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The industry is robust and going from strength to strength. The challenges though innumerable, are being tackled head on. However, the involvement of regulators is necessary to facilitate efficient change and we need to engage them in healthy debate and discussion, writes ABC Islamic Bank’s Naveed Khan
THE CHALLENGES:
A. Development of Asset Pools, which can be securitized
While the market is awash with liquidity on the liabilities side, the picture on the asset side is very different. It still remains a challenge to originate quality Islamic assets in significant size, shape and form. The main reason is that the bulk of the Islamic issues or borrowings that come to the market are mostly sovereign issues or public sector or quasi public-sector project finance debt. There is a shortage of quality rated debt or Sukuks in the private sector. Although there are a few examples of private sector sukuks from the UAE and Kuwait, there is probably one from Saudi, which is the biggest single market in the GCC.
Given the complexity involved in making the issues Sharia compliant and the lack of rating agencies, the available Islamic tranches of project finance are generally a sub-section of the conventional tranche.
B. Development of local and regional commodity markets
For the last few years, the main bread and butter product for the Islamic banking industry has been Tawarroq, which has proved to be the most versatile instrument for the provision of working capital finance. This product has been the subject of great controversy in recent times, as it has run afoul of some key sharia scholars who have deemed it non-sharia compliant. The main reason for this is the dubious nature or trade on paper, since the regional exchanges are not fully developed.
C. Create Islamic hedging derivatives, which can compete with conventional products
A few years back, there was a lot of excitement when the first Islamic derivative (a simple forward foreign exchange transaction) was executed. Since then there has been flow of Sharia compliant alternatives. Yet to date, there is no single Islamic house in the region, which provides a complete suite of these derivatives and hedging products despite genuine hedging needs from the market.
D. Engage regional regulatory regimes in an effort to clarify legal positions.
The CBB has played an exemplary role for other regional regulators to follow in terms of accessibility, openness, and the desire to hear fresh ideas. However, for the sukuk issuance and debt capital market to take off, the other regional regulators also need to address crucial issues such as asset ownership and registration of Musharakas as separate SPVs in some jurisdictions.
E. Standardization of trading agreements between interbank participants
This hampers the efficiency of Islamic inter bank markets especially for commodity morabahas, currency hedging and Profit Rate Swaps. There is thus a definite room for AAOIFI and IIFM to develop standard agreements like ISMA & ISDA.
CHALLENGES MET ALREADY OR BEING MET :
A. Capitalization of Islamic Banks
The size of capital for smaller Islamic bank has been restrictive on them vis-à-vis their counterparty lines and funding, often requiring them to suffer higher funding costs and being locked out of large underwriting and syndicated transactions. However a positive move in this direction recently has been the setting up of quite a few large Islamic banks in the region, with sizeable capital bases. This is an excellent development since these banks will be able to take on the big boys, and compete on level playing field. Moreover over time, rationalization of fragmented Islamic banks will enhance efficiency of scale, leading to lower funding costs and a greater degree of competition.
B. Greater consensus among regional sharia scholars
Whilst historically a matter of concern, it is delightful to see that of late most Sharia boards in the Middle East tend to be on the same wavelength. This progress deserves a huge vote of thanks to both, the Fiqh Academy and AAOIFI.
OPPORTUNITIES:
A. Buoyant regional economies demanding Islamic Products & Services
Perhaps the biggest opportunity for Islamic Banking today is that we operate in a market where latent demand (from corporate, retail and even governments) is much stronger than the available supply of products and services. Combine this with a back-drop of strong regional economic growth and the Islamic Bankers have no excuse not to step up to the plate.
B. Islamic Fund Management
Given times of excess liquidity, there is a need to provide Sharia compliant money market funds to investors and depositors who have few alternatives available either at the short end of the yield curve, or longer term where investors can go for early redemption without punitive charges. This area requires carefully thought through asset selection and structuring, rather than stuffing funds with local and regional real estate and equities at a time of economic boom. Looking at the size of the line for non-interest bearing deposits for the Saudi banking system alone underscores the huge potential for this activity.
