BASEL II REGULATION FOR THE SURINAMESE BANKING SECTOR

Transcription

1 MASTER OF BUSINESS ADMINISTRATION PROGRAM BASEL II REGULATION FOR THE SURINAMESE BANKING SECTOR THE IMPLICATIONS CONCERNING BANK CAPITAL By Aniel Ghisaidoobe Supervised by Dr. Howard Nicholas This paper was submitted in partial fulfillment of the requirements for the Masters of Business Administration (MBA) degree at the Maastricht School of Management (MSM) and The FHR Institute for Social Studies (FHR) Suriname August 2010

2 ACKNOWLEDGEMENT First of all I like to thank the board of directors of De Surinaamsche Bank N.V., namely Mr. Sigmund Proeve, Mr. Martin Loor, Mr. John Lie Tjauw and Mr. Henry Henar, for giving me the opportunity to be part of the MBA. Without their approval I would not have been doing the MBA. The second person I like to thanks is Mr. H. Lim A Po who has brought the MBA program in Suriname and gives Surinamese the opportunity to do the program in their own country rather than in another country or by distance learning. Another special person I like to thank is Mr. Howard Nicholas who is my supervisor for this thesis. Without his help I would not have been able to write a good thesis. His encouragement, guidance, motivation and critical remarks make me reach my goal. Furthermore I like to thank Mrs. Ingeborg Geduld - Nijman, Mr. John Tokarijo, Mrs. Ashna Ausan - Oedairadjsingh of de Centrale Bank van Suriname (CBvS), which is the Central Bank of Suriname, Mr. Ruud Frederikslust (retired Professor of the Erasmus University), Mr. Andy Sabiran of De Surinaamsche Bank N.V., Mrs. Djaienti Hindori, Mrs. Trees Hammen and Mr. Ronald Ferdinand of Landbouwbank N.V. for providing me the information needed for this research. Last, but not least, I like to thank my mother, father, wife, sisters and my friends for encouraging me throughout the whole program. Aniel Ghisaidoobe Paramaribo, August 2010 ii

3 ABSTRACT Basel II is a regulation developed by the Basel Committee. These regulations has been developed in order to create a level playing field between banks and to create financial stability and trust based on the factors risk and capital. Capital has become a very important item these days due to the latest financial crisis. Basel II is a regulation through which it can be determined if banking institutions are holding sufficient capital to cover risks. In Suriname no study has been done concerning the impact of the Basel II regulation on capital, therefore this research has been important to be performed. The research is about whether the Surinamese commercial banks fall short of Basel II capital requirement concerning credit risk. The Basel II regulation contains of two approaches in order to determine the capital requirement for credit risk, namely Standardized Approach and Internal Rating Based Approach. The standardized approach is based on ratings assigned to credits by external rating agency, while IRB is based on internal rating. The IRB approach cannot be used in Suriname, because data is not available. Furthermore it is an approach that cannot be used by every bank in the world. Based on these reasons and taking into consideration the objectives of the Basel Committee, the standardized approach is further analyzed for the banking sector of Suriname for the period 2007 till Under the standardized approach the Suriname banking sector does comply with the Basel II regulation although there is no external rating agency in the country. Furthermore the capital requirement for covering credit risk increased compared to the current regulation, namely Basel I. The reason behind this is due to the increase in risk weighted assets, while capital level did not change. Also is noticed that under Basel II the percentage increase in capital is greater than the percentage increase in risk weighted assets indicating that there is sufficient capital in order to cover the credit risk during the indicated period. In order to decrease the capital requirement an external rating agency could be establish, but it is important that this is being supervised by the Central Bank. Furthermore before implementing these regulations it is important that the local financial system is taken into consideration. Basel Committee should also further check the risk weights determined by them. iii

4 LIST OF FIGURES Figure 1.1: Research model... 5 Figure 2.1: The 3 Pillars of Basel II Figure 2.2: Type of risk covered within Pillar Figure 2.3: Expected and Unexpected Losses Figure 2.4: Confidence level of Expected and Unexpected Losses Figure 2.5: Snapshot of the credit risk approaches as described in Basel II Figure 2.6: Components of Tier 1 capital Figure 2.7: BIS ratio, Tier 1 and minimum capital requirement under Basel 1 ( ) Figure 4.1: Conceptual framework Figure 4.2: Snapshot of the risk weights under Basel II concerning standardized approach Figure 5.1: Comparison of BIS ratio under Basel I and Basel II during Figure 5.2: Comparison of RWA under Basel II with Basel I during the period Figure 5.3: Tier 1 and Tier 2 capital in percentage of total regulatory capital ( ) Figure 5.4: Tier 1 capital/ RWA ( ) iv

