consolidate positions from their trading desks, and make their “trading book” match up more seamlessly with their “banking book.” Banks have always applied a rigorous approach to the P&L process. They have also been very focused on meeting the reporting and output requirements for the regulators. To manage going forward, they need to apply a significantly increased level of focus and rigor to the quality and maintenance of data across the full suite of activities from front office through to back office.

Banks should also take the time now to prepare for what we call “intelligent growth.” In Asian anchor economies, such as South Korea, Singapore and Australia, lending to small and medium enterprises represents a major opportunity for banks. When banks enter these new markets, they can mitigate both credit and operating risk by using analytics and automating credit scoring to make the lending process more efficient and less risk-prone. Financial reform is important for restoring shareholder and customer confidence, and everyone will have more faith in banks that demonstrate financial stability and sound risk management practices. Getting there, however, is easier said than done.

Banks can expect more, rather than less regulation in the future, and the nature of this regulation is changing rapidly. Rather than ticking off a regulatory checklist, newly empowered regulators are using much broader judgment to determine banks’ true conditions. They are developing benchmarks based on global standards and international best practices and using such benchmarks aggressively. Adherence to this new regulatory environment places burdens on banks’ leadership, but it also provides forward-looking institutions with the opportunity to set the standard and create value through effective, flexible risk management processes.

But Asian banks cannot stop there. Asian banks have been hampered in their risk management and execution of growth strategies by an overall scarcity of talent. Consequently, major initiatives – such as expansion into emerging economies or the entry into capital market activities – have slowed while banks develop or recruit the talent needed to undertake such efforts. As talent is identified and developed, leading Asian banks can be expected to explore growth capital markets and transactional banking; in lending to small and medium-sized enterprises; and in wealth management.

While many Asian banks have robust capital structures and low leverage, there has been a consistent level of under-investment in technology leading to increased operational risk. Banks, especially in the emerging countries, are still operating on old platforms and a multitude of interdependent systems that are challenging to integrate and starting to inhibit growth. One key area that would require significant investment is in the area of global limits and exposure management, especially given their more regional footprint and increased market exposure. Asian banks’ ambitious growth plans depend on opening up new markets, but doing so without necessary investments in talent and technology will create unanticipated operational risk – exemplified by recent events which damaged banks’ reputations while inconveniencing customers.

With global banking regulations high on the G20 agenda, it is an interesting time. There is a lot of work that can be done now to better integrate risk and finance so that Asian banks optimize their capital position, continue to find new areas of growth and manage risks across the enterprise.