C. Lack of credible regional providers of Takaful & Re-Takaful products
This area remains under-tapped for a couple of reasons. The Islamic banking phenomenon, which has gripped the Saudi consumer market, has not spread as rapidly into other GCC countries. Secondly, there is as yet no credible provider of Takaful and Re-Takaful products with a regional platform.
The author is
Managing Director of ABC Islamic Bank
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Following an obscure history, hedge funds are finally taking centre-stage in a way that was not anticipated a few years back. Whether it be a multi-billion dollar merger driven by activist hedge funds, or the mind-boggling salaries of fund managers, hedge funds are never far from the spotlight. At USD 2 trillion assets under management and over 10,000 managers, the industry is at the fag end of the “discovery-phase” in its developmental cycle. Wide coverage in recent years has made the average investor familiar with hedge funds as an asset class, says Bahraini Saudi Bank’s Anand Subramanian, CFA
As recently as five years ago, hedge fund proponents were busy dispelling some common myths about hedge funds and their potential as an investment alternative. Hedge funds have come a long way since and are widely accepted as an asset class that holds promise. Unbridled growth has meant that the industry is at the cross-roads in many fundamental respects. Of utmost importance is finding the optimal balance between oversight and transparency on the one hand and maintaining secrecy on strategies that are the lifeblood of this sector, on the other. Equally daunting challenges include finding alternatives to dwindling sources of return, dealing with increasing friction over high fees and at a more fundamental level redefining their boundaries - as hedge strategies continue to evolve and proliferate.
In investments, trend-spotting can be as interesting and as humbling an exercise as forecasting. I have come up with a list of six trends, which in my opinion, seem to be shaping the industry. Some trends might be quite apparent and others, not readily so.
1. Hedge strategies will outperform long-only strategies over the next three years: This is not so much a trend as a prediction and is definitely controversial. Asset markets without exception have had a strong run over the past 5 to 6 years and continue to do so now. The rising tide of liquidity has lifted all boats. However if the laws of market cycles were to re-assert themselves, as they eventually will, hedge funds will be relatively well positioned to exploit the downside and defend their earlier gains. This might be a rather simplistic view if seen in the context of the wide range of strategies used by hedge funds. Some strategies tend to look like leveraged bets on the long side. Others camouflage illiquidity premiums as hedged returns. Without doubt, hedge returns will face a period of turmoil when markets turn, and managers scamper to re-allocate and pick up insurance. However, after this period of flux, hedge strategies are better placed to adapt to rising volatility and a market downturn than long-only managers. Some hedge funds have been criticized for their increasing correlation with indices. There are many criticisms about hedge funds that are valid, but higher correlation to indices in a rising market is not one of them. That said, the wheat will be separated from the chaff only when the winds of a market downturn gather force.
2. Hedge funds will become larger, driven by consolidation and natural attrition: As the numbers of hedge funds multiply by the day, the inevitable forces of economics come into play. At a basic level, it is difficult to believe that there are so many smart people around to manage so many funds, even after taking into account the massive brain drain from the long-only side. Pushing along this trend will be the increasing costs of setting up and running these funds on an institutional scale. Regulatory costs, manpower costs, research set-up and database costs, risk management and systems costs are all on the upswing. Institutional investors are taking a hard look at the standard 2 and 20 rules that describes the split between management and performance fees. Large investment banks, eager to get a foot in, have begun to acquire hedge funds, with over 14 deals announced over the last 12 months. (See table).
3. Hedge funds will address a wider customer profile: Hedge fund product offerings will span a larger customer base catering to institutional and retail investors. Of the two, institutional investors are having a more profound impact on the business. Unlike the private offices and wealthy individuals, the pioneering investors in hedge funds, institutions are demanding and getting greater levels of transparency and improved risk-controls. Hedge fund managers have to clearly articulate a strategy and their competitive edge before being rewarded with institutional money. Institutional money is also driving innovation and greater specialization as hedge funds are able to pump more resources into research. Institutions are using their bulk to pressure fees down. At the other end of the spectrum, retail investors, particularly in Europe are gaining access to hedge funds primarily through the fund-of funds route (see below for more details).