5 LIST OF TABLES Table 2.1: Risk weights under the standardized approach for sovereign and banks Table 2.2: Risk weights for corporate exposure Table 2.3: Market share of commercial banks in Suriname Table 2.4: Capital and RWA (in SRD thousand) and the BIS ratio under Basel I ( ) 24 Table 4.1: Snapshot of risk weights for the Surinamese Banking sector under Basel I and Basel II Table 5.1: Risk weighted assets on balance sheet items (in SRD thousand) Table 5.2: Risk weighted assets off balance sheet items (in SRD thousand) Table 5.3: Total RWA of the Surinamese banking sector (in SRD thousand) Table 5.4: Capital and RWA (in SRD thousand) and BIS ratio under Basel II during Table 5.5: Capital and RWA (in SRD thousand) and BIS ratio under Basel I during Table 5.6: Different type of assets in % of the total risk weighted assets in ( ) Table 5.7: Percentage increase in RWA under Basel II against Basel I in each year ( ) Table 5.8: % increase in capital and RWA under Basel I Table 5.9: % increase in capital and RWA under Basel I and Basel II ( ) Table 5.10: Total assets (in SRD thousand) and % increase in total assets ( ) Table 5.11: Snapshot of risk weights of the Surinamese banking sector and its impact on capital Table 5.12: % increase in components of Tier 1 capital ( ) Table 5.13: BIS ratio under 55% revaluation reserve in Tier 2 ( ) v

6 ABBREVIATIONS (A-IRB): (BCBS): (BIS): (CBvS): (DSB): (EAD): (ECAI): (EL): (EMU): (F-IRB): (HKB): (IMF): (IRB): (LBB): (LGD): (NA): (NPL): (OECD): (PD): (PDO): RBC: (RBTT): (SA): (SCB): (SME): (SPSB): (UL): (VCB): Advanced Internal Rating Approach Basel Committee for Banking Supervision Bank of International Settlements Centrale Bank van Suriname (Central Bank of Suriname) De Surinaamsche Bank N.V. Exposure at Default External Credit Assessment Institution Expected losses Economic and Monetary Union (of the European Union) Foundation Internal Rating Approach Hankrinbank N.V. International Monetary Fund Internal Rating Approach Landbouwbank N.V. Loss Given Default Not Available Non Performing Loan Organization for Economic Co-operation and Development Probability of Default Past Due Obligation Royal Bank of Canada Royal Bank of Trinidad and Tobago Standardized Approach Surichange Bank N.V. Small Medium Enterprises Surinaamsche Postspaarbank Unexpected losses Stichting Volkscredietbank vi

7 TABLE OF CONTENT ACKNOWLEDGEMENT... ii ABSTRACT... iii LIST OF FIGURES... iv LIST OF TABLES... v ABBREVIATIONS... vi CHAPTER 1 INTRODUCTION GENERAL OVERVIEW PROBLEM STATEMENT SCOPE OF RESEARCH RESEARCH OBJECTIVE RESEARCH QUESTIONS RESEARCH MODEL RELEVANCE OF THE TOPIC RESEARCH METHODOLOGY PROBLEMS AND LIMITATIONS Problems Limitations CHAPTER OUTLINE... 7 CHAPTER 2 BASEL REGULATION IN GENERAL INTRODUCTION IMPORTANCE OF BASEL II AND DIFFERENCE WITH BASEL I THE BASEL II FRAMEWORK CREDIT RISK Risk-Weighted Assets Capital THE SURINAMESE BANKING SECTOR BASEL REGULATION IN SURINAME CHAPTER 3 LITERATURE REVIEW CONCERNING BASEL II INTRODUCTION CREDIT RISK APPROACHES WITHIN BASEL II IN GENERAL STANDARDIZED APPROACH FOR CREDIT RISK INTERNAL RATING BASED APPROACH CHAPTER 4 RESEARCH DESIGN AND METHOLOGY INTRODUCTION DATA GATHERING METHODOLOGY vii

8 CHAPTER 5 THE BASEL II REGULATION FOR THE SURINAMESE BANKING SECTOR INTRODUCTION BASEL II CALCULATION IMPLICATIONS OF BASEL II ANALYSES CONCERNING REGULATORY CAPITAL CHAPTER 6 CONCLUSION AND RECOMMENDATION CONCLUSION RECOMMENDATIONS FUTURE WORK REFERENCE LIST APPENDIX I BASEL II FRAMEWORK APPENDIX II INTERNAL RATING BASED FORMULAS APPENDIX III INTERVIEW QUESTIONS APPENDIX IV DATA GATHERING CONCERNING THE DIFFERENT ASSETS ITEMS viii

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10 CHAPTER 1 INTRODUCTION 1.1 GENERAL OVERVIEW The recent financial crisis, which started in 2007, has once again proven how important bank capital is in order to control the international financial system in general and the financial system of a country specifically. Supervisory authorities such as the central bank and the government of several countries are continuously analyzing capital, which is a short word in banking terms, but a very important item. The increased attention towards capital adequacy globally is due to the huge losses several banking institutions have faced and are facing currently. Furthermore, capital adequacy is important in order to absorb losses due to worsening of the quality of credits. Last but not least, capital adequacy has become very important due to the uncertainty in the quality of capital itself (Where we stand on bank capital, 2009). Based on the above, capital adequacy is being defined as the minimum level of capital needed to protect a bank from losses (Kabir, 2005). So, capital is needed in order to control and measure the risks which are taken by the bank. These risks occur due to credits that are being provided to citizens, corporations or institutions to meet their needs. The risk these banks could face is that the granted loan is not being paid on time or never. Furthermore, in the last decades a lot of developments have taken place in the financial sector due to globalization and liberalization. Banking institutions are providing new types of products and services based on the needs of their clients. They are participating more and more in trading activities besides traditional banking (deposits and loans). Due to the increase in trading activities, risk also increases; therefore a minimum capital level is needed to cover the risks. Several regulations have been introduced regarding minimum capital requirement, which was needed to cover the risks. The first regulation was developed in 1988 under the name Basel I or Basel Accord. This regulation is the result of deliberation of the G-10 countries of the world by first establishing the Basel Committee on Banking Supervision (BCBS) in 1975 (Sen, 2005). The reason for establishing the BCBS is due to the Herstatt crisis in the financial market, which took place in 1974 due to failure in delivering US dollars which led to problems for a lot of banks in 1