4. Hedge fund economics will favor the larger funds: Increasing costs of research and the drive to stay ahead of the curve, have combined with pressure on fees driving the dynamics in favor of the larger funds. Recent research on hedge fund returns shows that contrary to popular belief, larger hedge funds have in fact been performing better than smaller hedge funds, after adjusting for survivorship bias and back-filled data. That seems contrary to the much bandied advantages of small size, greater flexibility and lower impact costs. Larger funds have been growing even larger in another classic example of investors chasing returns.
5. Fund of Hedge Funds (FoHF) will be under pressure: Institutions poured money into FoHF thanks to some clear advantages like instant diversification and more importantly due-diligence and monitoring in an unregulated asset class. However, as institutions became more comfortable with the asset class and transparency from fund managers improved, the value-addition of FoHF managers has come under increasing scrutiny. The additional layer of fees charged by the FoHF is driving the trend, but that is not all. FoHF struggle to reallocate between strategies as it entails a long drawn our redemption and subscription process. Capacity issues with underlying managers complicate any reallocation exercise. To top that, savvy investment banks are now rolling out low-cost hedge fund replication strategies. There is no doubt that FoHF will have to evolve; lowering fees might not necessarily be the right solution. Some might take the retail route, which, come to think of it, is a natural fit. Retail investors cannot question higher fees as they will never be able to replicate the diversification offered by FoHF. Others might look at IPOs to secure permanent capital. Many FoHF are diversifying their product offerings by focusing on single strategy, giving the investor complete control over strategy selection.
6. Spectacular hedge fund blow-ups will continue, but the impact might be well contained: Secrecy over positions and strategy is the lifeblood of hedge funds and this is difficult to balance against calls for greater oversight. Most regulators lack the skills to meaningfully regulate hedge funds. The list of investors in Amaranth is a telling reminder of the fact that even the so called “experts” can easily be caught on the wrong foot. Huge inflows into the industry have dried up returns in many traditional hedge-fund strategies, forcing managers into illiquid markets and more esoteric structures to extract returns. Access to leverage has been relatively easy for hedge funds thanks to investment banks chasing hedge-fund business and offering “bundled” solutions. While favorable market conditions might camouflage these risks, it is only a matter time before we hear of the next meltdown. More than 50% of hedge-fund blow-ups occur due to operational risks. Measuring and managing these risks are proving difficult if not impossible. Hedge funds, regulators and institutions are however learning to contain the potential impact of hedge fund blow ups as was the case with Amaranth. Undeniably, strong liquidity and buoyant market conditions had a major role to play in the orderly unwinding of Amaranth’s positions.
Hedge fund investors need to keep abreast of changes in the industry to capitalize on emerging trends. Be it fee structures, changing business models or evolving sources of returns, the impact of these trends on the hedge-fund sector are equally important drivers of investment performance of a portfolio as the skills of the manager and strategy allocation.
The author is Head of Investments, Bahraini Saudi Bank BSC
The author is
Head of Investments, Bahraini Saudi Bank
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There has been an unprecedented spurt in project financing in the Middle East over the last few years, however the overcapacity and construction costs pose major challenges to project financing in Middle East. Kapilkumar Kumra analyses current trends and looks at the future for this sector
The project finance market in the Middle East has become the largest Project Finance market in the world. As per HSBC Estimates, of the total global project finance debt of US$ 98.5 bn raised in the first half of 2006, US$ 33 bn, i.e. one dollar in every three, was raised for Middle Eastern projects.
Continued high oil prices have produced huge windfalls in GCC countries. On top of this there has been a growing inclination toward making domestic investments first and therefore the lion’s share of liquidity remains in the Gulf. Increased oil revenues, continued growth in China’s manufacturing industry and the favourable energy cost advantage in Middle East countries are all contributing to regional growth in investment.