11 meeting obligation towards their customers. This committee (BCBS) is an important international committee that concerns about banking supervision, but has no authority in order to force countries to accept the regulations. The goal of the first regulation was to establish stability within the banking sector and to maintain trust in the banking system based on determining the level of capital in the system (Gottschalk, 2010). Furthermore, it was developed to create a level playing field between banks, especially foreign banks. Based on these regulations the minimum level of capital is determined. This is being realized by giving a common definition of capital and by defining a method to calculate the minimum capital requirement of 8% (also known as the BIS ratio or solvency ratio) for banking institutions based on allocating different risk weights to the different types of assets. At the introduction of these rules this accord concentrated more on credit risk and the assets of a bank were classified in the following risk groups: 0, 10, 20, 50 and 100%. Due to developments in the financial markets, a new type of risk occurred, namely market risk. In order to protect the banking sector from this type of risk, BCBS introduced regulations regarding the minimum level of capital needed to cover the market risk. The last few years the Committee has felt that the Basel I regulations have not covered the risks properly due to increased investment in securities in the global market. In 2004 the G-10 revised the Basel I regulations and introduced the new rules known as Basel II. Basel I regulations concentrate on two types of risk, which are the credit risk and market risk. Basel II not just concentrates on these types of risk, but also on operational risk. It is a regulation that consists of 3 pillars, namely minimum capital requirement, supervision and market discipline. The 3 types of risk are being covered in the pillar minimum capital requirement. By implementing Basel II the first regulations (Basel I) is replaced. 1.2 PROBLEM STATEMENT As stated above, in every country there are supervision organizations for the financial sector. In Suriname these supervision organizations are the Central Bank of Suriname and the Ministry of Finance. Their aim is to control the financial system in Suriname for a healthy economic 2

12 environment by supervising the banking institutions and determining the monetary policy of the country. The CBvS has also implemented the Basel I regulation for the Surinamese banking sector. Although the rules were effective in 1988, the implementation in Suriname took place in the year Basel II has not been implemented in Suriname yet and no study has been done for the Surinamese banking sector. Although it is not mandatory to implement this regulation, some central banks have already implemented the new regulations. Other countries are preparing themselves to implement the Basel II also. Furthermore, several islands in the Caribbean, such as Bahamas, Netherlands Antilles, Jamaica, Barbados, etc have already planned to implement Basel II regulation. Suriname is also part of the Caribbean; therefore it is important to analyze the capital base of the banking sector in Suriname with regard to Basel II. Also supervisory authorities of several countries are currently paying a lot of attention to bank capital due to the current financial crisis. The New Accord is also about capital requirement for the banking institutions of a country. Therefore, it is important for the Surinamese banking sector to verify what these regulations will mean in terms of capital and risk weighted assets. As indicated, Basel II is based on three pillars. The focus of this research will be on the first pillar namely, minimum capital requirement. Within this pillar there are three types of risk being covered, namely credit risk, market risk and operational risk. In this thesis the emphasis will be on credit risk only. The reason why the focus will be on credit risk is because the Central Bank of Suriname has concentrated only on this type of risk within Basel I, although market risk was also part of Basel Accord. Another reason is that the Central Bank of Suriname is not controlling market risk and operational risk currently. There are no regulations in place for these types of risk. Finally, and the most important reason why the attention is paid on credit risk is that although banks are providing other types of products and services rather than traditional banking, credit risk is still the leading risk in general and in Suriname specifically. 1.3 SCOPE OF RESEARCH This research has been conducted in the period February 2010 up to August The study is conducted within the framework of the master thesis project for the Master of Business 3

13 Administration (MBA) at the FHR Institute of Social Studies in co-operation with Maastricht School of Management, with the specialization in Corporate Strategy & Economic Policy. 1.4 RESEARCH OBJECTIVE The objectives of this thesis are the following: - To identify the impact of the Basel II regulations on the minimum capital requirement regarding credit risk - To identify if the Surinamese commercial banks fall short (or not) in meeting the requirement concerning capital provisions under Basel II for credit risk 1.5 RESEARCH QUESTIONS The following research question will be addressed in the thesis: Do the capital provisions of the Suriname commercial banks fall short (or not) of the Basel II regulations, taking into account the credit risk? Analysis have shown that the Surinamese banks can easily comply to the Basel II capital adequacy requirement concerning credit risk, since at present (on aggregate level) these banks meet the minimum requirement as indicated by the Basel Committee. 1.6 RESEARCH MODEL In order to do a proper research it is important to indicate the areas of focus. This is done through a research model. In the figure below the research model is indicated through which the research questions will be answered and research objectives will be achieved. Based on this model the chapters of this thesis have been outlined. The first part of this model concentrates on the literature review concerning Basel II. The second part is about the implication of Basel II regulations for the Suriname banking sector. The analyses and results are stated in part three, while part four is about conclusion and recommendation. 4

14 Literature review concerning Basel II Theory on Basel II Importance of the Basel norms Risk definitions Risk weighted assets Capital definition Required capital calculation Approaches concerning credit risk Basel ii debates Debates concerning Basel II in general Debates concerning the approaches for credit risk Data and Interview Basel II analysis for Surinamese banking sector Financial Sector in Suriname Current situation concerning Basel regulation Capital requirement under Basel II Importance of the regulation for Suriname Analysis and Result Capital implications based on approaches Impact on risk weighted assets C o n c l u s i o n & R e c o m m e n d a t i o n Figure 1.1: Research model 1.7 RELEVANCE OF THE TOPIC This research is quite relevant to the Commercial Banks in Suriname and the Central Bank of Suriname. Bank capital and risk are currently hot items all over the world, due to the recent financial crisis. The new regulations were introduced before the financial crisis and the aim is to strengthen the financial system in a country. Some countries have implemented the Basel II regulations to control the increased risk through adequate capital base that has to be held by the banks. Although these regulations were introduced, several banks went bankrupt during the crisis. Therefore, it is relevant for the Surinamese banking sector to know what this regulation will mean in term of capital. Furthermore, the Central Bank of Suriname has only implemented the Basel I regulations. Basel II regulations have not been implemented and even studies have not been done regarding Basel II implementation or implications. Therefore, it is important to research if the Surinamese commercial banks have enough capital to comply with Basel II, to 5

15 know what the shortcomings are of these new regulation and what the implications are concerning capital and risk weighted assets in relation to credit risk. 1.8 RESEARCH METHODOLOGY The research methodology focuses on whether the Surinamese banking sector does comply with the Basel II regulation concerning capital adequacy. It consists of two parts: Theoretical part (literature study): Literature study regards the understanding of Basel I and Basel II, the importance of these regulations, risk weighted assets, regulatory capital, solvency ratio, debates concerning the Basel II. Information regarding the above mentioned items is gathered from: - Academic books - Articles Empirical part: Specific analysis will be performed regarding the banking system in Suriname, the current regulatory framework, the capital requirement under Basel II and the impact on capital and risk weighted assets. In order to do that data will be gathered from the following sources: - Reports produced by Central Bank of Suriname - Interviews with bank managers and the Central Bank of Suriname - Annual reports of the commercial banks - IMF reports 1.9 PROBLEMS AND LIMITATIONS Problems In this research the capital base of the banking sector of Suriname will be outlined based on the Basel II regulation. For this research information is needed from local authorities like the central bank and several financial institutions. This information could be sensitive data and could not be presented to the public. Therefore, it can be an obstacle for doing an adequate research. However, based on data gathered from interviews and limited documentation to which access was granted, the analysis has been performed for a proper research paper. 6

16 1.9.2 Limitations The Basel regulation has been developed by the G-10 countries and is not mandatory for other countries to implement it. Although it is not mandatory al lot of countries have these rules in place for their financial sector. The financial sector consists of the banking institutions, credit unions, insurance companies, cambios, etc. In this thesis the focus will be only on the banking sector of Suriname, which is a very important sector in Suriname. According to IMF almost 45% of the GDP of Suriname is equal to the total assets of the banking system. The commercial banks hold about 70% of these assets. Therefore the analysis will be done regarding commercial banks in Suriname. Furthermore, the focus will be on credit risk only, because there are several risk types occurring within the banking system, but credit risk is still the leading risk at most of the banks CHAPTER OUTLINE The thesis consists of six chapters, including this chapter, which is the introduction, and is structured as follows: Chapter 1: concerns the introduction to the research and explains why this research is necessary. Chapter 2: is about the background data, which is relevant for the analysis. It will indicate how Basel regulations have been developed, the importance, difference between Basel I and Basel II regulation and the Suriname banking sector will be outlined in this chapter Chapter 3: pays attention to the different approaches within Basel II concerning credit risk and view of others are also indicated in this chapter. Based on the different view it is determined which approach is better to be used. Chapter 4: pays attention to the research methodology in which the data gathering and how the research is approached, are outlined 7

17 Chapter 5: describes the Basel regulation in Suriname and the implication of Basel II on capital requirement and risk-weighted assets. Chapter 6: describes the conclusion and recommendations based on the findings of the research performed. 8