The main rationale for large investment activity however seems to be the low-cost feedstock argument. Soaring energy prices in Asia, Europe and the United States has made the GCC an attractive location for energy intensive industries, such as petrochemicals, aluminium and steel. The Gulf has 24% of all known natural gas reserves. The exhibit below gives details of natural gas prices in the world.
Due to low energy costs, the GCC countries enjoy a major competitive advantage in energy intensive industries. The chart above highlights cash cost in $ per tonne for primary aluminium production at smelters in the GCC compared to an aluminium smelter in Western Europe or China. While the cash cost works out to $1785 in Western Europe and $1695 in China, it is much lower at $1085 here. Further, the labour cost in GCC countries is lower than developed countries and the general business environment conducive for establishing businesses.
The GCC is now leading in many energy-intensive industries. Aluminium Bahrain (Alba) and Dubai Aluminium (Dubal) currently rank as the world’s seventh and eight largest aluminium producers and they continue to expand.
In petrochemicals, the GCC companies have almost a 30% share of announced additions to global capacity in ethylene and polyethylene, well above the regions 8% share of current capacity. The new expansions coming up in the six major energy intensive industries are given below:
Driven by the mega projects that have featured during the year with unit debt requirements that have increased correspondingly, the project finance market in the Middle East has become the largest project finance market in the world.
From the perspective of the project finance lenders this unprecedented growth in projects has raised two fundamental concerns
- Risk of overcapacity
- Spiralling of construction costs
Risk of overcapacity
The cyclical nature of the petrochemicals market imposes a big threat to the large number of expansions coming up. To illustrate, in the ethylene sector, with all the projected new additional capacity of apprx 20 MT by 2010, it is estimated that it will just take
- a reduction in 1% of GDP worldwide,
- GDP in china to come down to 6% instead of
8% anticipated in 2010 or
- additional production of 1.6 MT per year due to
de-bottlenecking
to get a capacity utilisation rate down to 82% in 2010, which would be the deepest trough for the ethylene sector in more than 20 years.
The conclusions of market research organisations vary widely between the consultants; and market reports seem to be more focussed on oil price scenarios than GDP scenarios. With large liquidity with the banking sector, the lenders are increasingly taking price risk without much clarity on the future working of the industry.
Spiralling of Construction Costs
Many a project recently planned has seen 40-50% cost overruns due mainly to hyper increase in EPC costs over the past two years. Prices for steel and concrete have risen by an average of 35% over the last three years. Commodities such as steel and concrete and specialised items like heavy lift cranes are in tight supply. There is a shortage of trained manpower. Contractors are also becoming more particular about which projects to bid for, leading to a potential absence of competition in a number of tenders.
This increase in construction cost has number of implications:
- With large liquidity with lenders in the market,
the cost increases are increasingly being
financed by larger debt. By adding more debt
it increases the break-even point, potentially
reducing the comfort area and increasing the
risk of downturn in the years ahead.
- There is considerable loosening of contract
terms; lower LDs, lower level of overall cap
on liabilities, lower level of guarantees, less
than optimal completion testing requirements,
unusual flexibility granted to contractor to meet
the minimum specifications.
- Given the size of the projects it has now
become almost commonplace to see multiple
EPC contracts implying potential risks of
interface/ cross liabilities between contractors,
etc.
- Further, the high capital intensity industries
such as the petrochemical industry are more
susceptible to the trough of an industry cycle.
The unit capital cost for a base petrochemical
project with low–cost feedstock is about 100%
of operating cash costs. Comparatively, the
unit capital cost as compared to operating cash
cost is less for a pulp and paper industry and
still lesser for a copper mining industry.
This results in a higher likelihood of margins
in petrochemical projects being squeezed
during troughs in industry cycle.
In a high construction cost environment, cash cost comparisons are inadequate to properly assess the impact of competition- the impact of fixed cost also needs to be factored into the competitiveness calculation.
Conclusion
Excess liquidity due to high oil revenues and competitive advantages of low energy cost and low cash cost of operations in GCC, has resulted in a large number of projects being announced in the GCC. Exuberance fuelled by liquidity needs to be balanced by an intense scrutiny of the economic environment and the competitive merits of the projects.
The fixed costs are increasingly an important factor in competitiveness of projects. Large construction cost increases are resulting in projects being financed by higher level of debts. High debt components in these projects have increased the break-even point. This increase in cost of capital can materially erode the feed stock advantage. Based on the high capital intensity and large cost increases, there is a need for greater flexibility on the part of lenders in structuring the financing of these projects. The flexibility can take the form that permits a series of periodic deferrals of principal, during the period of troughs in industry cycle. Cash sweeps can recover the deferred principal during the cycle’s peak years. Thus flexibility rather than higher leverage for financing cost overruns is the need of the day.
The author is Vice President-CIB with Arab Bank plc, Bahrain.
The author is
Vice President-CIB with Arab Bank plc, Bahrain
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The prevailing wisdom in the regional Private Equity (PE) field is that there is too much money chasing too few investment opportunities. While the truth of that statement is debatable, there is one general consensus among all: the Middle East North Africa (MENA) region is ripe, promising, flush with liquidity, witnessing decreased government regulation, with maturing capital markets that are fertile ground for PE opportunities writes SHUAA Partner’s Jamil Brair
Long considered a source of capital, with billions of dollars in government-backed funds putting their money and trust in external companies and fund managers, the region is now becoming a destination for wealth and investment opportunities; slowly emerging as a very strong candidate for the position of the fourth PE centre of the world, with its large population and diversified economies, offering investors attractive risk–adjusted returns with healthy growth prospects.
Gulf Cooperation Council (GCC) countries enjoy a stellar fiscal record: GDPs have doubled since 2002, a trend which saw per capita incomes following at a similar rate. Bolstered by political stability, a trillion-dollar windfall from soaring oil prices, strong public financing and robust credit ratings, the region is positioned in the forefront as a destination for capital.
In the GCC, Dubai is emerging as the region’s PE center. The city is experiencing full-throttle modernization that is generating numerous investment opportunities, albeit not at the same rate at which housing units are being pushed onto the market. Government deregulation, relaxation of laws governing foreign ownership and the emergence and multiplication of free-zones, have all contributed to giving Dubai an extremely healthy head-start.
In the larger MENA region, PE opportunities are emerging due to a growing government drive toward privatization, the relaxation of governmental constraints on foreign direct investments and attractive demographic patterns. Investment opportunities abound in Jordan, Turkey, Egypt, and to a lesser extent Lebanon and Palestine, due to continued regional instability. However other ‘frontier’ markets are opening up in countries like Algeria, Libya and Syria.
Nothing affirms the latent PE promise of the MENA region more than the recent entry of international PE giants, lured by the region’s potential and the low levels of penetration and competition.
And while international PE firms might jostle regional firms for position, their entry is viewed favorably by most regional players who see their arrival as an important catalyst to fortify and promote the region’s PE standing and raise the bar for compliance to international best practice standards. A symbiotic relationship through club deals, capitalizing on the PE expertise of regional players, is the order of the day rather than a full-fledged heated competition over investment targets. Moreover, international PE firms may prove to be potential exit candidates to the holdings of regional players.
Additionally, with maturing capital markets PE firms are presented with lucrative avenues for exits. MENA region stock markets grew at an average of CAGR 40 per cent during the period of 2002 to 2006, as compared to a CAGR of 15 per cent for the same period across US and European Markets.