18 CHAPTER 2 BASEL REGULATION IN GENERAL 2.1 INTRODUCTION In this chapter an analysis will be presented regarding the Basel II regulation developed for the banking institutions. Subjects as why the new regulations have been developed, what is the difference between Basel I and Basel II, what the Basel II regulations contains of, how risk weighted assets is being determined, capital definition and the Suriname banking sector will be outlined in this chapter. 2.2 IMPORTANCE OF BASEL II AND DIFFERENCE WITH BASEL I The Basel regulations have been developed in order to control several types of risk through bank capital. The Basel Committee first introduced the Basel I norms in 1975 and thereafter Basel II or the New Basel Accord in The reason, as described by Chorafas (2004) and Sen (2005), for revising the Basel Capital Accord is to control the very fast developments of the financial sector such as the innovation in banking products / services and the increasing globalization / liberalization of the financial market. Due to this move, uncertainty had increased in this sector. Therefore, the focus on the role of capital and the importance of capital reserve has become much more important to the banks. Sen (2005) has illustrated that the Basel I regulations were a one-size-fit-all approach for capital regulations in which, for example, all corporate borrowers were carrying a risk weight of 100%. So, there was a huge gap between the measurement of regulatory risk, which is based on the risk weights and the actual risk the banks of a country are facing. Through the New Accord different type of risk can be covered and several methods have been developed in order to calculate the minimum capital requirement. As stated, the aim of Basel I was to improve the stability of the national and international banking system through a solvency ratio of 8 per cent. The purpose of Basel II is to strengthen the stability of the international banking system, by improving the risk management of the banking sector (Gottschalk, 2010). The 8 % minimum capital requirement is also used within the 9

19 new regulations to determine the solvency of a bank. Although both regulations were created for stability of the financial sector with a minimum capital requirement of 8 per cent, there are differences between the 2 regulations. The major difference is that the OECD / non-oecd distinction is abandoned (S. Griffith-Jones & S. Spratt, n.d.). Basel I determined for the OECD countries a risk weight of 0% for sovereigns, while non-oecd had to use a risk weight of 100%. This was a very crude distinction because the very real difference between the sovereign s exposure of OECD and non-oecd could not be given. Within Basel II the risk is determined based on rating assigned by rating agencies. The second difference between Basel I and Basel II is that in the new regulations banks can adopt their own model to determine the risk for their capital requirement, thus they will no longer need to follow the risk assessment model developed by the Basel Committee. In the Basel I regulations, the regulators determined the risk weights and a single weight was indicated for a specific category despite their performance e.g. 100% risk weight for all corporate borrowers (good or bad loan). In the New Accord several models are developed which are based on the behavior of the performance of the assets. Another difference between these two regulations is that Basel II also requires capital for operational risk. As stated earlier, Basel I mostly concentrated on credit risk (since the introduction of the regulations) and market risk (this was added after some years into Basel I). The New Accord on the other hand includes, besides measurement of credit risk and market risk, also a framework for measurement of operational risk. Therefore, according to Basel II, capital is required for credit risk, market risk and operational risk. 2.3 THE BASEL II FRAMEWORK As stated above the Basel II regulation is a revised version of Basel I regulations and its goal is to increase the financial stability in the world. In order to do so, the new capital accord has been developed on three pillars (Basel Committee on Banking Supervision, 2006). These three pillars are (figure 2.1): - Pillar 1: Minimum capital requirement - Pillar 2: Supervisory review process - Pillar 3: Effective use of market discipline 10

20 Basel II Capital Accord Pillar 1 Minimum capital requirement Pillar 2 Supervisory process Pillar 3 Market Discipline Capital Allocation Internal Control by supervisor Reliable financial disclosure Figure 2.1: The 3 Pillars of Basel II Source: Constructed from Chorafas, 2004 Pillar 1 concerns about minimum capital requirement for different type of risk. Figure 2.2 illustrates the risks that are being covered by the Basel Committee. Credit Risk Market Risk Operational Risk Figure 2.2: Type of risk covered within Pillar 1 Source: Chorafas,

21 Credit risk is a simple and small word but it is very important for banks to control this. It is being defined by the Basel Committee as follows: The potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms. Hendriks and Hirtle (1997) describe market risk as follow: Market risk is the risk of loss from adverse movements in the market values of assets, liabilities or off balance sheet positions. These risks occur from movements in interest rates, exchange rates, equity prices or commodity prices, which influence the value of the on and off balance sheet positions. Operational risk is defined by the Basel Committee as follows: Operational risk is the risk of direct and indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. Because on the one hand, banks like to minimize the capital they hold due to economic resources, which can be directed for investment purposes and on the other hand, minimizing capital can lead to greater probability that the bank will not meet its obligation, the Basel Committee developed norms through which they control risk and the amount of capital that should be held. The norm, which is developed by the Basel Committee, is a minimum capital requirement of 8% against the risk-weighted assets. The major change between the minimum capital requirements within Basel II versus Basel I is the way it has to be calculated, where the measurement of risk plays a key role. So the calculation of the solvency ratio based on Pillar 1 is as follows: Capital Risk-weighted exposure from Credit risk + Charges for Market Risk + Charges for Operational Risk > 8% (minimum ratio) 12