Private equity opportunities also multiply around family businesses. With many currently at the second or third generation of ownership, they are often at a crossroads, looking for continuity by separating management from ownership. They are also concentrating on their core expertise and thus reorganizing their business interests. That said, the reluctance to relinquish ownership among family owned businesses is still prevalent, with some getting tangled in lengthy succession issues and/or showing an aversion to external managerial intervention. As part of its efforts to allay the fears of family owned companies regarding external ownership, the Ministry of Economy of the UAE, recently passed a law allowing these types of companies to float a minimum of 30 per cent of their share capital only, as opposed to the old threshold of 55 per cent.
Overall, its seems that certain themes and favorable catalysts have converged, to turn the pioneering efforts of a few regional PE firms into a reality that is set to position the region in a lead role on the global private equity scene.
It manages two funds: Its inaugural fund, SHUAA Partners Fund I, L.P., held its final closing in September 2005 with commitments of US$ 200 million. While its second fund, Frontier Opportunities Fund I, L.P., held its first close at US$ 58.5 million on January 31, 2007 and is targeting total commitment of USD100 million.
The author is Senior Vice President at SHUAA Partners Limited, the Private Equity arm of SHUAA Capital. SHUAA Partners is a DIFC-based DFSA-regulated entity
The author is
Senior Vice President at SHUAA Partners Limited, the
Private Equity arm of SHUAA Capital. SHUAA Partners is a DIFC-based
DFSA-regulated entity.
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Opportunities for financial institutions to increase revenues are becoming increasingly more difficult to find. This has led a number of financial institutions to contemplate foraying into wealth management as a way to generate new
top-line growth. Some firms have an existing affluent customer base, which they assume, can be easily converted to a wealth management portfolio Still others recognize the business need to constantly attract new clients. Whether through traditional or new customer segments, it is a challenge to create a robust wealth management offering, says Polaris Bikash Mathur
Today’s market competition is so intense that successful firms periodically need to carefully analyze their target customer segments, realistically assess their own strengths and weaknesses, besides monitoring and responding to the actions of their competitors. Factors like increased volatility and uncertainty, the growing number and complexity of financial products available and increased personal responsibility for future planning have contributed to a growing market of investors who realize they need advice. A clear focus area for institutions at the moment seems to be the mass affluent segment.
A validation of the importance of this segment and the need for them to administer self control has been echoed by many analysts. Leading research firm Forrester, notes “During the next 15 years, millions of mass-affluent baby boomers will hit retirement, and trillions of dollars will change hands. Mass-affluent boomers have become accustomed to researching investments online and making their own financial decisions. While most will reach out for financial advice as they approach retirement, this well-educated, tech-savvy group will expect the best of both worlds: easy access to qualified reps, as well as the opportunity to be hands-on in the financial planning process.”
This segment consists of the customers who fall between the high networth individuals (HNI) and the retail customers. To segment the market and tap into the mass affluent category, banks will need to develop strategies which provide wealth management services at reduced costs using new age technology.
Mass affluent customers will demand superior service and will expect advisors to have specialized and extensive expertise. With financial needs analysis, the mass affluent will be able to make informed decisions and have direct and ongoing influence on their investments. Technology will assist in enabling the advisor to be more efficient, serve more clients and in making self-service more plausible.
For the banks, it makes sense to spread operational and technology costs over a larger customer base (mass affluent) vs. limiting it to a smaller HNI base and yet keeping it exclusive (excluding retail customers). As a first step toward achieving this differentiated service, it is important for banks to be able to provide the customers with consolidated information and an investment strategy which will pave the way to administer self control.
To gain competitive advantage, banks need to have a customer-centric approach which provides superior service, relevant advice and a strong relationship bond. The following capabilities can enable the bank to help customers achieve self control:
Consolidated View of the Customer
A complete view of their own holding with the bank will help the customer understand his position and therefore his investment needs better. It will also help him to make a more informed decision based on the recommendations of the bank. At the same time, it is important for the bank to have a consolidated view of the customer. This integrated view will help the relationship manager analyze customer data and develop better strategies for managing the wealth.
Advisory Service
It is imperative that banks establish a strong bond with the customer. To build customer loyalty and trust, banks must demonstrate that they have only the best interests of the customer in mind. Through the process of developing a comprehensive financial needs analysis and the delivery of a complete wealth management strategy, banks have ample opportunity to cement this bond.
Enhanced time with the customer
Customer opinion is formed through a combination of personal experience, word of mouth and marketing. Human touch is a major lever in successful wealth management offerings. Customers are reassured by the level of individual attention they experience. They are more likely to be guided by the bank’s recommendations when they are able to spend quality time with the relationship banker. Queries and service requests from the customer should be efficiently handled by the bank. Being well informed about the customer and his banking activity, the relationship banker can add to the quality time with the customer. Of course, all this is possible only if the information systems are nimble and flexible enough to enable the banker to spend more and more time with the customer.
Technology enabler for Self control
There are several technology solutions in the market which facilitate the transformation of control from bank to the customer. They would typically give the relationship banker the power to design the customer experience. They provide several business products in a single customer view. They allow banks to focus on developing customer relationship and value by converting the branch to a customer acquisition center, exploiting the potential of an integrated relationship engine, improving the operational efficiency and enhancing customer experience in the branch.
There are technology solutions designed to deliver on the promise of non-disruptive, incremental modernization of customer-facing functions in leading banks around the world. It is meant to co-exist with other applications in the bank’s ecosystem, thus extending the lifespan of existing technology investments. These solutions offer wealth management and advisory services, including cross-sell prompts along with teller functions, account origination and everything that a branch banker would need on a simple menu.
The author is the Executive Vice President & Business Head of Polaris, Europe
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DIRECTORY
OF ARAB BANKS & FINANCIAL INSTITUTIONS |
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The introduction of Basel II has redefined how banks worldwide calculate regulatory capital and report compliance to their supervisors. By abandoning the 1988 Capital Accord’s “one-size-fits-all” approach for calculating minimum regulatory capital requirements, the Basel Committee (“the Committee”) has introduced a three pillar concept under Basel II that seeks to align regulatory requirements with the economic principles of risk management, says Salman Qureshi of Ernst & Young
Most banks in the region are investing significant resources towards Pillar 1 but may still be in the process of understanding the importance and implications of Pillar 2. This article, therefore, focuses on Pillar 2.
A key requirement under Pillar 2 is that the development of the internal capital adequacy assessment process is the duty and the responsibility of the bank. The supervisor’s role is to provide the basic principles and requirements as well as assess whether the framework meets its intended objectives. While Pillar 1 focuses on minimum regulatory capital requirements, Pillar 2 addresses the need to measure and manage economic capital.
Regulatory capital is defined by the supervisor and inclusive of Tier 1, Tier 2 and supplementary capital. Regulatory capital management is required by supervisors in order to ensure the soundness and stability of the banking system and protect depositor’s interests. Economic capital on the other hand, is primarily used by banks to support decisions about what business lines or transactions to pursue. Economic capital management requires banks to calculate risk-adjusted returns on capital within each business line in order to identify value-creating business lines.
The objective of Pillar 2 is to establish a process of supervision that complements Pillar 1. It requires an analysis by the bank of all of its risks (including those already covered by Pillar 1) and an assessment by the bank of the economic capital it needs to cover all the identified risks. This Internal Capital Adequacy Assessment Process (ICAAP) is then reviewed by the supervisor for its own assessment of the bank’s risk profile against the analysis conducted by the bank, to determine which, if any, prudential measures are imposed on the bank - these may take the form of capital requirements greater than the minimum requirements or other appropriate techniques.
Figure 1 (next page) illustrates the tasks under Pillar 2 – the ICAAP and the supervisory review evaluation process which are to be undertaken by banks and supervisors respectively.
While Pillar 1 mainly concentrates on approaches for the computation of a bank’s capital requirement, the ICAAP is expected to be an effective integrated framework of risk and capital management that is embedded within a bank which is subject to senior management oversight.