22 The objective of Pillar 2 is to review the capital adequacy of banks by a national regulatory authority. Through this Pillar the BCBS wants to stimulate the banking institutions to develop their own system concerning risk identification, measurement and control and determine the capital requirement. On the other hand, they have also indicated that the authorities must perform their audits to the banks regularly, as banks will have more freedom in calculating their capital requirement. Through Pillar 3 the Basel Committee wants to establish a reliable financial system based on market disciplines. It is about the transparency in financial accounts (relevant data). The focus of this Pillar is that not only regulators but also other participants in the market should have access to the capital adequacy of the banking institutions and the way these institutions control their risks. In other words, not only regulators but also the market as a whole will look over the shoulder of the financial institutions. By having these Pillars in Basel II, the Committee believes that risk management will be improved within the banking sector and that financial stability will increase. In appendix I a total view is given regarding the Basel II regulations. As stated, the focus of the research will be on credit risk, which will be outlined more in detail in the next section. 2.4 CREDIT RISK Simply indicated, credit risk means the risk a banking institution will encounter if a borrower cannot pay back the loan received from the bank. Therefore, the Basel Committee advises banks to set up a good credit management system in order to maintain credit risk exposure within acceptable parameters. Controlling risks is very essential for long-term success of the banking institutions. Because credit risk exposure is the leading source of problem for banking institutions (Matten, 2003), it is important to identify, measure, monitor and control credit risk as well as to determine that adequate capital is held against this type of risk. In order to control credit risk, the Basel Committee calculates this by dividing the capital of the bank by the risk- 13

23 weighted assets. So, the formula regarding the calculation of the capital ratio contains two variables, namely: risk-weights assets and bank capital (own funds). Capital Risk-weighted assets from Credit risk > 8% (minimum capital ratio) In the section below the nominator and denominator will be outlined, starting with the denominator first, because in that part the credit risk is being determined Risk-Weighted Assets A balance sheet of any organization consists of assets on one hand and liabilities & owners equity on the other hand. The above formula is thus a comparison of the right side of a balance sheet versus the left side of the same balance sheet. But, in order to do a correct comparison some modifications have to be done on the assets side as well as the capital side. In order to determine the capital charges for credit risk the Committee has developed 2 approaches. The 2 approaches to determine the capital ratio are: - Standardized approach - Internal Rating Based Method Standardized approach Within the Standardized approach the risk weights by commercials banks can be determined by the use of assessments performed by external credit assessment agencies, which are found eligible by the supervisory authority of the country. Earlier in this research paper, the weights are indicated according to Basel I. It was also stated that the weights were determined per category assets. Within Basel II the risk-weighed assets will still be calculated based on the categories of borrowers like sovereign, banks and corporate. The distinction with the first regulation is that within each group different weights are developed, which is based on ratings that depend on the performance of the borrowers. These ratings are granted by an external rating agency. This is a requirement if borrowers should be getting rated (see International Convergence of Capital Measurement and Capital Standards, 2006). If there is no external rating agency in a country, the Committee also determines weights for un-rated borrowers. 14

24 In the following tables the ratings are stated which will be used to determine the risk weighted assets exposure (Griffith-Jones & Spratt, n.d.; Basel Committee on Banking Supervision, 2001) The weights assigned to sovereign and banks, as determined by Basel Committee within Basel II, are presented below: Table 2.1: Risk weights under the standardized approach for sovereign and banks BBB+ to Credit Assessment AAA to AA- A+ to A- BBB- BB+ to B- Below B- Un-rated Sovereigns 0% 20% 50% 100% 150% 100% Bank (Option 1) 20% 50% 100% 100% 150% 100% Bank (Option 2) 20% 50% 50% 100% 150% 50% Bank (Option 2) Short-term loan 20% 20% 20% 50% 150% 20% Source: Griffith-Jones & Spratt, n.d.; Basel Committee on Banking Supervision, 2001 As stated in the table, there are two options regarding weights assigned to banks as borrowers, namely: - Option 1: risk weight is assigned to banks based on a level lower than the sovereign. - Option 2: determines the risk weights based on the external credit assessment. This option concentrates on a better risk weight than as described above, because it also focuses on loans with an original maturity of three months or less. For corporate exposure (which means credits provided to corporate clients) the Basel Committee has designed the following weights: Table 2.2: Risk weights for corporate exposure Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- Below BB- Un-rated Risk Weights 20% 50% 100% 150% 100% Source: Griffith-Jones & Spratt, n.d.; Basel Committee on Banking Supervision, 2001 Furthermore, in Basel II it is stated that loans that are secured by mortgages on residential property will be risk weighted at 35%, while for a commercial real estate a risk weight is used of 100%, despite of secured through real estate. Furthermore, the Basel Committee has also developed risk weights regarding Non-Performing Loans. 15

25 These weights are: - 150% (provision less than 20% of outstanding loan amount) - 100% (provision between 20% - 50% outstanding loan amount) - 100% (provision no less than 50% of outstanding loan amount, but weight can be reduced to 50% with supervisory approval) It is also stated that other assets that are not covered in the Basel II regulations will be risk weighted at the weights as indicated in Basel I Internal Rating Based (IRB) approach The aim of the Committee concerning the IRB approach is to make banks reflect their individual risk profile more accurately. In this approach banks will use their own internal model for measuring credit risk in order to calculate the capital requirement. In order to do so it is required that banks categorize their exposures into five classes of assets with different credit risk characteristics. These five assets classes are further divided in sub-classes based on borrower credit grades and relatively homogeneous characteristics. For each class 3 elements are very important, namely: - Risk components: estimates of risk parameters provided by banks some of which are supervisory estimates. - Risk-weight function: risk components are transformed into risk-weighted assets and therefore capital requirements. - Minimum requirements: the minimum standards that must be met in order to adopt the IRB approach for a given asset class. Through this approach the Basel Committee focuses on two types of losses, namely (Basel Committee on Banking Supervision, 2005): - Expected losses (EL) - Unexpected losses (UL) 16