The components of the ICAAP consist of the following:
- Board and senior management
oversight – strategic direction;
- Sound capital assessment;
- Policies and procedures to identify,
measure and report all material risks;
- A process that allocates capital to the
level of risk;
- A process that states capital adequacy
goals with respect to risk, taking account
f the bank’s strategic focus and business
plan;
- A process of internal controls, reviews
and audit to ensure the integrity of the
overall management process;
- Comprehensive assessment of risks;
- Monitoring and reporting; and
- Internal control review
In order to demonstrate to the regulator that a bank’s internal capital targets are well founded and consistent with its overall risk profile and current operating environment, banks would need to develop a robust risk management framework which addresses:
- its overall risk strategy;
- Board-level oversight of the risk assessment
process;
- policies and procedures for identifying,
assessing and reporting all material risks;
and
- Monitoring and reporting.
Strategic Direction
The starting point is for the bank to demonstrate its ability to set appropriate strategic objectives that relate to the bank’s risk profile. In doing so, the Committee places the responsibility of understanding the types and level of risks being faced by the bank on its Board and senior management. This responsibility also requires the Board and senior management to determine the risk tolerance for the bank in order to achieve its objectives.
Internal Capital Adequacy Assessment (ICAAP)
Within the framework of Pillar 2, banks are required to identify all of the risks to which they are exposed. The risks included should be broader than those that form the basis for the capital adequacy calculation within Pillar 1, i.e. credit, market and operational risks. These risks include but are not restricted to:
- Liquidity risk – includes both the risk of being
unable to fund a bank’s portfolio of assets
at appropriate maturities and the risk of being
unable to liquidate a position in a timely
manner at reasonable prices.
- Concentration risk – due to concentrations
to a limited number of customers, a sector or
geographic area;
- Earnings risk – possibility of current income
being lower than expected;
- Strategic risk – due to institutional changes
and changes in fundamental market
conditions;
- Reputational risk – due to adverse perception
of image on the market, in media, etc.
- Business cycle risk – through lending or
otherwise one may be vulnerable to business
cycle risks.
The impact of these identified risks should be measured using the various available tools to ascertain the bank’s exposure, mitigate these risks where possible and follow an ongoing process to monitor and report on these risks, as shown in the diagram below:
The bank’s internal capital assessment model should be able to demonstrate that it has enough capital to meet both the minimum capital requirements as well as the ability to address its business needs e.g. for institutions with large equity holdings, sufficient capital to address significant price shocks. Such an internal capital adequacy assessment process should not be an isolated activity but, rather, be integrated into the day-to-day operations and decision making of the bank. By incorporating the process into its procedures, the documentation should state whether, and if so how, the results of the assessment process affect the capital adequacy situation and capital policy.
Economic Capital Management
Economic capital management is for many banks a new concept. The underlying theme is for banks to calculate their business line returns in line with the associated risks and hence the economic capital level required given the risk and return. Economic capital planning can further be used by banks to support decisions about which business lines, products or transactions to pursue.
The Committee requires banks to align the risks to which they are exposed and the management of these risks with capital requirements.
Monitoring and reporting
Banks will also be required to establish systems for monitoring and reporting risk exposures to assess how the bank’s changing risk profile affects its capital needs. The senior management or board of directors of banks should regularly receive reports on their bank’s risk profile and consequent capital needs.
Conclusion
In summary, banks are presently focusing their efforts and resources on Pillar 1 but they also need to begin the process to evaluate the requirements under Pillar 2. There will be significant challenges faced by the banks in the region to develop an assessment process as well as the appropriate internal models for measuring risk. In addition, guidance and training may be required on appropriate techniques to determine required capital from risks not already included in the bank’s Pillar 1 calculations.
However, by creating a comprehensive ICAAP, banks can benefit through a stronger framework for the management of its risks and the integration of risk management into business line decision making, which can translate into lower capital add-ons required by the supervisor and improved risk adjusted performance in the longer run. Additionally, the efficient use of capital may provide a significant competitive edge over other banks in the industry.
The author is Manager, Business Risk Services, Ernst & Young, Bahrain.
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