26 While it is not possible to know the exact loss a bank will encounter, banks can still forecast the average level of expected losses, as banking institutions see this type of losses as a component of doing business. It is managed by the pricing of the credit exposures and through provisions which has been determined by the bank. Unexpected losses or peak losses are losses that do not occur every year and are difficult to determine, as they are predictable. These losses are beyond the expected losses. As it is never known when the UL will occur, pricing and provisions only cannot cover it, so capital is needed to deal with this type of losses. The above is illustrated in the figure below. Figure 2.3: Expected and Unexpected Losses Source: Chorafas, 2004 As stated by Chorafas the frequency of expected losses is higher than unexpected losses, but the impact of expected losses is less than the unexpected losses. The reason behind this statement of Chorafas is that expected losses are somewhat determined in stead of unexpected losses which are unpredictable. In order to cover the losses it is important to have sufficient capital. Based on BCBS the worst-case scenario is that 100% of all lending is in default. The probability that losses will be greater than expected and unexpected losses will occur when the banks are not able to meets its credit obligation based on their profit and capital. This part is called potential losses. In the figure below the expected and unexpected losses are equal at confidence level, which is determined by 100% minus the potential losses. Within Basel II a fixed confidence level is maintained. This is a percentage of 99.9%, because BCBS indicated that a bank is expected to 17

27 suffer from losses that are higher than regulatory capital once in a thousand year. In the figure below the above situation is indicated. Figure 2.4: Confidence level of Expected and Unexpected Losses Source: Basel Committee on Banking Supervision, 2004 In order to determine the capital requirement for the above losses the following risk components are essential: - Probability of default (PD): the average percentage of obligators that default in a rating grade in one year - Loss given default (LGD): the amount outstanding in case of the obligators defaults - Exposure at default (EAD): the percentage of exposure the bank might lose in case of the borrowers default (collaterals have to be taken into account in order to determine the percentage of default) - Maturity of the exposure: this is about the duration of the credit Based on these elements the banks will be able to determine its risk weights and capital required in order to cover unexpected losses, where it is indicated that only systematic risk should be taking into account with an assumption that this type of risk is normally distributed. Based on the above components and assumptions, the formulas have been developed for corporate exposure and retail loans, in order to calculate the capital requirement and the risk weighted assets. These formulas have been presented in appendix II. 18

28 The Basel Committee has further divided the IRB approach in the Foundation IRB and Advanced IRB approach. The difference between the IRB approach and the Standardized approach is that the risk-weights are not provided by Basel Committee, but are calculated by the institutions themselves. The Foundation IRB approach gives the banks the opportunity to determine the probability of default (PD) for their borrowers by themselves. So, the LGD and the EAD are being determined by Basel itself. With the Advanced IRB the financial institutions can determine all three parameters by themselves. In figure 5 a snapshot is given of the 2 approaches as indicated in Basel II. Object / Method Standard method IRB Foundation IRB Advanced Rating External Internal Internal PD estimate None Own Own LGD estimate None Supervisor Own EAD estimate None Supervisor Own Maturity None None Supervisor Credit Risk measurement Supervisor Supervisor Own Figure 2.5: Snapshot of the credit risk approaches as described in Basel II Source: Chorafas, 2004 For more information concerning the approaches, please read International Convergence of Capital Measurement and Capital Standards (2006) Capital Taken credit risk into account, the Basel Committee makes a distinction of capital, namely: - Tier 1 capital - Tier 2 capital This distinction is based on the capacity of each tier to absorb losses (Rough & Lee, 2008). Tier 1 capital is core capital of the financial institution. This is the figure that is shown as equity on the balance sheet of the financial institution. It consists mainly of owner s equity and retained 19

29 earnings. Based on Matten (2003) owner s equity consists of fully paid ordinary shares and noncumulative perpetual preferred stock. Retained earning is the part of the net income that is not paid back to the owners of a company as dividend. The table below shows all the components of Tier 1 capital. Components of Tier 1 Ordinary shares + Preferred shares + Retained earnings + Disclosed reserves (general reserve, share premium, etc) + Minority interest of subsidiaries + Less: Goodwill - Total Tier 1 Capital + Figure 2.6: Components of Tier 1 capital Source: Constructed from Matten, 2003 Tier 2 capital is called supplementary capital and consists of certain types of long-term debt and certain reserves (Matten, 2003). Tier 2 capital consists of the following are the components: - Undisclosed reserves: These are unpublished or hidden reserves. It is a reserve that is not being published but which is being accepted by the banks supervisory authority. This type of reserve can have the same quality of the published reserve, but because of lack of transparency it cannot be included to be Tier 1 capital and to include this as Tier 2 capital it should be accepted by the supervisory authority. It is a Tier 2 capital because it is not acceptable in all jurisdictions. - Revaluation reserves: these are reserves for properties or investments, which have a higher market value, but have not been revalued explicitly. Revaluation reserve as Tier 2 capital is limited to 55%. - General loan losses reserves: these are reserves that are not related to specific identified assets or liabilities. It is a reserve for unexpected losses. This form of capital is limited to 1.25% of risk-weighted assets (RWA). - Hybrid debt instrument: Convertible bonds and cumulative preferred shares are considered to be hybrid debt instrument. Hybrid debt instrument is an instrument, which has a combined characteristic of equity and debt. If this instrument has close similarities with equity, in 20

30 particular if it can absorb losses on an ongoing basis, this type of instrument is part of Tier 2 capital - Subordinated debt: debt that has a subordinated status in relation to other loans and is treated as a lower level of Tier 2 capital. It has a restriction of 50% of total Tier 1 capital. Furthermore, besides goodwill, investments in unconsolidated banking subsidiary and other banks or financial institutions have to be deducted from total capital. This type of investment is being seen as a normal loan and treated as normal risk weighted assets. 2.5 THE SURINAMESE BANKING SECTOR The banking sector of Suriname consists of a central bank, which is responsible for the monetary policy in Suriname. Besides the Central Bank, the Surinamese financial sector consists currently of nine commercial banks, of which one is a foreign entity. Till the end of 2009 there were eight commercial banks in Suriname (the analysis in this research will be based on data till the end of 2009). In 2010 GODO, which was a credit union, became a banking institution. Furthermore, the Surinamese banking sector is divided in three large banks and five small banking institutions (till 2009). The foreign bank, namely the Royal Bank of Trinidad and Tobago (RBTT), is considered as one of the large banks in Suriname (the owner of this bank is currently RBC, which stands for Royal Bank of Canada). The other two large banks are De Surinaamsche Bank N.V. (DSB), which is the largest and oldest bank in Suriname, and Hakrinbank N.V. (HKB). Three of the five small banks are fully stated owned banks, namely Landbouwbank (LBB), Volkscredietbank (VCB) and Surinaamse Post Spaarbank (SPSB), while the other two, Finabank and Surichange bank, are privately owned banking institutions. The three state-owned banks of Suriname are banks that are specialized in sector lending with a social objective. All commercial banks are operating under the supervision of the Central Bank of Suriname. The table below shows the market share of the commercial banks of Suriname. The market share is based on total assets of the commercial banks, the credits (loans) provided by the commercial banks to borrowers and the amount of money that has been deposits by people and institutions at the commercial banks. 21

31 Table 2.3: Market share of commercial banks in Suriname Total Small banks Total assets Net loans Total deposits Large banks Total assets Net loans Total deposits Source: Central Bank of Suriname Based on this market share, the IMF states that the Surinamese banking sector and also the financial sector is highly concentrated. What the IMF means with this statement is that the three largest banks in Suriname control a large part of the banking assets and also the financial system. Almost 83% of the total assets are accounted by the three largest banks established in Suriname. Based on information received from the Central Bank of Suriname and analysis performed by IMF, it is indicated that the three largest banks and the two privately owned banks have a relatively strong balance sheet and adequate capital based on Basel I compared to the three small state-owned banks. The Basel I regulation was introduced by the Central Bank in 2003 and is known as the Capital Adequacy regulations. 2.6 BASEL REGULATION IN SURINAME In 2003 after intensive research the Central Bank of Suriname introduced the Basel I regulation and is known as the Capital Adequacy regulation in Suriname. Together with the IMF the Central Bank of Suriname has done the research in order to improve the supervision of this institution on the banking sector. Based on this regulation the Central Bank has improved its supervision. During 2003 the Basel Accord of 1988 was already revised. The focus at the introduction of the Basel I was just on credit risk. After some developments in the financial environment, market risk was added in From these two type of risk the Central Bank have 22

32 decided to focus just on the credit risk, because this type is of risk was and still is the major type of risk for banking institutions in Suriname. These regulations are necessary for developing countries and also for Suriname, because the Bank of International Settlements (BIS), which was established in 1930, develops these regulations. The BIS was established after the great depression in The great depression was a world wide economic depression where the total financial system had collapsed. In order to save the financial markets it was decided to develop a platform for banks to which all banks must comply, otherwise it can lead to deterioration of the financial system. Furthermore, its focus is to have a standardized system in order to monitor financial reliability, because most of the financial issues are common and can occur at every bank. The Basel regulations are regulations which fall under BIS supervision. Not complying with the international regulations means that the banking sector does not qualified to be part of the global financial system. Therefore it is important to have these regulations for the Suriname banking sector. Another view was that international regulation is important but it should not be implemented as it is being proposed. Local conditions and environment should be taken into account. Based on this the international regulations should be adjusted and implemented. Solvency ratio in Suriname As indicated the Basel regulation concerns about the relationship between risk and capital. This relationship is known as the solvency ratio, also known as the BIS ratio, and is the result of capital divided by the risk-weighted assets. Because in Suriname the Central Bank concentrates on the credit risk the calculation is based on the following formula: Capital Risk-weighted exposure from Credit risk > 8% (minimum ratio) Performing this analysis based on Basel I and calculated by the Central Bank of Suriname, the solvency ratios in the period of are stated in the table below. 23